Market Risk Outlook
July 9, 2015
- SPX: 2,046.68
- DWCFT: 91.33
- RUT: 1,228.96
- NASDAQ: 4,909.76
Every single market sell-off since the beginning of 2013 has produced the broad-based belief that this ‘overvalued, artificially Fed-driven bull market’ is over. This latest Greece/China-led decline is no different: 1) investors are fully invested, complacently looking to buy the dip; 2) the market has not had a 10% correction for a near-record amount of time, and is thus due; 3) China is losing control of its economy, as evidenced by the lack of equity market response to its policy measures; and 4) the ‘pain trade’ is lower. This negative sentiment has cropped up with the S&P 500 down less than 5% from its 52-week high. At some point the bear case will come to fruition and become the predominate trend; but not after a 5% decline. Sentiment turns too negative too quickly, with headline commentary looking for the next ‘Lehman moment’. In my opinion the market has not peaked on a medium- or long-term basis; as such, dips should continue to be bought, and/or ‘waited out’. Of course the potential for a short-lived mini-bear market of circa 20% is always present; but as I explain later, I have several tools in place for side-stepping such draw-downs in order to take advantage of the associated individual equity & credit dislocations.
In the medium- to long-term there are four key drivers of market returns: economic conditions, monetary conditions, market technicals and market valuation. For market practitioners with time horizons of at least 12 months, getting in harmony with the “weight of the evidence” of these four factors can provide an enormous edge over fellow market participants looking to dance in and out of each 5% to 10% market wiggle. I break these four factors down into what I call the Market Mosaic (focused on the U.S. economy, and equity market as represented by the S&P 500):
- Economic Conditions
- Monetary Conditions
- Market Model
- 200dma Direction
Economic Conditions. All large-scale [depth and duration (i.e. >40% and 12 months long)] bear markets historically have taken place inside of recessionary economic conditions – 1929, 1937, 1974, 2002 and 2008 come to mind. Stating the obvious, these are the market environments to both avoid and take advantage of…not ‘wait out’. Though economists in the aggregate have a poor track record of forecasting recessions, fortunately it is not tremendously difficult to identify recessionary economic conditions in real time, prior to the bulk of large-scale bear market declines.
Two key indicators with respectable records of identifying recessionary economic conditions – Jobless Claims and Intermodal Rail Traffic – point to continued economic expansion for the United States economy.
And though some like to quote the length of time since the last recession as evidence this business cycle is ‘tired’ (speaking to global developed economies), I would point to the fact that the Federal Reserve, European Central Bank and the Bank of Japan have not only NOT begun raising rates – which I would argue is a rather strong indicator of where an economy is in its business cycle – but are still in emergency monetary policy mode.
Typically a central bank will raise rates when the inflation outlook picks up as a result of economic demand outstripping supply. Though crude, nominal GDP versus potential nominal GDP presents a reasonable picture of economic supply & demand. At year-end 2014, United States nominal GDP was $17.7 trillion versus potential nominal GDP of $18.2 trillion, or 97.3% of capacity. And for reference, at year-end 2007 nominal GDP was 99% of capacity, and at year-end 2012 it was 95%.
Monetary Conditions. The Fed – and all major developed market central banks – remains extremely friendly from a policy perspective, providing a major, and under-appreciated tailwind, in my opinion. (I say under-appreciated because market participants are so laser-focused on when the easy money ends, that they fail to see the extremely positive benefits that will remain in place well after it actually ‘ends’.) Of course this does not always mean monetary conditions themselves are friendly, as evidenced by aggressive easing measures beginning in early 2008 alongside steadily worsening corporate credit. You cannot simply say “don’t fight the Fed”. Fed policy must be looked at in a broader context of monetary conditions, and where the economy is in the business cycle. If the Fed begins ‘easing’ after many months of rate hikes, more than likely the easing is in response to economic weakness. As such, I prefer to amend “don’t fight the Fed” to read: don’t fight wide open credit markets.
At present, United States credit markets are wide open (with the possible exception of high yield Energy ), as represented by the Bank of America Merrill Lynch High Yield BB OAS. For all the recent market consternation, spreads are not nearly as high as they were back in 2011; and from a long-term perspective, right in line with historical norms for this point in the business cycle.
Market Model. The Market Model was born in early 2012 out of a project looking at the predictability of the Price/200dma ratio across market cycles going back to the 1920’s. I found the ratio on its own was of limited use, but when paired with valuation, alternative moving averages and momentum measures, extremely helpful. While far from perfect, the Model had a scary good track record, particularly since the early 1990’s.
In June 2014 the Model was on a BUY signal, but it has since dropped to a HOLD. With the HOLD rating following a BUY, and alternative Market Model-derived signals not flashing yellow or red, this is a bullish HOLD rating in my opinion.
Price/200dma. This ratio is useful when utilized in a highly basic trend-following construct. I do not have the exact figures handy, but something like the bulk of the market’s returns historically have come while the market is above its 200dma (yes, pretty obvious). So, it is a warning sign if and when the market falls some distance below the 200dma. I use 95% as the warning level. Currently, the market is at just about its 200dma. I would rate this bullish.
200dma Direction. Similar to the P/200dma, the bulk of the market’s returns historically have come when the 200dma is rising (again, obvious). I break the 200dma Direction indicator into two parts – slope and trend. The slope is the long-term direction of the 200dma, or the YOY growth rate; the trend is where the 200dma is headed at present – in other words, the 200dma could be higher YOY, but falling over the recent weeks and months.
At present, the 200dma is almost 9% higher than it was 200 trading days ago, and it is rising. A highly bullish configuration.
I will turn on the market faster than anyone – trust me; but based on the above, I see nothing to get bearish about at present. Certainly, I wish I could time these 3% to 5% squiggles better; but in my experience, more often than not it leads to missed opportunity.
The biggest risk to my ‘mosaic’ approach is that it is likely to miss mini-bear markets such as 1962, 1987, 1998 and 2011. While I am not overly concerned about riding out a mini-bear (I did in 2011), I would like to be in a strong position to take advantage of them. As such, I have several tools at my disposal that could – and likely would in the event of a mini-bear – override the medium- to long-term conclusion of the Market Mosaic. The tools include: a third-party sentiment gauge; a third-party market risk model, similar to my Market Model; the Market Model itself (for example it went to a SELL in early 2011); and a proprietary short-term market momentum indicator embedded within the Market Model.