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S&P500 and major corrections : Is another one coming?

8/6/2015

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Martin Zweig published his famous book „Winning on Wall Street“ in 1986. He outlined several macroeconomic and sentiment indicators, which helped him avoid or mitigate losses during bear markets. He was famous for 2 things: Having correctly predicted the crash in 1987,buying put options before it. And also being the 1. newsletter in Hulbert Financial Digest based on risk adjusted returns, because during the measurement period in 1985-1997, he never had a losing year.

While Zweig used many different indicators, he considered two of them most important : interest rates and debt growth. There isn’t a single indicator that’s correct 100% of time, usually they give confusing signals, so we have to be prepared what to pay attention to.

Goal of this article is to help the reader avoid the worst bear markets by either raising cash or selling short. I do not recommend shorting before a market (or individual stock) has topped. Always wait for a correction of at least 10%. I believe it’s impossible to forecast a top, and there is no need to do it. If you correctly assess a coming bear market, there is plenty of money to be made or losses to avoid many months after the actual top.

I have looked at the past 60 years and highlighted all corrections on S&P500 worse than 20%:

Picture
Source: finance.yahoo.com
As you can see, there were 13 corrections of that magnitude, ranging from -20% to -58% (subprime crisis). In terms of duration, they lasted from 1 month to 31 (dot-com bubble). We can even separate them into brief crashes (1966, 1980, 1987, 1998, 2011) and major bear markets (1961-62, 1968-70, 1973-74, 1980-82, 2000-2002, 2007-2009).

Interest rates and S&P500

Fed funds rate
Over the past 60 years, rates have gone from 1% to almost 20%, and then back to 0% (click on image to enlarge it). I have highlighted the start of each correction with red (market top), and the end with orange (bottom). As you can see, all market corrections started during or right after major rate hikes, by that I mean at least 1%. We can conclude that first hike might not be enough to bring a market down. However, it is quite evident, that rising rates are stock market’s enemy no.1. It doesn’t mean that when rates are rising you should sell everything, it means that odds of a correction are higher with each hike and it will happen in the end.

Consumer debt and personal expenditures

Data for consumer credit is available from 1968, this chart shows the YoY growth rate (click to enlarge).
Consumer credit YoY growth
Source: https://research.stlouisfed.org/fred2
Again, I have highlighted corrections here. It seems that most corrections occurred before or during major deceleration in consumer debt growth rate. If we look at worst market drops in 1968-70, 1973-74, 2000, and 2008, we can see a similar pattern in each. Debt growth kept accelerating towards the beginning, and then quickly fell off in middle of crisis. 

After it reaches extremely low or negative numbers, it’s usually a good opportunity to buy stocks as the deleveraging effect has already happened in most part. 

Rule: If markets are down at least 10% from peak and consumer debt growth starts declining, be careful.


Next chart shows the YoY growth of personal expenditures vs. corrections:
Personal expenditures YoY growth
Source: https://research.stlouisfed.org/fred2/series/PCE#
One man’s expense is another man’s income and vice-versa. If personal expenditures are falling, incomes are down as well. We can see that before or during major crashes expenditures declined significantly. If you had sold stocks or bought options in middle of bear markets in 1969, 1974, 2000 and 2008 after growth decelerated, you would have still avoided a 30% loss in each case. 

Rule: It can be said that when expenditure growth decelerates by at least 30% (let’s say from 10% to 7%), there is a high risk the correction will continue further.

Mortgage debt growth

Picture
Source: http://www.federalreserve.gov/econresdata/releases/mortoutstand/current.htm
If we look at mortgage debt growth, the only similarity can be seen in 1956, 1965, 1980s and 2008, where it declined before and during the market drop. A significant slowdown in early 1990s did not produce a crash, so again this indicator doesn’t work 100% of the time, but could be used in tandem with others to determine an impending crash. Rule: Slower mortgage growth is sometimes negative for stocks, but this indicator does not seem to work as well.

Corporate profits

Profits are ultimate drivers of individual stock prices. If they are going down, the company is probably not doing well. But it can also be applied to the general market:
Corporate profits growth and S&P500
Source: https://research.stlouisfed.org/fred2/series/CPATAX#
This chart shows year over year change in corporate profits. As you can see, almost every time when profit growth was negative, a major correction in S&P500 followed. This was true in the housing and dot-com bubbles, 1974 bear market and October 1987. Other periods show a significant decline in growth before market tops occurred. Again, if you waited until markets topped and sold off at least 10% you would save a lot of money. Rule: When profit growth is negative or decelerating, correction is around the corner.

Sentiment indicators

Martin Zweig used many different indicators like Put/Call ratio (which he invented), AD Line, High/low ratios, Barron’s ads and so on. But according to his book, AD Line was the most important.

Advance-Decline line is constructed at the end of each day. You simply take the number of advancing stocks, subtract the number of declining stocks and get a final figure. Over time this will develop into a line, which declines when more stocks are declining than advancing, and advances when the opposite happens. I have constructed my own line based on NYSE data.

NYSE Advance decline line
Source: http://unicorn.us.com/advdec/
AD Line kept declining from 1965 to 1982, a period of high interest rates and severe bear markets. From there it advanced steadily (along with general markets), until 1998 where it topped 2 years before dot-com bubble burst. This was repeated in 2007, when AD Line registered an all-time high in June, 4 months before the crash. It doesn’t work 100% of the time but in combination with other indicators discussed above it can be quite useful.

How to protect yourself against severe bear markets

1. Buying put options – Options give you limited risk and a big return potential in case you are right. Their downside is of course expiration and price, which might be higher in times of market turmoil due to increased volatility. You have to be quite right on the timing, or buy options with at least 6-12 months to expiration.

2. Shorting individual stocks – Best and hardest way to make money in bear markets. Do not hedge just for the sake of hedging. What will happen is that both your longs and shorts will go against you. Or as John Armitage once said: “If you need to hedge an individual position, perhaps you shouldn’t be in it.” 

Short only into a downtrend and each stock you short has to be that of a overvalued company, in a competitive industry with accounting red flags and whose earnings or assets have a high chance of declining over next year or two. Shorting individual stocks is extremely hard and requires days of thorough research, after which you might wait years to realize any profit.

3.  Selling long positions and going into cash – When markets have reached an elevated stage, P/E ratios are stretched and interest rates start going up, perhaps it’s a good idea to reduce some positions gradually and raise cash. You will sleep more comfortably and think with a clear head, which might help in determining the next step. However, do not get rid of all stocks in panic, as a bear market might not come and you will miss a lot of gains.

When interest rates are rising, indicators start flashing warning signs and markets make at least a 10% correction, the best way to protect a portfolio is to combine all three points. After a good year, buying puts for 1-2% of portfolio will not hurt much when you are wrong. Finding a good short candidate is tough but very rewarding. And lastly reducing positions in stocks which after thorough analysis seem to be overvalued, is a good way to take profits and raise cash to prepare for a bear market. 

Where are we now?

Interest rates are near zero, so to find a comparable period we have to go back more than 80 years to the Great depression. Federal funds rate data is not available from that period, but we can substitute it by a 3-month treasury bill yield.

Interest rates were very similar to current levels, and FED raised them 8 years after the crash. What followed was a quick recession, industrial production fell 20% and stock market lost half of it’s value in a few months. Realizing the mistake, they quickly reversed course and lowered rates, where they remained until 1941. 3-month treasury yield reached 0,02% during that time, which is the same value like now. Some prominent investors like Ray Dalio have raised concerns about FED’s plans to raise again, saying we might see 1937 again. After the 1937-41 bear, a huge bull market started that lasted more than 20 years.
Picture
Going back to present, profit growth had some negative quarters already and is at historical minimums, personal expenditures and consumer debt growth is declining and the AD line is 3,5% below it’s peak. Some indicators are flashing warning signs, but interest rates are still not moving up, and S&P500 is hovering near all-time highs.

For now, I will enjoy the ride but when rates start going up and markets down, I will quickly adjust to a new situation. Remember the goal is to avoid major losses during bear markets, not predict them precisely. Everyone wants to outperform the market, losing as little as possible during such periods is one way to do it.
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