How deep will the current correction take us? Are we near the bull market top? Will there be a Santa Rally this year?
I have been contemplating these questions and many more. I tend to focus on the strategic issues and not the daily movement in the markets because I employ a mechanical strategy and just try to determine when adjustments need to be made. But now – looking at the global strategic investing backdrop – is one of those times that is leading me to seriously consider making timing adjustments.
The larger questions are how are the markets reacting to the growing global financial stress and how are the central bankers are going to attempt to handle it. We never will fully understand all the linkages in the investing environment, but maybe we can understand enough to make better decisions. Here are a few current considerations to ponder.
- The economic sphere used to be the dog that wagged the tail (the financial sphere). Today the financial sphere has grown so large (and unstable) traditional economic factors may no longer be the cause a major market downturns. Watching what is happening in the financial sphere becomes equally or more important.
- A global credit bubble exists. Emerging markets and junk bonds are at the periphery and the major world economies are closer to the core. The US is the center of the core. When the financial sphere reaches a certain level of stress or the bubble is pierced, money initially flows from the periphery (fleeing risk) to the core (US stock market and bond markets).
- The periphery needs to decrease interest rates due to their slowing economies and increase their own QE to devalue their currencies to protect their exports. In effect the US has started to raise interest rates while the rest of the world is lowering theirs. This is leading to a rally in the dollar. Portfolio managers are moving funds to the US markets due to the perception this rally will be long term. Simply put money is flowing out of the periphery as seen in the I fund and into the S&P 500 and bond funds as seen in the C and F fund regardless of valuation levels.
- The end of US Quantitative Easing (QE) is affecting the global financial system and increasing stress in many ways. While everyone expected US interest rates to rise and the stock market to swoon, the global effect has led to money flowing into the US bonds lowering yields and supporting the S&P 500 index – the larger, more defensive stocks. The small cap stocks represented by the TSP S fund has traded sideways all year.
- A rallying dollar has the effect of monetary tightening on emerging markets as their economies are already slowing. This tightening has the knock on effect of reversing the global credit boom and making international dollar denominated debts difficult to pay back and feeding back into a rising dollar as investors need to dollars to pay debts and margin calls.
- The US energy sector (see Oil, Employment, and Growth at Mauldin Economics) is in reverse:
–Texas created 40% of all new US jobs since June 2009–Can you say Boom & BustSince December 2007 — Shale oil states added 1.36 million jobs — The other states lost 424,000 jobs — One third of S&P 500 capital expenditure has been due to the energy sector — A 40% drop in new well permits in November — Global oil demand will continue to decline and supply will continue to grow in 2015 exasperating the problem — Even in the case of imported oil, much of the profits were realized by US companies.
- The stock market is a leading indicator to the economy, so all the strong economic reports merely explain the past performance of the stock market. Current leading economic indicators still point to a growing economy but…
- The great recession was caused as much by the financial sphere freezing up as the economic sphere slowing down. It is possible the next recession will be caused by a meltdown in the financial markets. Recent reports state the many junk bond markets have frozen up once again due to Russia and the commodities bust. A lot of investors in risky assets are now trying to exit a very narrow window at the same time and in effect no one can get out.
- The global credit bubble has been pierced. It is the same and now much larger bubble we had in 2007, but the central bankers have become more proactive and worked hard to re-inflate the bubble in assets. They are desperately trying to keep THEIR re-inflated bubble intact (Japan’s surprise doubling down on QE in October, Mario Draghi’s “we will do all it takes”).
- One last note looking at my TSP Almanacs. From 1956 through 2011, 75% of all S&P 500 price gains could have been harvested by merely being in the market from the October lows of the mid-term election year until the following summer. That is not a misprint. We are in that period now and it is usually explained by the fact all the incumbents want to get re-elected and they do what they can to goose the economy now. Notice we did not have a budget fight this year. Notice the calls from Republicans to increase Defense Spending. The politicians are doing their normal election cycle dance, but the Federal Reserve may have co-opted their fiscal stimulus party with their easy money policies of late. To this point be sure, the politician’s and the Fed want to keep our over-inflated markets rolling another year. But the laws of financial physics have not been repealed so it will be an interesting year to watch.
So what does this mean to investing in the TSP funds? The financial sphere’s overall risk level is elevated and growing. But the central bankers will throw the kitchen sink at the problem leading to increased volatility in the markets. The US markets will initially benefit from inflowing funds, but at some point this will be reversed if fear continues to grow and spread in the financial sphere. Timing tops is hard and my valuation methods show that the market is nearly 200% above its mean historical valuations looking back over 100 years. It is the second highest historic valuation only exceeded in 2000.
The TSP G fund is looking more and more attractive. Even the F fund becomes risky in a financial crisis. Thinking of withdrawing your TSP funds after retiring. Think hard about it. Money market accounts at other financial institutions are also no longer risk-free. Your checking and savings and brokerage accounts just got moved to the back of the line behind your bank’s gambling funds (Derivatives) thanks to the rolling back of part of Dodd-Frank Act by our bought-out Congress with the passing of the latest budget.
So we have a timing issue. How much longer will periphery funds flow into the US market, how will the energy market effect the economy this year (remember the stock and bond market are leading economic indicators), how will the central bankers react, and how fast will the piercing of the global credit bubble take to reach the core (it can take years or weeks). The markets themselves will have to tell us and they do send signals.
Some of the largest advances happen in the terminal phase of bubbles. If you step aside now, expect that this can happen and you will miss out – just don’t jump back in at the top. If you stay in, understand as Dr. Hussman states in his commentary, that we are in that very small percentage of market history based on his measures that has ultimately lead to air pockets and significant market declines. It is just that we have been there for about a year now.
I am invested for both the strong season in equities and the Turn-of-Year strength (as I define it) and not for the undefined “Santa Rally”. I study seasonal tendencies in depth and they can be broken into periods of seasonal support and periods of seasonal weakness with a lot of neutral periods in between. Seasonal support does not translate into “rally”. It translates into certain times of the year when funds flow into the market and provide support to the market. If the market is neutral you might get a rally, if the market is in the middle of a correction you will see the correction pause and continue down after the seasonal support is no longer there. Or if a correction is complete the seasonal support may provide the catalyst for the bounce back.
We are at this point now with the Turn-of-Year seasonal support and I am hoping the bounce back occurs. If the market merely moves sideways, I will be worried and greatly reduce exposure at the end of this period. If the market bounces back, I still plan to reduce exposure due to the above concerns but not as much. If the Central Bankers appear to rapidly put the instability genie back into the bottle for a little while longer and periphery funds continue to flow to our markets, I might hold higher exposure to equities awhile longer. But at some time in the near future, that G fund is going to be the best performing fund by far.
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Categories: The Smart Bird