By Tiho, Short Side of Long
- Volatility levels are extremely low and complacent globally. In the US, the VIX was recently at 5 year lows. In Asia, implied volatility (IV) on all major stock indices has approached multi year lows as well. Finally, in Europe volatility is also very calm, but more importantly credit default swaps remain elevated, signalling the crisis is not finished by any stretch of the imagination.
- The Junk Bond market is encountering a major technical supply zone (resistance) on the HYG ETF. Price levels from 91 to 93 have been major selling points during the last several years. Furthermore, despite US equities marching towards new highs in March and August 2012, the Junk Bonds have been sending us a warning non-confirmation signal.
- Despite low volatility, behind the scenes, commodity currencies are starting to weaken. In particular, the Aussie Dollar is losing its bid as investors watch prices of Iron Ore free fall (60% of Australian mining export). From a contrarian perspective, investors are extremely bullish on commodity currenciesright now. Disclosure: I have shorted Loonie with OTM March ’13 Puts.
- All eyes should be on the price of Copper in coming days and weeks, as it gets ready for a make or break technical decision. Its decision will be one of the critical leading indicators for the future state of the global economy, as already discussed in the previous article. Other industrial metals, including Iron Ore and Steel, have not performed well as Chinese demand slows meaningfully.
So before we start, it is important to understand the context and conditions we find ourselves in right now. Currently, we are in an equity bear market from a secular perspective and at the same time in an equity bull market from a cyclical perspective. Actually, we are in one of the “best ever” cyclical bull markets when it comes to performance gains and length (according to the article). So with that in mind, we can all agree that sooner or later, this powerful and aged cyclical bull market will end. While the majority of you will probably want to know the when, we will focus on the what. In other words, what happens next?
In the last century there have been three great secular bear markets. These are usually known as long sideways trading ranges, where the common theme tends to be frequent recessions, contracting valuations and general investor pessimism. While dates tend to vary slightly, the chart below shows secular bear periods to be from 1906 to 1920 (blue), from 1929 to 1949 (red) and from 1966 to 1982 (green). The current secular bear market started in year 2000 and is highlighted in black.
The chart above, showing an average inflation adjusted secular bear market, best explains what happened. The secular bear market model has worked very well in predicting the bottoms in 2003 and 2009, as well as the top in 2007. However, someone recently changed the price from previous historical patterns. In reality, we should have already declined meaningfully in 2011 and found some type of a bottom by 2013/14. Does anyone still remember the May 2011 peak at 1370? While the decline did start in 2011, Helicopter Bernanke and Super Mario postponed the equity bear between September and December 2011, by doing various forms of monetary stimulus. By refusing to let equities correct through natural free market forces, central bankers have now overvalued the current cyclical bull market. Therefore, this most likely means that the next fall will play catch up on the downside in a much more violent and swift manner. Downside mean revisions are never a pretty sight.
Away from the price and time aspect of tracking the current secular bear market, we also have at our disposal a fundamental valuation tool know as the Cyclically Adjusted Price to Earnings Ratio, also known as CAPE 10. In the chart above, we can see that all great generational buying opportunities occurred when CAPE 10 reached a single digit ratio. We saw this in 1920, 1932, 1942, 1949, 1974 and 1982. Since the March 2009 bottom never reached single digit CAPE 10, it will most likely not be a major low in inflation adjusted terms. Since the current CAPE 10 is above 20, it is highly likely that more sideways trading and more selling will come before the real bottom is in.
As a side note, do keep in mind the astronomical overvaluations we saw during the Tech Mania of the late 1990s, which could have prolonged this secular bear market, that commonly runs for about 17 years, towards a longer 20 year span like in the 1930s/40s. After all, over 27 years has passed since the CAPE 10 was anywhere near single digit readings.
So if now is the time to expect another bear market of cyclical nature (30% decline), the million dollar question is, when will it be time to buy? While I cannot tell each one of you what to do, I can express my own opinions on what I plan to do in the future:
- Firstly I plan to respect both the time and inflation adjusted price of the current equity bear market. Relative to previous historical patterns, my secular bear market model shows that an expected bottom should be somewhere in the middle part of this decade.
- Secondly, I plan to monitor the way company earnings trend behave over a prolonged decade against price (CAPE 10) and only act if and when it approaches single digit levels. There needs to be a confirmation between point one and point two.
- Finally and most importantly, the chart above shows that we should only buy stocks after they have returned 0% gain including dividends over the annualised 17 year period. In other words, when the stock market goes absolutely nowhere for almost two decades, it is most likely time to buy!
For a wise long term investor, who was willing to bet a farm on it, periods when CAPE 10 reached single digits and stocks returned 0% over 17 years occurred in three periods overs the last 120 years. These were between 1918 and 1923, between 1946 and 1949 and finally between 1978 and 1984. Buying equities during any of those periods and holding for at least 17 years, made fortunes. A buying opportunity, similar to those mentioned above, is not here yet. The important thing to understand for long term investors is that US equities are still overvalued. Mr Bernanke and Mr Draghi need to let the free market work and let us see at least one more bear market, please. Disclosure: I personally do not own any stocks right now and currently hold short positions in most economically sensitive cyclical sectors (refer to trading diary).
- Outlook: I am of the opinion that the risk asset bear market is upon us and that the global economy continues to slow rapidly into a recession. United States GDP has grown 5 out of the last 6 quarters below 2%, which tends to be stall speed. German GDP is also at stall speed, similar to 2008. China and India are slowing meaningfully and could experience a serious hard landing. At the same time US corporate earnings and gross profit margins are at record highs, so I expect a mean reversion unlike so many stock analysts. More importantly, corporate revenue growth is already slowingmeaningfully. Cash levels with mutual funds, retail investors and money market funds are at extreme lows, financial stress is starting to rise, volatility is at very complacent levels and credit spreads are very narrow relative to fundamentals, so I expect a risk off scenario in due time.
- Long Positioning: Long focus is towards secular commodity bull market, with positions in Precious Metals and Agriculture. Largest commodity position is held in Silver, with central banks gearing to print money, as the global economic activity deteriorates. Since Silver has broken out recently, hedges have been removed and a small purchase was made. Any negative reversal, as global risk asset volatility rises, will call for hedging again. NAV long exposure is about 100%.
- Short Positioning: Short focus is towards secular equity bear market, with cyclical sectors and credit offering best selling opportunities due to deteriorating global economic activity. Mild to modest exposure is held short in the Junk Bond market, as well as various economically sensitive cyclical sectors like Technology, Discretionary and Dow Transportation. Apple parabolic has been shorted with long dated 2014 OTM puts and recently Put options have been purchased on the Pound and the Loonie (long USD). NAV short exposure is about 65%.
- Watch-list: A major short in due time will be US Treasury long bonds, as they are extremely overbought and in a mist of a huge bubble mania, but first we have to wait for the Eurozone dust to settle. Finally, while Grains have exploded up, Softs still present amazing value for long term investors, with Sugar being my second favourite commodity (after Silver).