June 15, 2009
“History doesn’t repeat itself, but it does rhyme.” – Mark Twain
- Of the many reasons we started selling equity in mid/late 2007 one of them is that it “felt like 1974.” It now feels a like 1975 – it feels like we will have a stock market decline in excess of ten percent that lasts for two months.
- Any such “correction”, especially within the context of the US economy attempting to gain traction and pull itself out of recession, will be extraordinarily scary because most investors continue to have doubts as to the sustainability of the current bull rally.
- The technicals of the market (supply vs. demand; selling vs. buying) provide evidence of a semi-major correction (10-15%) occurring before the end of 2009. If not already fully invested in equities, as scary as this pullback will be, ultimately it will prove to be an excellent opportunity for growth-oriented investors to get out of conservative investments and into stocks.
- It is important to note that an earlier early-summer-time pullback of 4-6% from current levels does not at all diminish the possibility of something larger later in the year.
- History is not nearly a perfect predictive tool. Still, it gives context as to what could reasonably happen, and when. A decline of 11% in the stock market, starting in September and lasting through mid-November, could reasonably happen.
Since the March 9th low, the stock markets have rocketed higher. However, price action alone rarely serves as an adequate measure of the strength of a rally. In fact, a deeper examination of the current market environment suggests that recent price gains may be masking a steady deterioration in the underpinnings of the rally.
There have been warning signs that this rally is not conforming to patterns normally associated with new bull markets. Two such signs are significant.
First, typically trading volume is very heavy from the bottom of the bear market and continues to strengthen. However, volume has not only declined notably over the last month, but volume has decreased on “up” days and to our dismay increases mainly on “down” days.
Another warning sign is “why” the stock market is going up. No, we are not talking about the proverbial “green shoots” for the economic recovery or attractive equity valuations.
At the end of the day, the price of anything is defined solely by supply (selling) and demand (buying). A review of stock market breadth for any recovery since 1938 shows that there is typically an equal distribution of sellers and buyers in the market place. Initially there was significant demand from the March 9 lows (bullish), but more recently the stock market has hit recent highs only on contracting supply (selling), as buying pressure has actually contracted.
In other words, considering both points, the rally is growing weaker and becoming less impressive. The rally is vulnerable to increasing supply (selling). Without active buyers to absorb any potential increase of selling, the reintroduction of sellers can push the market down considerably (10-15%) within a short period of time (months, if not weeks).
It is easy to discount historical similarities as mere coincidence. We are not interested in debating whether or not that is the issue. We are interested in framing what we expect (a large correction followed by a larger resumption of the bull rally) within the context of what is possible.
1974-1975: Over the first three months of the cyclical bull that started in December 1974, the Dow Jones Industrial Average (DJIA) gained 34%. The biggest correction was a four-day drop of -4%.
2009: Over the first thee months of the cyclical bull market that started on March 9, the DJIA gained 34%. The biggest correction was a four-day drop of -5%.
1974-1975: The advance started after a cyclical decline of -45% on the DJIA. The advance temporarily ended a nine-year secular bear market that started in 1966. The advance started 12-months into a recession.
2009: The advance started after a cyclical decline of -54% on the DJIA. The advance (temporarily?) ended a secular bear market nine-year secular bear market that started in 2000. The advance started 14-months into a recession.
Occurring around the time the recession ended in 1975, the biggest correction during the first six-months of the rally was a -6% drop over 21 days. (We don’t rule out that either 1) the recession is currently ending or 2) the stock market is going to drop -6% over the next 21-45 days).
It wasn’t until about seven months after the 1974 bottom that the market finally experienced a stiff and persistent correction – a decline of -11% lasting two-and-a-half months (translating to 2009 that equates to a large drop in the market starting in the last third of this year).
Again, we don’t want to suggest that we are using just history to create our forecasts. These comparisons should not be taken too literally as each cycle turns out to be unique in ways that are almost impossible to predict. And to be sure, when reviewing the broad spectrum of indicators, we find several differences between the environment of the mid-1970’s and today. However, we do find enough similarities to support the case that the market’s performance over the next few years will be more similar to the 1974-1976 period than any other during the past 90 years. Briefly, some similarities are as follows:
- Volatility and credit spreads. Like today, throughout the cyclical bull of 1974-1976, volatility and credit spreads both trended lower as confidence increased.
- Sentiment. Most reliable measures of sentiment bottomed at the December 1974 and March 2009 stock market advances.
- Earnings yields minus T-Bill yields. One of the differences between now and then is prices relative to earnings (the P/E ratio). However, when adjusted for interest rates, valuations are more similar.
- Commodity prices. Then, as now, the return of the rising commodity prices warned of rising consumer prices inflation to follow.
- Economic growth. In early 1975, and most likely today, GDP growth was negative but bottoming, the unemployment rate was rising but near an extreme, and the yield curve was steepening in anticipation of improving economic performance.
Bottom Line: It is expected that the US economy will turn positive (if only slightly) in 2009, allowing for the stock market to ultimately identify March 2009 the low for this bear market. However, the risks are large and the risks are many.
While it has diminished considerably, volatility remains high. Investing is a blend of art and science that attempts to, as best as possible, define otherwise arbitrary probabilities. While nothing is certain and while being too specific in any forecast can come back to haunt you, the probabilities favor a 4-6% correction in early Summer, a 10-15% pullback in late Summer/Autumn, and a resumption of the stock market rally that brings the S&P 500 to 1,100-1,200 points over the next eighteen months.
Forecasts are developed in order to create investment strategies. But just as importantly, investment managers must remain flexible in both forecasts as well as strategies. That flexibility is paramount because the downside risks to the aforementioned forecasts (in particular, a continued recession and/or a continued bear market) are material.
As such, we manage portfolios according to our forecasts but remain prepared to modify or even abandon them at any time. To sum up that consideration, we leave you as we found you, with a quote:
“If the facts change, I change my mind. What do you do, sir?” – John Maynard Keynes.