by Brian Pretti CFA, Contrary Investor. August 1, 2008
Set against the magnitude of credit cycle issues of the moment that indeed have very meaningful implications for what will be the reality of domestic economic outcomes ahead, questions have arisen as to whether we are now facing a relatively run of the mill bear market for equities or perhaps a bear of generational proportion. The thought has clearly made the rounds that the US equity bear market started in early 2000 was simply interrupted to the downside in 2002/2003 by incredible domestic monetary and credit cycle stimulus, as was truly exemplified by the literal generational bubble that was blown in US residential real estate prices, acting to lift both the financial markets and economy itself for a time. Of course no one knows in advance what financial market behavior and price trajectory will be ahead, but we do hope there are some signposts that may be helpful in guiding us as to potential ultimate downside severity. The bottom line is that big time bear markets really do indeed come along maybe once in a generation. They are infrequent by nature. By this, we're really referring to the devastating bears. You know, the ones that can change lives, destroy fortunes, and generally have investors swearing off equities forever. As investors in the current generation, we've clearly been conditioned over the last three and one half decades to view equity market corrections as opportunities. For the bulk of American equity market history, this has indeed been the case. But every once in a while, it's different. Every once in a while, we hit a generational event.
Before going any further, we have absolutely no way of knowing if we've embarked on a big time bear. A big multi-standard deviation event. We just thought it topical to at least address the unthinkable as simply one possibility in a number of outcomes. As we've preached far too many times over the years, the key to successful investment management is risk management. And that quite simply means we need to have a game plan for all potential market outcomes. Although this is far from a pleasant thought, we're simply contemplating how we might identify "the big one," if you will, if indeed that is to occur at all. Sincerely, the reason we are addressing this rather unpleasant thought is that these types of devastating episodes often coincide with once in a generation financial market or real world events. In the 1930's, the devastating equity bear was accompanied by the peak of a generational credit cycle, ultimately leading to the reality of economic depression as reconciliation played out. In Japan during the late 1980's, the equity peak was accompanied by not only the obvious equity bubble, but also a generational bubble in real estate valuations driven by their own credit cycle mania of sorts, likewise leading to Japan's own version of a "contained depression" in economic activity in the aftermath of the bubble peak. Without attempting to sound melodramatic, at the moment and although intertwined in nature, the US is facing both potentialities - a possible generational credit cycle peak, and a generational bubble in real estate that is now deflating. We told you this was not going to be pleasant, didn't we? The following chart chronicles the credit cycle dating back to the early 1950's. Just as an FYI, the peak in the 1920's was estimated to have been 270%. We're just a touch beyond that at the current time, no?
Although it has been a very long time since we have covered this topic, there is an old truism in the markets that in very severe equity bear episodes, the 200 month moving average of the equity indices is a potential downside target. We believe this is an important review exercise right now for reasons we'll explain in a minute. From current levels on an index such as the S&P, the 200 month MA is roughly 20% down from here. Let's put it this way, we're really in no mood at all to find out "the hard way," if you will, whether we may be headed there and possibly beyond in the current cycle. Moreover, as we look back across historical experience, in those instances were equity markets have broken the 200 month MA to the downside, this has been accompanied by very somber real world economic outcomes. In other words, this little exercise of examining movement toward the 200 month equity index MA has implications above and beyond simply tracking and/or anticipating equity price movement. This historical rhythm simply reinforces in our minds the very meaningful importance of the equity market as truly being a leading economic indicator. So to that end, are there warning signs of historical importance to keep us from this type of fate in the equity markets? Can we use the historical messages of the equity market as a potential forward marker of magnitude for the real economy in terms of trying to identify potential significant forward trouble? As always, history is a guide as opposed to a guarantor. We have a lot of charts to come that we apologize for in advance if indeed they play havoc with the printer friendly page.
First, a little trip back in time to view a bit of historical precedent across various markets and across various periods of time. In our own recent experience in the US, it's the NASDAQ that really walked us through its own crash event earlier this decade. As is absolutely clear in the chart below, the aggregate price destruction carnage in this index was stopped virtually dead in its tracks at the 200 month moving average, very near the lows of the broader US equity market in late 2002. As you also know, and with meaningful monetary stimulus also being an important factor, the real US economy went on to experience recovery as the NASDAQ has likewise not come near its 200 month MA again after the late 2002 touchdown. Point being, in terms of assessing risk in equity prices, the big time bear episode in the NASDAQ ended at the important 200 month MA. And given the fact that the 200 month MA was not broken to the downside in any sustainable fashion, the market was "telling us" back then that the real economy was not about to spiral downward.
If we roll back the clock to a decade earlier than the NASDAQ crash episode and have a look at Japan, the ultimate outcome for both equities and the real Japanese economy was quite different. From the peak, it took the NASDAQ two and three quarter years to touch down at the 200 month MA. For the Nikkei a decade earlier, it took close to five years (early 1995) before the Nikkei actually not only touched, but initially breached the 200 month MA to the downside. And, of course as is clear in the chart, post a multi year recovery above the 200 month MA after the initial breach, the second down side breach of the 200 month MA in early 1997 for the Nikkei was confirming not only a meaningful or generational equity bear market in Japanese stocks, but also an environment of economic malaise that continues to this day a good decade plus later. Was the breach of the 200 month MA associated with a serious real world negative economic outcome? Yes indeed. And since that time, the 200 month MA for the Nikkei has stood as meaningful upside resistance. In our minds, the multi-decade bear market in Japanese equities will be over when the Nikkei sustainably trades above its 200 month MA. It's pretty much as simple as that.
To reinforce the fact that the 200 month moving average of equity indices is quite the important secular demarcation line, as you'll see below, the last time the S&P 500 encountered its 200 month moving average was over 30 years ago in 1977. And that very brief kiss, if you will, was really part of a recovery process that started with a meaningful, and albeit temporary, down side breach of the 200 month MA by the SPX in 1974. But again, was the 1974 breach of this technical barrier then telling us something about the character of the domestic US economy in the 1970's? Sure it was, in the clarity of hindsight. As we all know too well, the latter 1970's were characterized as a period of stagflation, a term really not used too often again until just quite recently.
Following along this road of conceptual thinking just one more time, let's pull the curtains of historical experience way back and have a look at close to nine decades of S&P 500 experience (as being representative of the broad US equity market). Prior to the 200 month MA breach in the 1970's, one has to travel all the way back to the 1930's and early '40's to again see a violation of the 200 month moving average of equity index prices. As we have been saying and suggesting, we're looking for markers of once in a generation type of experience in this discussion. If the following chart is not representative of this type of generational magnitude or meaning in market message, we just don't know what is. The breach of the 200 month SPX MA in the early 1930's was certainly, like the Japanese experience of the present, foretelling of a generational bear in equities accompanied by the economic reality of a depression environment. And much like the Nikkei of the last two decades, there was indeed a brief period of equity index price recovery above the 200 month MA between mid-1935 and mid-1937 before yet another extended down side relapse for another four plus years. And during those subsequent years, much like the Nikkei of the present, the 200 month MA acted as important upside resistance.
In summation, a very meaningful technical demarcation line for equities in important bear episodes is the 200 month moving average. And it takes one mean bear market environment to get there. But as you can see in these examples we've shown, history tells us an actual encounter with the 200 month MA is rare. History also suggests to us that if indeed a 200 month moving average is broken sustainably to the downside in the midst of a bear market in equities, then the bear market itself and the economic outcomes surrounding this type of event are apt to be of generational down side importance. This is exactly what transpired in the US in both the 1930's and 1970's, and in Japan over the last two decades. We view these as very meaningful lessons of literally secular importance. Of generational importance. So although it's pretty darn easy to get caught up in the day to day of financial market and economic news events, we believe stepping way back and viewing the true long term provides us lessons that are quite simply invaluable.
Personally, we're believers in the almost monumental importance of the 200 month moving average. How wonderful to have such meaningful historical context from which to learn and help to interpret forward movement, right? But, of course, by the time an equity index arrives at its own 200 month MA, it has left a trail of incredible price destruction in its path, and it's a darn good bet that the tone of the real economy in such an environment where an encounter with the 200 month MA has already occurred would be very somber at best. In other words, by that time, an incredible amount of damage has already been done. Damage we'd rather avoid, thank you. You already know this brings up the most important issue of the moment - how can we perhaps anticipate an event such as this? How can we protect ourselves against the potential for a generational event, despite the fact that it's statistically a relatively low probability occurrence? When do we play perhaps the ultimate risk management card? We have a few thoughts.
In terms of trying to anticipate the character of the "runway" (the environment) toward the type of generational event we have been describing, we believe it's helpful to look at life in terms of percentage degrees of movement. Quite simply, how far above or below is the S&P at any point in time from its 200 month MA on a percentage basis? The answer to that question looking back over four decades lies below.
Before taking even one step further, we'll be the first to admit that this type of analysis is art, not science. That being said, as per the chart above, it has been very rare to see the S&P within roughly 20% of its 200 month MA. Very rare. As you can see, it happened for literally three months in 1970, but then not again until it was ready to plunge below the 200 month MA in 1974. Was the 1970 three month breach of the 20% line a warning? After the period of financial market and real world economic turmoil we shaded in from November of 1973 through June of 1980, the S&P breached the 20% barrier one last time in 1982 as if to bookend the period of financial market and economic pain, likewise the reversal back up heralding the major equity bull and prosperous economic period to come. Since 1982 right up until the present, the S&P 500 has never again been even 20% away from its 200 month MA. So can we suggest that when/if the S&P is 20% or less from its 200 month MA, we need to prepare and perhaps anticipate a less than pleasant forward outcome? As we look back across historical experience, we believe that 20% line is a warning bell to be heard. As you can see, not even at the equity market lows of 2002/2003 did the S&P breach the 20% line to the down side. Remember, we're looking for generational warning bells here. As the chart shows us, at what were the major lows of the S&P in late 2002/early 2003, the S&P remained 23.8% above its 200 month MA. Today that number is just shy of 29%, with the S&P having lost nowhere near the nominal top to bottom experience of 2000 through 2002. Point blank and germane to the current market environment, IF the S&P were to come 20% or less away from it's 200 month MA (which currently stands at 982, but is moving higher every month) anywhere ahead in the current cycle, we'd have to think long and hard about a potential full court press in terms of risk management.
Let's step back again one more time for some long dated perspective. One more time, from 1920 to present here's a look at the same data from the chart above spread over close to nine decades. We've circled in red the occurrences of a breach of the 20% line we discussed directly above. Outside of the periods we described in the chart above, the only other extended occurrence of a down side breach of the 20% line came during a six month period in 1949. Conceptually as was the case in 1982, was this also a bookend to the entire depression period? Heralding the big equity bull and real US economic expansion to come in the 1950's, as was the minor breach in 1982? The final retest? It sure looks that way to us. As always, historical precedent has an uncanny way of rhyming.
One last what we hope is a corroborative view of life before ending this discussion. Again, thinking in terms of truly long cycle or generational experience, the chart below shows us close to one century of the 10 year moving average of S&P 500 price only returns. Generational enough for you in rhythm? And this is exactly the importance we attach to a view of life such as this. You've probably heard the old adage far too many times that "over the long term, stock prices always rise." Of course, this depends what your definition of long term is, now doesn't it?
Okay, here's the deal as we view the historical context below. The only times the 10 year moving average of S&P 500 prices went into negative territory over the last 100 years were during periods of meaningful real world economic (and of course accompanied by financial market) upheaval. The fact is that over the 1913 through 1924 period you see, the US experienced four official recessions, two lasting almost two full years each (1913-1914 and 1920-21). The next breach of the zero line was the depression era. And then we had to wait a generation until the mid-1970's (the oil crisis and stagflation) for this breach to occur again.
Of course the very important issue of the moment is our present circumstance. NEVER since the early 1980's have we even been near the zero line for this indicator. Even at the equity market lows of 2002/2003, this 10 year moving average rested near 100%. But as of right now, the number is approximately 14%. Without reaching for melodrama, it will not take much nominal dollar downside from here to push this into negative territory. If that indeed comes to pass, it would be yet another indicator of important historical magnitude suggesting we batten down the hatches in generational fashion. It will be strongly suggesting meaningful economic upheaval has arrived, if indeed equities have retained their character as being a meaningful leading indicator for the real economy. You can see that in the aftermath of the historical peaks in this indicator (1920's and 1950's), it ultimately fell below zero in rhythmic fashion before the long cycle bottomed. We'd have a very hard time saying we're not in the process of tracing out the same behavior ahead in the current cycle, given that the prior peak in the late 1990's/early this decade was a record number of price extension to the upside.
So as we move ahead in our present circumstance, we suggest using the 10 year moving average of S&P price in conjunction with the relationship between the S&P and its 200 month moving average to perhaps signal us as to levels of true generational risk in both the financial markets and real economy. Remember, what we have presented in this discussion is interpretive art. We're simply trying to identify the appropriate rhythm of historical experience against which to view the current cycle. We know US credit cycle issues of the moment are incredibly important. We have called them generational in character in our discussions for literally years now. The advent of economic and financial market globalization is incredibly meaningful change. From a demographic standpoint, we have the baby boomers on the cusp of theoretical retirement at the exact time the ten year moving average of equity price only returns is as low as anything we have experienced in close to a generation. And we know the boomers are going to need to at least partially liquidate the financial assets they have accumulated along the way (inclusive of pension assets) to fund retirement lifestyles they believe they deserve. From our standpoint, we believe the multiplicity of issues converging at the moment are far from routine. They are far from cyclical. This is secular in terms of convergence. Again, we warned you this perhaps venture into the dark side would not be fun at all. We simply believe that in cycles such as we now find ourselves, having a sense of the very big picture is quite important. We have no way of truly knowing what lies ahead. Plenty of guesses? You bet. No matter what the probability, we just want to make sure we've at least thought through and are prepared to act relative to any potential outcome. After all, the last time we checked, luck favors the prepared.
© 2008 Brian Pretti