by Brian Pretti CFA, Contrary Investor. January 30, 2009
I have the feeling that critical to our investment decision making in 2009 will be successfully dealing with and navigating the “tension” between technical and fundamental analysis. We know the economic news of the moment is pretty much horrible. Hard to imagine how it can get much worse, right? Stick around. In like manner, there’s a fair contingent of the investment community and headline mouthpiece commentators simply itching to call a bottom in equities. We all “know” that in prior cycles, equities have bottomed before the economy has bottomed. In classic experience past, this has indeed been the rhythm of prior bear market and recession occurrence combo experiences. The standout anomaly is the 2001 recession, whereby equities did not bottom until late 2002/early 03, well after the official recession conclusion.
To make navigating the path ahead all the more difficult, we also know that there exists a high level of cash in many an investment coffer. Not too hard to understand given the events of the prior year. Cash in the US equity fund complex currently rests at a five year high, yet in nominal terms it still remains below 5% of total assets. Cash in money market funds as a percentage of the current market value of US equities rests at near two-decade highs. As a quick aside, I personally believe the “mountain of money” argument is shallow at best. I’ve heard this comment for decades and believe proponents of this type of thinking don’t seem to realize that a whole lot of money fund balances are never destined to find their way to the equity markets, yet a kernel of this thinking indeed applies to our present circumstances.
Quite unfortunately, the current players in the mainline broad institutional investment community have grown up living, breathing and eating relative performance. That’s all they’ve ever known. Absolute performance is an afterthought. I’m convinced that in market downturns negative absolute performance is brushed off by many as being an “everybody experienced this” phenomenon. Negative performance is experienced in herd fashion. But missing a rally or producing performance less than some wonderful “benchmark” in up markets is suffered individually and in emotional agony, if not panic.
Therein lies the potential institutional investor behavioral risk in 2009, let alone potential emotional behavior of individuals. With meaningful money on the sidelines and technical patterns dominating a lot of shorter term trading, coupled with the supposed professional need to have a good year after the 2008 shellacking, I have the feeling institutional investors will are primed to jump on and reinforce rallies more so than we have experienced in years. A potentially dangerous (to capital) confluence of circumstances. Although I may be way off base, it’s been my experience in the wonderful institutional world that client risk is higher when under performing in up markets than it is in collectively (with the crowd) losing money in down markets. It’s no wonder institutional investors have been “taught” to respond behaviorally to relative performance issues.
Finally, equity market performance from the peak in 2007 to the as of now 2008 lows was quite the wild ride. As I’m sure you have seen, very much akin to some of the larger non-Depression era historical equity market corrections, this was a big one. Very significant set against historical context. The recent top to bottom decline looked very much like the mid-1970’s total market decline, as an example. So it’s understandable that many in the current generation of investors would believe we’ve seen the worst and are looking for an entry point quite enthusiastically.
Personally, I have absolutely no idea what lies ahead. I have a lot of guesses and a number of game plans, but absolute certainty about what’s to come? Please. As I have written about for years now, I feel we’re in the process of reconciling the credit cycle of a generation. We’ve been here before and seen this very phenomenon in other economies. I am working under the current assumption that the US and probably the global economy is “resetting,” if you will, to a new level of normal. If we make the case that the credit cycle of the prior three decades clearly and positively influenced corporate earnings, GDP and asset values, then we need to ask ourselves just what the US economy, corporate earnings and asset values will look like in the absence of maniacal credit creation. Should the US economy really have become a $14.5 trillion economy? How much of this number was the result of prior credit cycle influence? And as that influence fades for now, where is US GDP headed? These questions necessarily also apply to corporate earnings and asset values of all kinds.
What’s an individual investor to do, right? The pro’s that can hang out in front of quote machines all day and actively trade in and out can control risk quite easily (which is the whole point of investment management anyway). But what about those who do not have this luxury of monitoring the markets constantly while they are open? Do they stick with equities? Do they press their bets if the markets start to lift off? Do they trust their assets to a mainstream investment community who largely rode the markets all the way down last year? What about investors who are decidedly long term in nature?
One of what I hope is the important exercises we have started walking through on our site starting late last year is the process of benchmarking our current real economic circumstances against historical experience. We’re benchmarking against prior recession and market bottom experience. Let me cut right to the chase. Remember, we know equities should bottom prior to recession conclusions. We also know that recessions, as well as bear markets for that matter, do not end when conditions get good, they end when conditions get “less bad.” So, if indeed the equity markets start to rally this year, and the cacophony of Street voice rises up to proclaim technical breakouts suggestive of a new bull market, what can we do to give ourselves a bit of surety that a rally is not just a rally in a secular bear market? A rally that’s ultimately destined to fail and take a fair amount of capital with it off to “money heaven”?
Importantly, we believe we need to benchmark to corroborate what we see in the financial markets as either being on the mark or wishful thinking relative to the reality of the real economy. The issue for the economy is magnitude and duration of the current downturn, regardless of technical breakouts in equities. To show you what I’m talking about, I’ll use one example that is but one tool within a toolbox of benchmark indicators. I’ve tried to repeat the example or conceptual format in the exercise you see below with as many indicators of historical substance I can get my hands on as of late. One of my favorite broader economic stats is the Chicago Fed National Activity Index (CFNAI). The reason I check in with regularity is that this is one broad indicator. The index is a weighted average of 85 indicators covering production, income, employment, hours worked, consumption, housing, sales, orders, inventories. You get the picture. Looking back over the prior six recessions, this is what we see.
At least as of now, only the mid-1970’s and early 1980’s recessions experienced more significant depth of decline. Quickly, as you probably know, the longest two post Depression recessions were the mid-1970’s and early 1980’s recessions – both 16 months in duration. Our recession is now 14 months old and will surely set a new post-Depression record. Remember, magnitude (as seen above) and duration.
In terms of the benchmarking process, have a quick look at the table below.
|History of Chicage Fed NAI, US Recession Conclusions and Recession Equity Market Lows|
|Month Of Chicago Fed Bottom||S&P Cycle Bottom||Recession Conclusion||CFNAI Bottom Relative to Recession Conclusion||CFNAI Bottom Relative To SPX Bottom|
First, we need to remember that the early 1980’s recession experience was really two back-to-back recessions. Can we really consider this one big experience that was interrupted by a minor upturn? Probably. So when looking at the relationship between bottoms in the CFNAI and the economy, maybe 1982 is a bit of an anomaly. Outside of that, the Chicago Fed index has bottomed almost right on top of past recession conclusions. Benchmark number one. We should expect a bottom in the CFNAI to be very near a bottom in the real economy. If the CFNAI bottoms anytime soon, we need to be open to the fact that the real economy is bottoming also. If that’s the case, equities should be firming. You already know the official recession conclusion will be “called” well after the fact, so we believe this benchmarking process is valuable.
The second benchmark is the bottoming in the CFNAI relative to the S&P recession cycle bottoms. This go around, the 2001 recession is the little anomaly, as explained earlier in this discussion. This is one of the very few instances where equities bottomed well after the recession. Excluding the 2001 experience, the average period of time the S&P has bottomed prior to a CFNAI bottom is 2 months. Again, that’s the average. But three to six months of lead-time is what the 1970, ’75, ’80 and ’91 recessions showed us. Okay, point being, again as part of the benchmarking exercise history tells us it’s a pretty good bet equities will bottom 3-6 months ahead of a bottom in the CFNAI. IF November 2008 was the low for equities in general, then we should expect a CFNAI cycle low anywhere from February to maybe April or May of this year.
As we move forward, I believe benchmarking the real economy against directional equity market movement will be important in terms of corroborating equity movement itself and helping us to decide whether what the markets appear to be discounting at any time is correct or otherwise. IF the equity markets were to begin a rally sequence and we do not see subsequent near term bottoming (getting less bad) in this and many other economic stats we are monitoring, then we could have a good sense for potential rally failure.
You get the point. I’m simply trying to equate directional equity market movement with the changing character of the real economy. I believe it’s very important in the current cycle that is quite foreign to most investors of today. Is this a precise timing tool? Far from it as it’s a darn good bet one will miss the exact price bottom if one waits for improving economic character confirmation. But for those trying to participate in potential rallies, I’d argue to you that in the current cycle, corroboration is the key and trumps speculation any day of the week. As far as I see it, it’s all about bench strength. Trust, but verify? You better believe it.
© 2009 Brian Pretti