What follows is a section from the “Looking Ahead” portion of my monthly letter to investors at T11.
In order to look forward with any sensible appreciation for what is going to occur, let's look back at an excerpt from last month's “Looking Ahead.”
We are presently in the midst of the aforementioned “reset.” One of the fortunate features of any bull market is its ability to swiftly move through periods of bearish adjustment. I don’t assume that this adjustment will move past mid-November. However, during that time the damage on the downside could be fairly extensive (5%+) for the major averages.
At its worst during October, the S&P was down 7.71% for the month. This swift period of downward adjustment came to an abrupt end on October 15th, with what is likely to be a significant low for all major averages. In fact, according to the evidence presented by the market, the low that was created in October is as important as the October 2011 and March 2009 lows.
Let's look at the evidence:
1. The short-term moving averages for the combined put/call ratio hit levels not seen in more than two years, signaling an extreme bearish stance by market participants during the beginning to mid-October. On October 13th, two days from the ultimate low, the CBOE combined put/call hit 1.53 to close the day. This was the highest recorded close on the put/call in more than four years, signaling an extraordinary amount of put buying among market participants.
2. The Russell 2000 of 2014 has a very significant correlation with the Russell 2000 of 1994. I outlined this correlation in an article on Zenolytics. The chart can be found by clicking here. In 1994 the max downside for the year in the Russell occurred in Q4 with a decline of 9.55%. In 2014, the max downside for the year in the Russell has been 10.58%. Both 1994 and 2014 were preceded by multiple years of significant gains in the Russell. In other words, they turned out to be periods of digestion within a larger run for the average. Following the digestion period in 1994, the Russell went onto gain nearly 30% in 1995. I expect 2015 gains to be similar in nature.
3.We have now experienced a 10% correction in the S&P. This qualifies as a “reset” of the bull market. Especially in the face of the fear it created during mid-October. Resets of this type are significant events, preparing the markets for their next cycle up. For examples look no further than the 1990s bull market that was filled with short-term violent resets that threw investors off the scent of the markets in a highly efficient, if not ruthless manner.
4. The 200 day moving for the S&P 500 was pierced to the downside for the first time in nearly 500 days. The 500 day period without a break of the 200 day moving average is the most the market has ever gone without piercing this technical measure to the downside. This is an extremely important piece of information the market is attempting to communicate with its participants. The message is that the market is abundantly strong. The bids that have been supporting the movement forward have been extremely persistent in nature, not being dissuaded easily. This type of persistence does not disappear overnight.
In fact, if we look back as far 1990 we see what has transpired after other record periods above the 200 day moving average. Here are some examples:
A. The second longest run after the this past one was from 1995-1996. The break of the 200 day MA took place in July. Just a couple months later the S&P was 10% higher. A couple years later it was close to 100% higher.
B. The 3rd and 4th longest runs took place in the 50s and 60s. Too far back to have any relevance. However, the fifth longest run took place from Oct 92-Mar 94. After the S&P 500 broke its 200 day MA in March 1994 it declined by roughly 5%. That was the low… for the decade.
C. The 7th longest run took place from Aug 96 – Oct 97. The break of the 200 day MA was a one day event here. 6 months later the S&P was higher by 30%.
The point here is that once you get a record run above the 200 day moving and the market resets by moving below it, the bids often come back in a powerful way because it is chance for those without adequate exposure to gain exposure at advantageous levels for the first time in quite awhile. The market inevitably moves higher. Often times, much higher and for much longer periods that participants expect.
5. One of the overlooked contributors to gaining perspective into the sentiment of market participants is not simply judging whether put/call ratios suggest excessive optimism or pessimism. Rather, it is valuable to look at overall patterns in the put/call as demonstrated by the moving averages.
The thinking behind this is that the reactions of market participants to a bull or bear market will invariably be identical regardless of the time or place. Bull and bear markets are after all a dance between various degrees of fear and greed. The put/call ratios demonstrate these emotions in fairly similar patterns during different stages of different bull and bear markets.
One of the more obvious traits of the put/call ratio during a bull market is for it to put in a series of lower highs and lower lows over a period of years as a bull market progresses. This is a reflection of conviction in the bull market becoming cemented in the psyche of investors, thus causing a fairly steady decline in the amount of pessimism necessary during each successive correction to put in a sustainable low.
As an example, here is what the bull market of the 1990s (starting in late-1995, earliest data available) looked like as reflected in the moving averages of the put/call ratio. 1995-1997 was the mid-stage of the bull market, as it turned out:
We are currently entering the mid-stage of the bull market, very much on the same track as the 90s bull. Notice the same pattern of lower highs and lower lows taking place each year:
The top to the 90s bull finally arrived when the put/call ratio as reflected by the 20 and 100 day moving averages, both dropped below .50 in late 1999/early 2000. The lowest point we have come to during this bull market was the drop below .75 for the 20 day moving average earlier this year. Those types of numbers may indicate that we are still in the early or possibly entering the mid-stage of the bull market when compared to the 1990s bull market. As you can see in the chart above, the earliest data in late 1995 shows the put/call in the .70 range.
The key takeaway here is that A) interpreting the put/call on an absolute basis is foolish. An investor must realize that during the progression of a bull market, the put/call gradually “recedes” with every higher high in the major averages. Therefore, one must expect lower readings to indicate extremes in sentiment. B) when looking at the current put/call moving averages, there is no indication that investors are nearing any extreme in sentiment when compared to the last great bull market of the 90s. If anything, we still have 3-4 years left before entering the stage of dangerous excess in approval of this bull market.
Lastly, given that we have officially put the proverbial nail in the coffin of QE with this most recent Fed meeting, it is important to discuss the future of interest rate policy as it applies to the equity markets.
The chances are high that in 2015 we will encounter our first in what is expected to be a series of increases in the Fed Funds rate. According to popular perception the tightening of the purse strings with respect to liquidity is certainly not a reason to be bullish going forward. This is especially true when you consider that popular perception considers this current bull market one that wouldn't exist without an inordinate amount of Fed induced “help” along the way.
If an investor is to look at the past data, however, it becomes apparent that interest rates have to move up quite a bit before the equity markets takes notice. Looking at past rate hike cycles, they have typically started in hindsight at what turns out to be the late-early to early-mid stages of a bull market.
Going back to 1990 we have two distinct rate hike cycles:
A. 1990s Rate Hike Cycle
- The first rate hike cycle started in February of 1994-March of 1995. This first stage of the rate hike cycle was particularly aggressive with the Fed raising rates by 300 basis points during this 13 month period. The S&P 500 responded by being down 2% during this aggressive rate tightening cycle. Hardly a reaction. In 1995 the S&P 500 was up 34%.
- The second cycle started again in April of 1997 with a small 25bp hike. Over the next 12 months the S&P 500 was up 46%.
- The third and last part of the rate hike cycle started in July of 1999 – July of 2000. During this period the Fed Funds rate increased by 175 basis points. The S&P 500 reacted by being up 6% during this period.
B. 2000s Rate Hike Cycle
- The first and only rate hike cycle started in June 2004 and continued all the way until August 2006. During this period the Fed Funds rate rose by 425 basis points. During this aggressive period of rate increases the S&P 500 rose 16%.
The point here is that choking off the liquidity that the market has become accustomed to is not necessarily a death sentence for equities. It takes a series of aggressive actions over a period of years to finally start influencing equity prices negatively.
The data certainly suggests that getting out of equities at the beginning of rate hike cycles is an exercise in foolish timidity. If anything, it can be argued the data shows that increasing exposure during the onset of tightening in the Fed Funds rate is a profitable strategy going as far back as data gathered from the 80s with respect to the performance of the S&P 500 relative to the Fed Funds rate.
In light of the aforementioned data, we have strong indication that the general market environment will continue to be accommodating to investors in the years ahead. There will, of course, be short-term bearish periods that work as effectively as this most recent decline to create enough fear in speculators to resume the uptrend in a more ebullient manner. This is normal in the course of any bull market.
Within an accommodating market environment what I must determine is which positions have the potential to outperform the greatest over the long-term. Invariably, the greatest outperformance will come from opportunities that have the least amount of coverage, understanding and attention among investors. These opportunities have the tendency to make up for their insolence in rather dramatic and sudden fashion over a period of weeks or months. The remainder of the time is spent digesting gains in what is often a painful, tedious march through vast realms of insignificant price action.
Most investors cannot handle this reality, making the decision to liquidate far ahead of what is the most opportune time to do so. After all, in a market of 10,000 stocks, your attention can easily be persuaded by a prettier girl who seems to embody everything your current girlfriend does not.
Nothing with respect to material fundamental developments have taken place within our portfolio holdings. Additionally, nothing with respect to material technical developments have taken place within our portfolio holdings. We have simply been burdened by the temporary reality of investor disinterest.
The only decision to be made is whether to fall in line with convention, in the form of following its “wisdom” into a place of fear and skepticism. Or to directly defy convention by using fear and skepticism as an opportunity.
Regards,
Ali Meshkati
