In my book, the best long-term market statistician is mutual fund manager John Hussman, whose free weekly column is more valuable than any high-priced newsletter.
Using a century of data, there is a very strong pattern of declines from a simple set of conditions. I’ll let Hussman explain them:
In the chart below, the bars indicate points in the past 20 years where the following conditions were true.
NYSE 52-week highs and lows both greater than 2.5% of total issues traded (composite highs work better than equity-only, because dispersion of interest-sensitive issues is often meaningful);
New highs no greater than twice the number of new lows;
S&P 500 greater than its level of 10-weeks earlier (some versions use the NYSE composite, but our index of interest is generally the SPX, and we are less interested in signals that might occur when the market is already down substantially);
McClellan Oscillator (the 19-day minus the 39-day smoothing of daily advances minus declines on the NYSE) below zero, which is another indication of dispersion;
Two signals within 36 trading sessions, which is helpful for reducing one-off noise.
Ominous? Not necessarily. Worth considering in the context of a much more troubling syndrome of overvalued, overbought, overbullish, rising-yield conditions? Sure.
Furthermore, the extreme in valuation (Shiller PE over 23 on record margins – Shiller PE on normalized margins would be closer to 29) means that regardless of the near-term outcomes, the returns of future years have been cannibalized. Because earnings grow remarkably steadily over the long-term (6% nominal is the average) stock market returns depend overwhelmingly on the price paid for a claim on these earnings. With the brief exception of the mid 1990s, 10-year returns have never been favorable when the S&P500 trades over 20x 10-year average earnings.
Furthermore, the Shiller PE appears to still be correcting from the late-90s bubble. We should welcome this trend, since valuations have in the past overshot to the downside. By the way, the previous examples of seriously undervalued markets all occurred after high inflation during the later years of secular bears (1917-1920, 1940s, 1977-1982).
A Shiller PE of 10 within a few years would fit nicely in this chart, though it would not be a pleasant experience getting there. Today, Shiller earnings are about $70.
The easy money for the shorts has been made. This doesn’t mean that the market is likely to rally, just that we have now enjoyed the portion of the decline that our intermediate-term sell signal in late September and early October all but guaranteed. This in no way rules out further declines immediately ahead, possibly severe. It is just that traders could easily find safer entry points for short-to-intermediate-term short sales, or worse exits.
Stocks remain at historically high valuations, economic headwinds are mounting, and bullish sentiment has been dominant for years, so we are likely at the start of a significant turn.
We finally have the classic syndrome that indicates an intermediate-term top. Upward momentum has stalled, as sentiment has remained elevated for several weeks. The combination of sideways prices on high bullish readings becomes very bearish when it has been sustained for a month or longer.
Here is the RSI and price picture (note declining trend in the momemtum indicator RSI since late August, and its resemblance to the topping pattern last spring):
Charts from Yahoo
A quick glance at sentiment shows sustained optimism:
Looking at the headlines, it is nice to see good news that results in a bump with no follow-through. We saw that in mid-September with QE Infinity, and last Friday with the jobs report. Rallies end on good news and declines end on bad news.
It would not be unusual to see another test of the highs, and for prices to linger at these elevated levels for another month or so, but the odds of a sharp decline are now elevated, and any further gains should be quickly erased.
The global economy is clearly on the downswing, with the US likely having entered a recession this summer (watch for revisions in GDP and employment data in the coming months). However, as in Sept-Oct 2007, the equity market has bounced from a brief oversold interlude to a new high.
Here is the NAAIM survey. This is a relatively new dataset, but it has proved high-correlated with proven sentiment indicators like DSI and Rydex fund activity). The survey is updated each Thursday with data from Wednesday.
Sentiment has been elevated for a month, which is sufficient for a significant decline, though the likelihood of a setback and the expected magnitude thereof grows with each week that it remains elevated. This, coupled with sideways price action for few weeks (we don’t have this yet) and a declining trend in daily RSI (possibly developing) would virtually lock in the case for an intermediate-term top.
EDIT: To clarify, this is not a screaming short-term sell yet, since the market has had a habit of creaping slightly higher over a few weeks from conditions like this. However, things can reverse at any time, and it is highly likely that any further gains will be quickly erased once the turn comes.
The macro picture of deteriorating economic data bolsters the case that a bull market top is near, so if this is an intermediate-term top it could prove to be the final top prior to a bear market. This cyclical bull is now 3.5 years old. This is long in comparison to the cyclical bulls of the 1910s and 1970s secular bear markets (18-36 months was typical), but short in comparison to the last cyclical bull (spring 2003 – fall 2007, 4.5 years).
Mish Shedlock’s investment management company, Sitka Pacific, provided this chart in their September letter (as a non-client, I only get delayed copies):
One lesson to be learned here, which they get into in the letter, is that prices bottom before valuation multiples. In the bears of the 1910s, ’29-early 40s and ’66-82, inflation appeared late in the game. BTW, this meshes with Kondratieff theory, where inflation leads to disinflation to deflation then inflation again, with asset values moving in tandem.
So, be prepared to buy in this coming wave down, if we get a nice drop over the next year or so, because select equities could be a nice hard asset to own through the turmoil in the currency and sovereign debt markets, which is likely to spread to the US, UK, Germany and Japan by later this decade.
This is from his always worthwhile weekly Market Comment (this week he makes an airtight case against taking market risk at this time, with a recession all but guaranteed and no cushion of safety or reasonable expectation of a decent return in stocks or bonds).
I liked his comment about how although his fund has been very conservative and fully-hedged for most of the last several years, this is more a reflection of unfavorable market conditions than some sort of permabear tendency:
The overvaluation, misguided policy, and misallocation of capital that has produced more than a decade of dismal returns for the S&P 500 has also forced us to take a regularly hedged investment stance in response (though we know that the ensemble methods presently in use would have done things differently in several periods, particularly 2009 and early 2010). While our investment approach is by construction risk-managed, it is not by construction hard-defensive or fully-hedged. These are positions that have been thrust on us by conditions that have, predictably, led to a decade of stock market returns far below the historical norm. Though the present menu of prospective investment returns remains unappealing, those conditions can change quickly, particularly in a crisis-prone environment. This is important to mention here, because I strongly expect that we will begin seeing opportunities – probably not immediately but also not in the distant future – to significantly and perhaps sustainably reduce the extent of our hedging.
We emphatically don’t need to wait for the world to solve its problems before being willing to accept risk. What we do need is for those risks to be more appropriately priced in view of those problems. We’re not there by any means, but a significant change in the market’s return/risk profile could come quickly. To quote MIT economist Rudiger Dornbusch (who was a professor to the new head of the ECB, Mario Draghi), “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.”
See this part on how his never-failing set of recession indicators is again flashing red:
Here in the U.S., our broadest models (both ensembles and probit models) continue to imply a probability of oncoming recession near 100%. It’s important to recognize, though, that there is such a uniformity of recession warnings here (in ECRI head Lakshman Achuthan’s words, a “contagion”) that even an unsophisticated, unweighted average of evidence indicates a very high likelihood of recession. The following chart presents an unweighted average of 20 binary (1/0) recession flags we follow (e.g. credit spreads widening versus 6 months earlier, S&P 500 lower than 6 months earlier, PMI below 54, ECRI weekly leading index below -5, consumer confidence more than 20 points below its 12-month average, etc, etc). The black brackets represent official recessions. The simple fact is that we’ve never seen a plurality (>50%) of these measures unfavorable except during or immediately prior to U.S. recessions. Maybe this time is different? We hope so, but we certainly wouldn’t invest on that hope.
Sentiment is still very anti-dollar (though not as extreme as last February-April), but the index is no lower than a few months ago, nor even a few years ago. Despite all of the dollar-crash and hyperinflation hysteria in recent years, early 2008 still marks the bottom.
MACD and RSI also seem to back up the case that the next big move is more likely up than down:
3 year daily chart:
5-year weekly chart:
The 10-year chart says it all: the dollar has already crashed, and as is typical in the financial markets, few noticed or attempted to take action until the move was already over.
A fair degree of complacency has snuck back into markets over the last month. We don’t have a strong sell signal in stocks yet, but if April marked the high in US and European markets and economic indicators are turning down again, this could be a good spot to start building short positions again:
Here’s the equity put:call vs the 20 day moving average, back to one standard deviation under its mean. Dipping lower would require the kind of extreme complacency that we’ve only seen twice in the last decade, so I wouldn’t count on it:
The dollar has also corrected its overbought condition (and is actually very oversold), which is key for a resumption of the deflation trade:
I’ve circled the times we’ve seen a low RSI on the daily chart make a double dip into oversold territory. Each instance was followed by a rally, both in the bear phase of 2008 and the bull phase of 2009-2010: