Stock
market gains for 2017 were strong, and it is reasonable to wonder: Where will
the market go from here? Will it continue to go higher? Will it stumble and
fall in 2018?
Two
well-known and respected investors have come out with very different forecasts
for 2018. Jeffrey Gundlach says (link) stocks are in an
accelerating phase now but will ultimately post negative returns for 2018.
The
S&P 500 “may go up 15 percent in the first part of the year, but I believe,
when it falls, it will wipe out the entire gain of the first part of the year
with a negative sign in front of it” – Jeffrey Gundlach
Or, are we
poised for a jump in stock prices as global growth accelerates, as Bill Miller
suggests (link)?
I
think we could have the kind of melt-up we had in 2013, where we had the market
go up 30 percent," -- Bill Miller
The tone of
these statements is different, but they could both be true. The market could go
up 15 to 30% in the first part of the year and then decline.
The CPM
investment approach does not make or use such forecasts. Instead, we evaluate
the market’s current ability to recover quickly from bad news and events. This
assessment is based on our Market Resilience Indexes (MRIs) and typically remains
relevant for a three-to-six week horizon.
Let’s
review what the Market Resilience Indexes are currently telling us, and
identify past periods that are similar to the current environment. This will
give us a sense of where we might be in a broader cycle of stock market
returns.
As of
January 5, 2018, the Macro MRI, which tells us about the longer-term price
cycles and trends, is at the 97th percentile of all weeks since 1918
— clearly a high level. Yet, the direction of the index’s change is
still positive, and decidedly so. Based on past cycles, the Macro trend could
remain positive for a few months.
The Micro
MRI, which tells us about the bursts of resilience lasting 6 to 13 weeks,
indicates that we have already experienced a period of short-term vulnerability
and that the market is likely to become more
resilient in the coming weeks.
Considering
all the MRI together for the Dow Jones Industrial Average, our assessment is
that the market can recover quickly from any bad news and events. Thus, our
portfolios continue to be fully invested.
Greater
resilience at both the Macro and Micro levels is consistent with Miller’s
“melt-up” statement and also with Gundlach’s view that prices will move higher
in the early part of the year.
Historical
Precedents
To see how
the current market environment compares with past periods in terms of its
particular mix of Macro, Exceptional Micro, and Micro MRI, we compared twelve
different statistics related to MRI levels, direction of movement, and pace of
change. Over 5000 weeks covering almost 100 years of weekly statistics were
evaluated for the DJIA.
We
determined the fifteen weeks most similar to the status as of January 5, 2018. The fifteen weeks clustered into five
different periods:
1996 – 6 similar weeks
1959 – 2
1955 – 4
1937 – 2
1926 – 1
The graph
below shows these dates on a price chart of the DJIA. “Price” is on a log scale
to appropriately show the magnitude of early price changes in percentage terms.
Based on
the number of weeks identified as similar, the 1996 cluster of six weeks is
most similar to the current environment. It is near the beginning of a strong
move upward in prices that lasted for four years until 2000.
The next
largest cluster occurred in 1955, with four similar weeks. This too was
followed by a strong market that moved upward, with some volatility, for about
10 years until 1966.
The 1959
cluster of two similar weeks was followed by generally higher prices. It is
within the upward trend following the 1955 cluster.
Two similar
weeks occurred in 1937. This cluster was followed by a sharp price decline and
a negative trend in prices that lasted until 1942, which is discussed below.
The week in
1926 was also followed by a strong market for three years until the 1929 crash.
Across all
the historical weeks most similar to last week, about 75% of the subsequent
13-week periods had positive returns. This pattern suggests a strong market in
early 2018. However, as mentioned for the 1937 cluster, some of the similar
weeks in the past were followed by declines. Two periods are noteworthy.
In the 1937
case, prices dropped by 11% over the following 13 weeks. This period became
known as the “1937 Recession.” It occurred at the end of the Great Depression
when an initial industrial recovery faltered. Unemployment jumped from 14.3% in
1937 to 19.0% in 1938.[1]
However, our current unemployment statistics are quite different — they are low. Furthermore,
growth is accelerating globally. Thus, the 1937 period may not be similar to
our own in an economic sense.
Another
cluster that is somewhat similar to the current week is just prior to the
decline of 1987. The week of September 4, 1987 is not shown above because it is
outside of the top 15 shown, but it is in the top 30 of similar weeks.
September 4th was followed by a 30% decline over the next 13 weeks.
While this is a chilling prospect and deserves consideration, a case can be
made that the broader conditions are different. First, the market had
appreciated 97% in the two years prior to September 4, 1987, whereas the market
appreciated 56% in the two years prior to last week. While both are large
numbers, the appreciation prior to the 1987 date is greater.
Second, in
1987, the market had been moving contrary to its resilience levels for about a
year prior to the crash. This is often
seen in the late stages of bull markets, which are overly euphoric. This stage
can last for several quarters. Today,
the market has been performing in a manner generally consistent with its MRI
levels, with the exception of the last month or so (noted below).
Thus, today’s
conditions are different. The positive
aspect of the 1987 decline is that it was followed by 10 years of strong market
returns.
While
acknowledging the cautionary precedents of 1937 and 1987, the cases of 1996 and
1955 do have the highest number of weeks similar to the current environment. These cases support a more optimistic view or
where we are in a broader cycle.
Recent
stock market behavior relative to our assessments of resilience gives
additional perspective. During the
recent two months of greater vulnerability, as measured by our MRI, the US
stock market did not decline — it went up.
This recent
market behavior could be telling us that we may be moving into a more euphoric stage,
where vulnerability does not result in price declines. If so, this heightened euphoria is just
beginning.
However, we
may find that the last two months of defiance could more reasonably be attributed
to the passage of the tax bill, which may boost corporate profits. Either way, the current market environment
does not yet appear to be excessively
euphoric the way it was prior to September of 1987 and in other major declines
of the last 100 years.
This
evaluation leans more toward the view expressed by Bill Miller —
stock market prices will move higher.
That said,
it is important to remember that our approach does not rely on forecasts. The analysis driving our research and model
portfolios is based on readings of the market done every week. We will evaluate
the market another 51 times in 2018 and will change our model portfolios as
needed. We can see the dynamics shift and the algorithms will shift the
portfolios in response to the changing dynamics so that if the stock turns down
as predicted by Gundlach, we will respond.
[1]
Economic Fluctuations, Maurice W. Lee, Chairman of Economics
Dept., Washington State College, published by R. D. Irwin Inc, Homewood,
Illinois, 1955, page 236.
