Is the Current Market Like 1987, 1998, or 2008? - Update #2

This post is the second update of my post, “Is the Current Market Like 1987, 1998, or 2008?” The original post was published December 27, 2018.  The first update was published January 9, 2019.  While the key points of these posts are described in this post, the prior posts can be found here:

LinkedIn     Original post                     Update #1
Blog            Original post                     Update #1 

This post discusses where US stock prices may go from here based on the status of CPM’s Market Resilience Indexes (MRI) as of February 1, 2019.  A brief description and the current status of the MRI for the Dow Jones Industrial Average is mentioned below.  Three scenarios mentioned in the prior posts are: 

Scenario #1 - reflects the experience of 2008 – A bear market rally moves prices higher but does not establish new highs and is followed by dramatically lower lows. The price declines of December 2018 would be seen as an indicator of coming slower economic growth. The bear market rally would be like the one that began in February of 2008.  The market ultimately bottomed quite a bit lower in March of 2009. There may not be the excesses in the financial system that we had in the 2008-2009 period, and we may not experience the same degree of loss that we experienced then.  Nonetheless, following the bear market rally, which we are now approaching the end of, there would be another meaningful decline. 

Scenario #2 - reflects 1987 – A bear market rally would be muted, but a longer-term positive price trend follows. The declines in late 2018 would ultimately be seen as a rapid, large-scale adjustment of valuations similar to the price declines of October 1987. There was not a strong rally (bear or otherwise) immediately after the October 1987 decline, but the decline did not foreshadow further deterioration in the real economy. Economic growth was strong pre-October 1987 just as it is now.

Scenario #3 - reflects 1998 – After the initial price declines, a rapid recovery to price levels as high or higher than what had been previously experienced. The declines at the end of 2018 would be seen as being driven by negative news-of-the-day events occurring at a vulnerable time. This would be like the decline ending in August of 1998 related to the Long-Term Capital Management crisis, which was quickly resolved. Economic growth was strong in 1998 just as it is now. However, then, as now, the Macro MRI indicated a negative trend in stock prices.  A more recent period reflects the same pattern.  The 2015-2016 period was similar.  The Macro MRI turned negative in mid-2015, and the yuan devaluation scare precipitated stock market price declines in August of 2015.  The US stock market remained vulnerable until mid-2016 and then became “most resilient” through the beginning of 2018.  During this period, the Fed cited global weakness and held off raising rates, which seemed to accelerate the shift to a positive Macro MRI trend. 

All three of these periods have Market Resilience Indexes in similar positions to their current status. 
Briefly, the MRI framework decomposes market price movements into three main cycles of resilience that support higher prices.  The up-legs of these cycles provide thrusts of resilience. Conceptually, the cycles represent the tone or mood of the market.  The up-legs indicate investor euphoria and market resilience.  The down legs indicate investor despondency and market vulnerability.  We focus on the up-legs of these cycles and give an index (e.g., DJIA) a rating based on how many of these three cycles are in their up-legs.  

These cycles of resilience are:
·       The Macro MRI indicates long term cycles lasting several quarters or years.  Currently, the Macro MRI is absent and indicates persistent investor despondency and a negative long-term trend in stock prices.  This status is consistent with all three scenarios. 
·       The Exceptional Macro, indicates a strong thrust of resilience and occurs infrequently, typically at major market bottoms.  Currently, the Exceptional Macro is not close to occurring, which indicates we are not at a major market bottom.  This status is consistent with all three scenarios. 
·       The Micro MRI indicates thrusts of resilience lasting 6 to 18 weeks.  The Micro MRI has been in the up-leg of its cycle from late December 2018.  It is currently at the 79th percentile of levels since 1918.  It is not unusual for the Micro MRI to peak at levels close to the 80th percentile. It is not unusual for the Micro MRI to move up about 10 percentile ranks in a week.  Thus, the Micro MRI could cease being positive this week or over the next few weeks. 

When all three MRI are providing resilience, a market index is rated 3, which means “most resilient.”  A resilient market is likely to recover quickly from price declines associated with bad news.  When none are providing resilience, a market index is rated 0, which indicates that the market is vulnerable to bad news and more likely to move lower. I provide additional information about the MRI framework at the end of this post

At the moment, the Dow Jones Industrial Average is rated 1, with only the Micro MRI providing resilience.  With only the Micro MRI currently providing resilience and its level being at the upper end of its historical range, we should expect a much more vulnerable market over the next few weeks.  When the Micro MRI ends the up-leg of it cycle, the DJIA index will be rated 0 (least resilient).  Without any positive MRI, it will be most susceptible to negative news and price declines are more likely. 

Recent price gains for the DJIA since 12/21/2018 have recovered (retraced) 62% of the decline from the prior high on 9/21/2018 (based on weekly closing prices).  This recent move higher is a greater move than was made after the abrupt October 1987 decline.  By the time the Micro MRI had reached a similarly high level (roughly the 80th percentile) in early 1988, it had recovered only 23% of its prior declines.  The relatively strong current bear market rally suggests that portions of the investor base continue to have high expectations for economic growth and that there has not been a large-scale revaluation of stocks.  This observation suggests scenario #2 (reflecting 1987) is less like current conditions and can probably be discarded from further consideration.     

The recent moves higher are more similar to the price recovery in 1998.  By the time the Micro MRI had reached a similarly high level (roughly the 80th percentile) in 1998, it had recovered roughly 76% of its recent declines.  This supports Scenario #3 (reflecting 1998) as being a possibility, considering current conditions.

Thus, current conditions are most similar to scenarios #1 (2008) and #3 (1998).  The important difference between these scenarios is price behavior at the very end of the up-leg of the Micro cycle.  In scenario #1 (reflecting 2008), prices failed to make a final push higher and then fell dramatically.  In scenario #3 (reflecting 1998) prices pushed higher at the end of the Micro cycle and subsequent declines were muted. 

Thus, discerning between these two scenarios will most likely be determined by price action and Micro MRI movements over the next two weeks.  If stock prices do not move higher, scenario #1 (2008) becomes more likely.  If prices move markedly higher, the scenario #3 (reflecting 1998) becomes more likely.  At the moment, the price trend seems relatively weak and most like scenario #1 (2008). 

It is important to note that the Micro MRI is still positive and providing resilience. Accordingly, our model portfolios have had relatively high allocations to stocks beginning January 4, 2019. The MRI algorithms had indicated a bear market rally was likely. The next market inflection point will occur when the Micro MRI does cease to be in the up-leg of its cycle, which is likely to occur over the next few weeks.

Please contact me with any questions or comments.

Jeffrey Hansen (Jeffrey.Hansen@me.com)

Background on The Market Resilience Indexes (MRI)

The CPM Investing framework is organized around three main MRI that are generated each week for each index (e.g. DJIA, US 10y Treasury).
1.      The Macro MRI indicates the long-term trend of resilience and is indicative of the long-term trend in index price. Macro resilience increases and decreases with a cycle lasting several quarters or years.  Each weekly reading indicates the level and direction of the long-term trend.  The peak of the Macro MRI generally coincides with a peak in index prices. The cycles of the Macro MRI are only somewhat rhythmic compared to the Micro cycles; the cycles are often interrupted or truncated. 
2.      The Exceptional Macro MRI indicates when the Macro MRI is nearing the bottom of a cycle and is likely to turn positive.
3.      The Micro MRI indicates bursts of resilience typically lasting 6 to 18 weeks.  The Micro MRI cycles are most apparent in the ups and downs of index prices throughout the year.  They can be thought of as normalized price movements. 

The MRI are additive. When they move together in one direction, they reinforce each other, and prices tend to follow that direction. When they move in opposition to each other, they tend to cancel each other out, and prices tend to be flat.

To describe the level of the Macro and Micro MRI, we indicate its percentile level within all its weekly levels since the inception of the index.  For example, the DJIA has over 5200 weeks of history since 1918. A level is described as, say, the 31st percentile within the historical range of levels.  Its direction is also important.  If it is moving higher (i.e., it is on its up-leg cycle), we say it is present and providing resilience.  If it is moving down (i.e., it is on its down-leg), we say it is absent and not providing resilience.  From readings of level and direction, we can estimate the MRI’s likely near-term course. 

For example, if a level of a Macro or a Micro MRI is at a low level and moving down, we can guess that it will not move down much longer. As it nears the 1st percentile, the very lowest level of its historical range, we can expect the MRI to shift to the positive leg of its cycle and move higher.   
The Exceptional Macro is either present or not.  When it is present, it can overwhelm the Macro and Micro MRI to produce price gains even when the Macro and Micro MRI are absent. 

The rating for a market index (e.g. the DJIA, S&P500) is defined by the number of positive MRI and range from 0 to 3:
            3 = Most resilient
            2 = Moderately resilient
            1 = Slightly resilient
            0 = Least resilient

If all three MRI for an index are providing resilience, it is rated 3, “most resilient,” and prices may decline in response to bad news, but prices recover quicker and more completely. 

When none are providing resilience, it is rated “least resilient” and bad news produces bigger declines with slow and incomplete price recoveries.

The MRI levels and directions at a given time for different asset classes can help us position portfolios to favor the asset classes (e.g. stocks, bonds, and cash) rated most resilient and to avoid those rated least resilient. Trades based on MRI levels and directions tend to be more reliable than trades based on actual price levels and directions. 

For purposes of estimating stock market resilience, the Dow Jones Industrial Average is superior to other major indexes.  It has a 100-year history, has fewer constituents and indicates inflection points more distinctly, and has less interest rate sensitivity and commodity sensitivity than do the Russell 1000 and the S&P 500.  Thus, while it sounds very old school to use the DJIA, it produces reliable signals and justifies the focus.  We do track and evaluate other indexes for context and confirmation.