The Real Correction Is Still Coming
Lance Roberts | Oct 07, 2015 12:18AM ET
In last week's update, I discussed the short-term oversold condition that existed at that time. To wit:
"As you will notice, the reflexive rally, and subsequent failure, have tracked the original predictions very closely up to the point. With the market once again very oversold on a short-term basis, it is likely that the markets could manage a weak rally attempt over the next few days."
The chart below is updated through Monday's close.
As you can see, the markets did retest the late August lows, and when combined with the very oversold conditions, led to a frantic "short covering" rally back to previous resistance. It is worth noting that the recent market action is very similar to that of the August decline and initial rebound as well.
Of course, the question that must be answered is whether we have seen the end of the current correction or is this just another "reflexive rally" that will fail?
h3 The 2016 Recession And Market Reversion/h3To answer that question it is important to examine some statistical tendencies as well as potential artificial influences.
In January of 2014, I penned an article entitle "The Coming Market Meltup and 2016 Recession." That article discussed several historical statistical precedents for such, at that time, an outrageous piece of analysis. To wit:
"However, looking ahead to 2015 is where things get interesting. The decennial pattern is certainly suggesting that we take advantage of any major correction in 2014 to do some buying ahead of 2015. As shown in the chart above, there is a very high probability (83%) that the 5th year of the decade will be positive with an average historical return of 21.47%.
The return of the positive years is also quite amazing with 10 out of the 15 positive 5th years (66%) rising 20% or more. However, 2015 will also likely mark the peak of the cyclical bull market as economic tailwinds fade and the reality of an excessively stretched valuation and price metrics become a major issue.
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Read market moving news with a personalized feed of stocks you care about.Get The AppAs you will notice, returns in the 6th and 7th years (2016-17) become substantially worse with a potential of negative return years rising. The chart below shows the win/loss ratio of each year of the decennial cycle."
"The statistical data suggests that the next economic recession will likely begin in 2016 with the negative market shock occurring late that year, or in 2017."
It is important to remember one simple phrase that is too often forgotten by the "bullish crowd:"
"Past Performance Is No Guarantee Of Future Results."
There are plenty of reasons that that the market could lapse into a far bigger correction sooner than the historical evidence would otherwise suggest. Such an event would not be the first time that an "anomaly" in the data has occurred.
However, with a Presidential election forthcoming there is sufficient reason to believe that "all guns will be brought to bear" to forestall the onset of an economic recession and major market correction. This reason I say this is because individuals "vote their pocketbook."
A recession/market correction would ensure a Republican victory. With Democrats currently in charge, it would not be surprising to see the Federal Reserve pushed into action with some form of monetary interventions, or negative interest rates, if the current market correction worsens.
It is worth noting that contractions/expansions in the Fed's balance sheet have had a very high correlation with subsequent market action as liquidity is pushed into the financial system. As shown in the chart below, the Federal Reserve has already once again begun to quietly expand their balance sheet following the recent downturn. Not surprisingly, the market has responded in kind with the recent push higher. My suspicion is that if such minor interventions fail to stabilize the market, a more aggressive posture could be taken.
As I stated back in 2014:
"The inherent problem with the analysis is that it assumes everything remains status quo. The reality is that some unexpected exogenous shock is likely to come along that causes a more severe reversion as current extensions become more extreme."
Of course, since then, China has become a severe drag on the global economy which is now filtering rapidly into the domestic economy. Given the weakness in the recent economic data from manufacturing to employment and production, Q3 GDP will very likely be well below 1% growth.
This means two things.
1) The Federal Reserve WILL NOT raise interest rates this year.
2) If the data continues to worsen, expect the Federal Reserve to become more "accommodative" for a period of time.
Such actions will likely, as stated, continue to "float" the markets for a while which will provide the time necessary to pass the election in 2016. This will also align with historical full market cycle as shown in the chart below.
h2 Current Rally Will Likely Fail/h2
While the "seasonally strong" period of the year could foster a further rally in the market, it is highly likely that it will ultimately fail. As shown, since the turn of the century there have only been two previous times when the market traded in oversold territory combined with all three major "sell" signals triggered. Both of these periods marked a much more severe bear market cycle.
Given the late stage of the current market cycle, the issue of rising global economic weakness and deflationary pressures and deteriorating earnings, many of the "bullish" arguments have been broken.
You Can Trade It, Just Don't Buy It
However, there is still enough bullish sentiment, and "hope" of a continued "bull market" to keep investors chasing returns until they finally become exhausted. Therefore, for individuals with a very disciplined "buy/sell" approach, the "seasonally strong period" will likely provide a tradeable opportunity through the end of this year.
However, this is not a "buy for the long-term" opportunity. The markets remain grossly overvalued, overbought and extremely deviated from its long-term mean. As John Hussman wrote last week:
"If there is a single pertinent lesson from history at present, it is that once obscenely overvalued, overvalued, overbullish market conditions are followed by deterioration in market internals (what we used to call "trend uniformity"), the equity market becomes vulnerable to vertical air-pockets, panics and crashes that don't limit themselves simply because short-term conditions appear 'oversold.'
While the concept of mean-inversion seems strange – almost preposterous – it actually aligns very well with what we know about so-called "secular" market phases."
What most investors do not realize currently is they could go to "cash" today and in five years will likely be better off. However, since making such a suggestion is strictly "taboo" because one might "miss some upside," it becomes extremely important for measures to be put into place to protect investment capital from the coming downturn.
(In other words, if you didn't like the recent 10% correction, you are not going to like what comes next.)
However, the importance of cash should not be dismissed. As I wrote in April of this year:
"The chart below shows the inflation adjusted return of $100 invested in the S&P 500 (using data provided by Dr. Robert Shiller). The chart also shows Dr. Shiller's CAPE ratio. However, I have capped the CAPE ratio at 23x earnings which has historically been the peak of secular bull markets in the past. Lastly, I calculated a simple cash/stock switching model which buys stocks at a CAPE ratio of 6x or less and moves to cash at a ratio of 23x.
I have adjusted the value of holding cash for the annual inflation rate which is why during the sharp rise in inflation in the 1970's there is a downward slope in the value of cash. However, while the value of cash is adjusted for purchasing power in terms of acquiring goods or services in the future, the impact of inflation on cash as an asset with respect to reinvestment may be different since asset prices are negatively impacted by spiking inflation. In such an event, cash gains purchasing power parity in the future if assets prices fall more than inflation rises.
While no individual could effectively manage money this way, the importance of 'cash' as an asset class is revealed. While the cash did lose relative purchasing power, due to inflation, the benefits of having capital to invest at low valuations produced substantial outperformance over waiting for previously destroyed investment capital to recover.
While we can debate over methodologies, allocations, etc., the point here is that 'time frames' are crucial in the discussion of cash as an asset class. If an individual is 'literally' burying cash in their backyard, then the discussion of loss of purchasing power is appropriate. However, if the holding of cash is a 'tactical' holding to avoid short-term destruction of capital, then the protection afforded outweighs the loss of purchasing power in the distant future.
Of course, since Wall Street does not make fees on investors holding cash, maybe there is another reason they are so adamant that you remain invested all the time.
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