The Smart Bird: It Should Come As No Surprise

A review leading up to the August correction

The market’s deeper correction should have come as no surprise. The warning signs have been flashing danger for some time. Market analysts who are only geniuses during bull markets will reveal themselves during deep corrections and bear markets. And perma-bears missed out on most of the gains the last five years. Defining the turning points is what matters most in investing for one’s retirement. One of the reasons this is so difficult is because the daily and weekly noise gets in way of the slower signals that take too long for most investors to notice.

So what were the warning signs? I laid it out on 18 August in The Smart Bird: Skating on Thin Ice and it is worth repeating.

Holding equities during conditions of poor market internals and high market valuations is not investing – it is speculating.  Add to the mix a rapidly rising aversion to risk in bond market then it becomes high risk speculating.

The conditions have been in place for some time and reached levels that in the past saw rapid losses in the stock market within short time frames . These signs were not daily or weekly noise, but months of deterioration in the indicators that signal trouble. Then we watched the New York Stock Exchange Composite bouncing off the same support line three times since 8 July to finally break through the ice last week.  Each market bounce was weaker than the last and the ice was crackling loudly. Did you hear it.

Breaking the Ice

Breaking the Ice

I do not think it can be repeated enough that the stock market is considered a leading indicator for the economy and not the other way around. But in the last 20 years, even this correlation has broken down. The economy’s growth rate never came close to justifying the stock market’s bull market gains as highlighted in The Smart Bird – It’s Not the Economy, Stupid.  So the incessant focus on every lagging economic indicator in the media is not going to ring any bells at the top.  Take a look at The Smart Bird – QE4 or Bust to understand what might be driving the stock market’s divergence from the economy’s underlying fundamentals.  Simply put, the business cycle has been replaced by a much more unstable financial cycle.

Two months ago in TSP Perspective: Expected Future Returns and Risks I asked my readers to reset their frame of reference for investing in the markets today and if you haven’t had a chance to reset now is as good a time as any.  Market valuation models that are highly correlated to predicting long term returns show the market could lose 50% of its value from the top and would only return back to its historical average valuation. I realize this requires a major reset for some, but it also shows the losses in the market currently are insignificant compared to the larger and likely possibility over the next few years.

Speaking of missing the bigger picture, I read an article from an analyst who wrote that the market indexes need to hold above their October lows to maintain their “uptrends”. Really? I cannot find any index where using even the most lenient interpretations have not already broken their uptrends. And so what if the market holds above the October lows, the long term technical damage to the charts have been done. This is not lost on the very large pool of technical traders and the smart money. Trends matter and they force attention on the underlining reasons for why the markets have been faltering.

BTW, a return to the October lows would be about a 15% decline for the S&P 500 (TSP C fund) and a 21% decline for the TSP S fund (the rest of the US stock market). I am not going to guess the immediate bottom here, but indications I track look a lot like 2011 as discussed in TSP Charts: C and S Fund Patterns to Repeat?  I will also add that the small and mid-cap stocks represented by the TSP S fund have more room to fall than the S&P 500 (TSP C fund) as I pointed out in Summer Walks and Market Observations.  As we see in the chart below, the TSP S fund has closed the gap in previous deep market corrections.  And we are not there yet.

An Updated Chart

An Updated Chart

The current situation is not lost on the central bankers who are twisting in their seats trying to determine what to do next. They are a wild card, but they are becoming much less potent at levitating the financial markets and the laws of financial physics may catch up to them.

While deep corrections can remedy market internals and produce nice luring rallies, we need to watch measures risk aversion to determine if follow on rallies are sustainable or merely relief rallies that trap buy-the-dippers. I save this analysis for the TSP & Vanguard Smart Investor members.

Invest Smart.