Perhaps one of the greatest mistakes an investor can make is to remain entrenched in one’s thinking and subject themselves to “data mining” in which they only read and/or listen to news articles or data that supports their views. What is often in excess supply are opinions, and what always seems to be lacking is humility. Humility is perhaps one of the greatest assets an investor can have as you always have a sense of caution that you may be wrong and it allows you to step back and take an objective look at incoming data. These days it appears that the perma crowd (perma bulls AND perma bears) remain as embattled and entrenched as Republicans and Democrats. The question I have is, where is the middle ground? WHERE IS THE HUMILITY?
As famous investor John Templeton said, "Bull-markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria." The time to be a bear was in 2007 when market pundits envisioned nothing but blue skies ahead and when in early 2008 Fed Chairman Bernanke said the subprime fallout was "contained." The time to have been a bull was late 2008 and early this year when we were in the pit of a crisis and it didn’t seem like things could get any worse. Back in 2007 I wrote several articles that went contrary to the consensus such as the following:
- Proceed With Caution (08/22/2007)
- Credit Erosion: The Worst Is Yet To Come (08/29/2007)
- Will Financials Be to This Bull Market and Economy What Tech Was to the Last? (09/05/2007)
Throughout 2008 I was incredibly bearish and suggested that the economy and stock market were heading further south, and the mantra I had was "sell strength." However, things changed this year as the economy began to stabilize and the massive and unprecedented monetary stimulus by the Fed began to take effect. Even just after a few days of the market lows in March of this year I still felt that we were headed lower and I was absolutely dead wrong in my article, "Not out of the Woods Yet, Not By a Long Shot!" (03/11/09). However, at the end of the article I said that "A move by the S&P 500 above 800 would tend to invalidate the above analysis and I could be proven to be far too bearish." I had to remain objective that I was far too bearish and followed famous economists John Maynard Keynes' example who gave the following response to criticism he received during the Great Depression for changing his mind on monetary policy when he said, "When the facts change, I change my mind. What do you do, sir?"
All investors will be wrong at some point and the trick is to admit your error in judgment early rather than being a broken clock that is eventually right well down the road. Being wrong is human; being stubborn in the face of changing facts is foolishness. Another pearl of wisdom summing up this thought comes from famous investor Peter Bernstein who said the following after a long and successful investment career (emphasis added):
After 28 years at this post and 22 years before this in money management, I can sum up whatever wisdom I have accumulated this way: The trick is not to be the hottest stock-picker, the winning forecaster, or the developer of the neatest model; such victories are transient. The trick is to survive. Performing that trick requires a strong stomach for being wrong, because we are all going to be wrong more often than we expect. The future is not ours to know. But it helps to know that being wrong is inevitable and normal, not some terrible tragedy, not some awful failing in reasoning, not even bad luck in most instances. Being wrong comes with the franchise of an activity whose outcome depends on an unknown. Look around at the long-term survivors at this business and think of the much larger number of colorful characters who were once in the headlines, but who have since disappeared from the scene.
Remaining Objective
My fear at the present time is the polarization amongst the financial community in which both the perma bulls and the perma bears hold fast to their camps rather being an independent who will listen to both sides objectively. One of these camps will be painfully wrong heading into 2010 as the bears argue for fresh new lows in the market while the bulls argue for a 2-3 year cyclical rally in the stock market that carries us into 2011-2012. Perhaps the key for 2010 will be for investors to check their egos at the door and instead of “telling” the market what to do they should “listen” to what the market is telling them, being open to both the bullish and bearish viewpoints.
In the articles I write I always try to listen to what the economic and financial indicators are saying and then convey that message illustratively. In my article from last week I was taken to task by several readers for suggesting that the worst of the recession is behind us. However, taking an objective view of the economy I will go one step further and say the recession is over, though saying the recession is over and saying a robust recovery lies ahead are entirely two different stories.
Employment is one of the four primary indicators that the National Bureau of Economic Research (NBER, the recession dating committee) uses in terms of dating recessions and expansions. Employment is key to economic activity as rising jobs leads to rising incomes and thus rising consumption and overall economic activity. As employment is a key indicator that NBER uses to date recessions I have developed two different employment recession indicators that suggest the recession is behind us and the NBER will likely declare the end of the recession sometime between May and August, with my personally leaning as either June or July of this year.
My first employment recession indicator has bottomed on the very month of the recession ends in four of the last six recessions, and it troughed in July of this year. The bottom in the indicator in this recession fell to the most negative value seen over the history of the indictor, though it has staged a dramatic reversal and is already in positive territory.
Note: Grey bars denote recessions
My second employment recession indicator often bottoms either one month before or after a recession ends, but has had several examples of bottoming 4-7 months ahead of a recession’s conclusion. Like the first indicator, the second employment recession indicator fell deep into negatively territory though it is on the verge of turning positive as the employment front has improved and is stabilizing. While the number of job losses is moderating, outright job gains will likely be anemic for some time given the excess supply of labor currently and the ability of companies to move employees from part-time to full-time employment rather than hire new workers.
Note: Grey bars denote recessions
One indicator that I have presented often is the composite of the manufacturing and non-manufacturing ISM employment indexes which has a strong correlation to overall employment with a six-month lead time. The ISM employment composite is forecasting a sharp moderation in job losses like we saw with last Friday’s employment report. Also suggestive of a moderation in employment losses is temporary employment that has improved markedly and leads overall employment levels.
Source: ISM, BLS
Source: BLS
In addition to an improving employment condition is that we may be at a turning point in terms of credit conditions as the delinquency rates on various forms of credit appear to have peaked. What is also encouraging, though painful for the economy at large, is to see the US consumer has finally come to terms with its own balance sheet leverage as credit growth is contracting at 5% year-over-year (YOY) with all forms of credit contracting as consumers reduce their debt burdens. This will be a long process as debt levels relative to incomes remains elevated, at least the trend is moving in the right direction.
Source: Equifax and Moody's Economy.com
Source: Equifax and Moody's Economy.com
With an improving economy and easy YOY comparisons for corporate profits over the next two quarters and ultra low interest rates, it’s hard to get overly bearish on the stock market. Often at times the credit markets will give a warning of a coming market top and as it now stands the credit markets remain in check and do not appear to be warning of a coming market top like they did in 2000 and 2007. For example, BAA corporate bond spreads remain flat as are BAA-AAA corporate spreads, in stark contrast to 2007 when both began to rise (inverted in chart below). Given a lack of red flags in the credit markets it is likely premature to call for an end to the current cyclical bull market.
Additionally, the type of internal degradation one sees at a market top appears to be lacking as the percentage of NYSE new lows is virtually silent, unlike the experience at the 2007 top. There is a divergence between the recent high in the S&P 500 and the percentage of NYSE new highs, but given the absence of a rise in NYSE new lows the divergence likely reflects a consolidation/correction is likely rather than a major market top.
As seen below, at the 2007 market top we saw heading into the July 2007 correction that the percentage of NYSE new highs was diverging with price AND the percentage of NYSE new lows were expanding so that both the percentage of NYSE new lows and new highs were north of 2.5% reflecting an unhealthy market with weak internals. As it now stands, only 1/10 of 1% of NYSE issues are trading at new lows and not warning of an imminent top.
In tying in today’s theme of staying humble and objective and commenting on the technical picture is commentary from market technician Carl Swenlin who revised his cycle work based on market action, with an excerpt below (emphasis added):
EXPECTING UPSIDE BREAKOUT
In fact, the market is consolidating during a time when I had expected it to be declining into the 20-Week Cycle low. Because of this I have had to reconsider my cycle assessment: It appears that the 20-Week Cycle low occurred on November 1, about three weeks ahead of schedule. Early or late arrival is a frequent occurrence, but not something we can know until after the fact. All we can do is adjust accordingly. At this point, I think a new 20-Week Cycle began on November 1. The next major cycle-related correction low is projected for April 10, 2010 when the 9-Month Cycle is due to bottom…
Next is a monthly chart of the S&P 500, and it contains some very bullish evidence. The monthly PMO (Price Momentum Oscillator) is rising off a very oversold reading (lowest since 1932), and it has crossed up through its 10-month moving average. There are only four other deeply oversold PMO bottoms since 1929, and all were associated with new bull markets. Four data points in 90 years is a thoroughly inadequate statistical base from which to draw conclusions, but, understanding how the PMO works, I think the bull market is likely to continue for at least a year and could easily challenge previous all-time highs. Be advised, however, the positive long-term picture does not eliminate the possibility of substantial corrections along the way, but a smoothly rising monthly PMO presents a solidly positive long-term technical picture.
To support Mr. Swenlin’s thoughts that the bull market may continue into next year is an analog to the Japanese experience in which the S&P 500 and the NASDAQ are compared to the Japanese secular bear market by overlapping the 2000 US market secular bull market top with the Japanese 1989 secular bull market top. Even in the context of a secular bear market in stocks it is conceivable that the rally could continue for a bit longer as the NASDAQ and S&P are following a similar path to the Nikkei 225 Index which suggests a top in the second half of 2010 and a renewed leg down to a secular bear market low in 2014.
Note: Price are deflated by their respective CPIs
Some may have a hard time understanding how the stock market could rally in the face of high and persistent unemployment and against a back drop of significant credit deleveraging, but there is a precedent. During the Great Depression stocks rose significantly during the 1930s even though unemployment remained stubbornly high and debt levels were reduced significantly. What appears to be an important point to focus on is monetary policy. There is a lag between monetary policy and stock prices and so monitoring the growth in the monetary base will prove quite insightful.
Many don’t understand how the stock market rallied more than 60% off the March lows even while the economy was shedding half a million jobs a month and consumers treated credit like the plague. Many analysts expected stock prices to fall to new lows (yours included) as the deleveraging theme played out, but what the Fed wants the Fed gets, and the Fed wanted reflation in assets. Comparing the Great Depression to the Great Recession (which is what the current experience is being called) shows how monetary policy affects stock prices.
There was a 19 month lag between when the Fed aggressively expanded the monetary base before stock prices bottomed during the first part of the Great Depression. The 1930s stock market gained steam and only topped in 1937, roughly a year after the Fed began to ease on monetary policy. This time around the Fed was much more aggressive, so much so the Fed expanded the monetary base by more than a 100% YOY rate, which explains why stock prices bottomed in only 10 months after the Fed’s action. Given the fact that the YOY rate of monetary expansion is still in the high double-digits it is conceivable the stock market could continue to rally in the months ahead.
Data Source: Bloomberg, Moody’s
While the stock market and the economy have stabilized this year there will be a price to pay for that stabilization from monetary and fiscal stimulus, and we may already being seeing the early signs of this as credit default swaps on sovereign debt issues begin to rise and credit agencies lower government debt ratings. We will have to pay for the sins of the past (over indebtedness) but the path of that payment is uncertain. We could have a deflationary spiral as some prominent writers suggest, or faced with a hard decision our politicians may take the more politically expedient route and attempt to inflate the debt away, but with either method their will be a price to pay despite how much money our government spends as our problems can not be papered away. This was the conclusion that FDR’s Secretary of the Treasury, Henry Morgenthau came to in 1939 after initially being a proponent in massive fiscal stimulus to cure the depression and employment. His comments are provided below:
We have tried spending money…We are spending more than we have ever spent before and it does not work. I say after eight years of this administration, we have just as much unemployment as when we started… And an enormous debt to boot!
Next year will likely continue the same theme as this year, which is the ongoing battle between deflationary and reflationary forces. While the economy is improving, much of the improvement is likely priced into the stock market. But as Keynes said, "The stock market can stay irrational longer than you can stay solvent," and so picking a market top is likely to prove quite difficult. Thus, being humble and open-minded by listening to the various messages of the markets will likely prove beneficial in determining when to turn from the bull to the bear camp.
