Markets Go Down Double-Speed

Markets

Goes Down Double-Speed by David Merkel, CFA of AlephBlog

This is the third time I have written this article during this bull market.  Here are the other two times, with dates:

The first time, we had doubled since the bottom.  Second time, up 2.5x.  Now it is a triple since the bottom.  That doesn’t happen often, and this rally is getting increasingly unusual by historic standards.  That said, remember that every time a record gets broken, it shows that the prior maximum was not a limit.  If you think about that, after a bit you know that idea is obvious, but that isn’t the way that many people practically think about extreme statistics.

Let’s look at my table, which is the same as the last two times I published, except for the last line:

spx_31294_image002 markets

Since the second piece, the gains have come slowly and steadily, though faster than between the first and second pieces.  As I said last time,

“In long recoveries, gains first come quickly, then slowly, then near the end they often come quickly again.  Things are coming quickly again now, but who can tell how long it might persist.”

Indeed, and after the first piece, the market did nothing for about 16 months, after which the market started climbing again at a rate of about 1.5% per month for the last 27 months.  Though not as intense as the rally in the mid-’80s, this is now the third longest rally since 1950, and the third largest.  It is also the third most intense for rallies lasting 1000 calendar days or more.  This is a special rally.

 

spx_8180_image001

And now look at the cumulative gain:

spx_24509_image001

 

Does this special rally give us any clues to the future?  Sadly, no.  Or maybe, too much.  Let me spill my thoughts, and you can take them for what they are worth, because I encouraged caution the last two times, and that hasn’t been the winning idea so far.

  1. To top the rally of the ’90s for total size, we would have to see 2700 on the S&P 500.
  2. It is highly unlikely that this rally will top the intensity of that of the ’50s or ’80s.  Gains from here, if any, are likely to be below the 1.7%/month average so far.
  3. For this rally to set a length record, it would have to last until 12/14/16 (what a date).
  4. Record high profit margins should constrain further growth in the S&P 500, but that hasn’t worked so far.  As it is, there are very good reasons for profit margins to be high, because unskilled and semi-skilled labor in the capitalist world is not scarce.
  5. Rallies tend to persist longer when they go at gradual clips of between 1-2%/month.  Still, all of them eventually die.
  6. At present the market is priced to give 5.5%/year returns over the next 10 years.  That figure is roughly the 85th percentile of valuations.  Things are high now, but they have been higher, as in the dot-com bubble.  We are presently higher than the peak in 2007.
  7. On the negative side, it doesn’t look like the market is pricing in any war risk.
  8. On the positive side, I’m having a hard time finding too many industries that have over-borrowed.  Governments and US students show moderate credit risk, as do some industries in the finance and energy sectors.
  9. Finally, the most unusual aspect of this era is how little competition bonds are giving to stocks.  In my opinion, that idea is getting relied on too heavily for a relative value trade.  Instead, what we may find is that if bond yields rise, stocks, particularly dividend paying stocks, will get hit.  By relying on a relative yield judgment for stocks, it places them both subject to the same risks.

I still think that we are on borrowed time, but maybe you need to regard me as a stopped digital clock with a date field, which isn’t even right twice per day.  Historically, if the rally persists, stock prices should only appreciate at a 8-9% annual rate with the bull this old.

That’s all for now.  I’m not hedging my equity portfolio yet, but maybe my mind changes near 2300 on the S&P 500, should we get there.

PS — the title comes from the fact that markets move down twice as fast as they go up, so be ready for when the cycle turns.  The first article in the series focused on that.

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About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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