8 Measures Say A Crash Is Coming, Here's How To Time It

Authored by Lance Roberts via RealInvestmentAdvice.com,

Mark Hulbert recently penned a very good article discussing the “Eight Best Predictors Of The Stock Market,” to wit:

“The stock market’s return over the next decade is likely to be well below historical norms.

That is the unanimous conclusion of eight stock-market indicators with what I consider the most impressive track records over the past six decades. The only real difference between them is the extent of their bearishness.

To illustrate the bearish story told by each of these indicators, consider the projected 10-year returns to which these indicators’ current levels translate. The most bearish projection of any of them was that the S&P 500 would produce a 10-year total return of 3.9 percentage points annualized below inflation. The most bullish was 3.6 points above inflation.

The most accurate of the indicators I studied was created by the anonymous author of the blog Philosophical Economics. It is now as bearish as it was right before the 2008 financial crisis, projecting an inflation-adjusted S&P 500 total return of just 0.8 percentage point above inflation. Ten-year Treasuries can promise you that return with far less risk.”

Here is one of the eight indicators, a chart of Livermore’s Equity-Q Ratio which is essentially household’s equity allocation to net worth:

The other seven are as follows:

As Hulbert states:

“According to various tests of statistical significance, each of these indicators’ track records is significant at the 95% confidence level that statisticians often use when assessing whether a pattern is genuine.

However, the differences between the R-squared of the top four or five indicators I studied probably aren’t statistically significant, I was told by Prof. Shiller. That means you’re overreaching if you argue that you should pay more attention to, say, the average household equity allocation than the price/sales ratio.”

As I discussed in “Valuation Measures and Forward Returns:”

“No matter, how many valuation measures I use, the message remains the same. From current valuation levels, the expected rate of return for investors over the next decade will be low.”

This is shown in the chart below, courtesy of Michael Lebowitz, which shows the standard deviation from the long-term mean of the “Buffett Indicator,” or market capitalization to GDP, Tobin’s Q, and Shiller’s CAPE compared to forward real total returns over the next 10-years. Michael will go into more detail on this graph and what it means for asset allocation in the coming weeks.

The Problem With Valuation Measures

First, let me explain what “low forward returns” does and does not mean.

  • It does NOT mean the stock market will have annual rates of return of sub-3% each year over the next 10-years.

  • It DOES mean the stock market will have stellar gains in some years, a big crash somewhere in between, or several smaller ones, and the average return over the decade will be low. 

This is shown in the table and chart below which compares a 7% annual return (as often promised) to a series of positive returns with a loss, or two, along the way. (Note: the annual average return without the crashes is 7% annually also.)

From current valuation levels, two-percent forward rates of return are a real possibility. As shown, all it takes is a correction, or crash, along the way to make it a reality.

The problem with using valuation measures, as Mark Hulbert discusses, is that there can be a long period between a valuation warning and a market correction. This was a point made by Eddy Elfenbein from Crossing Wall Street:

“For the record, I’m a bit skeptical of these metrics. Sure, they’re interesting to look at, but I try to place them within a larger framework.

It’s not terribly hard to find a measure that shows an overvalued market and then use a long time period to show the market has performed below average during your defined overvalued period. That’s easy.

The difficulty is in timing the market.

Even if you know the market is overpriced, that doesn’t tell you much about how to invest today.”

He is correct.

So, if valuation measures tell you a problem is coming, but don’t tell you what to do, then Wall Street’s answer is simply to “do nothing.” After all, you will eventually recover the losses….right?

However, getting back to even and actually reaching your financial goals are two entirely different things as we discussed recently in “Crashes Matter.”

There is an important point to be made here. The old axioms of “time in the market” and the “power of compounding” are true, but they are only true as long as the principal value is not destroyed along the way. The destruction of the principal destroys both “time” and “the magic of compounding.”

Or more simply put – “getting back to even” is not the same as “growing.”

Is there a solution?

Linking Fundamentals To Technicals

I have often discussed an important point in reference to our portfolio management process:

“Fundamentals tell us ‘what’ to buy or sell, technicals tell us the ‘when.'”

Fundamentals are a long-term view on an investment. From these fundamental underpinnings, we can assess and assign a “valuation” to an investment to determine whether it is over or undervalued. Of course, in the famous words of Warren Buffett:

“Price is what you pay. Value is what you get.” 

In the financial markets, however, psychology can drive prices farther, and further, than logic would dictate. But such is the nature of every stage of a bull market cycle where the “momentum” chase, or rather the physical manifestation of “greed,” comes to life. This is also the point where statements such as “this time is different,” “fundamentals have changed,” or a variety of other excuses, are used to justify rampant speculation in the markets.

Despite the detachment from valuations, as markets continue to escalate higher, the fundamental warnings are readily dismissed in exchange for any data point which supports the bullish bias.

Eventually, it has always come to a rather ignominious ending.

But why does it have to be one or the other?

Currently, the Equity Q-ratio, as graphed above, is at levels that have historically denoted very poor future returns for investors. In other words, if you went to cash today, it is quite likely that over the next 10-years the value of your portfolio would be roughly the same. 

However, before that “mean reverting event” occurs the market will most likely continue to advance. So, there you are, sitting on the sidelines waiting for the crash.

“Damn it, I am missing out. I should have just stayed in.” 

The feeling of “missing out” can be overpowering as the momentum driven market rises. Like gravity, the more the market rises, the greater the pull to “jump back in” becomes. Eventually, and typically near the peak of the market cycle, investors capitulate to the pressure.

Understanding that price is a reflection of short-term market psychology, the trend of prices can give us some clue as to the direction of the market. As the old saying goes:

“The trend is your friend, until it isn’t.” 

While the Equity Q-ratio implies low forward returns, technical analysis can give us the “timing” as to when “psychology” has begun to align with the underlying “fundamentals.”.

In the chart below we have added vertical “gold” bars which denote when negative price changes warrant reducing equity risk in portfolios. (The chart uses quarterly data and triggers a signal when the 6-month moving average crosses the 2-year moving average.)

Since 1951, this “equity reduction” signal has only occurred 17-times. Yes, since these are long-term quarterly moving averages, investors would not have necessarily “top ticked” and sold at the peak, nor would they have bought the absolute bottoms. However, they would have succeeded in avoiding much of the capital destruction of the declines and garnered most of the gains.

The last time the Equity-Q ratio was above 40% was during the late 2015/2016 correction and the technical signal warned that a reduction of risk was warranted.

The mistake most investors make is not getting “back in” when the signal reverses. The value of technical analysis is providing a glimpse into the “stampede of the herd.” When the psychology is overwhelmingly bullish, investors should be primarily allocated towards equity risk. When its not, equity risk should be greatly reduced.

Unfortunately, investors tend to not heed signals at market peaks because the belief is that stocks can only go up from here. At bottoms, investors fail to “buy” as the overriding belief is the market is heading towards zero.

In a recent post, It’s Not Too Early To Be Late, Michael Lebowitz showed the historical pain investors suffered by exiting a raging bull market too early. However, he also showed that those who exited markets three years prior to peaks, when valuations were similar to today’s, profited in the long-run.

While technical analysis can provide timely and useful information for investors, it is our “behavioral issues” which lead to underperformance over time.

Currently, with the Equity Q-ratio pushing the 3rd highest level in history, investors should be very concerned about forward returns. However, with the technical trends currently “bullish,” equity exposure should remain near target levels for now.

That is until the trend changes.

When the next long-term technical “sell signal” is registered, investors should consider heeding the warnings.

Yes, even with this, you may still “leave the party” a little early.

But such is always better than getting trapped in rush for the exits when the cops arrive.

Comments

zaphod Shitonya Serfs Thu, 08/09/2018 - 16:47 Permalink

You missed 2009, 2010 when there were tons of doomer articles explaining why the market was about to tank again (despite $4T being printed).

When the next downturn happens you can be sure everyone on ZH will be bragging about how they "accurately" predicted the downturn, you just have it ignore the entire missed bull market since 2009 to believe it though.

In reply to by Shitonya Serfs

Truther Free This Thu, 08/09/2018 - 16:35 Permalink

Traders, Analysts, bond kings, and every cock sucking roach that keeps predicting this and that.... Fuck you all, you're nothing but pure spectacle with deep pockets with embezzled worthless fiat, that doesn't even hold its intrinsic value.

 

Either audit the fucking FED, Fort Knox, or just STFU already.

In reply to by Free This

CoCosAB Thu, 08/09/2018 - 16:30 Permalink

This is ALL BULLSHIT!

 

The crash only happens when the FRS wishes!

 

The FRS & Friends are controlling the terrorist markets! They are like the BoJ!

sunny Thu, 08/09/2018 - 16:33 Permalink

I love following the technical analysis Roberts offers, he knows what he is doing...based on 1997 thinking.  Alas, these days technical nor fundamental analysis offer squat in terms of understanding HFT manipulated, algo driven market moves.  Any Fed member can get in front of a microphone and say simply 2 letters "QE" or the president tweet 2 words "tax cut" and all indices will be up a full percent in minutes.  

Life happens.

Truth_Hoits sunny Thu, 08/09/2018 - 16:37 Permalink

I've been trading since the year you mention above....it's easy to complain that there is not a way to make money in this market...as long as you believe that, you will be correct!

 

If you cannot adapt, you may as well roll-over. What worked in 1997 may not work today.

If you haven't been making money in the last 10 years, when will you make money?

My friendly advice to you...either adapt, change what isn't working, or get out completely.

 

Good luck to you, and have a nice day.

In reply to by sunny

taketheredpill Thu, 08/09/2018 - 16:38 Permalink

When the psychology is overwhelmingly bullish, investors should be primarily allocated towards equity risk. When its not, equity risk should be greatly reduced.

CRM114 Thu, 08/09/2018 - 16:44 Permalink

Assuming everything else is like the last time, when in fact nothing is.

Geopolitics is a mess, there's a massive invasion of economic migrants in many countries, a huge clash of cultures, almost open warfare between right and left, indebtedness (personal, corporate and national) that's way higher than ever before, almost all major countries have not only run deficits for years but have no credible plans to ever end that, the pensions timebombs are down to final seconds (and the Federal Reserve banks are sweating over which wire to cut, but it's the dummy detonator they are looking at), No developed country has had a party leader, never mind a national leader, who has had a positive opinion poll in years (with good reason). Then we also have no real markets due to QE and algos, and there's zero moral hazard for the big banks.

And all the data being used is well known to be manipulated way beyond usefulness.

There are any of a thousand possible triggers for the biggest collapse ever, and there's precious little national unity in any nation to even start the long haul back.

Me, I'm looking at the housing market deals, auto loans (and who, exactly, in my area is taking them out), and what isn't being mentioned in the MSM. That worked for me every time past.

My best guess? Sometime between 1 and 6 years.

Get out now, lock and load.

 

KTV Escort Thu, 08/09/2018 - 17:00 Permalink

The dying US stock market.

August average daily trading volumes for $SPY

2010: 242M

2011: 452M

2012: 118M

2013: 114M

2014:  94M

2015: 188M

2016:  68M

2017:  68M

Pindown Thu, 08/09/2018 - 17:08 Permalink

Why worry? Once Sugarmountain had taken enough money from Facebook he mad an earnings appearance that killed the stock. Just wait until the big guys form JP Morgan, Goldman Sucks, Warren Buffett and others have ripped off enough cash, then they will betray their once beloved companies and let them go down, down, down. It´s just a matter of time. There are two many stupid people out there, having to much money, buying that crap.

Blankfuck Thu, 08/09/2018 - 17:27 Permalink

What? NO WORRY! PRINT DA PONZI --PRINT DA PONZI --PRINT DA PONZI-! MOR MOR MOR!

THE FED RESERVE FUCKTARTS WILL BAIL THOSE POOR BILLIONAIRE BANKSTERS OUT--ALWAYS!

THEY CAN KEEP UP WITH PAYMENTS AND PAY OFF THEIR YACHTS, MANY MANSIONS, MISTRESSES AND MOR! MOR! MOR!

GRATIS AND PAID OFF  BY THE POOR SLAVE WORKING MAN WOMAN, CHILD OF THE USSA UNTIL THEIR DEATH!

FED RESERVE FUCKTARTS WIN! BANKERS AND CEOS WIN! 

nathan1234 Blankfuck Thu, 08/09/2018 - 20:27 Permalink

Not even 0.5% of people in the world know about and what the Ponzi scheme is. When they do know, I wouldn't like to be a banker or have been one. The owners of the Fed have deep underground bunkers. And they hope to decimate the populace so that they may survive. If one can print notes and buy your Gov, buy court decisions etc then they will.

We live in a rat's world and the rate is runner of the Ponzi scheme. the Greatest Ever Financial Fraud in the history of mankind. 

Print , print , print. Moar, moar and moaarrrrrr

In reply to by Blankfuck

FreeEarCandy Thu, 08/09/2018 - 17:46 Permalink

It is not about the numbers anymore. Its about having your money in a safe country when the great war breaks out. The USA has the largest military. Thus, investing in USA companies may not be profitable, but they are from a military stand point the safest place to have your money.

In the present environment, if you follow the numbers you are screwed.

Follow what the 1% are doing. Move your money to safe haven assets (i.e. too big to fail) regardless of the returns and then build a billion dollar bunker under some mountain.

Minburi Fri, 08/10/2018 - 02:27 Permalink

How can there be true "price discovery", when infinite sums of fiat can be conjured at the whim of the above the law assholes in charge of this shitshow?