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Today's Market WrapUp 11.19.2008 Mon Tue Wed Thu Fri Puplava Archive
Reviewing the economic reports over the last few months and doing various research studies have led me to believe that an economic recovery will not occur until late 2009. With that being the case, the historical script is to see a market recovery occurring roughly five months prior to the end of the recession, putting a likely ending point to this cyclical bear market in late Spring to early Summer. In terms of gauging an economic recovery I turn to the Economic Cycle Research Institute’s (ECRI) Weekly Leading Index (WLI), which confirms that an economic recovery is at least three quarters away (index leads GDP by nine months) as seen in the following chart. Figure 1 In terms of gauging a possible stock market recovery and overall market risk, I turn to a new indicator created by Bloomberg called the Financial Conditions Index (FCI). The indicator measures the health and stability of the money market, bond market, and stock market, and compiles the data into a composite indicator with values corresponding to z-scores, or standard deviations. When the index falls into negative territory it is signaling stress within the three markets and potential stock market weakness. For example, the FCI turned negative in 1998 with the collapse of Long-Term Capital Management (LTCM) and fell to nearly 2.5 standard deviations from its historical average. As the markets recovered so too did the FCI, returning to 0.00 though it never made it into positive territory. The FCI then retreated from neutrality in early 2000 prior to the stock market peak. The index remained in negative territory until the summer of 2003. Figure 2 The Bloomberg FCI is an effective tool for risk management and devising a simple strategy of moving into bonds when the indicator turns negative and into stocks when it turns positive would have generated only three trading decisions in the last 16 years. While one would have missed out on the climatic finish in the stock market last decade using this strategy, it also would have kept one out of the decimating bear market of 2000-2003. The indicator has proven its effectiveness as it remained positive throughout the duration of the last bull market from 2003 to 2007, and turned negative in July of last year just prior to the stock market peak. The index is shown below along side the S&P 500 with its turning points marked by vertical lines. Figure 3 Utilizing the strategy of going long the S&P 500 when the FCI is positive and moving into bonds, using the Pimco Total Return Fund as a bond proxy, when the FCI turns negative would have led to only three trading decisions over the last 16 years and a compound annual growth rate (CAGR) of 9.5%, more than twice the 4.5% return of the S&P 500. Not only would this model portfolio have provided more than twice the return of the S&P 500, it would have done so with nearly half the risk as the standard deviation of monthly returns of the model portfolio was 2.3% compared to 4.3% for the S&P 500. A portfolio that began in 1992 with $100K invested using this strategy would be worth $465K today, while $100K invested in the S&P 500 would be worth $210K. Figure 4 The whole point of the exercise above is to illustrate that it pays to be attentive to risk, as risk management is key to preservation of capital. Last Friday the FCI came in at a reading of -6.81 after touching -10 standard deviations at the October 10th lows. The reading is still quite negative, lower than any point during the last bear market, and indicates that a great deal of stress remains in the various markets. Using the general methodology of Bloomberg’s FCI, I created component indices that measure the health and stability of the money market, bond market, and stock market. As of last Friday, all three markets are still displaying a great deal of stress with a reading of -3.92 for the money market stress index, -2.42 for the bond market stress index, and -10.74 for the equity stress index, and -7.33 for my composite index of all three markets. Figure 5 Figure 6 Figure 7 Figure 8 Until the credit, bond, and stock markets stabilize, capital preservation should remain the top concern for investors. My composite stress index is still quite negative indicating that “THE” bottom is still far off. While the markets are oversold and ripe for a bounce, risk remains elevated and rallies should continue to be used as selling opportunities to reduce risk as the ultimate lows in the market are likely ahead of us, not behind. Chris Puplava Copyright © 2008 All rights reserved.
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