PER STIRLING CAPITAL OUTLOOK – OCTOBER 2015 by Robert S. Phipps
Capital markets are known for “reverting to the mean”, which is one reason why we have been predicting, since mid-summer, that the markets were overdue for a period of dramatic downside volatility. That prediction was proven quite prescient in the third quarter, when the equity markets followed the least volatile six months in U.S. market history (early February through mid-August) with the highest statistical volatility (and the biggest quarterly losses) since 2011.
With third quarter losses in the major domestic equity indexes ranging from 6.9% to 9.3%, and losses in Western European equity indices averaging 9.0%, these two regions actually offered a relative “shelter from the storm”. In contrast, the world’s emerging equity markets, on average, suffered a quarterly decline of 18.7% (their worst quarter since 2008). The S&P Latin America 40 Index dropped by a dramatic 24.1% during the quarter and the S&P Asia 50 Index plummeted a similarly remarkable 17.6%. The Japanese and Chinese stock markets fell by 14% and 25% respectively.
As a result of this decline, the equity markets of the United States, Switzerland, Italy, India, Canada, the United Kingdom, France, Japan, and Spain have now declined between 10% and 20% from their recent highs (a “correction”), while the stock markets in China, Germany, Portugal, Argentina, Brazil, Hong Kong, Russia, and Greece are all down at least 20% from their recent highs (the definition of a bear market).
Even as bearish as our commentary has been over recent months, the global reach of this correction has surpassed even our expectations, which begs the question of whether or not this is now the time to step in and start taking advantage of the recent carnage. At bare minimum, we believe that the time has come to step back from the proverbial “ledge”, sit down at your desk, and start making your shopping list.
On one hand, we are still waiting to see a few things fall in place before making a high-conviction call that the ultimate lows have already been reached. On the other, you will see from the following list of elements that normally occur in conjunction with a market bottom that this correction has already checked most of the boxes.
The first requisite for most market bottoms is the existence of extreme levels of bearish sentiment. This is based upon the premise that, if you are bearish (i.e. you are confident that the market is due to decline), you have already sold your shares. It therefore follows that, if bearish sentiment is very high (or bullish sentiment very low), then most potential sellers have already sold and very few potential buyers have already bought. This normally translates into high levels of sideline cash, and an environment with significant upside potential and reduced levels of downside risk.
There are a number of ways in which analysts measure market sentiment. One of the most useful is the Investor’s Intelligence Bull/Bear Survey of investment newsletter writers. This survey, which divides newsletter writers into three categories (bull, bear, and neutral), provides a very useful perspective due to its leveraged nature. In other words, because each newsletter can help form the market opinion of thousands of subscribers, it helps to measure the market sentiment of a very large sample size. At this point, bullish sentiment is as low as it has been since the depths of the financial crisis in 2009.
Further insight into the sentiment of the individual investor can be found through the American Association of Individual Investors (AAII) Bull/Bear Survey, which reflects expectations for six months into the future. The results of the most recent AAII survey (9/30/15) show a massive 11.2% jump in bearish sentiment, which is quite bullish from a contrarian point of view. To put these sentiment numbers into some perspective, the long-term average for bullishness is 38.8%, for bearishness is 30.3% and for neutral is 31.0%, so you can see that bearish sentiment is approximately 32% higher than normal. Indeed, AAII bullish sentiment readings have now fallen for the 30th consecutive week, which is the longest such streak in the survey’s history.
Moreover, over the past three months, investors have pulled $63 billion out of domestic equity mutual funds, which represents the biggest quarterly withdrawal in the past 30 years.
Indeed, in the latest Investor’s Intelligence Survey of Financial Advisors, only 25% said that they were bullish on U.S. equities, which means that there are fewer bulls now than there were in March of 2009, when the Standard & Poor’s 500 Index reached its bear market low of 666, and only slightly more bulls now than when the survey showed only 22% bulls immediately after the collapse of Lehman Brothers, when there were broad concerns about a potential collapse of the entire financial system.
All of this suggests to us that the selling has become irrationally extreme, that the vast majority of potential sellers have already sold, and that very few of the potential buyers have started deploying their sideline cash. While only time will tell if the ultimate low for this corrective phase has already been reached, we currently view the market as having significant upside potential coupled with somewhat limited downside risk.
In addition to excessive levels of bearish sentiment, one of the key components of most market bottoms is a successful retest of the initial reaction lows. This is something that we wrote about extensively in the September edition of this publication, when we illustrated that in seven of the previous eight times (dating back to 1934) that the domestic markets have experienced such a short, sharp correction, the market required a successful retest of the initial reaction lows (i.e. a double bottom) before they could make a sustained move higher.
As you can see from the chart of the Russell 3000 Index (which includes the 3000 largest domestic stocks), an apparently successful retest of the initial reaction lows has now taken place, and an attempt at a strong rebound is now underway.
Another factor that has turned in the favor of the bulls is the seasonal patterns that have been remarkably consistent in the past. Indeed, the most bullish six months of the year have historically taken place between mid-October and mid-April. According to the Stock Trader’s Almanac, the Dow Jones Industrial Average has, since 1950, averaged gains of 7.6% from November through April whereas, during the May through October period, it has only averaged gains of 0.3%. The relationship is even more dramatic if you measure from mid-October through mid-April.
There are a variety of reasons for this phenomenon, most of which are related to taxes. For example, because most mutual funds conclude their fiscal year in October, there is a tendency to sell losing positions in October to help offset the capital gains that they must otherwise distribute to their shareholders. These trades must settle by the end of the fiscal year, so there is a historic tendency for the first two weeks of October to be quite weak. We have a particular concern about tax-related selling this year, as fund managers may decide to sell as much as is necessary to offset all taxable gains, in order to prevent the need to present shareholders with a tax liability in a year when they are also likely to lose money. Among the other reasons for this seasonal tendency are the end of prior-year IRA contributions on April 15th, required minimum distributions (RMD) from IRAs and qualified plans, and the need to withdraw money from the markets in April in order to pay taxes.
From a seasonal perspective, this has been a textbook correction, as the third quarter is justifiably known as a period of violent sell-offs in the equity markets, and October is appropriately known as the month of major stock market bottoms.
Of note, it was in October that the critical retest of the initial reaction lows took place after the market corrections in 1990, 1998, and 2011.
A point of at least some concern to us is that, unlike in 2015, these (and many other retests) actually violate the initial lows. While it may seem nitpicky, history suggests that a violation of the initial lows is usually very important, as it is the violation of such a perceived area of support that tends to cause the capitulation selling that forces the last potential sellers from the market and puts in place the ultimate bottom.
For the record, we do believe that it is most likely that we have seen the lows for this healthy and very necessary correction, and that this will prove to be an excellent long-term buying opportunity.
However, without the existence of a high-volume, capitulation-type sell-off to confirm that the selling is, in fact, exhausted, we do have to allow for the possibility of another retest later in the month, particularly once the tax-related selling by mutual funds hits its stride. As strange as it may sound, we would have been happier to see a breach of the initial lows and the resulting bout of panic selling. Without that confirmation, it will take some time to confirm the existence of a sustainable bottom.
We will use the VIX fear gauge to illustrate our point. This tool measures fear as a function of how much investors are willing to pay for defensive hedges. As such, it is a great measure of the sentiment of professional traders. It is also an indication of how many “short” positions there are in the market, which is important, as traders are going to need to “cover” their shorts by buying the underlying stocks in the event of a rally.
The good news is that the markets tend to perform very well in the one and three-month periods after the VIX rises above the 20 level, which it just recently blew through.
The less than ideal news is that, while the spike in fear associated with the initial low (red arrow) was a classic example of how this index performs at a major market bottom, there was much less fear associated with the retest, which suggests that there may still be some pent-up selling pressure. If so, we suspect that it will be resolved over the very near term, after which we expect for the bullish seasonal patterns to take hold.
We started this report talking about the tendency towards mean reversion in the capital markets, and applied this concept to this year’s volatility in the equity markets. We would like to return to this concept, but to apply it instead to both short and long-term market returns. In regards to short-term (i.e. quarterly) returns, Bespoke Investment Group just produced a study showing both that weak third quarters are normally followed by strong fourth quarters, and that, with the notable exceptions of 1937 and 1957, the weakest third quarter returns were followed by the strongest fourth quarter rebounds.
If you apply the same concept to longer-term (15-year average) returns, you will find that, with an average annual return of only 3.76%, the new millennium has not been kind to investors. In contrast, if you also use 1945 as a start date, the actual average annual return for the Standard & Poor’s 500 has been 10% per annum, which shows just how substandard recent returns have been.
If you accept the premise of mean reversion, this should actually be interpreted as good news, as it suggests that the next 15 years should be much stronger than average. While this theory tells you virtually nothing about what is likely to happen over the remainder of October, it does provide yet another argument for taking the opportunity of the recent sell-off to purchase equities with a longer-term perspective in mind.
Regardless of whether the ultimate lows for this decline are already in place, or if we will still see more short-term volatility, there are a variety of other factors that give us reason to turn fairly bullish at this point.
To start with, the global equity markets actually sold off on the Federal Reserve’s decision not to raise rates in September. This is a 180 degree turn from recent history, when investors would panic whenever anyone from the Fed even talked about either ending their quantitative easing programs or raising interest rates. This suggests to us that, while not reflected in the Fed Funds futures market yet, investors have adjusted to the inevitability of a rate increase, which should make a rate hike much less dangerous.
We were also impressed by the market’s reaction to the terrible employment numbers on October 2nd. After selling off very hard initially, equities responded with the biggest upside reversal in four years. Few things in the investing world are more bullish than a market that rallies strongly in the face of bad news.
Whether we have seen the ultimate low or not, we believe that history will view current prices as an attractive entry point for equity investors.
Robert S. Phipps, GLO Member: He currently serves as company Director and lead manager for two of Per Stirling’s SMA portfolio strategies. He also authors the monthly Per Stirling Capital Outlook, which details the firm’s macro-economic perspective. In addition, he works directly as an advisor for a select group of individual investors, which includes primarily physicians, executives of technology-oriented firms, and retirees.