Monday, October 24, 2011
With the arrival of the fourth quarter (Q4), signs of hope have appeared, recession probabilities for the second half of this year have dropped, and equities have rallied on the realization that the outlook is far less dire than the markets had thought.
We are watching for confirmation that the market recovery and economic stability are here to stay for the rest of the year.
From stock market sentiment in the U.S. & Europe, to consumer confidence in the United Kingdom, to business confidence in Brazil, pessimism spread just about everywhere as the third quarter (Q3) of 2011 dragged on. But with the arrival of the fourth quarter (Q4), signs of hope have appeared, recession probabilities for the second half of this year have dropped, and equities have rallied on the realization that the outlook is far less dire than the markets had thought. Now we’re watching for confirmation that the market recovery and economic stability are here to stay for the rest of the year.
Thus far in Q4, the market action has been encouraging. In contrast to the August-September “Risk-Off” rally (where more defensive sectors performed better than cyclical sectors) that warned of more weakness ahead, we’ve seen “Risk On” rallying since the October 4th trough, reflecting the spreading view that the global recession fears have been overblown for the second half of the year. Is the current stock market advance sustainable over Q4 and into 2012? We believe it is. The answer should have a lot to do with these influences:
1. Economic conditions
A continuation of the (very) recent tendency of positive manufacturing and employment data could help lift economic confidence. That would encourage corporations to initiate buyback activity and, more importantly, spur equity investors to put their cash hoards to work. (Over the past two weeks, while the S&P 500 was rallying by over ten percent, investors pulled over $11 billion from equity mutual funds. That is the highest two-week total since early August, as the market completed its plunge from the early July highs. This seems to be an example of investors selling out at a market bottom, even if it is only a temporary bottom.)
2. Earnings season
In the average calendar quarter since 1994, 62% of the S&P 500 earnings reports have been positive surprises. During the Q2 reporting season, the percentage broke a streak of four straight quarterly declines, rising to 69%. As the Q3 reporting season ramps up, the beat rate will warrant attention. While the market would be supported by another quarter of relatively abundant positive surprises, a lower beat rate – while sentiment and confidence remains strained – would have a more pronounced opposite influence. Thus far, expectations appear to have been lowered enough for this earnings season to be no worse than neutral. As of October 2nd, the beat rate for all reporting companies is 63.7%, which augurs well (or at worst, neutral) for the rest of the season.
3. Tape conditions
In our August 14, 2011 report “The Process of Bottoming Out” we described the textbook expectation of the market’s chart pattern over the following couple of months as a bottom (albeit possibly temporary) was formed for the stock market after the waterfall decline of August 8th. Specifically, we wrote “after a waterfall decline in the stock market… there is almost always a basing period. That period can be divided into 1) a rally, 2) a retest of the lows, and 3) a new uptrend.” We are on rally watch to determine the durability, if any, of the current advance.
The U.S. market has outperformed during the European crisis this year, reminiscent of its outperformance during the “Asian Contagion” of 1997-1998. Both that period as well as today stand in contrast to 2007-2008, when the U.S. was the epicenter of the crisis. After the 1998 crisis started to recede, Asian markets accounted for the top seven of forty five markets from August through the rest of the year (and the S&P 500 gained 25% over the next four months). A similar hopeful sign today is that European markets have been the top eight performers since September 12. More of the same would suggest that conditions are stabilizing, and that the worst case default scenarios have been priced in.
The rest of the world should gain confidence if it sees Europe performing better, and the same can be said of the banks, the European banks in particular. In both absolute terms and relative to the Dow Jones World Bank Index, the Dow Jones excluding the U.K. Bank Index has moved higher since September 12. We will be watching to see if improving performance from the European banks continues to support the sector globally and also help the region’s markets, ideally leading to a new bullish reading on our Europe ex. U.K. composite model.
Another hopeful sign is the performance of the MSCI China Index, up 20% over the eight days from its low on October 5 through October 17. China previously displayed such strong eight-day momentum after its bottom in October 2008, when it led a global bottoming process. Given the leading tendency of recent years, continued leadership would be a good sign for the global market trend. And it would indicate that the Chinese economic contraction has seen a needed soft landing, not a dangerous hard landing with negative ramifications for the global economy.
7. Commodity-demand theme
We have long described China, emerging markets, resource stocks, and commodities as trending higher in secular bull markets that persist, but correct along the way. After this year’s corrections, uptrends would not only re-confirm the continuation of the secular trends, but they would also lend confirmation to the broader explanation for the Q4 recovery – that the economic outlook is better than the Q3 market performance suggested.
It’s quite possible that all seven of these influences become increasingly positive as the quarter progresses, underpinning the market advance. It’s also quite possible that another wave of worry is on its way, triggered in Europe, China, the U.S., or globally. A third possibility is more of the same – more trading range action in the midst of mixed signals and a lack of decisive market indications, not unlike 1946 (see below). Our approach is to watch the indicators closely and to be ready to act when the confirmation is evident.
1946 vs. 2011
Analogues work until they don’t work, and, unfortunately, they do not give advance warning of when the analogy is about to end.
Thus, internally, market analogues are typically used, in part, to identify possibilities and assign probabilities.
Often, in terms of internal investment conversations as well as via written reports to clients, we make market analogues. That is, comparing the action of market indexes at the present to past action in the U.S. or other markets. Popular examples that have been routinely cited in the financial media might be a comparison of the current U.S. market with the Japanese market post 1990, or comparisons that were made after the 1987 Crash with the market following the 1929 Crash. Admittedly, the problem with analogues is that they work until they don’t work, and, unfortunately, they do not give advance warning of when the analogy is about to end. Thus, internally, market analogues are typically used, in part, to identify possibilities and assign probabilities.
With that caveat, we would like to point out some instructive parallels between the current market and one from nearly seventy years ago. We have often times noted the importance of “90% Days” (for example, a 90% downside day is a trading day which exhibits 90% downside volume in conjunction with 90% downside price action, meaning 90% (or more) of the price movement of all stocks on a given exchange is lower) in signaling what is going on with the market. On rare occasion we might actually see 98% or 99% Down Days. There has never been a time when such big days occurred back-to-back. But there have been a few times that were close. On November 3rd and 5th in 1948, and on September 3rd and 9th in 1946. It’s the 1946 market, though, that seems to warrant further investigation.
As noted above, selling was especially intense in September 1946 with two 98% Down Days, which corresponded with the initial decline following the end of the bull market that had begun in 1942. A very similar pattern occurred in the initial decline from the July 2011 market high, with 98% Down Days occurring within one day of one another, on August 4th (a Thursday) and August 8th (a Monday). So at virtually the same area in the initial declines from the July 2011 top and from the August 1946 top, there were very unique instances of very intense selling that occurred close to one another.
But that’s only the beginning of the parallels. Investors can find their own reality when looking at technical patterns. And sometimes – sometimes – reality can be created when masses follow technical patterns, which is why it is worth noting that there was a lot of chatter prior to the July 2011 market top of the formation of a “heads and shoulders” formation (to avoid technical jargon, the only importance for this conversation is that it’s a bearish pattern). The same pattern formed at the 1946 market top. And when prices broke down from the 1946 top, they went into a precipitous decline of about two weeks in which the Dow Jones Industrial Average (DJIA) lost 18% from its August high reached just before the breakdown from the topping pattern. In the July-August 2011 decline, the DJIA dropped nearly 16% from its late July high (both percentages cited are on a closing basis).
Thus far, the factors the 1946 and the 2011 market tops have in common are: 1) two days of intense selling in the initial decline from the market peak (98% Down Days), 2) a “head and shoulders” technical pattern, 3) nearly equivalent sharp declines of about the same duration.
Additionally, it is worth noting that the four percent drop in the DJIA in the first three days of September this year was the fourth worst three-day decline to start the month since at least 1900. The other three were in 1931, 2002, and – that’s right – 1946. And the 2011 and 1946 declines shared similarity in that both exhibited a big spike in volume.
These many stock market similarities between today and the 1946 market got us wondering about what was going on in 1946 in terms of current events and the U.S. economy. According to a mid-2010 report by the Cato Institute entitled “Stimulus by Spending Cuts: Lessons from 1946”, one of the great worries of the day was the potential of a renewed Depression. Worries centered around what would happen while the wartime economy was transitioning to a peacetime economy, as the government removed its spending programs. Today there is concern that both fiscal and monetary stimulus is losing effectiveness as their respective proverbial ammunition dwindles.
To sum, the market tops in 1946 and 2011 appear to have a lot in common, both in terms of market action and economic backdrop. But what, if anything, do these similarities mean for the future? The 1946 market top marked the start of a sideways market (a channel of prices where money could be made when attention was paid to the volatility) that lasted until 1949 (which set the stage for a massive 17-year rally). The good news is that during that post-1946 sideways market the DJIA never made an appreciably lower low than the original bottom off the May 1946 market high. (A peak-to-trough drop of 23.2% in 1946 translates to an S&P 500 level of 1,040 points today, approximately the low of 2010. The S&P 500 hit 1,074 points on November 4th, a close analog.)
A big reason for that 1946 low being made and successfully held was the successful transition from the wartime economy to the peacetime economy. Today the question is not transitioning but rather reviving the US economy after the twin shocks of a housing collapse and a financial crisis. Up to now, the sell-offs in 1946 and today seem eerily similar. Certainly there is no guarantee that parallel paths continue, but it does give us an analog that helps us identify possibilities and parameters, and that at the very least the market is currently tradable for a rally.
The Final Bottom
As discussed in the August 14, 2011 report “The Process of Bottoming Out”, we have now seen the minimal classic signs for completing the post-waterfall basing and testing period.
A typical rally following the final bottom of a waterfall decline is +22% to 25% (the median and the mean). This projects to a range 1,344 to 1,375 (which is consistent with our August 14th revised Reward Zone of 1,350-1,400 points.
The S&P 500 fell -14.3% in the third quarter, its worst quarterly performance since Q4 2008. That marked only the 24th time since 1929 that the benchmark fell by at least 14%. Such large declines have created oversold conditions. The stock market has tended to rebound after -14% quarters, with the S&P 500 climbing a median of five percent the next quarter and twelve percent over the next year.
That historical study is just that, a look at past returns after a similar event. Whether or not the market follows historical tendencies depends principally on if the economy avoids a recession and if the seven aforementioned catalysts can propel the S&P 500 out of its 1,100 – 1,275 point trading range. If the bottoming process continues to unfold, we will continue to maintain U.S. equity exposure for growth-oriented portfolios. But whether or not that holding pattern is long-term or short-term depends on whether or not the final bottom is in for the stock market.
As discussed in the August 14, 2011 report “The Process of Bottoming Out”, we have now seen the minimal classic signs for completing the post-waterfall basing and testing period.
The waterfall low of August 8th was broken on October 4th, as has occurred in 73% of the historical cases.
Leadership stayed defensive throughout the post-waterfall basing and testing period. Since the October 3rd lows, however, sentiment has improved and we have seen a change in the character of the rally leadership, to more cyclical/higher beta sectors. We view this shift as a hopeful sign that investors are starting to regain confidence.
Our research had showed that an expectation of a lower low would not be materially lower than the August 8th waterfall low, and it wasn’t. Now that the lows have been broken, we have entered the period where important market bottoms are often made. How will we know if we’ve reached the final waterfall bottom?
We examined the market and sector history for the six-month period following the initial break of the bear market post-waterfall lows (such as occurred on October 3rd). In all, we found eight cases since 1929 where the S&P 500 broke to lower lows than the waterfall decline. The bias is to the upside, as the Reward vs. Risk ratio is nearly two-to-one in favor of reward, when measured from the initial break of the lows. History does show a wide trading range for the S&P 500:
A typical rally is +22% to 25% (the median and the mean). This projects to a range 1,344 to 1,375 (which is consistent with our August 14th revised Reward Zone of 1,350-1,400 points, though any respectable cycle composites shed serious doubts on the market making new highs for this year).
A typical further decline is -11% to -15% (the median and the mean). While these are skewed somewhat by the 1938 and 2008 cases, it still projects us a range of about 935 to 979 points.
The rally from October 4th allows us some comfort in calling a sustainable bottom for this rally, though it is worth noting that a U.S. recession would write a new script for expected chart patterns. It is admittedly possible we may not have yet reached the final bottom as the market has broken to lower lows a median of three times during the post-waterfall period. And that is why our approach is to watch the indicators closely, and be ready to act when the confirmation is evident.
As has been stated, our indicators have continued to describe a bottoming process that is likely to culminate in sustained rallying. We have seen a successful retest of the waterfall low based on diminished selling pressure reflected by downside volume, improved breadth, less violent volatility, and sentiment improving from negative extremes.
Weakness in Q3 has not, however, always been followed by strength in Q4. For example, Q3 declines were followed by Q4 declines in each of 1930, 1931, 1937, 1957, and 2008. Yet all five of these half-year periods shared a major condition – they all occurred in the midst, or at the precipice of, a recession. The implication is that Q4 performance will have a lot to do with whether the economy is entering a recession, or instead avoiding one.
The stock market leads the economy, so to focus on the economy to call the stock market’s moves is like putting the cart before the horse. But it is important in this instance because the stock market has only gone down enough so long as we are not going into recession. A struggling stock market in Q4 may portend a recession in early 2012, as opposed to a more likely scenario of late 2012. This, of course, is important information in determining which sectors or asset classes to invest in, versus which to avoid – and when. The bottom line, in regards to the correlation, is that the stock market has gone down enough, unless we are imminently going into a recession. (If the U.S. was in a recession now, or imminently slipping into one, we would target the S&P 500 to reach a range of 900-950 points.)
Bottom Line: Markets trend on fundamentals, but trade off sentiment. We do not have enough fundamental evidence to conclude that a cyclical bear market bottom has been made, but sentiment indicators suggest the rally could continue. We should simply stay flexible, and monitor the indicator evidence and our reward/risk entry points.
Bulls have a great deal of contrary pessimism in their favor, and the market may continue to rally as long as economic conditions don’t worsen for 2011. Bears, on the other hand, have an uncertain outcome in Europe and the rising risks of recession in 2012 if additional stimulus is not forthcoming. On a trading basis, the S&P 500 is expected to approach 1,300 points in 2011, perhaps surpassing that level by several percentage points in 2012.
On a fundamental basis, the U.S. experiences a recession, on average, once every six years. That means some economic expansions last two years, some ten years. By the summer of 2012 the current expansion will have trended for three years and will have exhausted stimulative fiscal and monetary policies, while maintaining a disturbingly high unemployment rate. A new recession cannot be held off forever, in even the best of scenarios and the best of times. We worry about recession in late 2012 (this is not a new concern for us; we have been expressing this concern since June 2009 when we first projected that the U.S. was coming out of recession).
Markets trend on fundamentals, but trade off sentiment. Our concern is that this rally, even if it lasts for six months, will be trading off of the sentiment of a significantly oversold market. Our concern is that the actual fundamentals for the U.S. shift to a negative trend.