With the markets up more than 20% off the early March lows, it’s hard not to get overly excited, but investors always need to keep their emotions grounded. While many of the fundamental and technical indicators I follow are far more constructive than they were heading into this year, suggesting the market is showing signs of “A” bottom, I still believe that those who jump head long into this market may find that the water is far shallower than they think. Just as easily as the tide of momentum flows in and raises the water levels it can easily flow out just after investors have already jumped in, causing considerable pain. I believe every investor needs to hammer into their heads, tape to their computer monitors, and post on their office walls two things: one a phrase and another, an image. These two things will go a long way in helping investors not to lose focus. The phrase is the title to this article, “This will be a process, not an event,” and the image below comes from an article in Barron’s of an interview with Ray Dalio from Bridgewater Associates. An excerpt from the Barron’s article is given below (emphasis added).
Recession? No, It's a D-process, and It Will Be Long
Let's call it a "D-process," which is different than a recession, and the only reason that people really don't understand this process is because it happens rarely. Everybody should, at this point, try to understand the depression process by reading about the Great Depression or the Latin American debt crisis or the Japanese experience so that it becomes part of their frame of reference. Most people didn't live through any of those experiences, and what they have gotten used to is the recession dynamic, and so they are quick to presume the recession dynamic. It is very clear to me that we are in a D-process…
The D-process is a disease of sorts that is going to run its course.
When I first started seeing the D-process and describing it, it was before it actually started to play out this way. But now you can ask yourself, OK, when was the last time bank stocks went down so much? When was the last time the balance sheet of the Federal Reserve, or any central bank, exploded like it has? When was the last time interest rates went to zero, essentially, making monetary policy as we know it ineffective? When was the last time we had deflation?
The answers to those questions all point to times other than the U.S. post-World War II experience. This was the dynamic that occurred in Japan in the '90s, that occurred in Latin America in the '80s, and that occurred in the Great Depression in the '30s…
What took place from the bursting of the stock market in 1929 to the onset of WW II was a long and arduous deleveraging process in which debt levels relative to incomes were reduced. The deleveraging cycle was not a single event but more than a decade long process. As such, the stock market remained in a secular bear market until balance sheets stabilized to levels that were healthy enough for them to expand once more. It was at this point the secular bear market in stocks was over and a new secular bull market began. However, during the long secular bear market were several cyclical bull markets that lasted several months to years with impressive returns, but these cyclical bulls were not enough to overcome the secular bear brought on by the deleveraging cycle. You can see this in the figure below of the S&P 500 from 1936 to 1945 compared with the image above, where the S&P 500 peaked (1937) a few years after the peak in household debt service levels (~ 1932) and bottomed roughly in line with debt service levels early in the next decade (1942-1945).
Source: Bloomberg
In addition to the debt service levels of the household sector we can see the dynamic of other relationships that become over extended at the ends of secular bull markets and subsequently take years to return to normal levels. One relationship that is helpful in terms of gauging deleveraging processes is the ratio of the stock market capitalization relative to the size of the economy (nominal GDP). Prior secular bull market tops were associated with the market capitalization of stocks roughly 70%-80% of the size of GDP, with secular bull markets beginning in the range of 20%-30%. Take notice that even while the S&P 500 has fallen more than 50% from its 2007 peak that the ratio of market capitalization to nominal GDP rests at levels north of the 1937 market peak and roughly in-line with the 1968 secular bull market peak, absolutely nowhere close to levels associated with secular bull markets beginnings.
Source: The Chart Store, Weekly Chart Blog (03/20/2009)
With a slightly different measure we can see a similar concept, this time using margin debt relative to the Dow Jones Industrial Average (INDU). The average margin debt level relative to the Dow is roughly 14%, though the trend in the ratio is clearly upwards sloping, with current levels resting at the upward trend (dashed red line). A decline to the long term average of 14% roughly coincides with one standard deviation below the trend (lower solid red line). The lower trend line lays roughly 30% below the trend, a level that marked the bottom in the market in 1975, the 1991 market trough, as well as the 2002/2003 market bottom. As the charts below show, we are still roughly only half way through the deleveraging process and while we may have seen this bear market's conclusion (which I doubt), it is far too premature to call an end to the current secular bear market that began in 2000.
Source: Bloomberg Hat Tip: The Chart Store
Source: Bloomberg Hat Tip: The Chart Store
The deleveraging process is alive and well in terms of delinquency rates of various assets, from residential real estate to credit cards. Residential real estate 60 day+ delinquency rates continue to rise from subprime to prime mortgages, with subprime delinquency rates resting at 33.94% and prime delinquency rates venturing into double digit territory at 11.22%. As the deleveraging process picks up steam we are seeing a spike in credit card delinquency rates. While Citigroup’s CEO Vikram Pandit helped spark a rally with the mention that the bank was seeing profits in the first quarter, he didn’t mention the dramatic spike in Citigroup’s credit card delinquency rates (pink line below). While credit card delinquency rates for other issuers may not show quite the dramatic spike that Citigroup does, the image below makes it abundantly clear that not only have delinquency rates not peaked, but they are actually accelerating as consumer balance sheets deteriorate amidst dramatic job losses. Comments on the trends in mortgage and credit card delinquency rates from the CEO of FICO in a CNBC interview make clear the point that we are not out of the woods yet and we should not become too caviler.
Before we do the credit cards, we are actually not done with the mortgage [crisis] - the worst of that is yet to come in fact. The thing about mortgages is you can predict when they are going to reset and you can sort of see what is coming. We easily have another 12 to 18 months of pretty ugly times in terms of mortgage resetting. ... Credit cards are next.
FICO (formerly Fair Isaac) CEO and Michael Porter, CNBC
Source: Bloomberg
Another key element that leads me from becoming too bullish in believing that the current bear market is over is corporate profits. The material presented below is a brief update from the work I did in two articles last year, “The Worst Is Yet to Come (08/27/08)” and “On the Road to Recovery? (11/12/08).” Corporate profits exploded to dramatic levels in the last bull market, benefiting to a great degree on a global economic boom as well as cheaper labor costs from overseas. However, corporate profits are strongly mean reverting (tend to revert to long-term average) and we can see in the figure below that corporate profits are more than 20% above normalized levels and 40% above bear market trough levels. With corporate earnings still likely to contract significantly investors may be mislead by current low price-to-earnings (PE ratio) levels, where the denominator in the equation is likely to decline much further, driving up PE valuation multiples.
Source: BEA
Source: BEA
What is likely to drive corporate profits further south stems from the consumer that has been shell-shocked into saving and has begun the deleveraging process. A retrenching consumer that is weighing on corporate profits as consumers cut back on spending and increase savings only tells part of the story. While reducing one’s spending habits will cut into corporate profits, think how much more severe is the affect on the spending habits of consumers who have lost their jobs and incomes, using unemployment benefits to pay for necessities, not wants. These trends and their relationships to corporate profits can be seen in the figures below. The log of corporate profits closely follows consumption levels relative to disposable personal income (DPI) with a lag of several months, and with consumption levels relative to income in a sharp decline we can expect corporate profits to deteriorate in the coming quarters.
Source: BEA, Federal Reserve Board
Source: BEA, Federal Reserve Board
As stated above, in addition to the negative effect that rising savings rate and falling consumption levels have on corporate profits is the relationship of employment levels and corporate profits as the two series are highly correlated as seen in the figure below. With job losses coming in at more than half a million per month corporate profits are likely to fall to much lower levels. Though the rate of change in the decline may begin to moderate the absolute level of the earnings decline will continue to drive valuation levels higher, likely acting as a headwind to rising stock prices as valuations can become quickly expensive when prices are rising (numerator in the in the PE ratio) and profits are falling (denominator in the PE ratio). “THE” bottom in the markets is likely to take place when the absolute levels of corporate earnings stabilize, and with current levels still 40% above bear market trough levels I am highly suspect of the current rally.
Source: BEA, Federal Reserve Board, BLS
In regard to my suspicions of the current rally, I think it may have come too far too fast. Prior bear market rallies begin to fade as the S&P 500 rises to 5% or more above its 50 day moving average, with yesterday’s close coming in at 5.73% above the 50 day moving average. While the strength behind the current rally must be respected and may drive the S&P 500 eventually back up to January highs of 943.85, or 17% above today’s levels, I would be more inclined to wait for a pull back before putting fresh capital to work.
Source: Bloomberg
I think some consolidation in the short term is due before the market heads higher. If the S&P 500 does manage to make a run at its January highs and 200 day moving average, given the material presented above, I think the market will head south once more as the negative economic fundamentals are too big of a force for the markets to ignore and “V-Spikes” in the markets are rare, with a bottoming process far more common. If the market does rally into the January highs and then heads back down I will be monitoring closely the backdrop to any subsequent rally. Upon another rally I will be looking at the FSO Stress Indexes to breach into positive territory, a development associated with the conclusion to the 1990 and 2000-2002 bear markets. As seen below, currently the FSO Stress Indicator is still below the worst levels seen during the last bear market, with caution and a great deal of skepticism still warranted.
Source: Bloomberg
The greatest improvements in the FSO Stress Index have come from the money market and US Treasury market sub indices, with the bond market and currency markets showing the least improvements since the October panic lows. Further improvements in the various sub indices will help drive the FSO FSI composite indicator to neutral levels.
Source: Bloomberg
Source: Bloomberg
So far the equity stress index is in the worst shape as the volatility index (VIX), a component of the equity index, is still well above normal levels. The VIX should be watched closely to determine the markets next direction as it is bouncing in between the 50 day and 200 day moving averages. A break of either moving average coupled with a trend line break may help to determine the market's short term direction, though the material presented above has me strongly leaning towards a retest of the recent lows at a minimum, whether or not the current rally continues higher and begins to fade.
Source: StockCharts.com
During this highly volatile period it is important not to miss the forest through the trees as volatility plays on the two key investor emotions; fear and greed. I believe that understanding that we are in the midst of a secular deleveraging process that will take place over many years will go a long way in helping investors make smart decisions, such as taking profits after sizable rallies as a buy and hold approach does not work well in secular bear markets that can appear as multi-year trading ranges. We are in a different climate right now than we were in the last twenty years as the secular bull market that began in the early 1980s turned into a secular bear market in 2000. I believe that the secular bear market that began in 2000 will last into the first half of the next decade, with sizable rallies in between now and then. With the markets in a likely declining trend at worst, and a trading range at best, the best advice in this type of climate can best be summarized in the words of Danielle Park, portfolio manager, Venable Park Investment Counsel, in a BNN interview she did last summer (emphasis added).
BNN: The Street (08/21/2008)
Danielle Park, portfolio manager, Venable Park Investment Counsel.
(Click image for video link)
The number one thing people have to get is that we are in a fundamentally different climate now than we were 82-99. And it means you can’t do the same old stuff and expect to do well. You can’t buy always, you can’t hold always. You have to have a strategy that exposes you to the expansionary part of each business cycle, and protects your capital when it turns down…
It does appear that the market is in a bottoming process, likely similar to the lengthy pattern that took place between 2002-2003. One important development that took place this month was an increase in risk appetites and stabilization in the currency markets. The unwinding of the Yen carry trade last fall was associated with the market's collapse in September-November. This can be seen when looking at the Euro/Yen cross rate that retraced six years of gains in just over a month! Since then the Euro/Yen cross rate has been in a trading range and the breakout to the upside above 1.30 in the cross rate was associated with Monday’s dramatic advance in the markets. It’s no coincidence that a breakout in a key resistance level in the Euro/Yen was also seen with the S&P 500 breaking above key resistance on Monday. Interesting enough, a similar occurrence took place late in 2002 when the Euro/Yen cross rate broke out of a trading range which was also associated with the market's bottom.
Source: StockCharts.com
Source: StockCharts.com
I am still strongly bearish on the economy but the message from the markets can not be simply dismissed. We could be in for a multi-month rally like we saw last spring that could take us up to the January highs. However, I think we also could easily see a nasty correction back down to the March lows for a retest of the bottom and investor’s will likely want to sidestep such a steep correction. I think three indicators that should be monitored closely for clues to the markets direction are the VIX index (highlighted above), the Euro/Yen cross rate, as well as the relative strength of key cyclicals, which would be the homebuilders, retailers, and consumer discretionary versus consumer staples. So far the S&P Retail Index’s relative strength to the S&P 500 has broken out of its declining trend, with the homebuilders and consumer discretionary versus consumer staples on the verge of breaking out. A break down in the VIX associated with strength in the Euro/Yen cross rate and breakouts in the three relative strength ratios below will be sending a very powerful message to investors, which is that the markets have discounted the worst and are in a bottoming/stabilization period.
Source: StockCharts.com
Overall I believe the bottoming process in the markets has begun, likely with several sharp rallies and sell offs over the remainder of the year, which is why investors should be making up their shopping lists. The bottoming process is likely to continue until investors can begin to see the light at the end of the tunnel, which will probably become clear in the second half of the year, which may see the final low in the markets. Looking at my Stock-Bond ratio does show we are looking to repeat the pattern of 2002-2003 bottom as the bond allocation percentage is showing divergence with the stock-bond ratio currently as it did then. We did break to new a low in March in the ratio which is why I think a retest is still likely, but the divergence in the bond versus stocks allocation percentage is a welcome sign to say the least after last year’s carnage, a welcome sign indeed!
Source: Bloomberg
