The biggest fear the market currently has is not the ongoing crisis in the Emerging Markets, not the suddenly slowing economy, not even China's credit bubble popping: it is that Bernanke's successor may have suddenly reverted to the "Old Normal" - a regime in which the Fed is not there to provide the training wheels should the S&P suffer a 5%, 10% or 20% (or more) drop. Whether such fears are warranted will be tested as soon as there is indeed a bear market plunge in stocks - the first in nearly three years (incidentally the topic of the Fed's lack of vacalty was covered in a recent Reuters article). So, assuming that indeed the most dramatic change in market dynamics in the past five years has taken place, how does one trade this new world which is so unfamiliar to so many of today's "younger" (and forgotten by many of the older) traders? And, more importantly, how does one look for the signs of a bottom: an Old Normal bottom that is. Courtesy of Convergex' Nicholas Colas, here is a reminder of what to look forward to, for those who are so inclined, to time the next market inflection point.
Five ‘Ring My Bell’ Indicators for a Market Bottom
With the Federal Reserve backing away from its bond-buying program, fundamentals matter again – what we call the ‘Old Normal’ approach to asset allocation and market/economic analysis. The 6-7% leg down for U.S. stocks since the beginning of the year may not be much fun, but when you start with full valuations and add a dose of bad economic news combined with lackluster earnings, it should be no surprise. Don’t look for Friday’s Jobs Number or Chair Janet Yellen’s testimony to Congress next week to bail out this market – that’s so 2013. Instead, dust off the Old Normal playbook for signs of a bottom: track the VIX, long rates, oil prices, gold and money flows.
Bells may not be the oldest musical instruments known to man, but they are among the most solemn. According to the archaeological record flutes and other wind instruments go back some 40,000 years, with some of the oldest examples unearthed in what is now southern Germany. Bells are comparatively much younger. The earliest examples are Neolithic Chinese and about 5,000 years old. Despite their relative new-boy status, bells are closely associated with religion, from eastern mysticism to Roman Catholic and other Christian faiths in the west.
Even Wall Street recognizes the special status of the instrument with its own aphorism: “They don’t ring a bell at the top or the bottom.” Turning points in capital markets are hard to spot, as they are an alchemy of human psychology, market dynamics, and news flow. They are a mystery, and being able to recognize them requires tremendous foresight. And lot of luck. No wonder it’s a bell in the old saying. “They don’t play a clarinet at the top or the bottom” just doesn’t feel right.
Turns out the bells were ringing in early/mid-January, because equity markets around the world have been in a swoon since then. The pullbacks range from modest – 6 to 7% for the S&P 500 and the EAFE developed market index – to more noticeable, like the 11% decline for the MSCI Emerging Markets index. Given equity markets’ sterling performance in 2013, a pullback of these magnitudes seems reasonable.
Still, market corrections seldom waft into the room like a lavender-scented spring breeze. Rather, they tend to feel like a nasty draft through a haunted house, cackling and creaking included. And so the current pullback feels ominous, with its combination of emerging markets concerns and news of a still-too-slow U.S. economy. Throw in a new Fed Chair in Janet Yellen and the U.S. central bank’s seeming commitment to walk away from Quantitative Easing regardless of market conditions and you’ve got the recipe for the market’s current ails. All courtesy of that eerie damp draft…
What seems different about this pullback is that we can’t expect policymakers to fix it for us – not for a while, anyway. The Fed’s decision to cut the QE bond-buying program at last week’s meeting seemed tone-deaf in the face of worries over China’s financial system. Congress may find a way to cut a debt limit agreement, just as they did with the budget. But there is no appetite for stimulus program to accelerate U.S. economic growth. Essentially, the training wheels are off for global economy and capital markets. If we coast off into traffic, central banks may intervene. But as long as all we get are some scraped knees, we are clearly on our own.
Since it won’t be policymaker headlines to reverse the current downward trend in risk asset prices, we have to go back to the pre-2008 playbook for some ideas of when the bells may toll and signal a near term bottom in values. Here are five such signals, and a brief discussion of each:
1. The CBOE VIX Index. If you want a signal to buy the open tomorrow, look no further than the VIX. With a close of 21.44 today, that is a one year high for the “Fear Index”. Buy when others are fearful, right?
Not so fast, Captain America… Remember that the last year was still under the sway of central bank policy and therefore exhibited very low price volatility. So a one year high doesn’t count.
Rather, consider that the 30 year average for the VIX is 20, and the standard deviation is about 6. That means 26 is the first stop on the VIX’s move higher (and it will likely go higher) before you can consider it a reliable “Buy” signal.
2. Gold Prices. Thus far in 2014, gold prices have done exactly what they should – move independently of financial assets. The yellow metal is up 4.5% year to date.
To signal a bottom in risk assets, however, gold is going to have to start going down. Think back to 2008, when it went from $975 in February to $718 in October as the financial crisis took its toll. That’s because when investors feel real pain, they sell everything. We aren’t there yet, so look for a few days when gold declines right alongside stocks.
3. Oil Prices. Crude oil prices have been remarkably resilient, starting the year at $98.42 and closing yesterday at $96.70. A piece of that strength is clearly Japan’s continued use of petroleum products rather than nuclear power, as well as the cold weather in the U.S. Still, if China were really imploding, would oil really be over $90/barrel? It seems unlikely. We therefore put oil prices in the same bucket as gold – until they start having a few bad days, don’t tell me all the bad news is baked into financial asset prices.
4. Treasury Yields. What a difference one month makes. At the end of last year, bonds were about as popular as the Hollandaise sauce on a cruise ship afflicted with mass food poising. Fast forward a month, and the largest exchange traded funds in the fixed income space are up over 1.5% even as equities falter. The claim that the old “60/40” mix of stocks/bonds in a portfolio is dead is, well, dead. Diversification still works.
Still, the safety trade back into bonds does signal something more ominous: lousy growth in the back half of 2014 and the increased chance of a shallow (but noticeable) global recession later this year. Look for 10 year Treasury yields to bottom at 2.5%, but any further decline means risk assets will get that next move lower.
5. Money flows. The largest shocker of 2014 is that U.S. listed ETF money flows are negative, to the tune of $15.4 billion in outflows. These have been so routinely positive for years now that any story about a “Bottom” for equities needs to explain why (and when) investors will start to be net buyers again. To put a finer point on this, since the beginning of the year investors have redeemed almost $28 billion of AUM in just 5 ETFs: SPY, EEM, IWM, VWO, and QQQ.
In short, we would like to see these flows flatten out and start to reverse.
Will be get the sun, the moon, and the stars to align with these five points? Probably not. The world’s not that simple. What does seem clear is that markets will remain volatile for some time. That’s Old Normal price action. It may take some getting used to, but ultimately that’s how capital markets are supposed to work.