An Extended Game of Hot Potato

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The period since 2010 has been largely characterized by a fragile underlying global economy coupled with a persistently overvalued stock market (though to varying degrees). We've seen little during this period but the effect of a hot potato being repeatedly passed from speculatively overvalued, overbought, overbullish market conditions driven by massive central bank interventions, to credit strains and emerging economic weakness nearly the instant those interventions are even temporarily suspended. As a result, by turns we've seen the repeated emergence of the same speculative "Aunt Minnies" that have historically accompanied major and intermediate market peaks, followed by the emergence of credit strains, economic pressures, and a flight to safe-havens.

The alternation is certainly not typical of market history. Nor is it typical of a complete market cycle or business cycle. As unsatisfactory as it may be, the market is presently in an extended game of hot potato which will be resolved by the eventual removal of both conditions.

When I was in college, I bought a stick-shift hatchback wagon that I used for years to haul equipment as the guitarist and lead singer for a rock band (the gig earnings went to buy time on the mainframe at Northwestern's Vogelback computing center so I could run investment research). If you've ever been a beginner driving a stick, you know that if you don't release the clutch just right, the car goes nowhere and then suddenly jolts forward once the gear engages. My impression is that this is largely what we're seeing in the economy. Each time underlying credit strains emerge, demand backs off as consumers and businesses become averse to spending. Then, each time central banks launch some massive new intervention, there is a jolt of pent-up demand that is interpreted as sustainable growth. This was the result when the Fed launched QE2, and we're seeing a replay as the ECB provides enormous loans to banks in return for "collateral" in the form of newly-created, unlisted bonds that European banks have simply issued to themselves.

But what if we are not, in fact, facing further economic weakness, and are instead on course for recovery? What indicators should we monitor, and how would our investment position change?

On the indicator front, as I noted last week, we use dozens of economic indicators and discriminators in practice, but a good, simple rule of thumb to gauge recession risk is to use the combination of the OECD leading indices for the US and total world, combined with the ECRI weekly leading index (WLI). The latest readings from the OECD come out this week. Given that the WLI is still negative, an upturn in both OECD measures - to about +2 on each - would help to relieve our economic concerns.

[Geek's Note: We use standardized values of the growth rates for all of these measures: WLI mean 2.2, std 7.6, OECD_US mean 2.8, std 5.1, OECD_W mean 2.8, std 4.3. Standardized values below -0.5 on all three of these are nearly always associated with recessions (and always when the average of the three is less than -1). A subsequent move above a standardized value of about -0.2 in at least two of these three has quickly marked new expansions in the past. The corresponding level to monitor on each of the unstandardized indices, of course, is mean - 0.2*std, which translates to levels of about 0.7 on the WLI, 1.8 on the OECD US leading indicator, and 1.9 on the OECD total world index. Again, this is a rule of thumb, but it has a good record for a three-indicator model. The index symbols for Bloomberg users are: ECRWGROW, OLE3US, and OLE3TOTA, which can be examined alongside USRINDEX, which is a binary recession flag].

Late update (2/13/12 10:45AM) Newly released figures from the OECD: OLE3US +0.465% (-0.46 standardized), OLE3TOTA -2.076% (-1.13 standardized). The current WLI growth rate is -4.30% (-0.86 standardized).

However, it bears repeating that even if we zero out our economic concerns (and the associated warning indicators in our ensembles) we still obtain very unfavorable expected return and risk estimates for the stock market here. This is because we presently observe a number of historically hostile syndromes that are almost uniquely associated with losses - not always immediately, but almost always large enough to make any intervening gains purely temporary. The stock market may very well enjoy a further advance from here. The likelihood of those gains being durable, however, is quite small.

We've heard a few objections that our concerns about market risk are inconsistent with the continued downtrend that we observe in new claims for unemployment. On that note, it's true that there are a few useful indicators that can be derived from new claims data. For example, the stock market often suffers when new claims rise above their 5-year average, from being previously below that level. But even in those cases, the stock market has usually been falling already, because stocks are short-leading and new claims are at best coincident with the economy. So rising unemployment claims are a "bearish continuation" signal, but should not be expected to provide early warning. More generally, the trend of new claims actually has very little to do with oncoming market action.

A particularly instructive instance is 1987. The chart below shows the 4-week average of new claims for unemployment that year. Notably, the persistent downtrend in new unemployment claims provided no barrier at all to the October 1987 crash. I've chosen this particular counterexample because we presently observe the same unusually overextended market conditions that characterized the 1987 peak. These include an overvalued, overbought, overbullish syndrome, which has become increasingly familiar near both major and intermediate market highs in recent years, including the peaks we saw in 2007, 2010 and 2011. The 1987 peak also featured the same "exhaustion syndrome" I discussed a few weeks ago in Goat Rodeo (basically a recent "whipsaw trap" syndrome coupled with falling earnings yields).

october 1987 crash

If you spend any time at all with historical data, you'll find a multitude of nearly equivalent ways to define an exhausted advance, and the average outcomes are almost always uncomfortable. When these conditions are coupled with any upward interest rate pressure at all, whether from corporate, Treasury bond, or T-bill yields, the outcomes are almost uniformly hostile.

As one of many ways to define "overvalued, overbought, overbullish, rising yield" conditions, consider the points in history when the S&P 500 was at a "Shiller" multiple of over 19 times 10-year inflation-adjusted earnings, the index was at least 8% over its 89-week moving average, within 2% of a 3-year high, with Investors Intelligence sentiment over 45% bulls, less than 30% bears, or both, and with at least one yield measure above its level of 26-weeks earlier (corporate, Treasury bond, or T-bill). This set of conditions produces a cluster restricted to about 8% of market history, and also self-selects for many of the worst times an investor could have chosen to buy stocks, based on the depth of the market's decline within the following 18 months.

While the criteria above are loose enough to include several false signals, the periods also include late-1961 (-25%), early-1966 (-20%), late-1968 (-30%), late-1972 (-30%, and a nearly -50% loss extending beyond that 18 month window), mid-1987 (-33%), mid-1998 (-12% over the next 13 weeks), mid-2000 (-35%, and a loss of more than 50% beyond that 18 month window), and mid-2007 (-55%).

We'd never recommend this as an actual investment strategy, but it's informative that even if an investor had simply avoided the market for a full 18-month period after every emergence of the foregoing set of conditions (including every false signal, and entirely regardless of what else happened over the next 18 months), that strategy would still have captured cumulative returns about 70% higher than a buy-and-hold since 1963, with periodic losses only about half as deep as a buy-and-hold approach. Again, we'd never recommend this in practice, but it underscores that although the market may move even higher over the near term, investors have achieved nothing durable from investing in overextended conditions like those we presently observe. On average, very weak market outcomes have followed for an extended period of time.

There are tighter ways to define conditions that exclude false signals but also miss some major declines (see A Who's Who of Awful Times to Invest and Extreme Conditions and Typical Outcomes), and looser ways to define conditions that capture even more historical plunges, but also invite more false signals. Regardless, the benefit of avoiding the major plunges nearly always swamps the cost of the occasional false signals.

The S&P 500 has lost more than half of its value on two separate occasions since 2000, and the value of avoiding major losses in a decline generally offsets missed gains very quickly (a 20% loss wipes out a 25% gain, a 30% loss wipes out a 43% gain, a 40% loss wipes out a 67% gain, and a 50% loss wipes out a 100% gain). My argument is certainly not that stocks will decline immediately, nor that they cannot advance further from present levels. Rather, the point is that even if such an advance emerges, the likelihood of those gains being retained by investors over the course of the full market cycle is exceedingly small.

This cycle of hot potato will end, and we will have opportunities to accept moderate or even significant amounts of risk, with proportionately high expected returns. As recession uncertainties resolve, and we observe a normal ebb-and-flow of investor sentiment and short-term price movement, I expect that we'll observe at least some of these opportunities in the months ahead. A major positive shift in our investment stance would most probably accompany a significant improvement in valuations, confirmed by improving market internals (a sequence that is characteristic of early bull market advances). With the market presently at (normalized) valuations that are associated with poor long-term prospective returns, with short-term conditions overbought and overbullish, and with intermediate-term conditions characterized by an exhaustion syndrome that has historically produced disproportionately weak returns over the next few quarters, I do not believe that we are faced with such an opportunity here. This will change, and we will respond accordingly.

Meanwhile, it's worth repeating that most bear markets wipe out more than half of the gains achieved during the prior bull market. There is very little chance, in my view, that gains from present levels will be retained by investors over the completion of the current cycle. There is equally little chance that investors who are willing to accept significant risk now will be prompted to reduce their risk later, until they encounter a market decline that is - by then - nearly impossible to act upon. Have we not seen this movie before?

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