Friday, May 25, 2018

Separating an Innocuous Correction From the Start of a Sinister Bear Market

Summary: It's true that equities fall before the start of most recessions. So why bother following the economy; why not just follow the price of equities?

"Market corrections" occur every 20 months, but less than a third of these actually becomes a bear market. Recessions almost always lead to bear markets, and bear markets outside of recessions are uncommon.  For that reason, discerning whether a recession is imminent can help determine when an innocuous correction is probably the start of a sinister bear market. Volatile equity prices alone are not sufficient.

The future is inherently unknowable. We can never say with certainty what will happen in the month's ahead. But the odds suggest an imminent recession in the US is unlikely at present and, barring a rogue event like 1987, a bear market is not currently underway. That means equities are most likely on their way to new highs in the coming months.

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Why bother following the economy? Why not just follow the price of equities?

It's true that equities fall before the start of most recessions. Take the last 50 years as an example. There have been 7 recessions and the S&P has peaked and started to fall ahead of all except one (the S&P peaked with the start of the recession in 1990). On average, the S&P has provided a 7 month "heads up" that a recession is on the way. That's enough for even the slowest investor to get out of the way. Enlarge any chart by clicking on it.

Thursday, May 24, 2018

New Highs In The A-D Line and the Small Cap Index Are Not Necessarily Bullish

Summary:  The conventional wisdom is that "healthy breadth" is necessarily bullish. This sounds  intuitively correct: a broader foundation - where more stocks are ticking higher - should equal a more solid market, but it is empirically false. Equities can continue to move higher when breadth is healthy, but new highs in the advance-decline line or in the small cap index have also preceded drops of 10, 20 or even 50% in the equity market.

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The conventional wisdom is that "healthy breadth" leads to higher equity prices. This sounds intuitively correct: a broader foundation - where more stocks are ticking higher - should equal a more solid market. Conversely, a narrowing market should be a warning of a likely market top.

But it is empirically false. Consider some recent research into this issue.

The Russell small cap index (RUT) has been making new highs even as the large cap indices have not. Because there are four times as many stocks in RUT as in SPX, many infer that breadth is broadening and that this must be bullish for all equities. "When the troops lead, the generals will follow."

Yet, as Mark Hulbert points out, small caps have peaked after the major stock indices in more than half of the 29 bull markets since 1926. If the conventional wisdom was correct, small caps should lead by peaking before the major indices, but this happened only a third of the time (Mark's article is here).

Sunday, May 20, 2018

Weekly Market Summary

Summary:  Equities are 2-5% higher so far in May, trying to add to their small gains from April and put behind a rough winter. This week, small caps closed at a new all-time high (ATH) and NDX broke to a 7 week high near its March ATH. This is constructive for the broader market. But new uptrends are defined by persistent strength; it's time for large caps to reveal the true character of this market.

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US equities fell slightly last week. SPX and DJIA lost about 0.5%. But May, so far, is tracking positive. Large caps are up 2.5%, tech stocks are up 4% and small caps are up more than 5%. The volatility index, Vix, has been crushed. Enlarge any chart by clicking on it.

Friday, May 18, 2018

Demographics: The Growing Prime Working Age Population

Summary: Demographics is a key driver of economic growth (and, thus, the stock market). Many investors fret over the aging of the Boomer generation.

But the Millennial and Gen X birth cohorts are almost twice as large as the Boomers. Behind the Millennials is Gen Z, a group almost as large as the Boomers. The mid-point of these three generational groups does not enter retirement age until 2055. This prime working age group heavily consumes housing and other goods as they pass through their reproductive and household formation years. "The movement of these younger cohorts into the prime working age is a key economic story in coming years."

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Starting around the year 2000, many investors began obsessing over the aging demographic profile in the United States. The concern seemed reasonable. The working age population in Japan had peaked in 1995, 5 years after the Nikkei stock index. The stock market had halved by 2000 as the working population declined (by 13% from 1995 to 2018).  Enlarge any chart by clicking on it.

Wednesday, May 16, 2018

Fund Managers' Current Asset Allocation - May

Summary: Fund managers came into 2018 very bullish equities. Cash levels had fallen to the lowest level in 4 years. Allocations to global equities had risen to the highest level in nearly 3 years. Bond allocations were at a 4 year low. Our view at the time was that "this is a headwind to further gains" in equities. That post is here.

Since then, global equity allocations have fallen and cash balances have risen. Investors are no longer at a bullish extreme, although the equity correction has not (yet) made them outright fearful.

In the past 9 months, US equities have outperformed Europe by 6% and the rest the world by 5%. Despite this, fund managers remain underweight the US. US equities should continue to outperform their global peers on a relative basis.

Fund managers' inflation expectations are near a 14 year high; in the past, this has corresponded with a fall in US 10 year yields in the months ahead. Commodity allocations are at a 6 year high.

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Among the various ways of measuring investor sentiment, the Bank of America Merrill Lynch (BAML) survey of global fund managers is one of the better as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $600b in assets. Our sincere gratitude to BAML for the use of this data.

The data should be viewed mostly from a contrarian perspective; that is, when equities fall in price, allocations to cash go higher and allocations to equities go lower as investors become bearish, setting up a buy signal. When prices rise, the opposite occurs, setting up a sell signal. We did a recap of this pattern in December 2014 (post).

Let's review the highlights from the past month.

Overall: Relative to history, fund managers are overweight cash and commodities, underweight bonds and neutral equities. Enlarge any image by clicking on it.
Within equities, the US is significantly underweight while Europe, Japan and emerging markets are all overweight. 
A pure contrarian would overweight US equities relative to Europe and emerging markets and underweight cash.