December 15th, 2014
by Lance Roberts, StreetTalk Live
Every major analyst has predicted that the S&P 500 will continue its meteoric rise into 2015. The table below shows the current 2015 end of year predictions:
- Bank of America Merrill Lynch's Savita Subramanian: 2,200
- Credit Suisse's Andrew Garthwaite: 2,100
- Goldman Sachs' David Kostin: 2,100
- Barclays' Jonathan Glionna: 2,100
- Deutsche Bank's David Bianco: 2,150
- Citi's Tobias Levkovich: 2,200
- UBS's Julian Emanuel: 2,225
- Oppenheimer's John Stoltzfus: 2,311
- Average of Estimates: 2173.25
If we assume that the S&P 500 closes the year out at approximately 2020, roughly where it is trading at the time of this writing, that would suggest a rise of 7.59% in 2015. (using the average of the estimates)
While such an increase would coincide with the expectation that 2015 could indeed be the year that the market "melts-up" prior to the onset of the next recession. Such was a thesis that I laid out very early this year in a post unsurprisingly entitled: "The coming market melt-up and 2016 recession."
In that post I discuss the collision of the Presidential Election and Decennial cycles which suggests, statistically that there is an above average chance that the markets could move higher next year.
"However, looking ahead to 2015 is where things get interesting. The decennial pattern is certainly suggesting that we take advantage of any major correction in 2014 to do some buying ahead of 2015. As shown in the chart, there is a very high probability (83%) that the 5th year of the decade will be positive with an average historical return of 21.47%."
"The return of the positive years is also quite amazing with 10 out of the 15 positive 5th years (66%) rising 20% or more. However, 2015 will also likely mark the peak of the cyclical bull market as economic tailwinds fade and the reality of an excessively stretched valuation and price metrics become a major issue.
As you will notice, returns in the 6th and 7th years (2016-17) become substantially worse with a potential of negative return years rising. The chart below shows the win/loss ratio of each year of the decennial cycle."
Bull Mania & The Next Recession
"It was in 1996 that Alan Greenspan first uttered the words "irrational exuberance" but it was four more years before the "bull mania" was completed. The "mania" of crowds can last far longer than logic would dictate and especially when that mania is supported by artificial supports."
"The statistical data suggests that the next economic recession will likely begin in 2016 with a negative market shock occurring late that year, or in 2017. This would also correspond with the historical precedent of when recessions tend to begin during the decennial cycle. As shown in the chart below the 3rd, 7th and 10th years of the cycle have the highest occurrence of recession starts."
Oil Sending A Warning Message
I was fully set to increase the allocation model this weekend back to full exposure, however, I am going to postpone one more week to see where the current correction heads.
The main driver behind this caution is three-fold:
1) As shown in the chart below we are already in the longest bull market on record without a substantial break along the way. Could the markets rise unabated for another year, or more, without consequences? Possibly, but the odds aren't good.
2) The S&P 500 has issued daily "short-term" sell-signals which suggest that the current correction is not yet complete. While it is highly likely that the market could bounce on early next week, any bounce at this point should be used to rebalance portfolios and sell laggards (review instructions at beginning of this missive).
3) More importantly, the decline in oil prices has ALWAYS either coincided with or led a market correction. The current divergence between oil prices and the S&P 500 suggests that a further correction is in the making.
With 75% of target allocations currently in equities, and already having cleaned portfolios by selling laggards and trimming winners, the current risk of remaining slightly underweight is fairly muted.
However, by waiting for one more week it will keep portfolios conservatively positioned until the market fully declares its intentions.
REMEMBER: It is NOT our job to FORECAST what the markets will do but ONLY to REACT to what it does.
The market is a giant living organism of human behavior and trying to predict what the market will do in two weeks, much less twelve months from now, is pure folly.
However, by looking at the price trends, and using some statistical analysis, we can garner a view of the direction that the "herd" is most likely heading in the short-term.
There is a fascinating analogy in nature, called murmuration, that very much resembles the "herd mentality" in the markets.
Starlings, which gather in the evenings to roost, will often participate in what is called a murmuration - a huge flock that shape-shifts in the sky as if it were one swirling liquid mass.
This behavior is often sparked by the presence of a predator, like a hawk, and the movement is based on evasive maneuvers. There is safety in numbers, so the individual starlings do not scatter, but rather are able to move as an intelligent cloud, feinting away from a diving raptor, thousands of birds changing direction almost simultaneously.
The question that has had scientists stumped is how a bird, tens or hundreds of birds away from those nearest danger, sense the shift and move in unison?
The secret lies in the same systems that apply to anything on the cusp of a shift, like snow before an avalanche, where the velocity of one bird affects the velocity of the rest. It is called "scale-free correlation" and every shift of the murmuration is called a critical transition.
Giorgio Parisi, a theoretical physicist with the University of Rome, wrote:
"The change in the behavioral state of one animal affects and is affected by that of all other animals in the group, no matter how large the group is. Scale-free correlations provide each animal with an effective perception range much larger than the direct inter-individual interaction range, thus enhancing global response to perturbations."
This is critically important to understand when it comes to investing as the markets, much like a flock of starlings, are an interconnected web of individuals all reacting simultaneously to the same set of inputs. When the direction of the a small portion of the "herd" changes, the rest of the "herd" changes direction and follow suit.
The idea of a "scale-free correlation" is a critical dynamic in market movements.
The crucial point is that in the financial markets the herd dictates the general price trend of the markets. Fighting the herd in either direction proves pointless UNLESS you can predict the next set of movements just before they occur.
Since consistently predicting the future cannot be done with consistency, our job is remain near the front of the "sterling flock" and recognize the changes in direction in the early stages of the occurrence and change course accordingly.
As I stated above, the general direction of the markets is still higher currently. However, there are some indications that the "flock" could be shifting to a new direction. We will likely know for sure next week and can adjust our "flight path" accordingly.
Have a great week.