is our 83rd report on the consequences of the stock market mania
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The articles below are
reprinted from previous issues of Crosscurrents
and are chosen for their timeliness
The Third Concurrence
REPRINTED FROM THE JULY 31st
ISSUE OF CROSSCURRENTS
The new margin data is usually posted at the very
end of the month and we must hurry to put together commentary and charts
to cover what we see as one of the most troubling developments in decades.
We got lucky on July 17th this time, when NASD released their tally which
includes both the NYSE’s numbers and their own to give the most accurate
picture available. Thus, we’ve had two weeks to study the situation
and conclude as you might guess, there are solid parallels with the 2000
peak in tech and the 2007 peak. Make no mistake, this is a veritable
stock market mania, the third in 15 years.
The June margin debt stats fell only $2 billion
shy of the April record of $550 billion. The tally represents 3.09%
of gross domestic product, the highest since just before the peak in September
1929. The lowest horizontal line on our chart represents the average
from 1958 to 1998. By 1999, the tech mania was underway, so our middle
line describes a 40 year period of normalcy and 16 years of manic activity.
Our Danger Signal line is arbitrary but clearly illustrates elevated risks.
Given stock prices were cut in half in two of the worst bear markets ever
from 2000-2002 and from 2007-2009, we believe our “danger” appellation
is well deserved. At well over 3% of GDP, the current reading likely
represents a condition so emphatically excessive that we should expect
not only a bear market but possibly a financial crisis to ensue.
What are the odds that we are wrong? What
are the odds that we have oversimplified the case for danger? What
are the odds that stocks could not only continue to maintain this level
of margin debt but perhaps, accommodate even more margin debt as prices
work their way higher? Clearly, we might have posed the latter question
as stocks rose 33% in 1927 or as stocks soared 40% in 1928, well before
the September 1929 peak. In each of those instances, stocks kept
on rising in an almost straight line to the stratosphere before the bubble
burst. The major difference between then and now was you could buy
stocks with only 10% down. As long as prices rose, the market became
the greatest wealth machine ever invented. All stocks needed to do
was rise 10% and a speculator had doubled his money. Take a look
at our featured chart again and factor in margin debt at 11% versus GDP
at the 1929 peak, as opposed to 3.09% at the end of June 2015. Thus,
leverage cannot work the same magic as it did in the Roaring Twenties.
We cannot run as fast and as high as then, and we will not fall as far
and as fast as then.
When the Roaring Twenties bubble finally burst,
the crash was far worse than what we witnessed in the bear markets of 2000-2002
and 2007-2009. All that was required in 1929 to completely wipe out
a margined speculator was a very ordinary 10% decline in price. So
many were wiped out so quickly that the country was plunged into a depression
that endured for the better part of a decade. The Dow Industrials
fell 89% and the highs of September 1929 were not exceeded for another
Regulation T now allows only 50% of the value of
the position to be purchased with margin. This makes a replay of
1929 impossible. Thus, at this point, we cannot compare the present
with the Roaring Twenties. Nevertheless, the circumstances today
are dire and have grown progressively worse as margin debt has expanded.
At the April peak, total margin debt was 32.1% greater than in 2007 and
83.3% greater than in 2000. The impetus to lever up to record levels
despite valuation extremes that have rarely occurred is bizarre.
Robert Shiller’s cyclically adjusted price earnings ratio (CAPE) remains
near 27, exceeded only in the Roaring Twenties, the tech mania of 2000
and the housing & stock manias of 2007—and Tobin’s Q ratio, which estimates
the fair value of the market, is at its third highest level in history.
A stock market burdened by excessive leverage is
marked by the need for rapid responses to price changes. It is the
antithesis of investment. The greater the leverage, the greater the
odds that a substantial break in price can catalyze a free fall.
Since the threat of downside movement, even tame downside movement, is
always present, holding periods contract. Our page one featured chart
in the March 20th issue showed holding periods had diminished to four months
and 14 days. At bottom left, our updated chart shows holding periods
have modestly contracted even further, to four months and 11 days.
No one wants to be left holding the bag if the bear ever decides to put
in an appearance. More importantly, there is simply no reason to
risk longer term positions anymore. The short term has become de
rigeur. This also means far less impetus for investors to stay the
course. Support is as tenuous as we have ever seen.
However, rather than spook participants as one
might think logical, the contractions in holding periods have not only
made players more bullish, they are now far less bearish. On page
three of the June 29th issue, we showed a two year moving average of Advisory
sentiment well above a third standard deviation from the norm, a circumstance
that on average occurs less than 0.3% of the time. From December
2002 through December 2013, advisory bears averaged 26.5%. Given
stocks typically rise on an annual basis, it is entirely reasonable that
bears remain in the minority. But since the beginning of 2014, advisory
bears have averaged only 16%, far below the historic norm. The bear
case has been so thoroughly discredited by the six year bull market that
one might easily infer bears are an endangered species. For much
of the bull market, the Rydex Ratio, measuring assets in bull and sector
funds versus assets in bear funds, traded between 12:1 to 16:1. Late
in 2014, the ratio took off and has since traded as high as 26:1 (now 23.5:1).
However, as we show here, as a result of the historic
changes in behavior of market participants, we now suffer the worst negative
liquidity in market history. While there is no readily acceptable
and popular indicator for liquidity, we believe our take is reasonable,
simply subtracting total margin debt from total mutual fund cash reserves.
As a result, net liquidity
reached minus $121.3 billion in March 2000,
which coincided precisely
with the tech mania peak.
Net liquidity reached minus
$192.6 billion in July 2007,
only three months before the
This past April, net liquidity
reached a stunning minus $255 billion
(net liquidity is currently
The S&P 500 peaked on May
Given the many technical indicators
illustrating negative divergences we are likely witnessing the third
concurrence of this indicator;
a major peak in stock prices
historic negative net liquidity.
Another Bear Market Target:
REPRINTED FROM THE SEPTEMBER
28th ISSUE OF CROSSCURRENTS
Despite the scary mini collapse from the May 20th
all time highs for the major indexes, there is almost no recognition that
a new bear market has commenced. The common theme is “correction,”
an overused appellation coupled by the financial media to practically any
downside burp that might dissuade the little folk from risking more of
their dwindling cash reserves on a market of stocks still blatantly overvalued
on a historical basis. We refer, of course, to Tobin’s Q ratio and
the Shiller 10-year cyclically adjusted P/E ratio (CAPE), which as of the
aforementioned all time highs, both illustrated fair comparisons with generational
price peaks, exceeded only by the madness in 1929 and 2000. While
both measures have now declined modestly, they remain at levels consistent
with major long term price reversals for stocks.
We have attempted to find a reasonable downside
target that when achieved, might again turn our view to the bull side.
It may appear that we have been permabears but nothing could be further
from the truth. There have been many points in the past at which
we beat the drum for stocks, most notably August 1982, December 1987, January
1990 and even in March 2009. Our goal here is to at least have some
idea how the downside plays in order to position and prepare for the next
One of many methods we use to gauge downside potential
is our regression line chart shown above. In a speech to the International
Federation of Technical Analysts (IFTA) in Washington, D.C. on November
8, 2003, we first laid out the case for an eventual long term bear
market target of Dow 6400 and SPX 680 six years before the fact.
The actual lows were 6469 and 666 respectively. How was a 6400 target
even considered reasonable? At the time of the speech, our regression
line was at Dow 7629 but appeared perfectly within reasonable bounds.
The fact is the regression line has held nearly three-quarters of all action
for well over a century. For decades, it was reasonable to conclude
5% annualized rates of gain for stocks, rather than the outlandish gains
brought about by stock manias. Our actual Dow target was refined
by other methods but was made possible by this chart.
Our charting methodology dealing with support and
resistance zones currently affords a bear market downside target of Dow
14,719, which is simply the October 9, 2013 print low, a level that should
represent considerable support. The good news? It is highly
doubtful that the March 2009 lows will ever be seen again. The bad
news is that lower targets than Dow 14,719 are both possible and reasonable.
Consider our regression line, currently at Dow 13,627, down 16.1% from
here and down 25.7% from the all time highs. Of course, this line
rises over time and will reside at Dow 14,308 one year from today.
Our premise is that 5% annualized average gains
for the Dow are an entirely plausible scenario for the long term.
However, as our chart implies, as often as not, it would also be reasonable
to see the Dow trade well under the line at some point. Thus, even
lower targets are not unreasonable. Given that the public seems about
as divorced from stocks as they have been for many years, the evidence
implies this particular mania is institutionally driven, rather than sponsored
by a foolish public. Clearly, Joe and Jane Stockholder have not been
active. As we illustrate at lower left, we have seen a steady outflow
totaling $540 billion from domestic mutual funds over the last five years.
From the beginning of 2007, our monthly stats show outflows of $702 billion.
The picture does not change when we factor in Exchange Traded Funds (ETFs),
which account for only one-sixth of the assets in domestic mutual funds.
The outflows are unlike any seen before in stock market history and are
outrageous indictments of the metamorphosis of Wall Street from a
veritable forum of investment to a circus of short term trading in which
institutions can and will front run the public every chance they get.
The current metamorphosis into a primarily institutionally
driven arena is not entirely without precedent. In 1972, institutional
Groupthink gave us the “Nifty-Fifty,” an elite class of stock that was
assured to be one decision only—buy. Consequently, prices skyrocketed
for only the select few. One study showed that between 1965 to 1972,
18 companies with an average P/E of 47 accounted for virtually all of the
S&P’s gains in that period. The same dynamic exists today, which
we have illustrated in our negative divergences charts over recent months.
As the broader market underperformed, any slack in the index was reinforced
by a relative handful of companies trading at insane valuations, such as
Netflix (NFLX) with a forward P/E of 320 and Amazon (AMZN) with a forward
P/E of 112.
However, despite the institutional similarities
to the Nifty-Fifty era, the present environment is set apart as never before
as margin debt has soared repeatedly to record setting levels. Below,
we have adjusted margin debt totals and the S&P 500 for the effects
of inflation to better illustrate what is at work. Ironically, the
new highs for the S&P 500 have been a bit illusory. The record
achieved in May 2015 is actually only one-percent higher than achieved
in August 2000. The broad based S&P 500 has gone nowhere for
15 years, whereas margin debt climbed over 51% on an inflation adjusted
basis. Without the support from borrowed monies, there is no way
the bull market would have looked the same. And based as it has been
on borrowed money, the end is likely to be uglier than expected.
As shown in our featured chart at center, net liquidity continues to lag
at record negative levels.
This circumstance is pivotal in determining both
the depth and endurance of the bear market. While we have offered
relatively modestly lower bear market targets of Dow 14,719 (down 20% from
the high) and Dow 13,627 (down 26% from the high), we are forced to admit
there is potential for greater damage. At important bottoms in the
past, so much had accumulated in the mutual fund cash reserves category
that the upside was almost automatic. However, the absolute level
of cash reserves has gone nowhere for over a year and the relative level
of cash reserves is the lowest of all time. If we are to rely on
the public to turn around a bear market, the wait may require a great deal
We will monitor our indicators
closely for significant changes. For starters, we would hope to see
net liquidity better than negative $200 billion and mutual fund cash reserves
over 4% of assets, a level last seen in August 2012. Valuations must
shift to a far more favorable stance as well. We would hope to see
the P/E of the S&P 500, still way too high at 19.7, down to 15 or lower.
We would also hope to see the dividend yield at 2.25%, at a more rewarding
level of 3% of higher.
For now, we firmly believe
we are in the grip of a new bear market.
There will be a lot more pain
before we see any gain of note.
An Investor's Worst Enemy
REPRINTED FROM THE SEPTEMBER
28th ISSUE OF CROSSCURRENTS
The metamorphosis from an investment market to
an arena controlled by mechanical means is also exemplified by the proliferation
of wild swings for daily trading sessions. It doesn’t matter much
if we look at just the good days as opposed to the bad days simply because
volatility is never an investor’s friend. As we illustrate in our
charts at bottom left and bottom right, lopsided sessions do not give investors
any chance to prepare or act. Mechanical strategies tend to resemble
one another, thus we typically see a pile-on effect in one direction or
the other. Not quite Groupthink, but let’s think of it as Groupspeed,
in which the biggest winners are the fastest, the traders who can position
in less milliseconds than others. This is precisely the kind of environment
that investors cannot tolerate, even when it is a big day to the upside.
Investors need time to react as they ask themselves if they should wait
for a pullback or just blindly pile on.
From day one on our chart below through all of
2007, a span of 23 years, lopsided volume days occurred only 1.9% of the
time. During the terrible bear market that ended in March 2009, lopsided
volume days occurred 15.4% of all sessions. Not by any means a fit
arena for man or beast, only machines and their algorithms. And since
the end of the bear market, although we see a relative lull on our chart,
lopsided sessions still occur 9.7% of the time, sufficient to keep investors
away, lest they stumble into one of those periods where heads can only
spin, rather than react. Also below, this slightly different perspective
may be a better picture of the effects of high frequency trading (HFT).
Again, our point is that wild swings offer no solace to investors, thus
they will avoid the arena, rather than participate. This is one of
the principle reasons why domestic mutual funds have suffered such enormous
outflows in recent years.
Volatility is anathema and
an investor’s worst enemy.
Note that this most recent
decline in prices is accompanied by a surge in the 50-day average of lopsided
days that is now actually in excess of the Crash of ’87.
The character of the stock
market has dramatically
and radically changed.
We Got It Right Again
REPRINTED FROM THE SEPTEMBER
28th ISSUE OF CROSSCURRENTS
When 2005 was about to commence, the common theme
was that it was a can’t miss year. After all, every year ending in
“5” dating back to 1885 had been positive and most had been super.
The average gain was a phenomenal 30.7%. A veritable guarantee, no?
Well, no. We felt differently and clearly went against the common
wisdom, calling for a rather drastic change in behavior in 2005 and last
December, we did the same for 2015, even though most analysts were still
stuck on the goodness of years ending in “5.” See our December 29,
2014 issue at http://www.cross-currents.net/m122914i.pdf for a reminder
of what we saw ahead for 2015.
Again, so far, we’ve
been right on track and virtually the only analysis that has called the
year correctly. We are down roughly 1500 Dow points for the year
and although we have not yet fallen 20% as expected, we fell as much as
16.2% into the August low.
No one else we are aware of
has been anywhere near as accurate
as our analysis of how the
year 2015 would play out.
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Alan M. Newman, November 19, 2015
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