Monday, June 4, 2012

2012 = 1998?

Weekends are a good time to think and reflect. After last week's carnage in the stock market, some thinking and reflection was more than overdue. The question I had was, "What is the market headed?"

When I consider the different dimensions by which investors evaluate equities, they present a mixed picture that is, while bearish, does not point to disaster:
  • Sentiment: bullish
  • Valuation: neutral to slightly bearish
  • Momentum: bearish
  • Macro: bearish, but subject to policy-induced whipsaw

Sentiment models are screaming "buy"!
Let's go through each of these one at a time. Martin T. over at Macronomics noted that Wall Street strategists are off the charts bearish, which is contrarian bullish.

As well, US 10yr yields are trading 3 standard deviations from the 30+ year downtrend, which indicates a crowded long in the Treasury safe haven trade.

Scott Grannis has noted the same level of exuberance when he asked "What record-low Treasury yields tell us". His take:
If I had to sum up what all this means, I would say that the evidence of market prices points to a very high level of fear, uncertainty and doubt among global investors. Today's record-low 10-yr Treasury yield is just the latest sign that investors are consumed by fears. When emotions reach such heights, as they did in the early 1980s and in late 2008/early 2009, investors willing to bear risk stand a good chance of being rewarded, provided the future turns out to be less awful than the market expects.

Valuation: Neh!
Typically, when sentiment is this bearish, Value investors are all crawling out of the woodwork and shouting, "I can't believe that there are so many bargains!"
While I have heard that comment directed at a number of European companies, i.e. these are real world-class companies trading at bargain prices (see one example at the FT article While all around ar, the same couldn't really be said of most markets. The Value investors just aren't there.
Consider, for example, this Barron's interview with Jeremy Grantham, who is known to have a value bias, on February 25, 2012 when the SPX was about 1360, which is about 6% above Friday's close of 1278.
We do a seven-year forecast every month. On a seven-year forecast, global equities outside the U.S. are boring. They've been so nervous the last year that they mostly reflect the right degree of fear about European problems. Emerging markets and developed markets outside the U.S. are within nickels and dimes of fair value. This is very unusual. We are in the asset-allocation business, and we like to see horrific roller coasters: It gives us something to get our teeth into. What could be more boring than global equity markets at fair value?
About a quarter of the U.S. equity market—the high-quality, boring, great companies—is about fair price, too. The other three quarters are overpriced, and based on our numbers have a slight negative imputed return.
While Grantham doesn't represent the final word in stock market valuation, he is a good bellwether for what Value investors think. As of the end of February, he believed that non-US equities were roughly at fair valuation. US equities are overpriced, with only a quarter, i.e. high quality stocks, at fair value.
His comments were not a stunning endorsement for the stock market.
A Dow Theory sell signal
The Dow Theory is one of the original trend following models, which is based on price momentum and looks for confirmations from different sectors of the market: industrials, transportation and utilities. Long-term market analyst and Dow Theorist Richard Russell recently flashed a major sell signal for stocks [emphasis added]:
IMPORTANT --- Dow Theory -- The D-J industrial Average recorded a high of 13,279.32 on May 1, 2012.  This Dow high was not confirmed by the Transports.  The two averages then turned down and broke below their April lows.  This action confirmed that a primary bear market is in progress -- it was a textbook bear signal.
Could you be a little more clear, Richard?

Macro picture gets worse
Last week, the news flow from Europe continued to deteriorate. The latest Greek tracking polls have SYRIZA on top again:

Not only that, the markets are now getting concerned about Spain - a country that's too big to fail. In the meantime, ECB head Mario Draghi stood aside last week and said that the ECB can't do much more. It's all up to the politicians:
Draghi told a European Parliament committee in Brussels that without more aggressive action by policy makers the euro “is being shown now to be unsustainable unless further steps are being undertaken.”

He said it wasn’t his job to make up for the failures of policy makers. “It’s not our duty, it’s not in our mandate” to “fill the vacuum left by the lack of action by national governments on the fiscal front,” on “the structural front, and on the governance front,” he said.
Last week, I wrote that investors should focus on China, not Europe. The news out of China is headed south. The latest PMIs are signaling a global slowdown, not just in China but in Europe as well. I raised the issue of when investors might focus on the question of capital flight out of China, when Tim Duy picked up on the same story. Should the market start to price in the tail-risk of capital flight, look out below!

Then we have the ugly US Non-Farm Payroll Friday. The only good news is that more data points of economic weakness will give the Fed political cover to act and unveil another round of QE. Despite what the central bankers say, don't forget that when things get bad enough, there will a policy response. As an example of the anticipated response, Mark Dow at Behavioral Macro believes that the IMF is putting on the face paint for a rescue of Spain. While the response may not fully solve the problem, it will kick the can down the road and spark a stock market rally.

A repeat of 1998 in 2012?
Putting it all together, what does it all mean? The market is supported by washed out investor sentiment, but not by valuation. The macro backdrop and momentum looks ugly. Is this the start of another cyclical bear?

Probably not. Valuations don't look excessively stretched, but they aren't screaming "buy" either. Major bear markets generally don't start with these kinds of valuation metrics.

My best wild-eyed-guess is that we will see a major air pocket like 1997 (Asian Crisis) or 1998 (Russia/LTCM Crisis) in which some macro event sparks a major selloff, but turns around based on policy response. There are plenty of macro triggers out there. Greece, Spain, China, etc.

Market analogues have limited uses, but look at the chart of the stock market in 1998. The market had an initial dislocation (Greece), stabilized and rallied (as we did a couple weeks ago) and started selling off again. At the nadir of the Russia Crisis that threatened to sink Long-Term Capital Management, the Fed came in and knocked some heads together to save the system.

Now look at the chart of the market this year and last year. See any parallels?

Don't misunderstand me. This is not a forecast that stocks are going to plunge this week. Analogues are analogies and they are imperfect. Markets are extremely oversold on a short-term basis and I don't think that we've actually seen the macro trigger for a waterfall decline yet, though there are lots of potential triggers.

Not enough pain
Nevertheless, were this scenario were to play out, it suggests that we haven't quite seen enough pain and we need one more capitulation down leg to equities. For now, my Asset Inflation-Deflation Trend Model remains at a deflation reading, indicating that the model portfolio should be primarily positioned in the US Treasury market. I will be primarily using that model and some short-term timing tools to try to spot the turn. Here is what I am watching. The chart below of the Euro STOXX 50 is falling, but not quite at the lows delineated by the 2009 and 2011 lows. Wait until the index approaches that zone and watch for signs of a "margin clerk" liquidation forced selling in the panic.

Here in Canada, I am also watching the ratio of the junior TSX Venture Index to the more senior and established TSX Composite. While there is a lot of pain, utter and blind panic hasn't quite set in yet.

When the blood starts to run in the streets, official intervention will be all but inevitable. At that time, that will be the opportunity to buy the pain in Spain.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


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Amar Harolikar said...

Hi Hui,

Beautiful analysis ! Loved the wide range of factors that you have been able to weave together, and the analogy with 1998.

I have been contrarian bullish (India Markets though) for a while now. I saw a reference to 'buying pain' in you's the title of a story I did last week !

Party time again: Time to buy panic for the Sensex ride to 80000

Thanks for taking the time to share your analysis.