To end 2009 I penned a piece titled, "2010: A Good Year for the Economy and a Mediocre Year for Stocks?" Essentially, looking towards 2010 my assumption was that the stock market had already priced in much of the economic improvement that is to come in 2010 and would not react as favorably to good economic news releases, a "buy the rumor sell the news" story if you will. The question is, if 2010 will not be an extremely impressive year for the stock market, will it represent a pause in the cyclical bull market that began at the March 2009 lows or a top?
As stated above, my going assumption was to not expect a dynamic year for the stock market even though overall economic growth rates would improve. This is not an uncommon situation as this was exactly the case in the 03/04 and 74/75 experiences. You can see this below when looking at how the S&P behaved after the bottom of the 1974 and 2003 cycles compared to the present case. In the 1974 cycle the S&P 500 corrected roughly 14.3% as it moved back towards its 200 day moving average (200d MA) before heading to a new high. In the 2003 cycle, the S&P 500 underwent a moderate consolidation in which it declined just under 10% over a five month period. The current cycle put in a peak in between the durations of the 1974 cycle and 2003 cycle tops and appears to be undergoing more of a correction like the 1974 example as the January decline is steeper than the sideways movement of the 2004 consolidation.
Figure 1
Source: Bloomberg
The key question for equity investors is not whether we will or will not consolidate/correct, but rather what comes next. Do we exhibit lift off like we did in 1975 and later in 2004 or do we roll over into another cyclical bear market? From an asset allocation standpoint, the outperformance of stocks relative to long-term Treasuries (LT USTs) argues for a bit of caution here as it did in 2004. You can see this below when looking at the year-over-year (YOY) total return for the S&P 500 less the LT UST bond return. We are currently nearing two standard deviations above the mean which has often marked peaks in terms of the stock market’s relative performance to LT USTs, which would argue that bonds are likely to outperform stocks over the course of the next year.
Figure 2
Source: Ned Davis Research
That being said, when taking a look from 30,000 feet a straightforward case can be made for stocks to outperform bonds when taking a multi year investment horizon as the 10-year stock to bond relative performance is at the lowest values seen in more than a half century as stocks are below their secular bull market highs seen in 2000, while LT USTs are just off their secular bull market peak from 2008. The extremely low ratio seen below in the bottom panel suggests that stocks are likely to prove to earn higher returns than bonds over the course of the next few years.
Figure 3
Source: Ned Davis Research
As today’s investor appears to be fixed more on the short-term picture, then Figure 2 above is likely most relevant and stresses a bit of caution until the ratio pulls back like it did in 2004, meaning we may be in store for a further correction/consolidation before an intermediate low is seen perhaps later in the month.
The Guy behind the Guy is You and I
While it may or may not be too soon to say that the stock market will peak this year, what is not too much of a stretch to argue is that the severe headwinds facing the U.S. economy will begin to outweigh the stimulatory cocktail of monetary and fiscal policy at some point, particular as valuations become stretched. We are still within the confines of a secular bear market that began in 2000 and the hallmark of secular bear markets is that the individual cyclical bull/bear markets that comprise them differ in duration than the cyclical bull/bear markets that occur within secular bull markets. To illustrate this point I often refer to the secular bull market in yields from 1954-1981, and the secular bear market in yields (1981-2003) as seen below.
Figure 4
Source: U.S. Board of Governors of the Federal Reserve System
Figure 5
Source: U.S. Board of Governors of the Federal Reserve System
Secular bear markets in stocks are often associated with a period of deleveraging or at least the absence of leveraging. This was the case during the Great Depression (1930s) and the secular bear market of the 1970s (see red arrows below). Conversely, secular bull markets often occur amidst an economy that is taking on leverage (debt) from a healthy starting point (low total debt/GDP), and the increase in debt is associated with an increase in consumption that leads to rising earnings and rising stock prices. A quick view of the chart below STRONGLY argues that we are not near a secular bear market low. If this is the case, then the cyclical bull markets present in our secular bear market are likely to be shorter in duration and magnitude than the cyclical bull markets that occur during secular bull markets. Thus, investors should be on alert for the end of the current cyclical bull market and not become complacent.
Figure 6
Source: Ned Davis Research
As mentioned above, the numerous headwinds facing the U.S. economy are likely to prove too much to bear for the stock market and coupled with rich valuations will eventually pull the market into a new bear market. While both Washington and the public may have had more than enough of bailing out Wall Street, the bailout of Main Street is far from over. Wringing out the excesses of the last bull market is ongoing as the private sector is still deleveraging and banks are still losing money on their loan portfolios. The current deleveraging cycle has pushed the number of unprofitable institutions well above the peak seen in the mid 1980s and we have yet to see a peak in the current cycle, or a peak in the number of failed FDIC commercial banks.
Figure 7
Source: FDIC: Quarterly Banking Profile
Figure 8
Source: FDIC: Quarterly Banking Profile
As the number of failed banks continues to soar with the FDIC insuring those banks' deposits, the Deposit Insurance Fund (DIF) of the FDIC has been steadily falling to the point that the DIF has been completely depleted. The ending fund balance for the DIF was -.243B in Q3 2009 and the FDIC now has a negative reserve ratio of -16%, indicating it has no funds to insure commercial bank deposits. Who will fill the FDIC’s coffer in addition to the fees coming from commercial banks? You and I, that’s who as the U.S. tax payer is ultimately the final backstop to FDIC insured deposits with the FDIC likely to tap the UST for funds to support its takeovers of failed banks. While the FDIC is the guy behind FDIC deposits, the guy behind the guy is you and I, the taxpayer!
Figure 9
Source: FDIC: Quarterly Banking Profile
To make matters worse, not only is the FDIC the next bailout coming, but the Social Security program may have to be bailed out as well as a Washington Post article points out below (emphasis added):
Social Security could be next to need a bailout
Don't look now. But even as the bank bailout is winding down, another huge bailout is starting, this time for the Social Security system.
A report from the Congressional Budget Office shows that for the first time in 25 years, Social Security is taking in less in taxes than it is spending on benefits.
Instead of helping to finance the rest of the government, as it has done for decades, our nation's biggest social program needs help from the Treasury to keep benefit checks from bouncing -- in other words, a taxpayer bailout.
No one has officially announced that Social Security will be cash-negative this year. But you can figure it out for yourself, as I did, by comparing two numbers in the recent federal budget update that the nonpartisan CBO issued last week.
The first number is 0 billion, the interest that Social Security will earn on its trust fund in fiscal 2010 (see page 74 of the CBO report). The second is billion, the overall Social Security surplus for fiscal 2010 (see page 116).
This means that without the interest income, Social Security will be billion in the hole this fiscal year, which ends Sept. 30.
Why disregard the interest? Because as people like me have said repeatedly over the years, the interest, which consists of Treasury IOUs that the Social Security trust fund gets on its holdings of government securities, doesn't provide Social Security with any cash that it can use to pay its bills. The interest is merely an accounting entry with no economic significance.
Going straight to the horses mouth (CBO) shows that the fiscal position for the U.S. is in fact dire over the next ten years, as highlighted by the excerpt below from the CBO’s outlook for 2010-2020 (emphasis added):
Congressional Budget Office
The Budget and Economic Outlook: Fiscal Years 2010 to 2020
Total trust fund surpluses are dominated by those for the Old-Age and Survivors Insurance portion of the Social Security program. Including interest and other intragovernmental payments, CBO estimates a surplus of 0 billion for that fund this year and a cumulative surplus of nearly .5 trillion from 2011 through 2020. The DI program is projected to run annual deficits through the entire projection period. For Social Security as a whole, the estimated surpluses peak at 9 billion in 2015 and decline to 7 billion in 2020. Excluding interest (which accounts for the bulk of the intragovernmental transfer), surpluses for Social Security become deficits of billion in 2010 and 2 billion over the period from 2011 to 2020 (see Figure D-1).
In the absence of legislative action, the Highway Trust Fund, the DI Trust Fund, and the HI Trust Fund will exhaust their balances during the baseline period, CBO projects. The Highway Trust Fund required an infusion from the Treasury’s general fund of billion in 2009. Depending on cash flows, the Highway Trust Fund could again be unable to meet obligations in a timely manner in 2010; CBO estimates that a transfer of several billion dollars could be needed to maintain the balance above the billion that the Department of Transportation suggests as a minimum. Because the rate of unemployment is projected to remain high, CBO estimates that the Unemployment Trust Fund, which received billion from the general fund last year, will require another billion in 2010. That transfer was provided for in the Consolidated Appropriations Act of 2010.
Economic weakness and rising health care costs are projected to cause a continuing decline in the balances of the HI and DI Trust Funds during the baseline period. CBO projects that the HI fund will exhaust its balance in 2016 and the DI fund will be exhausted in 2018. Once balances are exhausted, the programs eventually would be unable to immediately cover their obligations.
You can see in the table below that the net budgetary impact of all the Trust Fund Programs will steadily increase from a 0 billion deficit in 2009 to nearly a trillion dollars by 2020, one major headwind and funding liability for the U.S. economy over the coming decade.
Table 1
Source: Congressional Budget Office
The Budget and Economic Outlook: Fiscal Years 2010 to 2020
There Are No Black Boxes, Just Tool Boxes
While the economic headwinds highlighted above will ultimately weigh on stock prices and contribute to the formation of the next cyclical bear market, the timing is always the difficult part to get right. Perhaps the markets trade sideways for most of the year and then stage an impressive rally heading into 2011, or the markets may slowly be putting in a top and then enter into another bear market as 2011 approaches. Calling tops and bottoms really is a futile process as ones are often only seen after the fact. Many were taken by surprise when they thought the October or November lows of 2008 were THE lows, only to find the S&P 500 undergo a mini bear market by falling more than 20% in the first three months of the year of 2009. Instead of picking THE top or bottom, using simple technical analysis tools can help investors sidestep much of the bear market decline while also not getting out of the market too soon.
Several such indicators were highlighted at the start of last year (Priority #1: Risk Management, 01.07.2009) which readers may want to review, but one simple tool that has worked well during the Great Depression as well as the secular bear market of the 1970s is the weekly 15/40 exponential moving average (EMA) system. Buy signals occur when the 15 EMA crosses above the 40 EMA line and sell signals occur when the 15 EMA crosses below the 40 EMA line. A historical look at how this system performed in two prior secular bear markets is shown below.
Figure 10
Source: Bloomberg
Figure 11
Source: Bloomberg
The system has performed remarkably well in the current secular bear market as it has given no false buy or sell signals since the secular bear market began in 2000. The first sell signal occurred late in October of 2000 and never produced a buy signal during the strong counter-trend rallies that lured many unsuspecting investors back into the market. A buy signal was finally given in May of 2003, not long after the market’s eventual low and the system stayed on a buy signal until registering a sell signal just as 2007 was closing. The 15/40 EMA system remained on a sell signal until registering a new buy signal in August of last year.
Figure 12
Source: StockCharts.com
The system’s greatest short-fall is with “V”-spike bottoms as it tends to turn slower than the market, getting investors back into the market potentially well after a market bottom. However, the system works much better at getting one out of the market near tops as market tops are more of a process than an event like a V-spike bottom. The 15/40 EMA system is still on a buy signal although we may have a key test coming up as the recent correction has turned the 15 EMA signal line down towards the rising 40 EMA signal line as seen in the figure above. Interested readers can recreate the above chart by going to StockCharts.com and then typing in “$SPX” in the symbol box to create a chart of the S&P 500. To create the 15/40 EMA signal you need to change the period to “Weekly” under “Chart Attributes” and under the “Overlays” section you would select “Exp. Mov. Avg” twice and enter in the “Parameters” field 15 and then 40 as shown below.
Figure 13
Once completed you should generate a chart that looks similar to the one below, with the 15 EMA signal line in blue and the 40 EMA signal line in red. The 15 EMA on the S&P 500 is currently at 1092.61 with the 40 EMA currently at 1047.03. The 15 EMA would need to fall roughly 50 points to generate a new sell signal, potentially marking a new cyclical bear market for stocks.
Figure 14
Source: StockCharts.com
As this cyclical bull market matures the reward to risk profile for stocks diminishes. According to Lowry Research Corporation, they believe we are likely in the second phase of the three phase profile for a bull market. The first phase occurs when sellers have been exhausted and buyers are the dominate force in the market, driving stock prices higher. In the second phase sellers begin to emerge along with continued buying interest as market participants begin to take some profits. In this stage selectivity begins to increase as several sectors continue to advance as they are under accumulation (strong buying interest) while other sectors begin to lag behind the market as investors take profits in particular areas of the market. In the final phase of a bull market you have buyers begin to diminish and sellers then take a more prominent role in the market, and eventual selling pressure overwhelms buying power and a market peak forms. If we are in fact in phase two of this bull market then stock picking and sector selection are likely to prove vital roles in outperformance this year. Investors need to be on alert for an eventual market peak, though when this third and final phase of a bull market occurs is anyone’s guess. As highlighted above, using the 15/40 EMA signal may prove useful to help identify when this third phase has occurred.
