With the dollar surging, and with correlation momos no longer having a clue what to do courtesy of all correlations having recently broken down, here comes Albert Edwards to pour even more cold water on the rally, prophecying that the next leg of the bear market is just around the corner.
At this time of year I normally get requests for year-end forecasts. My erstwhile colleague, James Montier, always used to tell me never to offer pin-point forecasts as they are a hostage to fortune (in addition, he felt passionately that investing should not be based on what he termed the folly of forecasting).
But when I do give forecasts in a moment of weakness, often they appear extreme. Some clients have taken such umbrage that they try and get me fired! With that pressure not to stray too far from consensus, most sell-side analysts? forecasts end up as consensus mush ? and if they do deviate from consensus it is almost always on the bullish side. The industry quickly forgives a bull who is wrong whereas an erring bear must be hunted down, hung, drawn and quartered. Hence the industry gets what it deserves: economic and market forecasts that either call for mean reversion or which stick close by the current spot rate (with their usual bullish bias). But in reality the world is seldom ever like that.
Regular readers will know that many of my more extreme predictions have had an annoying habit of eventually coming true, albeit with the usual heavy dose of poor timing. Certainly when I see the current extremely low number of equity bears (the lowest since the market top of 2007 - see chart below), the likelihood is that the next leg of the long-term structural valuation bear market is closer than people might realise.
Next on plate: poor technicals and an H2 rally that has been running almost exclusively on fumes and liquidity rebate seekers.
The very weak German new orders and production data for October has certainly put a dent in the cyclical optimism that has abounded for most of this year. My own view is that the markets will march to a very different drumbeat next year. Chartwise, the S&P seems to be stuck close to its 50% retracement level from the October 2007 peak. In addition, many technical analysts are noting the poor volume and the divergence of the Relative Strength Index (RSI) which has made lower highs through the rally in the second half of this year (see chart below). This is seen as the H2 rally lacking strong technical underpinnings.
And even as the secular trend is ever lower (think Japan), the likelihood of such bear market rallies is always present (again, think Japan).
Our structural bearishness has never precluded participation in cyclical rallies. We have regularly observed that in Japan, the Nikkei used to enjoy strong cyclically led rallies of 40-50% (see chart below). But with the market still some 75% below its peak, investors tend to forget these rallies and only remember the gloom. A long-only equity investor could have made good money in Japan since the bubble burst.
Here is why leading indicators themselves are leading indicators of a major leg down:
The secret to making money in Japan was to remember to exit just as most investors had become convinced of a self-sustaining recovery. Investors should have sold as the leading indicators began to turn down (see chart below). They needed to sell despite protestations from economists that we were set for a mid-cycle pause and strategists telling us that the market was much cheaper than had been seen in recent years. In each case the sanguine voices were proved appallingly wrong. Even moderate fiscal tightening would pitch Japan?s economy back into recession and the Nikkei made new lows. At the stock level, my Quant colleague, Andrew Lapthorne, has demonstrated that in Japan value/momentum strategies needed to be replaced by reversal strategies (buying the losers/selling the winners) ? link. The buy and hold era was crushed by the reality of economic and market volatility.
And even as investors should have had years of practice with the Japanese model, they have yet to apply it to America. The problem is complacency rules, courtesy of Bernanke's Moral Hazard doctrine. Which is why the rude awakening is coming with a bang not a whimper.
For Japanese investors, it took some time to learn the new metrics of investing. Today, investors have no such excuse. After all, Ben Bernanke tells us we should learn the lessons of Japan and so we must. Though many commentators want to complicate the investment business, we try and keep our advice as simple as possible. The leading indicators have begun to turn down in the US (see charts below) and so risk assets are therefore dangerous. Almost no-one will be willing to predict renewed global recession and no-one will predict new lows in equities. And with the market so bullish (cover chart) a cyclical failure will come as a crushing blow to sentiment. It is time for caution. It is time to sell.
Will momos and quants embrace the impending downward slide with the same enthusiasm they rode the wave higher? Time will tell, but if the answer is yes, expect a major overshoot to the recent low of 666 on the S&P.