Is This Time Different?

V-O-L-A-T-I-L-I-T-Y. Hmmm…and I’ve been thinking that was a four letter word. If not, I'm sure it has made some investors feel like using some over the past month. Volatility is a funny thing really in that it works in both ways. Traders love it. Investors typically hate it.  If we own investments, we only like upside volatility. Downside volatility, at least to the degree that December has brought, is usually not a welcome item.

Clearly, this month has brought some serious consternation and fear into the average investor’s psyche. And no wonder, December brought a full on crash with major indexes down about -15% at the lows recorded Monday (Christmas Eve)! That plunge was totally irrational, born out of fear and panic. While our algorithm system gave us indications of shifting momentum, the economic data mostly concluded everything should be fine.

I mean just look at the data! Earnings for the S&P 500 are projected to grow by +7.9% next year while revenue is estimated to increase by +5.3%. All eleven sectors are projected to show year-over-year growth. The estimated net profit margin is +11.8% and that will be the highest net profit margin since FactSet started tracking the data in 2008. That’s not the kind of data that would suggest we should be expecting the end of the bull market. Nevertheless, the price action in markets this month seem to have priced in a terrible 2019. Could markets have gone too far?  

While the market is not “cheap” per se…it sure is much less expensive than it was in September! The forward PE (price-to-earnings ratio) for the S&P 500 has been pushed down to 14.2, which is below the 5-year average of 16.4 and the 10-year average of 14.6. Again, that is not the type of valuation data that would suggest everyone should sell their stocks. So we have to conclude that what we’ve just experienced is a bout of irrational investor activity. 

We’ve seen these irrational markets before. It’s super important that long-term investors keep a cool head. Keeping a cool head is something that’s hard to do when everyone around you is losing theirs. Over the years we’ve watched investors throw in the towel at exactly the worst possible times. Don’t run with the herd, as we’re fond of saying. If market sentiment can turn from positive to negative on a dime as happened in September, but especially in December, it can also just as quickly change from negative to positive. 

For example, just look at last Wednesday’s market action – largest point gain ever! This was also a 96% “upside” day. I won’t get into the details of this, but in 2002 Paul F. Desmond from Lowry’s Reports wrote a seminal paper titled Identifying Bear Market Bottoms and New Bull Markets (I’m happy to provide a copy if you want to geek out). In it, he explains that all bear market bottoms have been accompanied by one or more 90% downside days (we’ve had those!) and then new bull markets don’t start without at least one 90% upside day. Again, Wed. was a 96% upside day! This gives us reason to conclude that right now this is probably more of a buying / holding environment versus a selling environment.So what could make us change our minds? One element has to do with the Fed and one has to do with the credit cycle…which is still (sorta) about the Fed.

Historically, we get several signals before we get a recession; the yield curve (2yr / 10yr) inverts, unemployment rises and the Fed starts cutting rates. That has historically signaled that a recession is not far out and it would be a good time to leave markets. Our Escape Hatch Zones are calibrated to this type of momentum in monetary conditions and has historically been exceedingly correct. Look at this chart below and you can see that it was time to move to safety when the line in the top portion of the chart moved from “green” down through the 70 area. The last two times that has happened has signaled a deep bear market ahead and we responded with liquidating positions. But, as you can see in the far right portion of the chart the green on the top of the chart is nowhere near falling through that 70 line! It could fall off a cliff like it did in 2008, but there were a lot of other factors that caused that to happen then that are not present today.

Some people are pointing to slowing global growth as the culprit for falling stock prices here in the US. The last time markets corrected due to worries over a global slowdown was in early 2016. One January 2016 headline read "World Bank Downgrades Global Growth in 2016." That "downgrade" was to 2.9%, but even that would have been an improvement over the 2.4% growth in 2015. In May 2016 The Economist stated "World Economic Growth is Slowing." In that same month Forbes included 9 charts to explain the "Global Economic Slowdown." 

The odd thing about this slowing global growth hypothesis in early 2016 is that it turned into "global coordinated growth" in 2017. That 2.9% projected rate by the World Bank in January 2016 turned into a real rate of 3.2% and then 3.7% in 2017. So much for a slowing global economy! But some say that this time is different because the IMF has now lowered its 2019 projections from 3.94% to 3.7%. But how is that a slowdown from the real 3.7% of 2017?! The way we see it, that is still a pretty rapid growth rate for the global economy. Shoot, the slowest projected rates are still positive at 1.9%. There are no contractions! Meaning it’s not likely we see a recession due to contracting economic activity. At least not from the traditional way recessions come about anyway.

So, if there is no economic data that would suggest that a recession is around the corner is there anything else “lurking” out there that can throw the economy into a tailspin? Some would suggest that this time IS different because of the credit (debt) cycle. Some economists and newsletter writers have suggested that economic activity is now controlled by credit cycles that ebb and flow with monetary policy.  

Ordinarily, business cycles move from contraction to expansion. A growing economy peaks, contracts to a trough (what we call “recession”), recovers to enter prosperity, and hits a higher peak. Then the process repeats. The economy is always in either expansion or contraction.  Economists disagree on the details of all this, but the high-level question is why economies must cycle at all. Why can’t we have steady growth all the time? Again answers vary. Whatever it is, periodically something derails growth and something else restarts it. Regardless, it’s possible that the pattern broke down in the last decade. We had an especially painful contraction (2008) followed by an extraordinarily weak expansion. GDP growth should reach 5% in the recovery and prosperity phases, not the 2% to 3% we have seen. 

There’s no doubt that the world is awash in debt. Corporate debt is at or near all-time highs. Debt-fueled growth is fun at first but simply pulls forward future spending, which at some point is usually missed. Now it seems we could be entering the much more dangerous reversal phase in which the Fed tries to break the debt addiction by reducing liquidity (bond “roll-offs” and rising rates). The purple line in the chart below is the Fed’s balance sheet which is where the bond roll-offs are coming from. Right now the roll-offs amount to $50 billion per month, which in the grand scheme of things seems pretty small. But, it is still a reduction in liquidity and markets love liquidity.

“Old-style” economic cycle recessions triggered bear markets and you could see the recessions coming a mile away. Economic contraction slowed consumer spending, corporate earnings fell, and stock prices dropped. Peter Bookvar has suggested that’s not how it works when the credit cycle is in control. Lower asset prices aren’t the result of a recession. They cause the recession. That’s because access to credit drives consumer spending and business investment. Take it away and they decline. Recession follows. In other words, in an environment where companies that can’t service their debt (due to rising costs and falling access to liquidity and credit), they have little choice but to shrink it. They will do that via layoffs, reducing inventory and investment, selling assets or a combination of them all. All those actions reduce growth and, if widespread enough, could lead to recession. That would be a “this time is different” moment.

I hate to use the term “This time is different”…because it usually isn’t. But the Fed has done things (QE and QT) that they’ve never done before. And, as you can see in the chart just above it would appear that stock markets are taking some ques from the Fed’s balance sheet. Moreover, as markets have progressed into the world of Artificial Intelligence (AI), the statement “this time is different” takes on some new life for many of us. Have the big market participants acquiesced their traditional decision making to a computer algorithm? Do they simply push the button that the computer suggests that they should push? While I would agree that computers have impacted the markets, I’m not sure I’m ready to say that they have “changed the rules”. Nevertheless, I have been and continue to test various forms of algorithmic trading along with integrating a form of AI into our traditional methodologies. If the machines are impacting (changing?) the rules, then we will have the machines to read the machines better.

So as it stands, there is a fair amount of evidence helping us to feel more comfortable that at least a near term bottom is here or close. Again, it may have come on Monday. The previous Friday and then this past Monday had many signs of capitulation…spiking VIX readings, historically high put call ratios, and perhaps one of the best signals yet – Greenspan says the bull market is dead. He and other government officials have not had a great history of picking tops or bottoms. Who can forget Greenspan’s “there’s no housing bubble” call in 2005?! 

Anyway, this was the headline on CNN Business on Dec. 18: 

Alan Greenspan: Investors should prepare for the worst 

That, by itself doesn’t mean much, but when combined with other data – put call ratios, VIX readings, price action – it takes on more significance.

A very reliable buying indicator that remains underused by technicians is the ARMS Index or “Trin”. In order to cut out the extreme day-to-day variations, we use a 10 and 15 day average. Since 1960 there have been 17 other times when this Index had readings equal to its reading after Wednesday's bounce. One year later the S&P 500 was up all 17 times with an average return of +21.9%. One week later markets were higher 14 times with an average return of 1.1% and three months later the average return was 6.1%.  

I’ll end this letter with a bit more information that is shaping our perspective regarding recovery. Conditions suggest we are in a good economy that has simply experienced a sharp selloff and not the beginning of a protracted bear market. These types of sharp selloffs have a tendency to reverse themselves quickly and sharply. Since 1950 there have been only five other times the S&P 500 has dropped by -17% within four months of a 52-week high. The following Table shows the five times plus the performance of the S&P 500 in subsequent periods of time: 

Now I understand that this is not a lot to go on with only five data points, but there is a remarkable consistency among them, and every single time period was positive.