Quo vadis, stock market?

Is the stock market a discounting mechanism?

If one looks back at market history, the idea of the stock market functioning as a discounting mechanism becomes very dubious, especially if one looks at the history of the past 10 years. The truth is, sometimes it is, but most of the time it isn't. Since the Asian/Russian crisis of 1998, the market has behaved as a coincident rather than a leading indicator – at times it even lags developments in the economy.

This has been quite obvious in the 2000-2002 bear market, when the market actually bottomed out well after the economic recession in terms of GDP contraction did (in other words, the market lagged the economy), and it has become glaringly obvious in the course of 2007 – 2008.

Consider for instance, that there was a roughly 500 point one day decline in the DJIA on February 27 of 2007, for which two immediate potential triggers could be identified at the time: one was a sharp overnight decline in China's stock market. This was the 'reason' hyped in the press, and can therefore actually be ruled out as a significant trigger – not least because Wall Street had never before worried about what stocks did in China. The second, more credible trigger event, was a sharp decline in a derivatives index product that most stock market traders had up to this point in time never heard about: the sub-prime indexes of the family of ABX-HE indexes , which are run and managed by Markit. Essentially these indexes represent certain residential mortgage debt pools and are used by banks, hedge funds, broker dealers, etc. to hedge mortgage backed debt , respectively speculate on its value.

The sharp decline in these specific indexes signaled growing distress at those mortgage lenders that had specialized in the sub-prime sector of the mortgage market – firms like New Century Financial , Novastar Financial, Fremont General or Accredited Home lenders, the stocks of which used to be market darlings but had been under some pressure for over a year already (in their case, the market actually did fulfill its discounting role), suffered large additional declines. Indeed, it didn't take long for these firms to go under.

However, the one day 500 point market decline remained a one day wonder. Not only that, the market went on to blatantly ignore the message from the then visibly growing distress signals emanating from anything connected with sub-prime mortgage lending, and went on to furiously bid up all sorts of financial stocks, so that several of the companies that by now have been reduced to a status of bankruptcy, zombie-dom or have been nationalized by the government respectively become subject of 'take-unders' by their former competition, reached either new all time highs in the summer of '07 or came close to reaching all time highs.

As examples, consider the charts of the XBD (broker-dealer index) , FNM (Fannie Mae) and ABK (Ambac). In spite of the by then well-publicized problems besetting anything that was involved with mortgage lending and associated derivatives, these stocks traded at very high levels as late as October of 2007.

What accounts for the market's apparent inability to spot even quite obvious economic problems in advance? One can't be entirely certain, but a John Kenneth Galbraith bonmot comes to mind: 'there is (now, was) too much money to invest, and not enough intelligence to guide it'.

The financial industry has grown by leaps and bounds in the just ended era of massive money and credit inflation – and it's a good bet that the amount of 'market intelligence' has not managed to grow at the same rate. To put it bluntly: anyone who was involved in bidding up FNM to almost $70 in October of 2007 was completely asleep at the wheel, and has probably been weeded out by now.

Be that as it may, the fact remains: one can not count on the stock market to 'discount' anything in advance.

(click on charts for larger images)







The Value Trap

The recent sharp decline in the stock market – which not surprisingly, has happened coincidentally with a sharp deterioration in all sorts of economic backdrop data – is best viewed as the 'point of recognition'. Finally, denial about the economy's prospects and the likely extent of financial and economic damage inflicted by the collapse of the biggest credit bubble in history has given way to a collective recognition that the stock market can not be expected to levitate through the ongoing disaster. Elliott wave practitioners are basically of one mind that the crash was a wave 3 down at several degrees - which in E-wave parlance is known as the 'recognition wave' – i.e. the moment when most market participants realize what the direction of the new trend actually is.

As mentioned in the brief report on the gold sector, due to forced deleveraging, many stocks have apparently become quite undervalued now. Several well respected value investors, such as Mr. Buffett (see here) or Mr. Hussman (see here) have advanced arguments to the effect that the panic has created a buying opportunity, irrespective of any further short term damage that might occur. It is certainly correct that risk is now smaller than it used to be; this is obviously a truism, since stocks have become much cheaper.

However, i strongly suspect that a problem with market psychology that i have remarked upon previously in conversations on e-mail lists and fora is still at work here: there has been, and continues to be, a general tendency to underestimate the current bust, both in terms of its likely duration and its likely extent.

Consequently, given the market's consistent failure to do any 'discounting', one should probably be very careful when evaluating this current 'buying opportunity'.
One thing one must keep in mind is that p/e ratios travel in secular cycles. They tend to move from extreme undervaluation to extreme overvaluation and back again, over fairly extended periods of time (20-30 years in each direction, sometimes even longer).

I still remember vividly how the extremely high p/e ratios in Japan's stock market anno 1989 were considered an 'exception to the rule', with countless rationalizations forwarded as to their likely imperviousness. These included assertions such as 'Japan's institutions must invest in stocks' (the 'wall of money' argument) , or 'shares in Japan are never really sold, they are merely passed around between long term holders' (the 'keiretsu' system of extensive cross-shareholdings was supposed to keep share prices aloft), or 'Japan possesses a superior economic model' (the interventionist Ministry of Trade and Industry was actually seen as a positive influence on Japan's economy), and so forth.
Unfortunately for those who believed all this, the Nikkei has fallen to a 30 year low this year, with its average trailing p/e ratio threatening to break below 10.
'Below 10' is actually precisely where p/e ratios tend to fall in secular bear market periods, historically. This puts the current trailing valuation of the S&P 500 Index into perspective – after all, the average decline in GAAP corporate earnings reported so far in the current earnings reporting cycle has been 40% year-on-year.

Lessons Learned?

Let me briefly return to the nature of the current bust. Many, if not most, market observers have for quite some time – in my opinion wrongly - believed that this bust is comparable to previous post World War 2 era busts. Often one has heard arguments to the effect of 'we have seen all of this before' , comparing the situation to what happened e.g. during the 1998 Russian/LTCM crisis, the late 80's/early 90's S&L crisis, the 1987 stock market crash, and recently, more pertinently, but still missing the mark, the mid 1970's bear market and recession.

Lately, comparisons to the experiences made in the 1930's depression have been voiced more often, but are far from having entered into the mainstream consensus. The consensus with regards to this type of comparison is that 'we have learned from the mistakes made in the 1930's, and they will not be repeated'. The current Fed chairman Mr. Bernanke specifically is thought of as a pre-eminent scholar of the 1930's depression, and therefore deemed to be uniquely qualified to avert a similar calamity. One should however realize that people believed the very same thing when the 1930's depression started. Back then, it was believed that the still relatively young Federal Reserve, with its modern 'flexible' currency system would not repeat the mistakes made in the bust and depression of 1873 to 1894. As an aside, in 1873 it was strongly believed that the powers of intervention then in the hands of the secretary of the treasury would surely avert any bad economic outcomes from following on the heels of the 1873 financial panic. Surely the mistakes made in the 1830's would be avoided. Every era shares this belief: namely, that the interventionist wizards at the top will somehow pull a rabbit out of their hat.

Apart from the fact that consensus thinking is apt to be wrong a priori, one can state with reasonable certainty that whatever lessons have allegedly been learned have actually been the wrong ones. While some of the mistakes that have been made in the 30's will likely not be repeated, new mistakes will be made in their stead, and the one, crucial mistake, is being repeated already. Readers of this blog know of course what i am referring to: the idea that fiscal and monetary interventions can avert the bust – this idea is as wrong as it can possibly be. Not only will they not avert the bust, they will make it worse.

Let's briefly look at the major differences between the 1930's situation and today. We know already what the similarities are: in both cases, a giant credit and asset bubble led to malinvestment of capital and capital consumption on a vast scale, laying the foundation for an enormous bust. In both cases, the government felt called upon to intervene in the economy and markets on an unprecedented scale in order to ward off the bust.

The differences are less obvious, so let me try and briefly summarize them: Today, we have 'more furniture to burn to heat the house'. Imagine the economic downturn as akin to a harsh winter (indeed, in the Kondratiev Longwave theory, a secular deflationary bust is referred to as the 'winter season'). If you decide to get through the winter by burning the furniture, having two desks to burn is comparatively better than having just one. Of course it would be better to go out and cut wood, store it somewhere dry, and use it for heating purposes. That is however not the path we are taking. The governments of the world have already decided that burning the furniture is what we're going to do.
Since we have more furniture – i.e., accumulated wealth – than we had in the 1930's, we will hold out longer, and it won't get quite as cold.

The second major difference is one of scale and complexity. For instance, we have far more debt relative to economic output than we had in the bad old days. A large amount of this debt is unproductive – it has either been used for consumption, or has been wasted on investment projects that will not generate any wealth, ever (many such projects only appeared to be profitable while the credit expansion was still ongoing). Both the financial system and the production structure of the economy are vastly more complex than they used to be – the global division of labor as well as global economic interdependence are far more advanced.
On the one hand, one can hope that this complex system will prove to be more resilient than its historical predecessors, on the other, it is this very complexity that makes it difficult to judge what the ultimate effects of the credit contraction and the many 'unintended consequences' of officialdom's interventions will be.
The bureaucrats are like the proverbial bulls in a China-shop – everything they do to plug a hole in the dike on one end immediately opens up new holes elsewhere, which then begets new interventions, and so on, in a never ending cause-effect chain reaction.

In terms of market volatility, size and extent of government interventions, the ratio of debt to economic output and the recent speed of economic deterioration, one really is forced to look back to the 1930's to find any remotely comparable events. We can therefore state: the current bust, regardless of the fact that it will most likely not become quite as bad, is at least of the same general degree.

The short term market outlook, considering technicals

It is always difficult to talk about the short term market outlook, especially when the market is in what appears to be a corrective formation. It often feels like a coin toss, so one is forced to resort to 'if...then' formulations. Anything else is a bit disingenuous – one may get a short term call right, but one can never be certain – it is a matter of probabilities.
Generally, this is easier when the market structure is clear, during impulse waves.
However, from a technical perspective, regardless of what system one uses, one must first and foremost consider the main trend. The main trend is the larger undercurrent upon which the smaller ups and downs play out, and it exerts an influence even during the counter-trend moves.

To make a long story short, in spite of the market's severely oversold status, it is just as likely to immediately break lower to for instance retest the 2002 lows as it is to produce a larger corrective rally first. Normally, one would expect a severe price crash to bring forth a sizable corrective rally, and from the point of view of empirical evidence this has to be regarded as the higher probability bet. The biggest problem with this is that almost everyone seems to agree, and the market tends not to reward consensus opinions. On the other hand, a rash of mutual fund redemptions, extremes in the Investors Intelligence bull/bear ratio, a seemingly – so far – successful retest of the early October low, all support the idea that a bigger corrective rally is now, or will soon be underway.

As can be seen on the chart below, prices will give us a decisive 'if – then' answer soon:



(click on chart for larger image)

The retest of the early October low has produced a number of divergences, that theoretically are short term bullish. However, the market is also closing in on a short term layer of resistance, with further resistance levels indicated by the Fibonacci grid in magenta.
So here is the short term 'if-then' proposition: the dotted blue support line must not break – if it does, then the 2002 lows become a likely target area (SPX 770-780 region). An obvious problem with the re-test is that it has come so quickly. Very little time lies between the two lows. This makes the 'double-bottom' weaker than it otherwise would be.
Noteworthy is also the 'flight of the bears' – consider the chart of the NYSE short interest ratio deviation below:



(click on chart,etc.)

A lot of short positions have obviously been covered. This can also be observed in the Rydex bear fund cash flow ratio, which has declined to a multi-year low (Rydex fund cash flows are a useful microcosm of sentiment):



(click on chart for larger image)

In short, the 'the low is in' consensus should be subject to some healthy doubt. The recent rally has been largely marked by short covering, and there will be less short covering buying power from here on out.

However, it is also quite clear that shorting an already severely oversold market is quite risky – if the market overcomes the layer of price resistance as per the chart of the SPX, then a larger retracement rally , likely toward one of the Fibonacci retracement levels (1040 or 1210) can be expected; this will probably happen regardless of whether or not the market makes new lows first.

The long term market outlook and its dependence on inflationary policy

The market's longer term outlook is to my mind a less problematic topic. A secular bear market started in 2000, and as such secular downturns go, it is highly unlikely to only last 8 years. To wit, Japan's secular bear market has made it to the ripe old age of 19 years as of 2008.
As Bob Prechter and others have remarked, in real terms it is as if the intervening inflationary cyclical bull market in the Dow/SPX of 2002-2007 never happened. In terms of gold (i.e., real money), the market just kept going down, and is now down by some 75%. This is to say, if not for a massive credit and money supply expansion having artificially supported nominal prices, we would be at completely different depths of bear market despair now.

To what levels the market will eventually fall in nominal terms is highly dependent on how 'successful' the central banks are with their policy of inflation, or 'reflation' as it is euphemistically called. It seems unlikely that a 'success' similar to the real estate credit bubble that has brought us to this juncture will be achieved – after all, what is there left that can be inflated? However, one must be aware of something very important here: the very real 'threat' of deflation that is now barreling down on the global economy, is first and foremost a political issue.

Similar to inflation, deflation leads to a redistribution of resources (see Huelsmann,pdf) , only it is a redistribution away from those who profited from inflation to those who were prudent, are debt free and in possession of savings – i.e. , the victims of the previous inflationary cycle. As Huelsmann correctly points out, the supply of money is irrelevant in terms of society's overall wealth – any size of money supply can fulfill the necessary functions money needs to fulfill (to put it differently, it matters not how much money is in one's bank account, what matters is what this money can buy).

If you consider who in society profits the most from inflation, and consequently stands to lose the most from deflation, it becomes quite clear that an inflationary policy will be pursued come hell or high water. The entire modern-day welfare-warfare state is crucially dependent on the inflation of money and money substitutes. The state would shrink without it. Also, the current elites would be replaced by new elites in case of a deflationary collapse of the system (these are also points made in Huelsmann's essay). In addition , we note that the debt expansion of recent decades has ensnared a large part of Western society – 'allowing' deflation to run its course unhindered is simply not politically palatable.

Due to the fact that the banking system is now extremely capital deficient and impaired, the traditional credit transmission mechanisms of the fractional reserve banking system are temporarily not working (it does not matter how many times the White House entreats commercial banks to 'start lending' – they won't do it, because they rightly fear that they will only add more future defaults to their tattered asset base).

However, central banks are already adapting their modus operandi to this circumstance, and can be expected to come up with more non-traditional measures as needed. The direct injection of money into the economy via buying of commercial paper at below market rates as currently practiced by the Federal Reserve is one way in which the banking system is bypassed, and we can rest assured that Mr. Bernanke and the Fed's board will come up with many more ideas in attempting to stem deflation as time goes on. It seems most likely that fiat money will be devalued further, i.e., the approximate 97% devaluation of the dollar since the birth of the Federal Reserve is likely to continue.

Could it be that the central banks will be overwhelmed by the sheer speed and scale of the deflationary contraction? At the moment this can actually not be ruled out completely. Remember what i said above about the 'general tendency to underestimate the crisis'. Even though central bankers have presumably more insight into the problems and potential exposures besetting institutions within their regulatory ambit (very likely the CDS market has already cost Heli-Ben a sleepless night or two), they have only very recently awakened fully to what is going on – which is exemplified by the Fed's balance sheet ballooning by well over 100% over the past 5 or 6 weeks alone. In addition, a large part of the financial system is outside of the regulatory ambit of the central banks – what is commonly referred to as the 'shadow banking system' could well develop deleveraging and default dynamics that will be comparatively difficult to contain.

Ironically, the little propagandistic trick that is used to ensure public support of the central bank system – namely that CB's pose as 'inflation fighters' although they exist primarily to pursue a policy of inflation, may be one of the things that has delayed their reaction. Remember, only a few months ago, the lagged effect of a previous tighter policy stance was not yet in full flower – commodity prices continued to soar, specifically the price of crude oil (as an aside, one can only cringe in despair when one hears central bankers declare that rising oil prices are 'exerting inflationary pressures'; a more thorough confusion of cause and effect is difficult to imagine).
So for a while, the central banks were worried that they might be in danger of losing their 'inflation fighter' reputation, and while they acted reactively and very much ad hoc to the ever more deteriorating financial scene, they were reluctant to pump all-out. Consider that reluctance a thing of the past.

The main point of the foregoing is the following: the historical experience with secular bear markets and secular periods of p/e multiple contractions tells us that the stock market will continue to decline quite a bit more in real terms (this is notwithstanding the fact that the secular bear market will be comprised of several cyclical bull and bear markets – it will be a sequence of lower highs and lower lows in real terms); how low the ultimate low will be in nominal terms will however largely depend on how determined and creative the central banks get in their 'reflation' efforts, or whether they will actually be overwhelmed by the deflationary credit contraction that is currently underway.

One thing that seems fairly certain is that the 'buy and hold' method of investing in stocks will remain a losing proposition for years to come. This should eventually lead to a large swing in the 'allocation pendulum' – institutional allocation percentages that have swung toward bigger and bigger portions of funds being allocated to stocks are likely to revert to much smaller stock market allocations, reaching their low point just in time for the next secular bull market's beginning. Note also that the demographic boost that the stock markets of the Western world received via the 'boomers' is turning into a demographic drag - as of now.

A final remark regarding the mutual fund industry: a more stubbornly bullish bunch is nowhere to be found. The mutual fund cash-to-assets ratio recently stood at a historically paltry 4,5% - considering a roughly 45% decline in the S&P 500 Index from the top, this slightly elevated number (the all time low hit in 2007 was just below 4%) can probably largely be ascribed to the decline in asset values. In other words, whatever selling mutual funds have engaged in appears to have been in reaction/anticipation of redemptions, and not out of fear of a declining market. This is in stark contrast to past bear markets, which have unfailingly seen the industry raise its cash on hand to much higher percentages. This is a fount of potential future selling pressure that one needs to keep an eye on.

Errata: in a previous post i mentioned that the Fed's base money expansion in 1929-1932 stood at 98% annualized; this was erroneous, it should have read: 'the total amount of the Fed's monetary expansion between 1929 and 1932 stood at an annualized rate of 98%'.

charts via stockcharts.com, marketgauge.com, decisionpoint.com