A Market Downturn and the Risk On/Risk Off Trade

From greed to fear

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The following is an excerpt from a communication Jim Puplava sent to his asset management clients on 15 November 2012. —FS Staff

If you can keep your head when all about you / Are losing theirs and blaming it on you; / … If you can think—and not make thoughts your aim, / … Yours is the Earth and everything that's in it…

—"If—," by Rudyard Kipling (1910; written in 1895)

My wife Mary gave me an embossed plaque of Rudyard Kipling's poem "If—" for my 60th birthday. Several of my portfolio managers have the poem hanging on their walls. It is in times like this that the meaning of "If—" resonates the most with me. Volatile markets call for rational thinking in order to make the best decisions regarding the portfolios we manage. What I see moving markets is pure emotion without regard for logic, so we must best keep our wits about us.

There are many crosscurrents in the markets right now and at the top of the list are reactions to worries about the "fiscal cliff." Economists all agree if Washington is unable to resolve this issue the U.S. economy will head into recession next year and unemployment will head back up toward 10% again. This would be an unwelcome outcome and the stock market would most certainly suffer.

Recent responses to a survey of our asset management clients reflect the prominence of these worries with market participants. According to our survey results, our clients are most concerned about (in this order):

  1. Having enough income in retirement
  2. Significant downturn in the stock market
  3. Major breakdown in the financial system
  4. Collapse of the U.S. dollar
  5. The fiscal cliff and its effect on taxes and investments

All of these issues are justifiable concerns. For a few months now I have been discussing retirement income issues in the Lifetime Income series on Financial Sense Newshour, so at present, I'd like to address worries about the markets.

If any or all of the latter four were to transpire each would impact the markets, the banking system, and the bond market in a negative way. A dollar collapse would cause inflation to spiral out of control leading to a spike in interest rates, and a collapse of the U.S. economy.

I don't want to make light of any of these worries. However, in several cases, their occurrence is unlikely. The dollar is more likely to strengthen in the near future, the economy is improving along with unemployment, and, in my opinion, the stock market has a greater probability of heading higher than heading lower.

Crises Become Catalysts

Why do I believe this? Once a crisis gets resolved it then becomes a catalyst for the markets to move higher which is exactly what has happened since 2009.

S&P 500 DAX
Source: Bloomberg

Since the March stock market bottom in 2009 the stock market has climbed a wall of worries from the housing market, Greece and the PIIG countries, another recession, a hard landing in China, the U.S. debt ceiling, Fed QE policy, the elections, to the latest worry du jour: the "fiscal cliff." Yet despite all of these worries the S&P 500 is up 104% since the March 2009 bottom. The German stock market has faired equally as well up 98% from March 2009.

We have been in a strong cyclical bull market since 2009 although you wouldn't believe it judging from investors' and portfolio managers' reactions. Individual investors have steadily sold stocks since 2009 and have been diverting that money into bond funds, an unwise choice discussed by Tom Smith in his recent editorial "Bonds vs. Bond Funds." Portfolio managers have been equally reluctant to invest in the markets, preferring bonds and cash. If it has been a bull market, it has been one without the participation of individual investors or institutional support.

I Think We're in a Cyclical Bull Market, But What If I'm Wrong?

Despite the numerous crises and worries out there we think there is more room for optimism than there is pessimism for the short-to-intermediate-term outcome for both the economy and the markets. Yet, nobody can predict the future with absolute certainty so the question remains: what if I'm wrong and the worst outcome for the markets lies directly ahead of us?

As I explained to my clients in our recent annual investor meeting, our long-held buy-and-hold money management approach changed in the aftermath of 2008-2009. We've been refining our management style over the last several years, and are now following a stricter, and yet more flexible, discipline when it comes to managing money.

We have adapted our management style to today's markets which are characterized by government intervention—both fiscal and monetary—and to the new realities of debt deleveraging.

We use three strategies in making and applying our investment decisions; some apply to our decision to be more in than out of the market and vice versa, and others apply to our decision to be in or out of a specific sector or stock/asset. They are listed below in sequence of application and priority.

  1. Leading economic indicators, both U.S. & global
  2. Technical conditions in the market, market sectors, and individual stocks/assets
  3. Need for hedges, generally partial movements to cash, positions in precious metals, and put options (for our clients' accounts authorized for Level 2 options trading)

Red Flag #1: Indicators Signal Upcoming Economic Downturn

At the top of the list of our analysis tools is a series of economic indicators, both domestic and international. If the leading economic indicators (LEIs)1 begin to roll over and decline it would tell us the economy is slowing down and in danger of heading into recession. We also follow a composite recession indicator which has proven to be very accurate.

Red Flag #2: Technical Indicators Signal Breakdown in Market

If the economy began to weaken we would expect to see the major stock indexes and the stocks we hold start to break down.

If either of these red flags go up, it's time to review portfolios and take action. 

But What if I'm Right and the Market Is Headed Up?

The Economic Indicator Report Card: Right now all of our economic indicators are pointing up, indicating that we should experience stronger economic growth in Q4 of this year. In fact the Conference Board's report on Tuesday of this week states the following, "the U.S. is best positioned to keep the global economy from an acute slowdown in 2013… Given the U.S. consumers' brighter outlook, the U.S. may be in better shape than many of the other mature economies."2

The Technical Indicator Report Card: Right now our technical indicators are diverging from our economic indicators as the tax implications from an Obama victory are triggering a lot of tax selling in anticipation of a rise in the capital gains tax next year. In addition to the tax-related selling there is the issue of the fiscal cliff and all of the negative consequences for the economy and the markets if politicians drive us over the cliff.

It is our opinion that, as the most telegraphed disaster in recent history, the fiscal cliff is probably already discounted by the markets as well.

What about the Fiscal Cliff?

Now that the elections are over the fiscal cliff is all the financial media can talk about. We believe the "fiscal cliff" was always contrived. Like anything the media does, it over-dramatizes events and is always looking in the rearview mirror. We were in this same exact position in 2010 and in 2011. In 2010 we settled the issue on December 6th, 25 days before the tax cliff would hit in 2011. In December 2011, we settled the issue on Thursday, December 22nd, 8 days before the tax cliff would transpire on the last day of the year. Here we are with 14 scheduled days for Congress remaining before we go off the cliff again.

A Deal Is Likely

Our macro view is that a one-year extension of the Bush tax cuts with a firmly scheduled commitment to work out a comprehensive tax overhaul in 2013 is the likely outcome. There may be a loss or capping of some itemized tax deductions and loopholes on upper income Americans that are traded for some spending cuts in the short term. This plan likely will be sold as a "paying down of the deficit" so the public can feel something is getting done and the markets can breathe a sigh of relief. The real battle over tax and entitlement reform is likely to begin next year. Trying to address these issues in a holiday-shortened working month is unrealistic.

There is too much pressure from both business and labor leaders to let this issue go unresolved over the holidays. No party got a mandate from voters so it is time to negotiate, and both parties are under pressure to cut a deal. A failure to compromise—allowing the economy to go over the cliff—would lead to a major voter backlash, not to mention a movement to tar and feather our legislators. Neither party can afford to appear intransigent in their political views on avoiding the cliff.

On the Upside: Good Economic Surprises

In the meantime, the one consistent element on the economic front in the past two quarters is economic surprises. Economists have been consistently underestimating economic markers and overall performance of GDP. While economic uncertainty has declined, Fiscal Cliff fears have skyrocketed. As shown in the graph below, peaks in crisis fears often coincide with market inflection points.

Media contraindicator
Source: Wolfe Trahan & Co, "The Fiscal Cliff, The Economy and The Outlook for Equities", Portfolio Strategy, 12 November 2012, subscription required to view.

In addition, investor fears are also reflected in bets made on the double-short ETF (SDS), which is now at an all-time record; higher today than the market bottom in 2009.

Source: Wolfe Trahan & Co, "The Fiscal Cliff, The Economy and The Outlook for Equities", Portfolio Strategy, 12 November 2012, subscription required to view.

Why We Remain Positive Despite the Fiscal Cliff Worries

Despite today's current laundry list of worries I would like to highlight a number of positive developments.

  1. LEIs turning up with plenty of positive economic surprises
  2. Housing now leading the economy
  3. Consumer confidence at record levels
  4. Unemployment claims falling
  5. Global central banks all in easing mode
  6. ISM New Orders rising
  7. U.S. becoming a major oil producer again
  8. QE$ coming in either December or January

I don't want to spend this entire editorial addressing all of the positive aspects of the U.S. economy. But in summary, most of the leading indicators are pointing to accelerating economic growth into the end of the year. The economic LEIs are now at multi-year highs and global LEIs are continuing to improve. So barring some unexpected event that we can't see at the moment we expect the market to rebound from the recent correction.

Pattern of Resilience

Since the president got reelected the market has pulled back by 5 percent. It is down close to 7 percent from its all-time high reached on September 14th. As shown in the graph of the S&P 500 above it has risen consistently after the resolution of each crisis since 2009. I expect that trend to continue even though we may have further to go on the downside in the short term. Markets never go straight up and it is normal to go through a correction after experiencing a precipitous rise as we did from the May bottom to the September high, which saw the S&P 500 rise 196 points or 15.3%.

Stocks Still Pretty Cheap

As shown in the graph below, the PE (price-to-earnings) multiple for the index has fallen sharply since 2009.

Source: Bloomberg

Stocks aren't as cheap as they were at the market bottom in 2009, but they are also not expensive. The Dow Jones Industrial Index is selling at 12 times earnings with a dividend yield of 2.72 percent. At the market's peak in 2000 the Dow was selling at 27 times earnings. The S&P 500 is selling at 13 times earnings with a dividend yield of 2.3 percent. At the peak of the market the S&P 500 sold for 30 times earnings. Furthermore, the yields of 2.8% for the Dow and 2.3% for the S&P 500 compares favorably to the yield on a 10-year treasury note of 1.58% and 2.7% for a 30-year treasury bond.

Removal of Pre-Election Uncertainty

Now that the political election is over we can remove one more uncertainty that has dominated the US economy and markets for the last year, and attention can move away from headline political issues in favor of economic fundamentals, business strategies and profits, and economic performance. Once that happens, I believe investors will notice that a distinct improvement has taken place as the LEIs are telling us.

Now that the Affordable Care Act is definitively the law of the land, businesses will have to adapt to the new costs and regulations. They will have to get on with hiring and making investment decisions that make financial sense under the new rules and regulatory environment. If they refrain from hiring and making new investments, I believe it will be for business reasons and not political ones.

Electoral clarity will also transform the political calculations in Washington. Neither side got a clear mandate so it will be time to roll up the sleeves and compromise. The destructive motivations are now gone and neither party wants to been seen as obstructionist. The President appears more conciliatory, as do the speaker of the House and the minority leader of the Senate. If he follows second-term trends, the President likely will be more focused on his legacy than on trying to win an election. He introduced universal healthcare and decapitated Al Qaeda, and he can say he pulled us out of the greatest recession since the Great Depression.

However, the President knows he'll need to compromise if he wants to get anything done in his final term. With the LEIs continuing to improve, the job market getting better, the housing market improving, and the financial crisis behind us, the system is gradually starting to improve. Both sides will quickly have to work together and compromise if they want to claim credit for economic growth. Neither side wants to go down as the party that wrecked a nascent recovery. The time for cooperation has arrived.

Keeping Our Heads When All About Us Are Losing Theirs

In summary, we believe there is more room for optimism than pessimism going forward. This may not be the view of the mainstream financial media, or even the view of many of the newsletter writers and financial thinkers you follow. However, I have never known the media to be forward-looking. Instead the media continues to focus on looking at the world through the rearview mirror. At PFS Group, we are not going to be driven by media fears or the emotions of network anchors or by an ideology.

We have a positive view looking forward. However, if we're wrong our indicators will tell us our view is wrong and we will then act accordingly to protect capital for our investors. In this market, all of us need to be aware of the need to continuously monitor the environment, and make adjustments as necessary.

1 See a list of the ten components of The Conference Board Leading Economic Index® for the U.S. at http://www.conference-board.org/data/bcicountry.cfm?cid=1, near bottom of press release.

2 Matthew Walter, "Global Economic Growth Seen Slowing," The Wall Street Journal, 13 November 2012.

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About James J Puplava CFP