SHOW AND TELL: MY WEEKEND EMAIL TO INVESTORS
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The last time we experienced a sovereign debt crisis that managed to roil the markets in a similar manner to what we have experiencing recently was 1998. I pointed out the similarity in the structure of the decline between 1998 and 2011 several weeks ago.
It is fair to say we have now exited from the depressed portion of reaction to the crisis and moved into the acceptance phase of dealing with various ills - all related to debt - that plague the global economy. The question now becomes twofold:
1. Has the market kept with the structure of the 1998 sovereign debt crisis in exiting the depressed phase and moving into the acceptance phase?
2. What has happened in the past when the market has succumbed to negative fundamental developments and then put together a rally of greater than 10% in just a nine day period as we have recently experienced?
The similarities between the 1998 Russian crisis and the 2011 European crisis continue to be impressive from purely a price action standpoint. The Russian crisis bottomed on October 8th, 1998. The European crisis bottomed on October 4th, 2011.
The rally experienced in the nine day period following the bottom on October 8th, 1998 was 14.84%. The rally experienced during the nine day period following the bottom on October 4th, 2011 to this past Friday is 14.06%. It is rare to see a market rally in excess of 10% during a two week time frame. Rarer still is for that rally to be born within four days of the anniversary of the resolution to the last major sovereign debt crisis experienced 13 years ago.
It is important to now take a look at what has happened when we have experienced rallies in excess of 10% during the 4th quarter when the psychological foundation was as depressed as what we saw earlier this month. To tell of how rare such a rally has been in the past it has only occurred three other times in the 4th quarter over the past 15 years. I chose the to isolate the 4th quarter being that it has characteristics that are much different than the remainder of the year.
To measure depressed psychological moods I used the 50 day moving average of the put/call ratio to be within 5% of a 52 week high. The only other qualifier was that the market rallied greater than 10% during a 9 trading day period. Here is how the markets have done 1 month, 3 months and 6 months following such a rare event:
October 8, 1998 - S&P 500 bottomed at 923 intraday - 9 days later +14.84%
1 month later: +23.51% 3 months later: +38.14% 6 months later: +45.61%
October 10, 2002 - S&P 500 bottomed at 770 intraday - 9 days later +15.58%
1 month later: +13.64% 3 months later: +20.52% 6 months later: +14.03%
November 21, 2008 - S&P 500 bottomed at 740 intraday - 9 days later +13.42%
1 month later: +17.57% 3 months later: +4.73% 6 months later: +20%
In looking further at the price action during the above mentioned periods, 9 days seems to be the starting point for a short-term consolidation phase in the markets. Therefore, it would be wise to assume that risk/reward has been skewed here to a point where buying into long positions doesn't provide a favorable risk/reward tradeoff over the very short-term. Longer-term we can see that the worst case over a 6 month period from the date of the bottom was essentially a flat return in the market.
It is now becoming obvious to Wall Street participants that the rumors of the economies demise based on apocalyptic expectations out of Europe have been highly exaggerated. The positive cycle in technology as well as continued demand from developing nations seems to be enough to offset the negative impact of a financial system that is built on a foundation that has suffered multiple cracks and deficiencies in the developed world.
We continue to undergo a seismic shift in what we know to be true with respect to the economy and the forces behind it. It seems that we are in a time and place where highly efficient micro-cycles within grand macro-cycles are causing short to intermediate term havoc in the financial markets. The grand macro-cycle being that of the process of deleveraging developed economies. Deleveraging is taking place everywhere from the financial institutions; to within the governments that oversee the financial institutions; to the average consumer that is dependent on both the government and the financial institutions they oversee.
The micro-cycles come in form of small shocks that are continually witnessed along the way. What we have experienced with respect to Europe recently is an example of a micro-cycle within the grand macro-cycle. What has become increasingly fascinating and blatantly obvious is the speed with which the micro-cycles operate. The near schizophrenic pace with which market participants assign varying degrees of values to assets based on incorrect information that is perceived as 100% truth is mind-boggling and without precedent.
The modern investor has two choices as to how they to operate going forward:
1. Deal with the volatility and invest for the very long-term (5 years+) knowing that value in a company will eventually be realized by what has become an inefficient and self-cannibalizing marketplace.
2. Operate in sync with the micro-cycles, with investment time horizons no greater than a few months and often times weeks in length. Basically a realization of the inefficiency taking place, followed by an attempt to profit from it.
Each method has its drawbacks. When investing for the long-term within such a cycle you can be susceptible for enormous drawdowns far and away above what would be expected during a "normal" market.
When investing over the short to intermediate term, the opportunity for error is greater and more attention needs to paid to risk in the overall portfolio.
There is also the dilemma of the increasing number of asset classes that the modern day investor has to choose from and the macroization (made that word up) of the financial markets.
It used to be that US investors had a world of 10,000 investments to choose from. In the current market, with the advent of ETFs and global access there are literally over 50,000 ways to allocate funds. Competing asset classes will obviously slow value creation in the market. Small and mid-cap companies will essentially be victims of a overly-competitive environment that renders many companies ineffective due simply to the lack of capital available to them through the public markets.
We are already seeing an increasing attention paid towards ETFs and only the largest, most liquid companies such as AAPL. This puts a further strain on an already inefficient marketplace. It also slows development of the companies that will determine the future of the economic cycle once the influence of AAPL and AMZN has long passed.
All issues to think about on this Sunday, with the hopeful goal of finding a means to adjust profitably.
I hope you have been well.
Regards,
Ali Meshkati
