To suggest that there’s plenty to worry about in the current financial market and economic cycle is an understatement. I could spend pages of discussion space. Although scenario planning and assigning probabilities to a series of multiple outcomes is essential to the risk management process, so too is the abandonment of personal ego in being emotionally accepting of short term outcomes. Although I’ve heard it said many a time that the four most dangerous words in investing are “it’s different this time”, I’d suggest that’s partially true. There exist another four words that can be equally, if not more costly. And those words are “this shouldn’t be happening”. Especially for those with short term investment mandates, being right and making money can be two very different things. So in one sense, at perhaps the most basic level really any investor needs to honestly ask themselves that very question. Just what do they expect to get out of investing? To be right about future outcomes? Or simply to grow and compound capital over time? If the answer is the former I strongly suggest the investor fund their account with monopoly money so they can do zero damage to their net worth. My personal view is that being right is in very large measure the need to stand on an emotional pedestal of intellectual triumph. Growing and compounding capital over time is about discipline and risk management, in other words it’s an exercise in emotional self control.
You know full well we’ve started off the year with quite a bang in the financial markets. As usual, the market does what it can to emotionally and often financially disappoint the many given the almost ubiquitous mainstream Wall Street message of conservatism and focus on yield in their collective 2012 outlook diatribes. Although we have plenty of recently converted equity bulls really out of necessity, there also exist a fair amount of folks who strongly believe “this shouldn’t be happening”. A few weeks back I penned a discussion in these pages focusing on what I believe to be the two key drivers of the current cycle. The first driver is the easy one; it’s the rhythm of global central banker on again and off again stimulus. In English, money printing. The second driver is the rhythm of the short term movement in real business input costs (think commodity prices) and how they influence shorter term cyclical business decision making with a bit of a lag. Prices down and business prospects look up a bit, and vice versa. The last piece of this key drivers puzzle is to also be aware of how central banker monetary actions can and do influence those same commodity prices that are business input costs. This has been the dance playing out since 2009 and one that shows no signs of change at present.
Now, maybe the current policies and actions of global central bankers “shouldn’t be happening” as they are debasing currencies. This is truly a grand experiment in central banking as we are certainly in uncharted central bank balance sheet expansion waters. What potential unintended consequences lie around blind curves we know not. But the key point is that regardless of personal opinion, “it is happening”. For many years as part of a larger analytical toolbox, I’ve used a few key macro charts to personally help me maintain “emotional self control”. One of those happens to be the interplay between the 10 and 40 week exponential moving averages of the S&P. One can apply these same technical parameters to many an asset class. Although I have not attached the history of the S&P itself to the chart below, anyone familiar with market movements over the last decade and one half is all to aware that this has been an excellent macro tool. Maybe someday that will change, but through to the present the message has been correct. Regardless of what I think “should be happening’, the chart below forces me to maintain emotional and decision making balance. It tells me what is happening.
And surprise, as mentioned above and as discussed more fully in my last piece, Fed monetary stimulus actions have influenced the direction of the equity market, using the S&P as a proxy, in the current cycle. Now the ECB is in the game big time. This is what has happened and this is what is happening. Will it continue to happen? The answer to that question will shape the market direction of tomorrow.
Enough personal pontificating about the need to maintain emotional control and decision making discipline. Maintaining emotional control in investment decision making does not mean that as human beings we will not worry. I wish that chart above put me to sleep every night, but it does not. With every currency unit printed and every tick higher in the equity futures, I’m going to worry. In the wonderful investment business, once you stop worrying you can also stop worrying about your career, as it’s a pretty good bet it will be over.
In the never ending search to find recognizable fingerprint patterns of human decision making displayed in those devilish man made concoctions known as technical charts, I want to end this discussion with a question. So, in the midst of all this wonderful emotional self control, discipline and zen like monetary expansion peace, just when should I really start worrying? Sorry, I should not have used the word should, right? When might I/we really start worrying? It just so happens that at least according to the historical playbook of life, the time to start worrying is when others stop.
Although measures like the VIX can be helpful, so are sentiment measures, the TRIN, and one I’d like to briefly focus upon – the put/call ratio. Right to the point, the historical record of the put/call ratio very much validates the old market truism that “markets climb a wall of worry”. What lies below is the 22 day moving average of the put/call ratio over the 2005-2008 period. The 22 day moving average approximates a monthly (about 22 market days) smoothing. I’ve inserted the red dotted lines in the chart to make a point about the wall of worry. You’ll see that each successive spike in the put/call ratio (happens in each S&P correction of meaning over the cycle) put in a higher high as the S&P traveled into its final peak in 2007. The “higher highs” in the P/C ratio at each peak are eventually followed by higher highs in the S&P. Moreover, the P/C ratio also puts in a more than well defined series of higher lows at each interim S&P high. The message of all of this is that at each interim S&P low from 2005 to the market peak in 2007, fear (as measured by the P/C ratio) was actually higher than the prior correction low, not lower. A nominally higher market did not breed confidence, just the opposite. Same deal at each interim market high, the P/C ratio was higher each time implying that at each successive high investors were “more worried”.
But into the final S&P peak in October of 2007, the unblemished series of higher lows and higher highs put in by the P/C ratio over the cycle is broken in terms of trend. Investors were “less worried” at the October 2007 peak than they were at the prior summer 2007 peak as measured by the P/C ratio. It was a divergence whose monitoring and ultimate message would have paid in spades. Never again to this day has the final spike in the P/C ratio in August/September of 2007 been bested using the 22 day MA. The time to have started really worrying in 2007 was when others stopped, at least as measured by the P/C ratio.
So where are we today? Have a look. A few things are going on in the chart below. First, looking at 2009 through early 2010, notice the very subdued volatility in the P/C ratio. Early in bull markets, there’s not a lot of worry, so to speak. But as the bull ages, worry picks up. The first big spike up in the 22 day MA of the P/C ratio came as QE I ended in April/May of 2010. The correction into the summer of 2010 was not a fun event as Euro worries were escalating, but the Fed was soon to arrive on scene.
In true “wall of worry” fashion, the spike up in the P/C ratio in the most recent correction last summer was quite a bit higher than what was seen in the summer 2010 correction. Higher highs for now are intact.
Now, you can see the low the P/C ratio put n during early 2011. It was a lower low compared to January and May of 2010 (the previous lows for the cycle). Wait a minute, does this negate the wall of worry pattern in the P/C ratio for the current cycle? I don’t think so and here’s why. Look at the interim market highs of January 2010, May 2010 and April of 2011. If you look closely at the P/C ratio at each of these important interim S&P 500 highs, you’ll see they all occurred with a “higher low” P/C ratio. “Worry” was at a higher point at each actually higher market low. The early 2011 P/C ratio fall did not come at a corresponding equity peak.
So how might this help us ahead? History suggests that the next interim equity market high comes with a “higher low” in the P/C index and each equity correction is accompanied by a higher high in the P/C ratio. If this does not occur and an interim price peak is accompanied by a lower low in the P/C ratio, it will be a finger print divergence in line with what was seen at the important 2007 peak. We’re not there yet. This is simply an exercise in emotional self control and thinking ahead. It’s a potential scenario to which I have to assign a probability. I’m fully ready to really start worrying, when it’s clear by their actions (not their words as in sentiment indicators) others have stopped.
