Clear the Mechanism

There was a scene in the movie, "For Love Of The Game," where Billy Chapel (played by Kevin Costner) plays his last game as a professional baseball pitcher. As he steps to the mound he is bombarded by his environment (the fans, the players, the field, the smells, the lights, etc.) and soaks it all in. From there he focuses in on his catcher and the distance between him and the plate. At that time he tells himself to “clear the mechanism”, and one by one each distraction is removed. The noise of the roaring fans is silenced, their faces blur, and all that remains is his opponent in front of him as his eyes zero in on the catcher’s glove. This process of removing the distractions all around him allows him to focus on the task at hand and clear his mind.

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Similarly, investors are bombarded by distractions from every day noise from financial television, newspapers, and newsletter writers, and knowing what the right course of action is can be confusing at times as the bulls and bears rage against each other and emotions run high. At times like this it can be quite helpful to “clear the mechanism” and remove emotions from one’s decision making.

Taking a step back and looking at the big picture makes it clear that we are still within the confines of a secular bear market that began in 2000, while we are currently undergoing a second cyclical bull market that began in March of this year. The current secular bear market is the fourth one since the early 1900s and has so far been comparable in terms of magnitude, though not duration. The prior three secular bear markets lasted on average 191 months, or nearly 16 years, and witnessed an average decline of 68.60%. The current secular bear market is 108 months old, just over half the average life a secular bear market, though it witnessed a 65.54% decline from the 2000 top to the March 2009 low.

Source: Ron Griess, The Chart Store, Inc.
Taken From: Market Observations (11/03/2009)

While the current secular bear market has reached a decline comparable to the prior examples its duration has been much shorter. Given the relatively young age of the current secular bear market the current cyclical bull market is not likely the start of a new secular bull market as we are likely to remain within the confines of a secular bear market into the next decade (how’s that for a tongue twister?). Supporting the notion that the current secular bear market will continue into the next decade is the ongoing deleveraging in the private sector. A hallmark of secular bull markets is a leveraging up of private sector balance sheets while secular bear markets witness either flat or declining leverage as consumers pair back their debt levels.

You can see this dynamic below when looking at the ratio of household liabilities as a percentage of disposable personal income (leverage) versus the S&P 500 deflated by the CPI (real stock prices). The secular bear market in the 1970s saw the financial leverage of households remain relatively flat while the great 1980-2000 secular bull market witnessed unprecedented leveraging of household balance sheets. An anomaly in the current secular bear market that began in 2000 was the delayed deleveraging in the private sector that began nearly 10 years later. This was no doubt in thanks to the market manipulation by former Fed Chairman Alan Greenspan who fostered a housing bubble with ultra-low interest rates and slack oversight of the mortgage industry lending standards.

Source: Federal Reserve, Standard & Poor’s, BLS

While Mr. Greenspan could entice consumers and businesses to take on more debt to reflate the economy towards economic growth, current Chairman Mr. Bernanke is not having the same level of success as consumers are finally reconciling their elevated debt levels. The current environment is witnessing several firsts, such as the first time in more than a half century that the household sector is showing a negative growth rate in debt growth. This is in concert with corporations also reducing debt, another first as both sectors of the economy have never both delevered at the same time.

Source: Federal Reserve

If we are still within the confines of a secular bear market, at which point should investors be concerned that the current cyclical bull market will end and practice some risk management by reducing exposure to stocks? This is an important question investors need to ask themselves as a buy-and-hold strategy has been shown to be a losing proposition during secular bear markets. When should the focus shift from capital appreciation (the return ON capital) to capital preservation (the return OF capital)?

Risk Management: Clearing the Mechanism

This then brings the discussion back to the point of this article in which investors are faced with both bulls and bears defending their positions and it can be tazing to ones emotional capital to determine when to begin taking some chips off the table and prepare for another possible cyclical bear market. At times like this using simple risk strategies that are based on the market’s price action and devoid of emotion can help one “clear the mechanism.” Today’s article is a perfect bookend to the year in which the first article written this year dealt with risk management (Priority #1: Risk Management). In that article four risk management indicators were discussed with examples given for how they performed in secular bear and bull markets.

These four indicators were combined into an overall risk model that simply allocates capital between stocks (S&P 500) and bonds (10-Yr UST’s) based on how many indicators are giving buy and sell signals. If all four indicators were on sell signals the model would allocate 100% of capital to bonds while it would allocate 100% to stocks (S&P 500) if all four indicators were on buy signals. This system works well in scaling one into and out of the stock market as it is not based on a single indicator.

For example, the first sell signal was given in September of 2007 and the fourth sell signal was given in February of 2008, so that by February of 2008 the model was 100% invested in bonds and 0% invested in the S&P 500. The model is slow to give buy signals with a “V”-spike bottom as several of the indicators are based on momentum, and so the first buy signal this year was seen in the middle of June while the third buy signal was given in early October. So far the model still has one indicator on a sell signal (The PFS Group US Financial Stress Index) and so it is 75% weighted in the S&P 500 and 25% weighted towards 10-Yr UST bonds.

Looking at how the model performed over the last 19 years shows how utilizing a risk management system can potentially improve market returns by avoiding the pain of being 100% invested in stocks through the duration of bear markets. The benefit of such a system can be seen below when comparing the portfolio values over time of 0K invested in the model, bonds only, and the S&P 500 only, with an initial investment in January of 1990 in each. What the model demonstrates is the importance of risk management in investment decisions rather than a pure buy-and-hold strategy.

Looking at all four indicators in terms of their proximity to sell and buy signals shows that there is presently no major alarm to call for significant defensive positioning. The three indicators that are currently on buy signals shows that they are not at risk of reversing as they are moving further away from their signal lines and the last sell signal (The PFS Group US Financial Stress Index) is on the verge of generating a buy signal. The PFS Group US Financial Stress Index is the most complex indicator of the group as it is a composite that measures the stress of the money market, bond market, stock market, Treasury market, and currency market. A description of the indictor is given below:

The indicator is based on a measure created by Bloomberg that was a stress index composite of the money market, bond market, and stock market. I made several modifications and also added stress indexes for the US Treasury market as well as currency markets so that my stress index reflects most major financial markets.

The Stress Index reached record oversold conditions in October of 2008 and has since improved significantly as four of the five individual market components are in positive territory, with the currency component being the only stress component that is still negative as currency volatility remains elevated. The overall Stress Index and its component readings from the record lows seen last fall and its current readings can be seen below.

As the overall trend in the four risk management indicators is towards improvement rather than deterioration, it is perhaps too soon to become overly bearish on the stock market. What should be emphasized is the indicators are predominantly based on momentum and thus require market deterioration to occur before they generate sell signals, and thus do not call absolute tops and bottoms.

While the risk indicators have a general bullish tone to them there is no questioning that the market is still overextended when compared to key moving averages such as the 200 day moving average (200d MA), and is thus susceptible to a market correction. Even during the strong cyclical bull market that occurred after the devastating 1974 bear market, the S&P 500 underwent nearly a 15% correction back down to its 200d MA in 1975 as it worked off its overbought condition before moving higher. We could have a similar episode in which it would take a nearly 13% correction to bring the S&P 500 back down to its rising 200d MA and still give a bullish tone to the market as the rising 200d MA indicates the market trend is still up.

Ignoring market commentary and opinions and listening to the simple message of the four risk indicators highlighted in the beginning of the year (Priority #1: Risk Management) shows that the market message is still bullish as three out of the four indicators are still flashing buy signals and the fourth signal is close to giving its own buy signal. “Clearing the mechanism” says the bulls still have the upper hand, though the market is presently overbought and may need to correct first before heading higher.

As we are still within the confines of a secular bear market investors need to be on the alert for when the cyclical bull market that began in March of this year may come to an end. The various risk indicators mentioned above will be monitored closely in 2010 to determine the transition from cyclical bull to cyclical bear. Given the monster rally off the March lows it is conceivable that the present cyclical bull market may be in the latter innings, and returns in 2010 are likely to be more difficult to come by -- all the more reason to monitor the market’s health as we head into 2010.

About the Author

Chief Investment Officer
chris [dot] puplava [at] financialsense [dot] com ()