May 21, 2012
Over the past two weeks, the S&P 500 has lost months of upside progress in a handful of sessions. This is the very characteristic initial outcome of the overvalued, overbought, overbullish syndrome that has been in place until recently (the decline has cleared the overbought component). The good news here is that we now estimate the 10-year prospective total return on the S&P 500 to be about 5.2% annually as a result of the recent decline. As a rule of thumb, a 1% market decline in a short period of time tends to increase the prospective 10-year return, not surprisingly, by about 0.1%. However, that approximation is less accurate over large movements or over extended periods of time, where growth in fundamentals and compounding effects become important.
The bad news here is that given the sharp deterioration in market internals, and the likelihood of an emerging recession, we have no basis to expect market losses to be contained to such minimal levels. It is important to recognize that the scope of our concerns is on the order of 25-35% market losses over 12-16 months, and those concerns aren't meaningfully resolved by a 5% decline over the course of a few sessions. A good week in the market is unlikely to change our assessment unless it produces a material improvement in our measures of market internals. The fast, furious, prone-to-failure rallies that often result from short-term oversold conditions aren't generally enough, and usually reflect short-covering rather than sustainable investment demand. Improved valuations are often supportive of that sort of sustainable demand, but that would require a much larger decline than we've seen thus far.
Massive monetary interventions have not done much for the economy, but have proved capable of provoking speculation for several months at a time. As I've noted recently, there may be latitude to take a more constructive stance between the point that any new monetary intervention produces an improvement in our measures of market internals, and the point where we re-establish an overvalued, overbought, overbullish syndrome. Without a material improvement in valuations or market action here, we remain defensive. Undoubtedly, the best outcome would be a strong improvement in valuations, followed by signs of improvement in our measures of market action, which is the typical sequence of events that complete a market cycle and can launch a very favorable investment environment.
In the meantime, however, a bad week is unlikely to change our assessment unless that bad week includes a market crash. Last week was not a crash, though a free-fall appears increasingly possible, as the reality of emerging recession (and all that it implies for fresh credit risks, sovereign defaults, fiscal imbalances, banking strains and other problems) will likely smash against the consensus view of economic expansion in next few months.
I continue to view the U.S. economy as most probably entering a recession that will ultimately be marked as beginning in May or June of 2012. We are very much in agreement with the ECRI on this, though our methods are different, and our conclusions are clearly still seen as "fringe" views by the consensus.
For the financial markets, those risks are compounded by the unbalanced "risk-on" exposure that investment managers and institutions adopted early this year, encouraged by a short-lived burst of economic activity, and faith in a central-bank backstop. When heavy "risk-on" positions established in recent months are forced to squeeze out through a narrow exit, large price adjustments may be needed, since investors who are less tolerant of speculative risk seem unlikely to respond with the requisite demand until improved valuations provide a sufficient incentive.
As John Kenneth Galbraith wrote in 1955, "Of all the mysteries of the stock exchange there is none so impenetrable as why there should be a buyer for everyone who seeks to sell. October 24, 1929 showed that what is mysterious is not inevitable. Often there were no buyers, and only after wide vertical declines could anyone be induced to bid ... Repeatedly and in many issues there was a plethora of selling orders and no buyers at all. The stock of White Sewing Machine Company, which had reached a high of 48 in the months preceding, had closed at 11 on the night before. During the day someone had the happy idea of entering a bid for a block of stock at a dollar a share. In the absence of any other bid he got it."
Illiquidity is a very unpleasant thing when you've got an inappropriately speculative position and you're under pressure to close it out. The very high beta exposure taken by managers and institutions lately (see Unbalanced Risk) strikes me as particularly dangerous in an environment where we continue to estimate the market's return/risk profile among the most negative 0.5% of historical instances.
Will the Federal Reserve come in with QE3 in an attempt to prop up the market? Maybe. It doesn't matter to Bernanke that the Fed's interventions are reckless, promote speculation, distort resources, punish savers, produce only temporary economic effects, and will be nearly impossible to unwind. But the Fed will undoubtedly feel compelled to "do something." Apart from dollar swap lines (which the Fed is likely to reopen to Europe in efforts to reduce banking strains there), more QE is all the Fed can hope to offer. Let's face it - when your only tool is a hammer, all the world looks like a nail.
Still, we've observed diminishing returns from the Fed's interventions, there is no political tolerance for the Fed to intervene in securities involving any credit risk that would be borne by U.S. citizens (purchasing European sovereign debt, for example), and the yield on the 10-year Treasury bond is already down to 1.7%, which is far below where it stood when prior interventions were initiated. It seems a hard sell to argue that yields aren't low enough, and that the Fed needs to intervene to drive them down further. Even so, it's clear that Wall Street responds to Bernanke like a bunch of Pavlov's dogs. Provided that renewed Fed intervention is sufficient to improve our measures of market action, I expect we would have some latitude to respond with a more constructive position until an overvalued, overbought, overbullish syndrome is re-established.
Frankly, I doubt that investors will find the third time to be a charm in the event of another round of QE. This is why any willingness to accept risk will far more tied to our longstanding measures of market action and other testable factors than to some novel "Bernanke faith factor" that we have no way of testing historically in any kind of rigorous manner. Yes, the stock market advanced in 2009-2010 when the Fed tripled its balance sheet. But there is no material long-term relationship between the size or growth rate of the monetary base and stock market fluctuations. Rather, QE has had its effect on the markets by essentially starving investors of safe yield and making them feel forced into increasingly speculative corners in search of return. With safe yields already so depressed, I suspect that we will see already diminishing returns become even weaker, because there is little left for the Fed to squeeze.
As I've frequently noted in recent weeks, there are numerous ways of defining the basic "syndrome" of a richly valued, overbullish market where favorable internals (breadth, leadership) or other driving factors have fallen away. Presently, the market remains richly valued on normalized earnings, and is coming off of a speculative peak with an abrupt and persistent initial decline. The guys at Nautilus Capital recently noted that just a 5% decline from a nearby peak, coming off of a 25% prior advance, has historically been fairly hostile to forward returns. Bill Hester notes that going back as far as Depression era data, that same behavior coupled with a rich Shiller P/E (anything above the mid-teens) and a preponderance of daily declines in recent data (say down 11 days out of 14) has preceded even worse outcomes - particularly in the context of a weak economic backdrop. I should note that we also saw a "leadership reversal" last week - a shift from a preponderance of new weekly highs to a preponderance of new weekly lows. All of this reflects what might be called a "liquidation syndrome" that is selective for awful drops that began in 1969, 1972, 1987, 2000, 2007, and the more moderate but still steep losses in 1998, 2010, and 2011.
The chart below captures a fairly simple filter of instances when the market lost 5% or more over a 2-week period, from a market peak in the prior 6 weeks (within 5% of the prior 52-week high) that was characterized by a Shiller P/E over 19, more than 50% advisory bulls, and fewer than 25% advisory bears. So the bars simply identify quick initial declines from overvalued, overbullish peaks. But the fact that they coincide with so many important cyclical bull market peaks says something about how those peaks are formed.
It's important to note that on long-term charts like this one, small distances actually represent weeks of data, including many days where stocks advanced and everything looked just fine on a near-term basis, so we certainly shouldn't rule out the typical "fast, furious, prone-to-failure" rallies that usually punctuate extended market slides.
Note that with few exceptions, even when the near-term outcomes have been benign, the outcomes within the following 12-18 months have typically been terrible. Of course, this is one simple and imperfect measure. Our present defensiveness is based a far broader ensemble of evidence, as well an army of related syndromes. On the basis of objective data, we estimate the prospective market return/risk profile to be in the most negative 0.5% of all historical observations.
As for my opinion about market conditions, I have to agree with Richard Russell, who said last week "I think we're now in the second half of the primary bear market that started back in 2007. It won't be pretty." Richard is undoubtedly the pre-eminent authority of Dow Theory, which is often disparaged, but actually holds up nicely in historical data if you make Rhea and Hamilton's writings operational. As a side note on this, from a signal extraction standpoint, you can think of the Transports as carrying a signal about demand and distribution, and the Industrials carrying a signal about production, and both carrying a common signal about more general factors like risk aversion and so forth. From that perspective, the initial weakness we saw in the Transports, coupled with resilience in the Industrials, has been consistent with the buildup of unsold inventories we've seen in recent months. The groaning weakness of both indices in recent weeks - breaking simultaneously below the sideways channel that Hamilton refers to as a "line" - is a classic Dow Theory sell signal. While we don't use Dow Theory formally in our own work, it does provide some interesting confirmation of our analysis at times, for example, in early 2003 when we removed about 70% of our hedges (see the April and May 2003 market comments, also see Notes on Risk Management for a discussion of why we did not respond similarly in 2009).
My impression is that Richard's comment about the "second half" of the primary bear market reflects the view that - unlike most bear markets and economic downturns - the downturn that began in 2007 was never really resolved, but was instead just pushed off and deferred by massive monetary interventions, accounting changes, and the like. This, in addition to the fact that the S&P 500 remains below its 2007 peak. So rather than being a distinct primary bear market, and a distinct economic downturn, what we're likely to observe ahead will be largely a continuation of the original unresolved mess of bad credit and unrestructured debt, now also writ large across Europe.
Banking risk and resolution
On the subject of distressed and unrestructured debt, a report from the Financial Times last week included the following:
"The unit at the centre of JP Morgan Chase's $2 billion trading loss has built up positions totalling more than $100 billion in asset-backed securities and structured products - the complex, risky bonds at the centre of the financial crisis in 2008. These holdings are in addition to those in credit derivatives which led to the losses and have mired the bank in regulatory investigations and criticism. The unit, the chief investment office (CIO), has been the biggest buyer of European mortgage-backed bonds and other complex debt securities such as collateralized loan obligations in all markets for more than three years... The unit made a deliberate move out of safer assets such as US Treasuries in 2009 in an effort to increase returns and diversify investments."
"In November 2010, even the British Bankers' Association, a lobbying group, explicitly noted the scale of the CIO's activities in a warning on the fragility of the UK mortgage market: 'The JPM CIO has taken more than 45% of the total amount of UK residential mortgage backed securities that has been placed with investors since the market re-opened in October 2009'."
Based on this and other reports, it's not clear that the recent losses at JP Morgan were simply the result of a speculative trade gone bad. Rather, my impression is that the problems at JPM may be the result of using highly leveraged, illiquid derivative transactions as a "cross-hedge," intended to reduce the risk of default in a whole portfolio of complex positions including (but not limited to) European mortgage debt, but with the long and short portions of the position behaving unexpectedly in relation to each other. I'd be much more interested in how large JPM's mark-to-market losses are on the European mortgage-backed bonds than how much loss they've sustained on the hedge. Maybe the right question isn't why they lost money on the hedging transaction, but why they apparently have a boatload of questionable assets so massive that they need to use whale-sized leverage to hedge the default risk in the first place.
On an encouraging note, there is a clearer direction from the FDIC in how it would respond to a major bank "failure" (a word that is often thrown about to scare the public into accepting bailouts, but in nearly all cases simply means that the bank would fail to pay off its own stockholders and bondholders). Last week, Martin Gruenberg, the acting FDIC Chairman, outlined the planned response of the FDIC to the resolution of a "systemically important" institution:
"The most promising resolution strategy from our point of view will be to place the parent company into receivership and to pass its assets, principally investments in its subsidiaries, to a newly created bridge-holding company." In the process, shareholders would appropriately be wiped out, subordinated debt would be wiped out, senior unsecured debt could be written down to the extent that losses were still uncovered, and senior bondholders would get equity and convertible debt in the new restructured institution. Depositors would be unaffected, as would be other bank customers.
Gruenberg observed "These measures go to the goals of accountability for investors in the failed company, and the viability of the new well-capitalized private entity. We believe that this resolution strategy will preserve the franchise value of the firm and mitigate systemic consequences. This responds to the goal of financial stability."
This is very good news, and is also a largely proven strategy, because it's close to how Sweden durably resolved its own banking crisis in the early 1990's. This kind of response would provide a durable base for renewed economic growth following any future episode of major credit strains. If you have a financial crisis in which bad debt isn't restructured, there is really no moving ahead. It's good to see that there's somebody in charge who understands that.
The Market Climate is characterized by unfavorable valuations, unfavorable market action, and a continued army of hostile syndromes that have historically been associated with unusually steep market losses over the following 6-18 month period. On a very short horizon, the market appears significantly compressed and open to a standard "fast, furious, prone-to-failure" bout of short covering in order to clear that condition. The problem here is that economic conditions are beginning to surprise significantly on the downside (see last week's Philly Fed report), and credit strains are rapidly increasing in Europe. So barring some monetary intervention, shorts may not be particularly inclined to cover much here. In that event, the failure of the market to provide a relief advance could produce something of a run for the exits as managers holding high-beta positions cry "Uncle!" into a market that isn't particularly willing to absorb those positions without a significant discount. For that reason, I have no particular view about short-term market direction, except that it is likely to be a roller-coaster of sorts. Hold on to your hat.
Looking out beyond the very short-term, suffice it to say that we continue to estimate the market's expected return/risk profile to be among the most negative 0.5% of historical observations. Strategic Growth and Strategic International remain fully hedged, while Strategic Dividend is close to 50% hedged. Strategic Total Return continues to carry a duration of about 2.8 years, with just under 14% of assets in precious metals shares, and a few percent of assets in utility shares and non-euro foreign currencies.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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