My all-time favorite movie by far has to be Braveheart (1995). My Father and I both saw it several times in the movie theaters and the film went on to win the Academy Award for Best Picture and Best Director. The movie was filmed with many vivid scenes and the one that comes to mind is when the English cavalry were bearing down on William Wallace (Mel Gibson) and his fellow Scots.
The theater would reverberate with the subwoofers as the movie showed the cavalry approaching in slow motion as the hooves would hit the ground. You could feel the tension as the horses drew nearer all the while William Wallace shouts, “HOLD… HOLD… HOLD.” Wallace didn’t want his men to raise their spears too soon for doing so would alert the cavalry of the trap and they would about face to avoid being impaled on the spears. Using the scene as an analogy for investors, the approaching cavalry is the fear of missed opportunity by not being invested. The scene aptly describes what my stance would be on the markets, “HOLD… HOLD… HOLD!”
My gut tells met that we are going to get some kind of economic response from all the mud being thrown at the wall by both the Fed and Treasury; at some point some of the mud is going to stick and the markets will be discounting this months ahead of time. I’d wager that the earliest the recession will end will be late in the third quarter to the end of the fourth quarter, with my gut leaning towards November or December. The S&P 500 bottoms prior to the conclusion of a recession on average of six months and taking the November bottom would imply that the market is anticipating the recession to be over by May which I highly doubt, with a bottom in March to June more likely.
Assuming I’m correct on the current recession ending late in the year, there are two possible outcomes for the stock market that I can see. The first is that the November lows do hold and the markets bottom roughly 12 months prior to the recession ending as it reaches a trough on the early side of prior occurrences. This may indeed be the case when taking into context the amount of stimulus being thrown at the markets and economy, with the markets bottoming earlier than the historical script because of this, with a successful retest of the November lows still possible.
Another scenario that could play out is that investors got ahead of themselves and the bounce off the November lows is nothing more than a simple bear market bounce working off some of the negative momentum before turning down once more. The November lows would be breached and final bottom sometime occurs in the first half of the year, potentially in May or June, which would be six months prior to when I suspect the recession ends.
The best case scenario is the first scenario in which we have indeed bottomed. Putting in a low in early January would lead to a higher low above the November low, and then a move above the January high on the S&P 500 of 943.85 would lead to a higher high, signaling that the trend has changed and the bear market is over. Another case within the first scenario would be a successful retest of the November lows before the market heads higher, and the worst case scenario would be a breach of the November lows, scenario two.
If the best case scenario plays out and investors remain on the sidelines, the only thing to lose is a missed opportunity with investors likely buying in at higher prices once the January highs are breached and confirm that the bear has returned to its cave. If the next best case plays out with a successful retest of the November lows, then sidelined cash will have missed a roughly 15% correction and can buy in at cheaper prices. If the worst case scenario plays out then another bear market (20%+ correction) within this mamma of a bear market would result with it being anyone’s guess where the final low will be, and sidelined cash will be happy it missed the carnage.
LISTENING FOR A SYMPHONY
Beta Still Underperforming
The origin for the English word symphony comes from the Greek word symfonia, which means accord, agreement, unison. One of the definitions for “symphony” provided by Dictionary.com is “anything characterized by a harmonious combination of elements...” What I am looking for is a harmonious agreement in the markets that the trend has indeed changed to signify a bottom is in. A few signals here and there may be nothing more than a bear trap while a wide range of signals all providing the same symphonious message would give greater conviction for a bottom call.
As of yet I do not hear a symphony of market signals as many instruments (markets) are playing to a different tune. One typical sign of a conclusion to a bear market is that early cyclical and high beta sectors begin to outperform the broad market as investors anticipate an economic recovery and become less risk-averse. One way to gauge this development would be to see the information technology sector, financial sector, and consumer discretionary sector outperform the S&P 500, while defensive sectors like health care, utilities, and consumer staples begin to underperform the S&P 500. Below is my Beta Index which is composed of the S&P 500 Financial, Consumer Discretionary, and Information Technology sectors relative to the three S&P 500 defensive sectors.
As you can see below, the Beta Index put in a lower high in October of 2007 relative to its top in July, signifying negative divergence with the market. Since then its trend has accelerated downwards after the May 2008 top (long dashed lines), and then further deterioration was seen after the September 2008 top (short dashed lines). The January 2009 low in the Beta Index marginally breached the low seen last November, showing negative divergence with the S&P 500 as investors remain risk-averse.
Figure 1
Source: Bloomberg
What I am looking for is a replay of the 2002-2003 bottom where the Beta Index (white line) reached a low in October of 2002 and then a higher low in March of 2003 while the S&P 500 (orange line) retested its prior lows, setting up positive divergence (dashed white line) and signaling investors appetite for risk was increasing and that the bear market was near a close.
Figure 2
Source: Bloomberg
Digging beneath the surface shows why my Beta Index isn’t putting in a higher low. The figure below shows where the weakness is coming from in the high beta sectors. The Technology sector put in a higher low during the July 2008 bottom, though the Consumer Discretionary and Financial sectors failed to do so, and so a green light in confirmation was not seen. The picture is improved as now two sectors have put in a higher low. While the S&P 500 has put in a higher low in January (top figure), only the Technology (red) and Consumer Discretionary (blue) sectors are outperforming the S&P 500 as their relative strength (RS) ratios to the S&P 500 have put in a higher low in January. The Financial sector (green) continues to make new lows and so only 2 out of the 3 beta sectors are giving a green light. Better than the July 2008 bottom, though still not 3 for 3.
Figure 3
Source: StockCharts.com
Looking at the RS ratios of the defensive sectors showed the S&P 500 outperforming the Health Care sector at the July bottom as it put in a higher low relative to Health Care, though it put in a lower low relative to Consumer Staples and Utilities, so only 1 out of 3 signaled a bear market bottom. Currently the picture is improved as the S&P 500 has been outperforming both the Utilities and Consumer Staples, but is not outperforming Health Care, so 2 of the 3 sectors are signaling a market bottom. When looking at the collective message of the six market sectors, 2 out of 6 signaled a market bottom at the July 2008 lows, 0 out of 6 at the November lows, and 4 out of 6 are giving a green light currently. It is probably prudent to wait for all six sectors to be signaling the same message as strength in the beta sectors is typical during bear market bounces and may be from short covering and momentum traders.
Figure 4
Source: StockCharts.com
The Achilles heel is the financial sector as that is where the focus currently lies. Financials are getting a dramatic bounce on the news from a possible “Bad Bank” aggregator that will buy the bad assets from the banks. While the rally in financials (using the XLF exchange traded fund (ETF) as a proxy) has been dramatic, we have seen rallies like this before and it will take more to turn the picture bullish. The XLF has struggled with its 50 day moving average as well as 50 on the RSI. Signs that would turn the picture on financials more constructive would be to see a decisive break above the 50d MA, a break above the declining RS ratio, and a shift in the RSI to the bullish overbought zone of 70+. Since the XLF top in early 2007 the RSI has shifted from the bullish 80 to 40 zone to the bearish 60 to 20 zone. Thus, a breach north of 60 into the positive zone would be a shift in momentum into bull market territory. If the XLF fails to achieve those three signals then this is nothing more than a bear market bounce that will likely pull the markets lower.
Figure 5
Source: StockCharts.com
Bond Yields Improving, Looking for a Lower High in Spreads
One of the things that gave me pause from turning more bullish after the November lows was that bond yields were still rising on the lower end of the corporate spectrum, with B-rated bond yields rising as well as their spreads relative to the 10-yr UST. Since the January low, yields on B-rated bonds have come down as have their spreads (both shown inverted below). This is a significant positive to the markets with investors likely discounting the Fed making loans to small businesses, mentioned in its December statement, which would help lessen the strain on the lower end of the corporate bond spectrum.
Figure 6
Source: Bloomberg
While spreads and yields are improving, confirmation is still needed. What would confirm the bottom is in would be for another sell off in the markets with B-rated yields and spreads failing to breach their early January highs (lows in chart above). This was a similar setup to what was seen in the last bear market.
The peak in B-rated bond yields (orange line, inverted below) came in early 2001 and did not breach those levels during the late 2001 sell off, and were marginally lower (higher in chart) in the 2002 sell off, and significantly lower (higher in chart) during the early 2003 sell off, displaying positive divergence with the S&P 500. Spreads (orange line, inverted) on B-rated debt reached a high (low in chart) in early 2001 with a successful retest in the October 2002 sell off, and reached a lower high in early 2003, also displaying positive divergence and signaling a market bottom was in.
Figure 7
Source: Bloomberg
Bonds Outperforming is Negative
One long term signal that works great for getting in and out the markets is an exponential moving average (EMA) system on the stock-bond ratio, using the S&P 500 as a proxy for stocks and the Merrill Lynch 10-Yr U.S. Treasury Futures Total Return Index as a proxy for bonds. When the 20-week EMA (red line) falls below the 40-week EMA (black line) a SELL signal is generated and BUY signal results when it moves above the 40-week EMA. This system kept investors in the S&P 500 for most of the bull market in the 1990s with only one whipsaw seen in 1998, and got investors out at the top in 2000 and into Treasuries. The system avoided the pain of the last bear market with no false buy signals and got investors back into stocks in the middle of 2003. The system gave a sell signal in late 2007 and helped investors avoid the pain seen last year and remains on a sell signal. The timing of the system’s signals for getting in and out of the S&P 500 is seen below which charts both series in Figure 9.
Figure 8
Source: Bloomberg
Figure 9
Source: Bloomberg
While the system gave a whipsaw in 1998 my bond allocation model (which invests solely between stocks and bonds) was flashing a very dramatic red flag as it moved towards a 90%+ bond allocation as stocks were greatly outperforming bonds. After the correction in 1998 my model was allocating only 25% to bonds as it was sniffing an equity rally. Bear market bottoms in the S&P 500 are typically seen when the bond allocation reaches below 25%, which was seen during the March and November lows of last year. The model is currently allocating 35% to bonds (and thus 65% to the S&P 500) and isn’t flashing any red flags (high bond allocation), though the EMA system hasn’t moved to a buy yet, thus advising equity only investors to remain on the sideline.
Figure 10
Source: Bloomberg
Significant Stress in Various Markets Signifies Caution Still Warranted
My FSO U.S. Financial Stress Index (FSI) is still deeply into negative territory as of last Friday and below any of the extreme negative readings seen in the prior bear market, signifying a high risk environment. A move above zero gives the all clear signal and we are far from breaching into positive territory. The FSI was an excellent indicator in separating bear market bounces from the real McCoy in the last bear market as bear market bounces see the FSI typically approach zero before heading back down.
Figure 11
Source: Bloomberg
My FSI is an equal-weighted composite that measures the stress in the bond market, equity market, money market, currency market, and US Treasury market. Below is a bar graph showing the various readings on the stress indexes and composite index at the October 10th panic lows and the readings as of last Friday. As can be seen, the greatest relief has come in the money market with the various facilities created by the Fed to ease the strain in money markets producing the desired effect. Significant improvement has also been seen in the equity stress index as the volatility in the markets has come down since the October/November panics, with similar action seen in the Treasury market. What has only marginally improved is the stress in the bond market, with a decline in yields in the lower rated spectrum of the bond market signaling potential further easing. What has actually worsened is the stress in the currency markets as volatility has increased with violent swings in foreign currency exchange rates.
Figure 12
Source: Bloomberg
The volatility in the currency markets likely reflects the battle going on between continued deleveraging and leveraging (reflation). The Asian currency crisis in 1998 pales in comparison to the current situation as the stress in the currency markets is literally off the charts. What is encouraging is that, while the currency stress index is below its October 10 levels it is above its extreme level of -5.31 seen on October 24th. This has to be taken with a grain of salt as the reading is twice as negative as the reading in 1998.
Figure 13
Source: Bloomberg
Global Economy Deteriorating
The readings for industrial production or net exports outside the U.S. are deteriorating, and doing so at an alarming rate. Even the growth juggernaut China is slowing as seen below that shows confidence slipping and economic growth falling. The global growth picture is going to prove quite dim in 2009, which will remove the positive effect that net exports provided to growth for U.S. GDP in 2008, with GDP surprises in 2009 likely to the downside for this reason along with non-residential real estate investment moving from a tailwind to a headwind.
Figure 14
Source: Bloomberg
Do you feel lucky punk? Well, do ya?
To answer Clint Eastwood’s question in Dirty Harry, I would have to say no, BUT getting there. While many signals have turned bullish I am waiting for the harmonious symphony of various fundamental and technical indicators to get into the same tune to signal a bottom is in. Until then I would be content on missing out on some gains for the sake of avoiding downside risk with sidelined cash, or to put differently, “HOLD…HOLD…HOLD!”
