A slightly pessimistic tone has
developed in the markets. The geopolitical risks involving potential clashes
with North Korea and Venezuela seem to have influenced markets. We also have
words of caution from well-known investors about near-term market declines.
Jeff Gundlach, a well-respected bond manager, has said that those holding risky
bonds should start heading for the exits; he mentioned high-yield bonds and emerging market bonds. Others have echoed his comments.
This is a good time for us to assess
the stock market’s ability to rebound from geopolitical shocks, its maturity,
and how this bull market might proceed from here.
In a letter to clients a few weeks ago,
I recommended reducing the equity exposure of their portfolios to 80% from 100%
by July 28. Our research indicated that the stock market was losing resilience,
and a shift in allocation was appropriate at that time.
While our portfolios became more
defensive, many of our indicators suggest that the market will be able to
rebound from any near-term declines that may be caused by moderate shocks. The
long-term trend of the stock market is still positive. Near-term vulnerability
will be replaced by higher resilience in a few weeks.
Of course, the magnitude of a
geopolitical event is important ― a sizable nuclear conflict may overwhelm any inherent market
resilience. Nonetheless, the market is still relatively resilient and should be
able to recover quickly from market declines that fall short of that
unthinkable event.
Regarding the cautious tone from
well-known investors, we do not see the typical signs of the stock market
reaching a peak and then experiencing protracted declines. Again, the
longer-term positive trend in the DJIA is still intact.
What History Tells Us About Market
Declines
Our research on the last 100 years of
stock market price movements indicates that protracted market declines are
typically foreshadowed by a weakening of our proprietary Macro Resilience
Index. Weakening resilience suggests greater vulnerability, and then some catalyst
occurs to initiate the protracted decline. The progression from resilience to
vulnerability to decline typically takes place over a period of a few quarters,
giving advanced notice to reduce exposure to the stock market. This is
generally true for the prominent declines of 1929, the 1970s, 2000, and
2008. We are not yet in that type of
environment.
However, the sharp decline of 1987
stands out as unusual. This decline was not foreshadowed by a smooth reduction
in our long-term resilience measure. If we are indeed coming to a major decline
while our long-term trend measure is still positive, it would be generally
similar to 1987. Let’s take a closer look at what led up to the sharp 20%
decline in August and September of 1987, exactly 30 years ago.
Our measure of the long-term trend (the
Macro MRI) did shift to a vulnerable reading in November of 1986, almost a year
prior to the decline, but it switched back to positive in May of 1987. And it
made these changes after a long upward trend – almost 3 years after a decline
in the Macro MRI and the stock market in late 1983 and early 1984. The Macro
MRI had moved to a high level that placed it at the upper extreme of the range
it has traversed over market cycles since 1918.
Today, the Macro MRI is positive, steady,
and well short of its historic extremes. Furthermore, it is moving higher in a recovery
from the phantom bear market we experienced in 2015/6 ― just over a year ago. In short,
measures suggest this market is simply less mature and less extreme than the
situation in 1987.
Let’s take a look at how prices
actually moved in 1987 compared to today. The chart below shows the DJIA in
1987 with recent price movement as an overlay. These series start August 9th
of 1984 and 2014.
The first thing that catches one’s eye
is that the periods of strong upward movements and declines line up fairly
well. Based on the apparent synchronization of peaks and troughs, one might
conclude that we are on the precipice of a major decline.
However, as mentioned earlier, the
level of maturity of the bull market is quite different. We estimate that our
current level of maturity (corresponding to the current price level shown by
the green triangle) is where it was in June of 1986 (white white), well over a
year before the big decline. We define
maturity as the level of our Macro MRI, which can be thought of an indicator of
investor euphoria.
The chart above focused on price
patterns, not actual returns. The chart below shows the same price movements in
terms of returns.
The returns since the beginning of the
chart for each time period are quite different. From August 9, 1984 to the top
of the market in 1987, the DJIA rose 113%. Over the period from August 9, 2014
to August 9, 2017, it has risen 32%. The difference is big.
This information does not suggest there
is no risk at this time. Thirty-two percent in today’s environment may somehow
be equivalent to 113% in the 1980s environment of rapidly decreasing interest
rates. Historically, the best course of
action has been to respond to the dynamics of the market as they present themselves
at the time rather than to focus on repeating overall price patterns. Our view could change in a matter of weeks
should the underlying dynamics change.
Near-term Outlook
I believe we will have a few weeks of
soft prices and perhaps moderate declines. When those pass, we can expect a
continuation of high resilience for stock prices.
Other Markets
Emerging market bonds, as Jeff Gundlach
suggests, appear to be at an inflection point. This asset has been resilient
for several quarters but is quickly shifting to being vulnerable. There is
still short-term resilience, but that is likely to fade in a few weeks.
Historically, this asset has not decline dramatically during the early stages
of vulnerable periods.
The SPGSCI (commodity index) is
generally resilient. It has been borderline with a potential shift to
vulnerable, but the shift has not taken place. Short-term resilience is
developing.
