August 10, 2009
- The recession has either ended or is at the cusp of ending. This increases the probability that March 2009 marked a low for this bear market and that any correction over the next few months is not likely to signal the resumption of the bear market.
- The risk of a sizable correction occurring over the next few months is notable. However, the difficulty (nay, impossibility) of identifying either the time of and/or the magnitude of such argues seriously for the increased exposure of US equities now, not later. (The lack of regard for a correction does not dismiss the importance of keeping close tabs on indicators signaling a reversal, such as tape action, sentiment, valuation, interest rates, money supply growth, etc.)
- Mid-Caps over large-caps. The performance ratio of mid-caps to large-caps has tended to outperform after market bottoms and continues to outperform after economic bottoms.(As with the market as a whole, the pace of mid-cap outperformance has also tended to moderate after bottoms).
In our July 23, 2009 White Paper “Recession Ending. Recovery Beginning.” we made it a point to remind readers what we first introduced in the June 18, 2009 White Paper “It Feels Like 1974.”
In both instances, and now for a third time in three consecutive calendar months, we reminded investors that 1) according to our composite cycle charts a 2.5 month stock market correction could reasonably start in August/September and bring stock prices down 10-15%, and 2) that such a correction – should it occur – likely would not signal the beginning of a resumed cyclical bear market, but rather it would be a buying opportunity for growth-oriented investors.
And now that we are confident in assessing the either the recession has ended or is, at least, on the very cusp ending, the probability of a 10-15% stock market correction signaling the resumption of the bear market has significantly shrunk.
As such we are reminded of mid-2006 when (admittedly a year too early) we modestly set our sights on decreasing equity exposure – in part do to composite cycle charts. The correction never came in 2006. And if the correction does come now, there is no guarantee of the timing (nor the opportunity to enter at the precise low); nor is there any guarantee that any such correction would be as meaningful as what we might expect and/or hope for.
So, instead of focusing on a correction that may or may not come, and instead of focusing on the eventual depth of such a correction (there have already been three corrections in the range of 4-8% in the last five months and all were largely unnoticed by investors), instead we intend to focus on the probabilities. In particular, as indicated earlier, that given the improvement in economic conditions that, despite an expected correction, the direction of stock prices for the rest of the year and into 2010 is probably up and not down.
Also as explained in earlier papers, for the six month period after the recession has ended (the rest of the year and into 2010), the market has tended to rise albeit at a slower rate of ascent than the prior bear market bottom (March 2009) to recession end (about now) phase. This diminished rate of return is the “cost” of safety; it is the price of focusing on the concern of lost wealth as opposed to greedily fretting over the possibility (not probability) of lost opportunity.
The average six-month return for the S&P 500 after a recession end has been +14.4%, and positive in 93% of the cases since 1927. The battle of Reward vs. Risk is in favor of reward. (For those who like a little more nuance, the median of the best rallies has been +18.3%, while the median of the worst declines has been -5.4%.)
Granted, the potential profitability in more recent decades is far less attractive. For instance, the average six-month return for the S&P 500 after a recession has been +4.3% since 1975. But the good new is that the batting average of success, at 80%, is still very good; the rewards still outweigh the risks. The median of the best rallies since 1975 has been +16.4% while the median of the worst rallies has only been -9.4%.
As the markets gradually come to the realization that the economic outlook is better than had been expected, it follows that the earnings outlook will start appearing less dire than expected. And the transition from economic and earnings gloom to a more hopeful outlook helps explain why the market has tended to rally through the economic and earnings bottom. In particular, historically, the six-month period following the recession’s end has favored small- and mid-capitalization stocks over large-cap stocks as the acceleration of earnings is not only magnified for small- and mid-caps relative to large-caps, but also are more susceptible to upside surprises.
Bottom Line: If the market continues to follow the historical script, a steady uptrend lies ahead. Consistent with this likelihood, we continue to seek additional allocation to US equities. And while the pace of the market’s ascent is certain to slow, and while a sizable correction that lasts from September to November could be in the cards, we would need compelling evidence to move toward more defensive positions.