May 26th, 2011
Guest Author: MacroTides. See About the Author at end of the article.
Coming into 2011 we suggested there were three major themes that would play out in the course of this year. We thought the U.S. economy would slow, particularly around mid-year. Most states would have to tighten their budgets by cutting spending and jobs, and raising taxes, before their 2012 fiscal year began on July 1. On June 30, the end of the Federal Reserve’s second round of quantitative easing would create some uncertainty since it represents a de facto tightening of monetary policy. The U.S. economy has not achieved a self-sustaining level of growth in our opinion, and these headwinds were expected to weigh on growth in the second half of 2011.
During the last 110 years, the stock market has alternated between periods of extended advances and declines. Swinging like a pendulum, each secular bull market or bear market lasts between 15 to 25 years. The recent secular bull market lasted from 1982 until 2000, or possibly until 2007, since the broad market averages made higher highs in 2007. A conventional 15-year secular bear market from the peak in 2000 targets an end in 2015-2016, or 2022-2023 if the high in 2007 is used.
Historically, economic contractions accompanied by financial crisis have lowered annual GDP by -1.0% for a decade or longer. In 2008, we experienced the largest global financial crisis in history, and the echoes of that event continue to reverberate in the global economy. If economic activity grows more slowly, as we have expected since the current recovery began in 2009, a decline in the S&P's P/E ratio to below its long term average would be rational. If valuations are to approach those seen in 1942 or 1982, the stock market could easily experience another decline of 30% or more by 2015-2016.
Within this context, we believe the stock market has been in a cyclical bull market since the low in March 2009. Our goal is to identify when this cyclical bull market will give way to the next leg of the secular bear market. The Major Trend Indicator is still in the bull market camp, but since it is designed to identify the major trend, it will never pick the top or bottom with precision. A quick read of the S&P 500 chart shows that since the low on July 1, 2010, every low and high has been higher. This is the classic definition of an uptrend. A decline below 1294 on the S&P will be a warning that the intermediate trend is weakening, and with a drop below 1249, a confirmation that the intermediate trend has turned down. Short term, the decline from the high on May 2 at 1370 looks choppy, and suggests the market will rally again to at least test 1370, as long as the S&P does not drop below 1249.
In last month’s letter, we thought the S&P might make a run at 1400, after breaking out above 1332. We suspected that investors would sell into this rally, since most expect the market to decline after the Fed ends QE2 on June 30 and wouldn’t wait until July 1 to see what happens. “Our guess is that the market will top before mid-May and then decline into July.” The S&P topped on May 2. In early April, bullish sentiment was rampant. The Investors Intelligence survey showed 57.3% bulls and only 15.7% bears, while the American Association of Individual Investors registered 43.6% bulls and just 28.9% bears. In anticipation of the decline most expect once QE2 ends, sentiment has become far less bullish, with the AAII survey showing 14.6% more bears than bulls last week. This is constructive and supports our view that a test of 1370 is likely, before the market becomes vulnerable to a larger decline.
In a Special Update that was sent to subscribers of MACRO TIDES on March 29, we recommended the purchase of four ETFs. Here are the opening prices for the recommended ETFs on March 30, and the prices they were sold: Brazil (EWZ) $76.04, stopped May 3 at $76.18, Korea (EWY) $63.68, stopped out on May 17 at $63.95, Australia (EWA) $26.44, half sold on April 27 at $28.25 and half stopped on May 4 at $26.90, S&P Small Cap 600 (IJR) $72.61, half sold at $74.70 on April 26, and half stopped on May 24 at $71.39.
The stock market has not rewarded equity investors over the last decade, with the S&P returning a scant average annual return of 1.4%. Many investors have become gun-shy, especially after 2008 and the failure of traditional asset allocation to protect and preserve their capital. Many baby boomers simply cannot afford to lose any more money, since the value of their 401(k)‟s and homes are not worth what they expected or planned, as they get nearer to retirement. The miniscule return offered by most money market funds of .25% or less has left investors frustrated, and looking at alternatives to the stock market or a money market fund. Many investors have chosen to move some of their savings into bond funds, just to get a modest return.
The bond market also experiences secular bear and bull markets, with the last secular bull market beginning in 1981, when the 10-year Treasury yield peaked near 15%. Yields are now near a multi-generational low, so the risk of a secular bear market in bonds is higher than most investors realize. If bonds do enter a secular bear market in the next few years, bond yields will rise, and bond fund investments will lose value. Without realizing it, frightened stock market investors, if they increased their allocation to bonds, may have jumped from the frying pan into the fire.
We believe the 10-year Treasury yield will remain range bound, between 2.7% and 4.0% for months, since the economy will prove weaker than expected, and the prospect of a European debt crisis attracts safe haven money. Any weekly close above 4.0% will be very negative. With the 10-year Treasury bond yield near 3.1%, we expect it to drift up toward 3.3%.
As noted last month, “Sentiment is obviously at an extreme, and suggests that when momentum does turn up, the Dollar will have a multi-week rally, maybe longer.” We think the Dollar has made an intermediate low, and recommend buying the Dollar’s ETF UUP at $21.56.
As discussed last month, “Gold is now tagging the trend line (top blue line) that connects prior highs in May 2006, March 2008, and November 2010. We’ve been watching this trend line for some time, but didn’t think gold would run up to it so soon. Looks like a good place to lighten up. A decline below $1,450 and this trend line would confirm a top.” Gold dropped to $1462.50 on May 5, after spiking to a high of $1577.40 on May 2. We think Gold will fall short of its May 2 high, and then decline and test $1462.50, and eventually dip to $1400.00. The graph below shows the SPDR Gold Trust ETF (GLD) 2005 to date.
Shiller Explains How to Use his Trailing PE Ratio by Jeff Miller
Secular Cycles for Stocks by Ed Easterling
Using Forward Earnings Estimates by Jeff Miller
Profiting from Forward Earnings Estimates by Jeff Miller
Market Valuations and Longer Term Perspective by Doug Short and John Lounsbury
Consensus: A Groundhog Decade for Stocks by Ed Easterling
Bull or Bear? Let History Be the Guide by John Lounsbury (at Seeking Alpha)
About the Author
Macrotides is a monthly subscription newsletter written by a wealth manager associated with a major Wall Street investment bank. The author’s firm has requested that he not use his name to avoid any incorrect implication that his views might reflect those of the bank. The author has written investment advisory subscription newsletters based on macroeconomic analysis and market technicals for more than 20 years. Enquiries can be made at MacroTides@firstname.lastname@example.org