Client Note {Part II}

We're publishing today part II of a recent note we sent to clients.  We'll publish the conclusion tomorrow.

Could we have a stock market crash?  There’s been talk of that on the television lately.

Investors decided in mid-December that their economic projections were too optimistic.  They went into risk-off mode and have sold every rally since then. But this change in market sentiment shouldn’t be confused with a crash. The financial press needs headlines to grab attention.  The return of market volatility since 2015 is a great way to get those eyeballs back watching CNBC or reading the papers.  I’ll define a market crash, as when an unexpected event catches too many investors on the wrong side of the market.   Something important to note is that you usually need a catalyst for that to occur.  That’s usually an unexpected event washing up over the transom that has everybody looking for an exit all at once. Typically these events also resonate well beyond Wall Street.  In 2008 it was the banks, in 2000-01 it was the events around the terrorist attacks and the bursting of the dot.com bubble. Market sentiment may have changed, but so far we’re seeing a pretty typical correction in stocks, not the sort of far reaching event that historically has led to a catastrophic event for stocks.  That’s not to say that stocks can’t decline further, but again a true financial crash is still by our work a low probability event absent that unexpected catalyst.  Even the flash-crashes we’ve seen in the past few years have had more to do with short term issues that have righted themselves almost right away.  

What are your current market assumptions?

We do not assume.  Our system uses a probabilistic assessment that weighs market evidence based on three factors, fundamentals {both market and individual sector}, valuation and money flow analysis.  Based on the weight of the current evidence, probability suggests that we are in a market consolidation.  A market consolidation is a period where stocks correct by both time and price.   Right now the market’s pattern appears similar to how equities traded in 2011-2012.  The red box in the included chart highlights that period.  By the time that corrective phase started, stocks had advanced nearly 100% from the 2009 lows.  Like today, slowing economic growth was one of the factors that marked that period. There were three peak-to-trough corrections in 2011-2012.  They are numbered on the chart and produced declines of 16%, 11% and nearly 10%.  At the lows of each correction back then you were looking at stock prices that were not that much different than a few years before.  You could also find the financial press full of stories about how the bull market back then was over.  Each time the market bent but didn’t break. Near the end of December 2012, stocks traded only about 3% higher than they had back in February of 2011-almost two years of going nowhere. Stocks advanced another 50% coming out of that corrective phase.  

The US markets have now marked time consolidating between roughly 1,820 and 2,120 on the S&P 500.  That’s about a 16% price band and not too far off the market’s historical 14% volatility.  The price declines in this phase are similar to what we’ve seen in other consolidating periods. The percentage bands look larger because of how much prices have advanced over the last few years.

That line of reasoning-that we are in a consolidation-will be right until it is wrong.  It will eventually be wrong because one of two things will occur.  The first is that markets will turn and ultimately break out to new highs.  We think stocks will ultimately experience a rally.  Right now markets are very oversold by our work.  However, we think it is a lower probability event in this current environment that stocks will power forward to significant new highs in the near term unless we see better economic news and better investment sentiment. The second way we can be wrong is that markets break convincingly lower.  In that case we would have to become more defensive in our portfolio structure.

So what are you doing? 

The first thing you have to do is recognize how things have changed and then adapt that change to portfolios and client mandates.  In aggregate we made fewer new purchases for clients last year because we found little back then we judged attractive enough to put larger amounts of money to work.  We have higher levels of cash right now in most client accounts as a result.  Cash is an asset that currently pays nothing.  However, it is a nice hedge to have when markets are declining.  We will use this period as we do all corrective phases as a period to reassess and reorganize where needed in client accounts.  We could also raise some more cash on rallies to higher prices.  As we have indicated before, there are also levels of market participation or events that might via our disciplines force us to raise more cash, especially if we believed the market was resolving this corrective phase to a lower level of trading.  We are always attracted to ETFs where the current market dislocation has brought the fund down to levels where the dividend is attractive.  Many ETFS that specialize in paying dividends are now trading at levels where the dividends are paying 3.5-4%.  That should provide a cushion in case of further market declines.

*Long ETFs related to the S&P 500 in client and personal accounts, although positions can change at any time.