Expect More Volatility in 2006
We can measure the amount of expected forward volatility and then try to determine what the market will do in the future.
"Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble...to give way to hope, fear and greed" - Benjamin Graham, Famous Value Investor
The Year and Quarter in Review
Throughout the year, we mentioned that we did not have terribly high hopes for the stock market, expecting more of a year of frustration and choppiness. Those who were looking for a great year for the Dow just because the year ended in "5" (please note we commented numerous times how ridiculous a concept that is. In our view-it is as good as the supposed "Super Bowl indicator" whereby stocks do better the year the NFC team wins the Super Bowl) were thoroughly disappointed as the Dow limped in with a -0.61% return on the year, not including dividends. The NASDAQ and S&P 500 didn't fare much better. Bond indices across the board weren't a lot better; with returns settling in the 2% area for almost every kind of fund and index (we are proud to have beaten these indices handily). The significant event of the year in my mind was the lack of volatility in our markets and the compression of return. Below I will state that I think this lack of volatility is about to take an abrupt change and that 2006 may have some frustration along with increased volatility. Let me state ahead of time that while I try to keep my commentaries as simple as possible, the reason for the lack of volatility this year is a complicated one and the reason for a change may be just as complicated. So please forgive me if it is complicated (you can always e-mail me at email@example.com or call me with questions).
Our Take on 2006 (and a little bit beyond)
Past readers of our commentaries know we have repeatedly highlighted that markets tend to run in cycles. These include secular versus cyclical (long-term vs. short term) and the Presidential Cycle. While at Sedacca Capital Management, I felt that a secular bear market had begun in 2000 and would run about one third to one half of the prior secular bull market's duration. That secular bull, depending upon whom you ask, either started in 1974 or 1982 (I like to use 1982 because that would mean it started while on my Honeymoon!) and ended in 1998 (the peak of the NYSE advance/decline line) or 2000 (the peak of the S&P 500 and NASDAQ). In any case, the secular bull lasted somewhere between 16 and 24 years with a percentage gain in the neighborhood of 1500% to 6500%, depending on the index, clearly the most prolific of all time. The secular bear market that follows, if like other times in history, should last between 8 and 12 years, meaning the S&P 500 peak of approximately 1550 in March of 2000 should not be surpassed until 2008-2112. What lies in between can be as many as a dozen cyclical bull and bear markets that nimble investors who understand the big picture can use to their advantage. It does not mean sizeable returns cannot be made, it just means that it is paramount to understand the big picture thoroughly and not be afraid to have a view that is opposite of the crowd, particularly at extremes. Investors who hang on to the mantra of "buy and hold" until the end of the secular bear are going to find that the last "buy and hold" investor has sold and lost interest. That is exactly how secular bull markets start-when there is "neglect" and indifference towards stocks. I would even stick my neck out and say that the day CNBC goes off the air because the public has lost interest in stocks will be the day the next secular bull begins. It is those types of events that mark important tops and bottoms of markets. It reminds me of how legendary value fund manager Julian Robertson closed up shop in early 2000 - just about the time value stocks bottomed and started a 6 year run of out performance. These sorts of "watershed events" happen all the time. Many investors use magazine covers as a great contrary indicator also. Business Week, as useful as I find its content has this habit of putting a bear on the cover at the end of a bear market and a bull on the cover as the bull market ends.
Of all the cycles I have studied in the markets, by far and away the most important and accurate has been the Presidential cycle. I have written repeatedly about this over the years, and unfortunately, 2006 is the worst year during this cycle. As I wrote in my Pre-Year End Commentary, what every first-term President wants is a second term and what every second term President wants is a great legacy and for his party to become re-elected. So it should come as no surprise that fiscal and monetary policy is not particularly accommodative during the first and second year (neither is consumer confidence or Presidential approval ratings during these years). Let's be honest, if you were running for President in 2004, when would you want to have the best economy, market and ratings In 2001 or 2003-2004? The question is rhetorical enough not to answer. It is also no surprise that the Fed raised rates at every meeting in 2005. While I think they are very close to done, one thing is for certain; look for the Fed to be easing in 2007 and 2008 as we approach the 2008 election. Also, look for some sort of fiscal stimulus like the dividend tax rate reduction of 2003. How important has the Presidential cycle been (by the way, if my records are correct, it has occurred every term in the past 25 terms!)? From my commentary link above, you will see that if you had bought stocks at the first day of every term since 1950 and sold on October 1st of the second year of every term, you would have lost 35% of your investment over the entire period, not adjusted for inflation. If, on the other hand, you had invested your funds on October 1st of the second year and sold on final day of the fourth year, you would have earned 70 times your money. The study can be found here. Incidentally, the market bottomed in October 2002. You are free to agree or disagree, but from where I sit, it is not a pattern that I intend to fight.
Why We Expect More Volatility in 2006 in Stocks
It is estimated that as much as 75% of all trading done in stocks these days is done by hedge funds, arbitrageurs, and Wall Street trading desks and others with supposed "black box" strategies. I said earlier that there would be a complicated section, well here it comes. When volatility compresses, all of the capital that is sloshing around trading desks and the hedge fund community must find a way to produce acceptable rates of return. Particularly in the hedge fund community, a community I used to reside in so am familiar with the pressures to perform, you are paid handsomely (usually 1.5% plus 20% of the profits) to produce consistent absolute returns all the time. As volatility in actual indices shrunk throughout the year, there were not many big macro bets to be placed (outside of selected sectors like gold, oil and emerging markets). So what these funds have consistently done is "sell forward volatility." While this sounds complicated, all it really means is for them to sell forward put and call contracts that are "out of the money" hoping for no volatility and for them to expire worthless. Sometimes these positions are hedged and sometimes they are not. My point in this discussion? We can measure the amount of expected forward volatility and then try to determine what the market will do in the future. Our study, as depicted in this picture, shows that when volatility expectations are low (fear of volatility is low) stocks tend to fall and vice-versa. While not shown here, we have further enhanced the study to spot the moment in time in which there is a change in trend of expected volatility and the trend in the market changes. While these are slightly lagging indicators, it is amazing how well they have worked. Note the black line is volatility expectations and the orange line is the S&P 500 index. The red arrows are peaks in each index and are in direct contrast to the black arrows which are troughs in the index. Note how the red and black arrows usually occur in opposite indicators simultaneously.
Please note that when volatility expectations have been low recently, stocks have not been the best place to be and that when volatility expectations rose (fear rose), stocks rallied. Keep in mind that this was during a year of unusually low volatility. Our guess, and we are positioned this way, is for volatility to increase this year, perhaps by a lot. We will look to use our proprietary indicators of volatility expectations as well as continue to track our investor sentiment indicators to attempt to time our entry and exit points. Note that we consider this market for the nimble, not the "buy and hold" crowd. Even though we maintain many core equity fund positions, if I think the market has enough downside at any point, even those will be pared back. Our first goal is to protect capital and also be tax-efficient but sometimes the market isn't that accommodative. Our best guess for movements during the year? A choppy beginning as IRA and pension inflows makes their way into the market with the potential for a sell off of a few percent. We place the odds of markedly new highs as remote, particularly with equity mutual funds with record low levels of cash as a percentage of assets. We are looking for a major low in the late-Summer to as late as the October-November period. A lot depends on the Fed and how our new Fed Chairman Ben Bernanke does in the event of any type of financial accident or terrorist attack. A financial accident in my opinion could be started by the increased volatility and resultant unwinding of naked options positions. Will he really 'drop money from helicopters' as he said he would do in 2003 in order to ward off deflation? It is interesting trivia to note that the last three incoming Fed Chairmen were faced with a crisis of one sort of or another (Greenspan walked right into a stock market crash and Paul Volcker right into an inflation crisis). Will Bernanke's crisis be the unwinding of the housing bubble? Market bottoms usually are accompanied by a crisis. It could be a GM bankruptcy (they already are bankrupt when considering their under-funded pension plan), or a derivative mess, take your pick. But as they say a picture is worth a thousand words. In the past, I have compared the parabolic moves of the bubbles in gold, Japan, the NASDAQ and homebuilding stocks. Here, please find an updated version as of the end of 2005. Amazing isn't it? I'll leave you to your own conclusion how it ends.
Considering that most anecdotal and statistical evidence I read suggests that housing at least lost momentum. Whether it loses momentum, flattens out or experiences actual falling house prices is for those with crystal balls (jeez, I wish I had one). If the top in stocks indeed precedes fundamentals by 6-9 months, housing weakness (and weakness in housing shares and earnings) should be felt rather soon, if not already. But in the paragraph below, I would like to cover the most important issue facing us as both a nation and as investors and how we intend to protect client capital, which is perhaps the most important theme for investment managers and investors, both individual and institutional.
The Myth of a "Mountain of Cash" and the "Conundrum" of the Yield Curve
Because of my long-term background in the world of bonds, I usually get questions about where I think rates are going. Lately, however, all of the questions I get-and there have been a lot of questions, is about the "inversion of the yield curve-the yield curve is considered inverted when 2 year Treasury notes exceeds that of 10-year Treasury notes." The funny thing is that is usually a question for bankers or bond managers, but not retail investors. In past commentaries, I have written about why there is no conundrum and why long-term rates have not risen along with short-term rates during this 13 step Fed-tightening cycle that began in May 2004. The Wall Street Journal recently ran a story that consumers had reached a record net worth of $42 trillion as a result of rising home prices and the stock rally since October 2002's low. But nowhere did I see mention of the record mountain of debt associated with these assets. Think of it this way, both sides of the consumer balance sheets are bloated at the same time. This is what haunts me every day while managing portfolios. Imagine that you bought 1000 shares of Google at $85 and still owned it when it hit $400 per share, and you took out a margin loan of $200,000 and bought a condo or another Internet stock. You now have a record net worth, but you also have record liabilities as well. It is really what is covered in Accounting 101. The left side of the balance sheet is assets and the right side is liabilities. When the right side of the balance sheet becomes large, the left side needs to continue to grow or the right side takes over. It is akin to having an overdrawn checkbook-sooner or later you have to pay off the amount you have overdrawn or drown in debt and interest payments. Imagine what would happen to the person who borrowed against the Google stock only to watch it fall to $200 (not a prediction). They would go from record net worth to zero net worth-otherwise known as a margin call.
Why am I ranting on about this? I am simply not sure what asset classes can be counted on to grow enough to support the liability side of the balance sheet. And this is not just at the individual level. Debt at EVERY level relative to GDP is off the charts. So, while there is $600 billion of cash on S&P 500 balance sheets and pundits ramble on about how stock buybacks will support the stock market, no one talks about the $35 trillion in Total Credit Market Debt, or about 3 times GDP. Yes, I know this is all negative stuff, and no, I am not a perma-bear, but this is one of those times that we cannot ignore these statistics. It would be irresponsible to do so. We would rather be overly defensive at some points than to take constant risk just to beat the market every month.
So what about this conundrum as Mr. Greenspan calls it, and the yield curve inversion? Here is my take, which has remained constant for quite some time. If we have a huge debt position, and asset prices stagnate (or heaven forbid they fall) what happens to the debt? It overtakes the system (global margin call?), which would make the consumer slow down spending and start saving again. Considering that over two thirds of GDP comes from the consumer, one can easily see how a severe economic slowdown or even recession (a tough one at that) could rear its ugly head. This is really Business Cycles 101, but in overdrive. If housing stalls, as we believe it will, the "cash-outs" will stop and the negative savings rate both here and in Canada will have to switch to net savings. This is bad for the banks that have made the loans, and for people who have sold volatility as mentioned earlier. At this point, the Fed turns on the spigots and enough money is created to get it rolling again.
In my humble opinion, that partially explains the low long-term yields here. I think the market "smells" a possible accident and is simply pricing it in. Banks have been told to tighten lending standards and the Fed is hurting all of those with "Interest Only" ARM's, of which there are many. The other explanation is that our rates are the highest in the developed world, and our deficits encourage foreigners to recycle our deficits here to buy our cheap bonds. In any event, does the inverted yield curve matter? It may or may not, I just feel it happened for a totally different reason than in past business cycles when the Fed was actually trying to cause a recession to keep inflation low and flush out weak competitors. This Fed knows the potential of the debt bubble exploding-at least I hope so.
As for bond positioning, we own virtually no corporate debt, but are "bar belled," meaning we own short and long term bonds, with little in between. In addition, we are totally avoiding the financial sector and corporate bonds in general, in case a credit crunch does ensue. I have lived through a few of them and it is not good to be in corporate bonds. We have a healthy dose of long-term, high quality municipal bonds that have recently rallied smartly, which in the spirit of full and fair disclosure; I intend to part with in January, before seasonality for municipal bonds becomes negative into the spring. We would likely buy short-term treasuries with the proceeds, but there are no guarantees. Eventually, if our equity market call is correct, some of those funds will eventually be funneled into equities later in 2006.
We wish you and yours a healthy and prosperous 2006.
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