Research & Advice

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This Time It Is Different

September 7, 2007

It’s different this time – it’s a phrase that has gotten a lot of investors into trouble in the past.  So I went to Ned Davis Research and extracted from them some historical similarities to this time as an effort to try and use that information as a predictor.

Using information going back to 1984 the following NDR-created table “summarizes the important macro themes, the quantitative representations of the macro themes, and the years with similar occurrences of the macro themes.”

Key Characteristics of

 

Quantitative Rules

 

 

Similar Cases

Current Environment

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fed Rate Cut

 

 

Fed cuts rates at leat six months

1984, 1998,and 2001

 

 

 

 

after the last hike

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Global Commodity Uptrend Intact

CRB Futures Index two-year trend line

1984, 1988-1989, 1994-1995,

 

 

 

 

slope (beta) >= 1

 

 

and 2000-2001

 

 

 

 

 

 

 

 

 

 

Weakening Dollar

 

 

At least twelve consecutive months of

1985-1988, 1990, 194-1995,

 

 

 

 

negative year-to-year change in the trade-

and 2002-2005

 

 

 

 

weighted US dollar index

 

 

 

 

 

 

 

 

 

 

 

 

 

Declining Home Sales

 

Negative year-to-year dollar changes in

1984,1987,1989-1991,

 

 

 

 

total single-family home sales

 

1994-1995, and 2000

 

 

 

 

 

 

 

 

 

 

Real GDP Growth Between 2-3%

Consecutive quarters of real GDP year-

1986-1987, 1989-1990, 1992,

 

 

 

 

to-year growth between 2-3%

 

1993, 1995, and 2006

 

 

 

 

 

 

 

 

 

 

Slow Earnings Growth

 

S&P 500 GAAP Earnings growth rate

 

 

 

 

 

 

>=15%, but 6-month point change of the

1985,1989, 1995, 2000,

 

 

 

 

growth rate <0

 

 

2004-2005,and 2006

 

 

 

 

 

 

 

 

 

 

Business-Over-Consumer Spending

Consecutive quarters of declining,

 

 

 

 

 

 

negative year-to-year point changes in

1984,1992, 1996-1997,

 

 

 

 

PCE/CAPEX

 

 

2000, and 2004

 

 

 

 

 

 

 

 

 

 

Regarding this table, NDR points out that “the years 1989, 1995, and 2000 contain the most occurrences of the macro criteria.  More specifically, the months ending June 1989, March 1995, and June 2000 appear to be the dates with the greatest overlap.   However, please note that each of these selected periods fails to capture at least two of the macro themes.  None of the tested years exactly match the current macro environment, which leaves some uncertainty in analysis.”

Without going into all the details, following is the summary of what history tells us might happen in the next six months:

  • The Federal Reserve will cut the Federal Funds rate.
  • Commodity demand will continue to grow.
  • The US dollar will continue to weaken.
  • The housing market will remain weak.
  • GDP growth will be between 2-3%.
  • S&P 500 GAAP Earnings will see slowing growth (but still see growth).
  • Business spending will grow more than consumer spending.

So while we should maintain that the term “this time it is different” is more of an exception than a rule when it comes to the stock market and the economy, we also have to accept that this time (like most times) the current scenario only rhymes, it does not repeat.  Said another way, while every cycle is pretty similar to some other cycle, they are still different.  This makes it impossible to perfectly forecast anything, but it does give us some good guidance.  In particular, with so much focus on a very likely Fed rate cut later this month (more focus than typically), it is very difficult to assess the likely scenarios for stock market leadership after the first Fed cut because some typical reactions may have already been “priced in.”.

It is widely expected that on September 18th, the date of the next FOMC meeting, the Fed will cut the Federal Funds rate by one-quarter of one percent.  Historically, while ignoring similarities and differences for any particular cycle, we can review how certain S&P 500 sectors performed after the Fed’s first cut.   But to be more accurate in forecasting, it helps to know if the cut is occurring when in a recession, when not in a recession, or when a recession is coming.

First let’s start with the last mentioned scenario – that the Fed will cut rates in September and a recession comes on the heel of the cut.  There is only one case for this, which is when the Fed cut rates on January 3, 2001 and the economy fell into recession a couple months later.

Not only is having just one sample not statistically relevant (actually neither are the other samples, but I’ll get to them in a moment), but the stock market was also in the midst of a huge crash – which is a very meaningful difference to this current cycle.  But since I have said that we are not in a recession but that I would not rule one out in 2008, this scenario seems important enough to review.

I won’t break down the sector performance because, as I said, there isn’t a lot of statistical relevance and there was a lot of meaningful (and correct) valuation restructuring occurring.  In this scenario, 22 days later the average S&P 500 sector was up 0.5%;  63 days later the average S&P 500 sector was up down 12.9%,  126 days later the average S&P 500 sector was down 6.3%;  252 days later the average S&P 500 sector was up down 12.6%.  While the technology sector performed very well in the early on (22 days later), it performed horribly during all the other aforementioned times – but technology was drastically over-owned and over-valued at that time.

The fact that this scenario (a cut then a recession two months later) only happened once is overshadowed by the fact that we were in the midst of the worst stock market crash since the early 1970s.  As a sector, technology was so drastically over-owned relative to other sectors as well as so hugely over-valued relative to its historical mean that it greatly affected the resultant returns (the sectors is actually under-owned now). 

Should a recession begin shortly after a September rate cut it is more likely that the market would react as it has in past periods where a cut has occurred during a recession – so let’s look at that:

 

 

 

S&P Sector Leadership After First Fed Rate Cut When In Recession

 

 

 

 

 

(12/9/1974, 5/30/1980,11/21/1981)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

# of

 

 

 

 

 

 

# of

 

 

 

% gain 22

cases out-

 

 

 

% gain 126

cases out-

S&P 500 Sector

 

days later

performing

S&P 500 Sector

 

days later

performing

 

 

 

 

 

 

 

 

 

 

 

 

 

Financials

 

 

8.3

 

3

 

Consumer Discretionary

26.1

 

2

Materials

 

 

6.2

 

3

 

Information Technology

23.2

 

2

Utilities

 

 

7.5

 

2

 

Industrials

 

 

23

 

2

Energy

 

 

6.2

 

2

 

Materials

 

 

17.4

 

2

Consumer Discretionary

6.1

 

1

 

Health Care

 

16.2

 

2

Consumer Staples

 

4.8

 

1

 

Consumer Staples

 

15.2

 

2

Telecom Services

 

4.7

 

1

 

Energy

 

 

23.4

 

1

Industrials

 

 

4.5

 

1

 

Utilities

 

 

12.3

 

1

Information Technology

1

 

1

 

Financials

 

 

11.6

 

0

Health Care

 

0.6

 

0

 

Telecom Services

 

4.3

 

0

Mean

 

 

5

 

 

 

Mean

 

 

17.3

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

# of

 

 

 

 

 

 

# of

 

 

 

% gain 63

cases out-

 

 

 

% gain 252

cases out-

S&P 500 Sector

 

days later

performing

S&P 500 Sector

 

days later

performing

 

 

 

 

 

 

 

 

 

 

 

 

 

Consumer Discretionary

19.6

 

3

 

Consumer Discretionary

47.2

 

3

Information Technology

18

 

2

 

Information Technology

28.3

 

2

Industrials

 

 

14.4

 

2

 

Consumer Staples

 

26

 

2

Consumer Staples

 

12.2

 

2

 

Health Care

 

23.2

 

2

Materials

 

 

10.9

 

2

 

Materials

 

 

20.9

 

2

Health Care

 

11.8

 

1

 

Industrials

 

 

24.1

 

1

Utilities

 

 

6.2

 

1

 

Financials

 

 

17.5

 

1

Energy

 

 

3.6

 

1

 

Utilities

 

 

13.8

 

1

Financials

 

 

7.8

 

0

 

Telecom Services

 

16.8

 

0

Telecom Services

 

6.7

 

0

 

Energy

 

 

1.5

 

0

Mean

 

 

11.1

 

 

 

Mean

 

 

21.9

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

However, I do not believe that we are in a recession.  As such, it is possible that we will see sector reaction more similar to the following table:

 

 

 

S&P Sector Leadership After First Fed Rate Cut When Not In A Recession

 

 

 

 

 

(6/6/1989,7/6/1995)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

# of

 

 

 

 

 

 

# of

 

 

 

 

% gain 22

cases out-

 

 

 

% gain 126

cases out-

S&P 500 Sector

 

days later

performing

S&P 500 Sector

 

days later

performing

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Financials

 

 

1.1

 

2

 

Health Care

 

22.6

 

2

 

Health Care

 

1.5

 

1

 

Telecom Services

 

19.2

 

2

 

Consumer Staples

 

1.5

 

1

 

Consumer Staples

 

16.7

 

2

 

Energy

 

 

0.9

 

1

 

Energy

 

 

12.7

 

1

 

Consumer Discretionary

0.9

 

1

 

Financials

 

 

11.6

 

1

 

Telecom Services

 

0.7

 

1

 

Utilities

 

 

10.8

 

1

 

Utilities

 

 

0.6

 

1

 

Industrials

 

 

8.4

 

1

 

Information Technology

-0.3

 

1

 

Consumer Discretionary

3.5

 

0

 

Industrials

 

 

-0.2

 

0

 

Materials

 

 

2.4

 

0

 

Materials

 

 

-0.6

 

0

 

Information Technology

-6.8

 

0

 

Mean

 

 

0.6

 

 

 

Mean

 

 

10.1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

# of

 

 

 

 

 

 

# of

 

 

 

 

% gain 63

cases out-

 

 

 

% gain 252

cases out-

S&P 500 Sector

 

days later

performing

S&P 500 Sector

 

days later

performing

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Health Care

 

12.9

 

2

 

Health Care

 

32.2

 

2

 

Consumer Staples

 

10.4

 

2

 

Consumer Staples

 

28.1

 

2

 

Financials

 

 

11

 

1

 

Energy

 

 

20.3

 

2

 

Telecom Services

 

9.9

 

1

 

Industrials

 

 

19.8

 

2

 

Industrials

 

 

5

 

1

 

Telecom Services

 

16.5

 

1

 

Consumer Discretionary

5

 

1

 

Financials

 

 

15.9

 

1

 

Materials

 

 

3.5

 

1

 

Consumer Discretionary

10.5

 

0

 

Utilities

 

 

4.9

 

1

 

Information Technology

9.5

 

0

 

Energy

 

 

3.7

 

0

 

Utilities

 

 

8.2

 

0

 

Information Technology

0

 

0

 

Materials

 

 

3.8

 

0

 

Mean

 

 

6.6

 

 

 

Mean

 

 

16.5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Notably different is that non-recession periods have averaged only about half of the returns of the recession period.  In the non-recession period, Health Care and Consumer Staples do the best.  Also, Financials do well while Information Technology does poorly.

Is this time it different?  Given the tone of this report, I won’t suggest a complete flip-flop, but I wouldn’t be surprised to Financials slip the rankings while Information Technology climbs the rankings.

The Technology sector has a lot of immunity to credit crunch concerns that are currently plaguing the Financials and begging the Fed for a rate cut.  Plus Technology profits will benefit from the CapEx business spending we mentioned earlier.  Combine the positive fundamentals with favorable relative strength in the NASDAQ index versus other indices (DJIA, S&P 500, etc.) and a better-than-average return for Technology is likely.

And to be certain, we are talking about just a handful of indicators.  But, as usual, I like to let you know some of the information I am considering.  And this information suggests that CapEx business spending is strong within a growing (non-recessionary) economy and thus will likely help Technology stocks as Health Care and Consumers Staples also perform well.