Wednesday, February 17, 2016



The current market return/risk profile is within the most negative climate we can identify going back decades. The basis of this classification is fairly straightforward. Historically, once an extended speculative period of extreme overvalued, overbought, overbullish conditions gives way to increasing risk-aversion, as indicated by deterioration in market internals and particularly in the presence of hostile yield trends in the form of widening credit spreads, the stock market has become vulnerable to vertical losses. Though not every instance of this syndrome has been followed by a market collapse, every notable panic and market crash across more than a century of data has featured that basic setup.

Valuations remain extreme on the basis of measures most tightly correlated with subsequent 10-12 year S&P 500 total returns in market cycles across history. When investors are inclined toward speculation, as evidenced by indiscriminately uniform market action across risk-assets, even obscene overvaluation can be followed by further risk-seeking. At present market internals have deteriorated substantially, including spiking credit spreads in the debt markets. Beyond those factors, we also observe evidence of an oncoming global economic downturn, including a U.S. recession.

In the absence of a clear resumption of risk-seeking across the global economy, further monetary easing is likely to be ineffective in reversing the current strains we are seeing in the market. As investors recall from the 2000-2002 and 2007-2009 plunges, both which were attended by continuous and aggressive monetary easing, monetary easing in itself is not typically enough to provoke resumed risk-seeking.

Warning with a capital "W"

Even if you focus on historically-informed, value-conscious, full-cycle investing, and generally don't place much attention on short-term technical factors or specific patterns of price action. The current setup is one of the few exceptions WHERE YOU SHOULD DEFINITELY BE PAYING CLOSE ATTENTION! In a market return/risk classification that is already the most negative we identify, where a sustained period of speculation has given way increasing risk-aversion, the position of the market relative to very widely identified "support" (about the 1820 level on the S&P 500) is of particular note.  LAST WEEK I IDENTIFIED THIS LEVEL FOR YOU AND SAID A BOUNCE WAS VERY LIKELY.

Often, well-recognized support levels become places where dip-buyers and swing-traders line up on the buy side, on the assumption that they'll be rewarded if the market bounces from that support, and that they can quickly cut their losses immediately if the support level is broken. The problem here is that when too many speculators set their stop-loss points at the same level, and valuations are still elevated, there may be neither speculators nor value-conscious investors willing to bid for stock anywhere near those support levels once they break. The resulting gap between eager sellers at a high level and willing buyers at a much lower level is the essential element of market crashes, because every seller requires a buyer.  ALSO REMEMBER THAT THE TENSIONS IN SYRIA ARE RISING QUICKLY AND THE MARKET MAY GET A VERY NASTY SURPRISE AND GO THROUGH THE LEVEL NOTED ABOVE WITHOUT BLINKING, IF SYRIA BLOWS UP. THERE ARE ALSO NUMEROUS AND NOTABLE CREDIT ISSUES AT SOME VERY BIG BANKS.

Market crashes have historically emerged only after a familiar profile of market behavior that features a compressed market retreat of about 14% over 10-12 weeks, a rebound between 1/3 and 2/3 of that decline, a fresh retreat that slightly breaks that initial level of support, a one-day barn-burner advance, and then a collapse as the prior support level is broken. Once rich valuations have been joined with poor market internals the break of a widely-identified support level has often been followed by vertical market losses.  

The present widely-followed "support" shelf for the S&P 500 is roughly 14% below the 2015 market peak. Most domestic and international indices have already broken corresponding support levels. Given the obscene valuations at the 2015 peak, my impression is that a run-of-the-mill completion of the current market cycle, neither an unusual nor worst-case scenario from a historical perspective, would comprise an additional market decline of roughly 40-50% from present levels. I certainly don't expect that kind of market loss in one fell swoop, my immediate concern is that the first leg of this decline could be quite steep.

Emphatically, my concern is not simply that the market has retreated by some amount to a widely-identified support level. The issue is the context of rich valuations and poor market internals in which that market weakness has emerged, because when a widely- identified support level gives way at rich valuations, in an environment where poor market internals convey a shift toward risk-aversion among investors, the break can behave as a common trigger for concerted attempts to exit. Though the 1929 and 1987 crashes are the most salient instances, there are numerous less memorable examples across history. 

I have chosen to call this particular climate a Warning with a capital 'W' because every historical market crash of note is found within this one set of conditions. 

Those conditions are: extremely unfavorable valuations and poor trend uniformity. At present, the market is displaying the same set of characteristics as it did just prior to past market crashes. In both 1929 and 1987, the market crash began about 55 trading sessions after the peak. During those sessions, the market traced out a characteristic pattern of declining peaks and troughs, with a one-day rally just after the third trough, roughly 14% down from the peak, and then five days of cascading losses. This is exactly the pattern that the S&P has traced since its late-March peak. !!!!!!

The market followed with a 24% plunge over the following 6 weeks (and an even greater loss on an intra-day basis). It took more than 5 days, but then, the S&P 500 was already down substantially from its 2000 extreme even before that plunge.

Perhaps the rally since Friday is instead a "successful retest" of prior support. Given that leading economic data, coupled with poor market internals, continue to indicate an imminent U.S. recession, I tend to doubt that possibility, but we'll take the evidence as it arrives. Investors should ensure that their market exposures and investment horizons would allow them to tolerate a potential 40-50% market loss over the completion of this market cycle. 

Meanwhile, remember that investors, in aggregate, cannot exit the stock market, or any other market for that matter. Every security that is issued, including base money created by the Federal Reserve, must be held by some investor, at every point in time, in precisely the form it was issued, until that security is retired. The only question is how eager buyers are, relative to sellers. Prices don't advance because money goes "into" stocks. Every dollar that a stock buyer brings into the market goes right back out in the hands of a seller. No, prices advance because buyers are more eager than sellers. Prices decline because sellers are more eager than buyers.

Support for an increasingly risk-averse market now rests on the fragile resolve of dip-buying speculators primed to cut-and-run at exactly the same nearby support level, beyond which stands a rather shallow pool of powder-dry, value-conscious potential buyers who remain unwilling to commit that powder anywhere near current levels, in a risk-averse market where further central bank intervention is likely to be futile.

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