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Is the stock market headed for a major downturn?

Thursday, August 4th, 2011

It is amazing when markets – in the short term – prove themselves to be driven more by mass psychology than by fundamentals. In the short term, market turns are noise driven. Whether based on the autocorrelation effect (selling begets more selling) or by panic mongering media one should never take heed of short term selloffs as sign of a pending crash, nor should they take heed of rallying markets as sign of a new bullmarket.

Instead those entrusted with managing money (whether for clients or their own families) should focus on fundamentals, and not let movements dictate positioning. At Covert Analytics we always advise money managers go down the following checklist (answers are of course provided by our software :-) )

1) What is the support for risk assets? Our GRASP (global risk asset support or pressure) model, points to still strong support for risk assets, with monetary policy loose, the money supply still growing and volatility still relatively low. One recent question mark was the S&P dropping below the 200 day moving average. Await till month end or before a material drop below, before acknowledging a new bear market.

~ still supportive of risk assets

2) Are valuations supportive of equities over bonds? Equities (cyclical risk) versus Bonds (no cyclical risk) is the age old question. Equity yields are surging far ahead of interest rates, particularly in the US with the US 10 year hitting 2.5%.

~ fundamentals favor equities

3) What are technicals telling you? Currently risk assets have experienced a tremendous short term selloff. As Barry Ritholtz points out, the 7 day RSI is even below the Feb / March 2009 bottom !  See link (http://www.ritholtz.com/blog/2011/08/rsi-at-extreme/).

~  risk assets are oversold

Each selloff has its unique features. This one is no different, what with the debt ceiling issue in the US and renewed Eurozone fears. However our base case scenario is that the debt ceiling will be resolved (actually it is a non event issue with the US Treasury taking in revenues of 200 billion monthly) and that the Eurozone crisis is not a 2011 event.

Punchline: listen to Covert Analytics … our feeling is that this year is strikingly similar to last year (when the S&P bottomed in late August) and had a tremendous end of year rally.

 

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Where will the stock market be in 5, 10 years?

Wednesday, October 20th, 2010

 

Higher.

Let’s start with a historical look at ten year stock market cycles.  The chart below starts (see 1) in December 1937 when the US stock market (excluding dividends) was down 40% over a full 10 year period.  Though the stock market was extremely volatile (a 20% decline followed the 40% ten year collapse, then a 50% rally, and a subsequent 40% decline – see Note).

A massive post WWII boom was experienced in America in the 1950s and 1960s, but the major stock market gains were investors who “entered the market” in the late 40s, and enjoyed the cumulative 10 year return of 300% (see 2). Markets moved gradually higher during the 1960s, and in the 70s suffered a major inflationary headwind and in real terms were down over 70%.  In nominal terms, by the late 70s stock investors had suffered a 10 year cumulative return of roughly 0% (similar to today?, see 3).

Thus began the glory days of corporate America and the global financial system.  Stock investors were handsomely rewarded for entering the stock market in the early 80s.  To give you an idea, the S&P was trading at 111 in March 1982, and by March 2000 was trading at 1,500.  The bulk of this gain was concentrated in the tech bubble of the late 90s, but still this was an amazing period for equity investors, with only one negative calendar year in 17 years on a total return basis! As such investors were handsomely rewarded with a cumulative 10 year return of nearly 350% through the end of the decade (see 4).

Now begins the dreary 2000s which had its own boom- bust cycle.  The current 10 year return (through October 2010) is currently -17%.

What is most interesting is that the historical average of  a 10 year investment in US stocks (excluding dividends) is capital appreciation of 107%.

This reminds us  of some important lessons of investment management:

  1. That no matter how euphoric or demoralizing financial price trends may seem, at some point, conditions change and the markets establish a new trend.
  2. It is extremely difficult to time a market top or bottom
  3. Markets often correct through the mean (as you can see by the average 10 year return)

Our take from the above is that it is easy to project that the upcoming years will have very low returns: there is a historical precedent (negative annualized returns for the past decade), fundamental reasons (risk free rate near 0%, difficult earnings environment, etc), demographic reasons (the huge portion of Americans set to retire in the upcoming 10 years that will not stomach the volatility of Equities and prefer to have stable Fixed Income investments), etc.  But looking at the historical cycle tells us that experience would beg to differ.  What is clear is that after abnormally high (low) returns, one should never lose sight that stock market assets in a healthy economy will likely produce returns far below (above) the mean. What’s more, taking a lesson from Prospect Theory, we should note that humans are fallible.  As markets move for an extended period in one direction, investors will overestimate the likelihood that markets will continue in the same direction.

So, what would be a new direction? Above average returns. Let’s hope.

Note that in June 1937 Roosevelt’s administration took drastic steps in an ill fated attempt to balance the federal budget. The S&P fell 20% through March 1938.  It rallied 50% through the end of 1938, and then fell again another 40% through 1942. This was of course due to the effects of America’s war time economy subsequent to the Pearl Harbor attack and Eisenhower beginning a massive front in Europe.

 

 

 

 

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Economic Expansion Outpacing Money Supply Growth

Monday, June 7th, 2010

This is an interesting graph.

Top Chart: Rolling 12 month returns on the S&P 500

Bottom Chart: Monetary Supply (M2) divided by Industrial Production (IP)

 

The bottom chart is meant to imply if money supply growth is outpacing industrial production. In other words, when this index spikes (as it did in 2002 and in 2009) this means that the monetary supply is increasing due to Federal Reserve actions and this is not finding its way into the real economy. We take the decline both in both instances to represent when money growth found its way into the real economy and industrial production “caught up” with policy actions.

We think this is a positive for markets. Clearly the original impulse response (12 month return on the S&P was over 40%) is over. Now markets are in Act II, and clearly recent news from the European debt crisis imply we are in for a mid cycle slowdown. A slowdown does not imply the market and economic recovery is over. As was evident in 2003, markets rallied like crazy from their bottom, formed a stable base that finally gave way to a new bull market.

Economic fundamentals and the corporate profit picture points to a healthy recovery, even though recent market action would imply the opposite. What is going on in Greece is not pretty, and it could easily cascade to less important economies (Hungary) as well as more important economies (Spain). Just like a household that is having trouble paying its debts should not take on more debt to be able to pay its interest payments, global central banks should not throw more debt at a problem caused by too much debt.

 

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Speculation on Future Stock Market Direction

Monday, April 12th, 2010

I am of the opinion that the stock market still has some legs in this rally. As you can see in the chart below looking at month end numbers for the S&P, you can see a very similar co-movement between the current cycle (“the Great Recovery”) and the mid-70s bear market (“Oil Crisis”).

 
Note: “Great Recovery” till April 12, 2010, using monthly numbers. The Oil Crisis is from December 1974 – December 1976.

Clearly at Covert Analytics we espouse a cross asset class, global approach to investing. In other words the decision to invest in stocks is not only based on how risky the US market is, but also, how risky is it compared to other markets, how risky is it compared to bonds, etc.  Clearly at this point in the cycle, with the S&P up over 70% (factoring in daily prices), it is hard to have an “all-in” approach to stocks. But I am still very optimistic at this point of the cycle, regardless of how much little upside is displayed by historical comparisons like mine above.

I do not think the market is likely to reverse direction. Clearly the tendency after a deep downturn has been to underestimate the efficacy of economic and monetary policy as well as the resilience of the business sector. It is very in vogue these days to speak of the new normal and how this means boring corporate profitability and a market with limited upside.  What if everyone is wrong? What if we are facing a stronger than expected stock market environment?

If you look at historical stock market cycles, the average cyclical bear market has been followed by at least two years of positive returns.  Of course we acknowledge that 2009 was a strong recovery year, and there are many risks out there. However, lets look at some market indicators to see how they are pricing in the recovery.

  • Dr Copper / Oil  are up sharply. Crude is only a couple percentage points away from its 52 week high, and Copper is signalling a very strong demand for the commodity.
  • Yield curve is still very steep. Strongly positive sloping yield curves (steep) imply an upcoming economic recovery. The difference between the 10 year and 3 mo money market yields across the G7 are very high (353 bps in the US, 344 bps in the UK, 260 bps in Euro-zone, 327 bps in Canada, 322 bps in New Zealand, etc).
  • Still low interest rates. Recent studies by Siegel have implied that low risk free rates encourage risk taking and thus higher multiples of earnings.
  • Accomodative monetary policy.  Federal Reserve bank is sitting tight at current levels, and so is the ECB / BoE / BoJ, etc. Only select commodity currency countries are in hiking mode (Australia).
  • Junk spreads continue to compress. Single B spreads were 629 bps as of December 2009 and have compressed to 598 bps.

I guess our conclusion is the following, as long as short rates stay at zero, there is a high propensity for economic growth to accelerate, and for the stock market rally to continue.

Sincerely,

The Covert Analytics Team

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In the market today April 2, 2010 …

Thursday, April 1st, 2010

Nice continued move in the market today. I continue to believe that the economy is in a sweet spot where low rates continue to fuel economic activity, consumers are recovering, and businesses are eager to grow after 2 years in the trenches (doldrums). The S&P has edged up now for five straight weeks. Volume continues to be moderate.  This trend of higher prices on medium to low volume is healthy to me. It tells me that retail investors are not piling back into the market, which would be signs of a overly optimistic retail investor (ie signs of the end of the trend).

In fact, headlines are pointing out that the market is hitting an 18 month high (or about September 2008). Incredible isn’t it? In September 2008 before Lehman went under we were already undergoing a recession in the US, following the collapse of Bear Stearns, and putting up with a hectic seizure of the financial system. Unprecedented in many ways. Anyways, at that point the US market was still only 30% below its peak in November 2007.

Yields on US Treasuries are edging up. The US 10 year yield is hitting nearly 3.9%, which is  a relatively substantial selloff for the US Treasuries. It is likely there is more to come, but this is not the time. I think rates will rally from here and you will see the UST 10 at 3.5% within a few months.

Gold and Crude rallied really strong this week, with GLD hitting over $110 and Crude spiking to $85. Though historically speaking these are not outrageous levels, they are breakouts from recent ranges. This has clearly coincided with a selloff in the US Dollar (the EUR rallied to over $1.35).

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Will stocks outperform bonds ?

Tuesday, March 9th, 2010

Over the long term, it is clear that stocks outperform bonds and cash. Since 1926, the compounded annual return on stocks (large cap) was 9.8%, compared with government bonds return of 5.4%.  This is including three periods of horrible equity market performance:

- the 1930s (Great Depression)
- the 1970s (Great Inflation)
- the 2000s (Great Recession)

The last 40 years show a different picture however, with stocks returning 9.5% and bonds returning 9.3%. Is this amazing risk adjusted outperformance in bonds to continue? It is unlikely.  Here is the important differentiating factor to remember going forward:

Since the early 1970s bonds had high and falling yields, but now have low and possibly rising yields.  It is important to remember that back then, US yields peaked above 15% when inflation was high. Currently 10 year US Treasuries are yielding 3.7%, and Eurozone 10 year is yielding 3.1%. The likely path of least resistance is for yields to increase (which would depress prices) or stay relatively low thus earning a yield like return.  Either way, the glory days of the bond market are behind us.

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Some need-to-know tidbits on market timing

Tuesday, March 2nd, 2010

We grew up in the ‘hood.  The “hood” of academic circles.  Our formative years in money management were spent surrounded by brilliant academics, a few literally with Nobel Prizes, a few more PhDs, and a bunch of graduates from Wharton / Kellogg etc.  This should be a great start, you would say? It actually wasn’t.

Quoting Warren …
In retrospect, we all learned a bunch. What I would sarcastically say is that we learned what not to think.  In our defense, even Warren Buffett said at his 2009 annual shareholders meeting that if he taught a course on investing, the first thing he would do is unteach the “efficient market hypothesis”!

Cross-Check
The problem was we were building a new type of money management firm, based more on index-investing (since you could not outperform the index) rather than blindly allocating to managers. The problem with that approach was still that you needed an asset allocation approach to “beat the business cycle”. The “Chicago boys” thought this was a waste of time, markets were efficient, you could not outsmart them, etc.  This greatly upset the other half of us, who wanted eventually to run our own hedge funds and were insulted at this death knell to our future careers.

Our focus has always been on using quantitative techniques to identify when investment opportunities offer the most probable profit. Thus why we developed Covert Analytics. We were frustrated that some basic tools were not commercially available for portfolio managers, money managers, investment management firms, asset allocators, family offices, whatever label you want to give them.

Fast forward to Covert Analytics
Our platform is not a market timing software.  Our software is about identifying when forces are in place to propel asset markets further, or when valuations, monetary conditions, etc are so stretched that a price collapse is likely in the medium term.

What the Research Says
We realize how important the confidence our clients place in us is. Our entire premise is that asset allocation is the most important decision a money manager has to make. More important than security selection, more important than the aggregate effect of tactical trades, etc. Here are some studies we recently evaluated and their conclusion on market timing.

  • The Clairvoyant Investor Not Much Better Off
    Sharpe (1975) imagined an investor who had two assets to choose from: US Stocks and Cash, and invested with perfect accuracy in the “higher returning asset” plus transaction costs.  The results were rather disappointing: Perfect Timing resulted in a 15.3% annual return versus 12.8% for Buy and Hold, an outperformance of 2.5% annually.  This did include however pretty high transaction costs.
  • Missing the 10 Best? Invest in Cash
    Jeffrey (1984) did an analysis on comparing perfect accuracy with horrible accuracy, but the most interesting conclusion we thought was this: If the 10 best performing stock market years out of his study are missed, then the resulting return is equivalent to a cash return.
  • Out for Best 7%, Return of 0%
    Chandy and Reichenstein (1993) came to a similar conclusion as Jeffrey: using monthly data since 1926, they concluded that if an investor missed the best 7% of monthly returns, then the remaining 93% of the months provide a 0% return.

Clearly market timing is  a tough task. We believe that with our approach, and a wide variety of assets, outperforming the market in a systematic way is achievable.  What this research proves is the following: forecasting bull markets is just as important (actually more important) than forecasting bear markets over the long run.

BTRheT

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Principle versus Practice: Forecasting the Market

Friday, February 5th, 2010

Forecasting the stock market is never an easy task.  The principle behind a bull market are simple enough: if valuations are attractive, liquidity is plentiful and the earnings outlook is favorable, then it is reasonable to expect the market to rise.  In practice though, it is not always that simple.

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US Stock Market Outlook

Wednesday, January 27th, 2010
 
The S&P 500 today had a shakeout in response to the Federal Reserve announcement.  It has since made a great rally (not shown on the graph!!!).

S&P 500 Intraday

 Regardless of the noise today – please note the 5% correction we have had over the past two weeks. This coincided with earnings season.  It is interesting that 3/4 of the companies that have reported earnings beat estimates, according to Bloomberg.  If you look at an average 4Q earnings report, it is typical to see a 8-10% increase in revenue y-o-y but a nearly 20% gain in earnings.  Shows that companies are being run very efficiently; Gavekal says they are being run even more efficiently than sovereigns!

S&P 500 Intraday for past 15 days

The trend from March 2009 seems still well in place. It is clear the pace of stock gains has moderated since about November, and we are having another 5 % selloff. In the graph below there are arrows indicating the 5% corrections that have occurred since the rally began.  In other words, no need to cry wolf yet.  Markets are trading reasonably well and we believe they are in great shape.  In other words, any further weakness in the broad market would be seen as a short term buying opportunity for those investors who have not entered or have a lower than target allocation.

S7P 500 past 12 months

 

On a similar note, we acknowledge the many tailwinds that are facing investors … they include ( this is a non exclusive list compiled by us ):

  

And the case for the bulls is as follows:

Bulls ...

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Start asking the right questions

Friday, January 15th, 2010

As an investment advisor you are primarily responsible for 1) having a view on the markets and 2) how to position your portfolios (given their unique constraints) according to those views.  Too often more attention is paid to the vehicles used to implement those decisions. In other words, rather than spending the bulk of your time deciding how much to allocate to Equities, you spend the bulk of your time picking Equity fund managers.

The article below is a perfect example of this.  Though it is a good article, from the Financial Times Fund Management section, it should not be groundbreaking news to investment advisors. It should be met with a shrug of the shoulders.

The wrong question still has a good answer!

Too often outperforming Equity managers still cost portfolios to suffer substantial drawdowns in a bear market. Too often the best bond fund outperforms its benchmark by 300 bps annually during a market cycle that saw Equities double.  You see where this is going? Start asking the right questions:

In general, here is our view …

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