Research & Advice

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1987 Remembered

August 29, 2007

Back in June I wrote an article I entitled “Return Compression is the Enemy” where I outlined that asset classes (large cap, small cap, value, growth, etc.) and sectors (technology, financials, etc.) all had been performing very similarly and as a logical result it had become difficult to outpace the stock market indices (if everything is performing the same, how do you outperform?).

In an effort to use this data as a forecasting tool I looked at past periods where this type of return compression was present to get a glimpse of how the market had acted afterwards.  I wrote that “there has been a lot of return compression over the last 12-months. Over the last year the percentage of S&P 500 stocks that outperform that index has dropped from 60% (about the highest since 2002) to 41.2% (the lowest since about 2000).  So while that was clearly bad news for investors trying to beat the overall market last year, our job now is to determine how to use this current knowledge.  In other words, what does this type of return compression mean for the outlook of the stock market?  Unfortunately the signals are mixed. 

Historically (and remember, we are only looking at one indicator out of dozens and dozens) when these readings dip below 43% the market tends to follow with good strength.  But there are important exceptions.  The most recent was the crash of 2000 (when this compression ratio last dipped below 43%) as well as the just before the crash of 1987.”

In that article I had argued against the likelihood of a 20%-type crash, instead continuing to look for a typical once-per-year 10% drop, probably sometime in the summer.  So far that is what we have seen.  But, since it is very likely that the markets will re-test their August 16th lows, I do have to take into consideration that about one-third of the time that there is a 10% drop it turns into a 20% drop. 

Typically a 20% drop isn’t the end of the world (although sometimes it feels like it); especially because that type of drop, on average, takes almost a year (332 days), so we have plenty of time to adjust our portfolios.  However, in a 1987-like drop (and from July 19th to August 16th we went through a mini-1987) you just can’t systematically get out of the way – damage will be done to your portfolio.

Now the good news is that “circuit breakers” have been put into place so that the market will not sustain a similar 2-day 20% meltdown.  However, with the recent removal of the uptick rule (up until very recently you could only short a stock after it ticked up – known as the uptick rule; now you can do it whenever you want and that helps to spark and snowball violent downward movements) as well as all the quantitative hedge funds all doing the same things when the market goes down (their models have them selling automatically as the market goes down, exascerbating the problem and actually hurting stock prices and themselves – it’s part of the quant problem nobody seemed to understand had to be part of the model), there certainly is the potential for steep downward spikes in a short period of time (think 1997-1998 Asian Contagion – a 7.2% drop on October 27th, 1997 in US stock prices and a 20% drop over the fall of 1998).

Ned Davis Research put together an interesting table comparing then and now.  There are twenty similarities and eleven differences, as follows:

SIMILAR…

 

2007

 

 

 

1987

 

 

 

 

 

 

 

 

 

 

The Tape

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   S&P 500 first drop from high

-9.40%

 

 

 

-7.80%

 

 

 

 

19 trading days

 

 

18 trading days

 

 

 

 

 

 

 

 

 

   Recovery rally

 

5.2% (to 8/24 high)

 

 

5.60%

 

 

 

 

 

 

 

 

 

 

   10% correction drought

second longest

 

 

third longest

   (at peak)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   Divergences at peak

Percentage of new highs,

 

Same

 

 

 

 

90-day advance/decline ratio,

 

 

 

 

 

 

Dow Utilities

 

 

 

 

 

 

 

 

 

 

 

 

 

   Small-caps

 

Underperformed into peak

 

Same

 

 

 

 

and after

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Externals

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   US Dollar Index

 

Weakened into market peak,

 

Same

 

 

 

 

maintaining long-term downtrend

 

 

 

 

 

 

 

 

 

 

 

 

   Crude Oil

 

January-July rally, then weaker

 

Same

 

 

 

 

 

 

 

 

 

 

   CRB & Gold

 

Maintaining Uptrends

 

 

Same

 

 

 

 

 

 

 

 

 

 

   CPI less core CPI

 

0.1% for July

 

 

Same for peak month, August 1987

 

 

 

 

 

 

 

 

 

   Consumer Confidence

112 for July

 

 

111 for August

 

 

 

 

 

 

 

 

 

   US budget deficit

 

Narrowed to $166B for July

 

Narrowed to $169B for August

 

 

 

 

 

 

 

 

 

   Baa bond yield momentum

Reached bearish mode six weeks

Reached bearish mode 11 weeks

 

 

 

before peak

 

 

before peak

 

 

 

 

 

 

 

 

 

   Composite global

 

Yield momentum positive at peak

Same

 

   interest rates

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   Advisory service sentiment

72% bulls when market peaked

 

74% bulls when market peaked

 

 

 

 

 

 

 

 

 

   Net retirement of equities

Positive for 12 straight quarters

 

Positive for 14 straight quarters

 

 

 

through Q3

 

 

through Q2

 

 

 

 

 

 

 

 

 

Other

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   Economic Expansion

Sixth year since recession

 

Fifth year since recession

 

 

 

 

 

 

 

 

 

   Presidential term

 

Seventh year of two-term Republican

Same

 

 

 

 

 

 

 

 

 

 

   Fed Chairman

 

Second year of a new term

 

First year of a new term

 

 

 

 

 

 

 

 

 

   Trade tension

 

With China

 

 

With Japan

 

 

 

 

 

 

 

 

 

   Strategy influence

 

Quant trading

 

 

Program trading

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

DIFFERENT…

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   Y/Y CPI

 

 

2.4% for July

 

 

4.3% for August

 

 

 

 

 

 

 

 

 

   Discount rate

 

Cut after peak, first following

 

Raised after peak, first following

 

 

 

tightening cycle

 

 

easing cycle

 

 

 

 

 

 

 

 

 

   Y/Y T-Bill yield

 

Falling yields starting in June

 

Rising yields starting in July

 

 

 

 

 

 

 

 

 

   Profit margins

 

7.6% in Q1

 

 

3.8% in Q2

 

 

 

 

 

 

 

 

 

   Y/Y S&P earnings

 

up 16% in Q2

 

 

down 2% in Q2

 

 

 

 

 

 

 

 

 

   S&P P/E

 

16.9 in July

 

 

22.9 in August

 

 

 

 

 

 

 

 

 

   T-Bill yield /earnings yield

0.9 at peak

 

 

1.4 at peak

 

 

 

 

 

 

 

 

 

   10-yr. yield minus 3-mo. Yld

0.2 at peak (flat yield curve)

 

2.7 at peak (steep yield curve)

 

 

 

 

 

 

 

 

 

   Real M2 minus Ind. Prod.

up 5.4% in July

 

 

down 8.3% in August

 

 

 

 

 

 

 

 

 

   Uptick rule

 

No

 

 

 

Yes

 

 

 

 

 

 

 

 

 

 

   Circuit breakers

 

Yes

 

 

 

No

 

The last item indicated in that chart – circuit breakers – should protect us from a 20% drop in the market in any given day.  But it doesn’t rule out a 5%+ drop or a crash over a very short period of time.  Still, should the stock market continue to go south, I don’t see that as a high probability (well, I guess “high” is relative – historically speaking there is a one-in-three chance that the current downtrend will hit a “crash” level of 20%).  The higher probability event (we’ll go ahead and give it a nearly two-in-three chance) is that the stock market will come close to re-testing the August 16th market lows (1,370 points on the S&P 500) sometime over the next two months and then prices will rebound.

So what has to happen to get the crash?  Well, certainly the elimination of the uptick rule and the advent of quant trading is not going to help.  But the bigger problem is going to be the economy and whether or not we get into a recession.  So far there is a measured recession in the housing market, but it has not (yet) affected to the broader economy to the same extent.  As long as economic recession is avoided then a continuation of the market’s correction will most likely simply retest recent lows and end up being a standard once-per-year (technically about once every fourteen months) 10% correction that everyone forgets about months later.