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.
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.
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.