Indicators and Interpretations for 2007
O.K., I admit that I come across as overly bearish at times, at least in my commentaries. And being bearish since October 10th, 2002 would have been the wrong thing to do. Fortunately, from a cyclical standpoint I have been in line with the market’s theme since then (for details, go to the “Past Market Predictions” section on the home page).
But cyclical viewpoints aside, I have been very forthright about my secular (i.e. long-term) views. And those views are, in a word, super-bearish. Not just bearish, but super-bearish. Essentially I believe that we are in a long-term bear market that could last another four-to-seven years (think 1966-1982). But why then am I not positioning portfolios for a potential calamity? Simply stated, I try to stay invested in line with the weight of the evidence. And in the short-term (let’s call it “very” short-term, because I could change my mind in days and/or weeks and/or months), the evidence is that the inevitable calamity I fear is beyond the horizon (just how for beyond – well, I’ll keep a lookout).
So what might be a catalyst for such a calamity? Oh, boy. Take your pick: a collapsing dollar, wage pressures hurting businesses, falling home prices and rising defaults, slowing EPS growth for US companies, continued high oil prices, an inverted yield curve…the reason really doesn’t matter so much as the inevitability. And while there has not been too much downside volatility in the last few years, here is a table that shows what we usually (and eventually) have to look forward to:
Of the possible catalysts, one not mentioned above but is still rather disconcerting to me is that there is a historical correlation between the end of a Federal Reserve tightening cycle and a subsequent decline in the stock market. The chart below shows that 77% of the time (10 of 13 cases), the S&P 500 P/E has declined from the time off the last rate hike to the first rate hike.
Admittedly, we never know for sure if the last rate hike was in fact the last one until history allows us that view – but for now it seems safe to assume that June 29, 2006 was the last hike of this cycle. This table shows that the P/E compression was not do to a rising “E” (accelerating corporate earnings), but rather because of a falling “P” (declining stock prices).
As measured by the median, the Fed usually starts reducing rates six months later (that would be December 2006, but in my Economic Outlook report I indicated that I wouldn’t expect a Fed easing until the second half of 2007). Using the same measure, the P/E ratio has declined by 7.6%.
The Bottom Line: Using the data from this particular historical slicing, we could expect the S&P 500 to be trading at about 1,275 points when the Fed starts easing again. But again, I do not want to focus on this one tree and miss the entire forest – right now the weight of the evidence tells us that the stock market forest is growing.
However, adding some sense of urgency to the concern of stock-market-crash inevitability is that since 1900 this current cyclical bull market, at 1,573 days, is the third longest in history. The only two other that have beaten this current stretch were the “Roaring ‘20s” and the “Bubble ‘90s”. The first chart below (Cyclical Bull Markets) shows this and it shows that this current stretch has extended to nearly three times the median. The next chart (Cyclical Bear Markets) shows the market slides subsequent to the rallies.
So, for lack of a more technical description of what this means, we are due for a significant stock market correction. The good news is that the bear markets which follow 1,000+ day bull markets have been no worse in magnitude than the rest of the bunch. Those particular crashes have only had a median decline of 23% versus the historical group median of 27%.
Interestingly these same declines have been much shorter in duration, lasting only a median of 87 days compared to the group’s 363 days. So, using this pattern and applying today’s stock market prices, a correction starting on April 1st would last until July and bring the S&P 500 to about 1,260 points (pretty close to the aforementioned price level reached under the pattern of the Fed’s tightening/easing cycle).
The above historical data helps us gauge some possible downside risks – but as the below chart (also created by NDR) shows, there is still room for upside reward.
When talking about investments, the term “reversion to the mean” is bandied about quite frequently – and for good reason. To be brief, stock market prices tend to trade “around” an average, and if that average is exceeded in either direction then the prices will eventually adjust to get back to “around” that average. The amount of variance from that average can be measured by counting standard deviations from the mean.
Using data from the last three decades, the S&P 500 could reach 1,575 points, where it would be overvalued. At 1,575 points, the index’s P/E would be above 21 – one full standard deviation from the mean P/E. That’s a fairly generous 8% return from today’s levels.
For the S&P 500 to be fairly valued and revert to the mean (using 35-year mean P/E of 16.1), the index would have to trade at about 1,165 points. Now we could certainly go higher in stock prices before we revert to the mean, but even from today’s levels that translates to a nearly 20% decline.
The last indicator I wanted to discuss today is called the Decennial Pattern, or what historically happens in a calendar year 10-year cycle. The bottom line is that years ending in “6” or “7” (such as 2007) usually see a very, very stiff correction. I’m not relying too much on this cycle pattern as the four-year Presidential pattern was (somewhat) disrupted last year. In 2006, historically speaking, the market “should” have corrected right through October and only then make a low – the correction “should” have been more than just 8%.
Nonetheless, here is what has happened historically:
- 1906-1907: Bear Market of -48.5%
- 1916-1917: Bear Market of -40.1%
- 1926: Correction of -16.7%
- 1937-1938: Bear Market of -49.1%
- 1946-1947: Bear Market of -23.2%
- 1957: Bear Market of -19.4%
- 1966: Bear Market of -25.2%
- 1976-1978: Bear Market of -26.9%
- 1987: Bear Market of -36.1%
- 1997: Correction of -13.3%
- 2006: Correction of -8%
- 2007: ?
So far the worst we have seen in 2006-2007 was the 8% correction in the Spring/Summer of last year. Since March 2003 we have been participating in the longest stretch of market gains without a 9.6% correction in all of market history. This, as well as the aforementioned charts and graphs, argue that the market is getting to a point where we should be expecting a pretty stiff pullback.
Still, I give the bulls the benefit of the doubt. As gloomy as this report was, there is still a lot of good news in the market and the economy – perhaps the best being the stock market’s momentum. For now my greatest concern is not that the stock market will correct or crash – it will. My greatest concern is figuring out when it is happening (the timing tools for finding a market top are unfortunately very weak in their precision) and if it will be something we should sit through (something routine or moderate) or if it is something that dictates an asset class modification (something severe, a bear market).
I will keep watching for you.
Modified June 5, 2008