Perspectives

The Smart Bird: The Seasonality of Surprises

The question of the week is whether the SP500’s spike to a new all-time high is a true breakout or a false breakout.  It may not be long before we find out, but as someone whose core investment strategy is based on historical seasonal patterns, we are happy to sit on the sidelines and see how the divergences works out.  We have until October to access the situation and typically the market gives back much of its summer gains by the end of Fall.

I say it may not be long, because looking at our TSP almanac data *since 1988* we see that the market’s seasonal weakness does not truly set in until mid-July as opposed to “Sell-in-May”.   This week is Options Expiration week which also historical has been favorable to the markets.  So before you jump back into the markets and chase the new highs, you might want to wait a bit to see if the seasonal pattern of weakness holds.

Alhambra Investment Partners found an interesting seasonal pattern that is also worth considering today – a pattern of recovery in expectations and monetary conditions during the 2nd Quarter.  The annual pattern they observe is:

 weak start, spring rebound, summer “tightness” that takes up the remainder of the year and spills into the next. The prevalence of changes in especially financial behavior each July and August is striking, giving a new “dollar” spin to “sell in May and go away”.

As you read their observations later in the post about how often in Spring it appears everything is back on course, one should keep in mind that recent tax withholding’s for the 2nd quarter appear to show something is amiss with the economic rebound narrative (chart is provided by David Stockman of Contra Corner using Treasury data).

withholdings

And even if the decline in SP500 revenue and earnings finally stops in the latter half of 2016, we need to ponder how earnings might bounce 50% higher in 2017 to come close to justifying current market valuations – especially since accounting gimmickry has been stretched beyond limits already.  Today, we find that the SP500 earnings per share reported to the SEC (blue) are back down to 2007 market peak levels as well as the 2010 post-recession rebound levels.  Note the Pro-forma earnings reported to investors managed to stay level in 2015 thanks to a quarter trillion dollars worth of accounting exclusions.  SP500 GAAP earnings for 2016 continues to fall.

GAAP thru 2015

We also ponder what makes today’s stock market worth so much more than 2007 (just prior to plunging 50%) or 2010 when the SP500 was under 1300 with still rising earnings. The rectangles show those levels in the next chart and I also highlighted with a red circle something that just does not look right.  Speculator expectations are running high about something positive going forward and frankly I do not think it is the economy.

2007 Redux

My definition of market risk is simple.  It is how much and how likely an investor is to lose a substantial amount of money in a particular market.  Since the market can carry a significant amount of risk for a long time, we cannot use it for timing the market in the short term.

But today’s equity market is sporting significantly elevated levels of risk and holding onto to it a lot longer than usual thanks to the central banker’s goal of maintaining “financial stability” after blowing yet another bubble.  And the only way to *attempt* to maintain bubble stability to to provide ever more stimulus ever more often. And front-running, risk-surfing speculators know this.

 

A few recent patterns worth watching

Much of the current rally in the high yield bonds and the stock market comes from the recovery in the price of oil and commodities.  But as we see in the next chart, the oil patch (red) maybe following the same pattern this year as the last two years.  If the June through February pattern holds, a return to low oil prices could bring back investor risk-aversion. It is our first divergence worth watching this summer.

Oil 2 year pattern

My view has been that when the US was tightening monetary policy, the global dollar strength put significant pressure on emerging markets and global credit creation.  With expectations that the Fed is now on hold, some of the pressure has been lifted globally putting a short term floor in global equity markets.

Alhambra Investment Partners recently pointed out another monetary (currency) pattern that lines up with the stock market’s recent liquidation events – Yuan devaluations by China. China has used the term “grim” when talking about the global economy recently. Currency devaluation will be seen as a critical tool to keep their export driven economy from collapsing.

Yuan devaluations

And my favorite pattern are future earnings expectations.  Sometimes they make it all the way to September before giving up hope….

13 July sometimes sept

More than Coincidence

As touched on in the first quote, Alhambra Investment Partners found what appears to be an annual pattern seen in recent years of distress (2007-08, 2011, 2014-16).   Could they have found evidence of the drivers for the seasonal tendencies of the stock market?   It all sounds erily familiar to 2016 so far.   Here is an excerpt from Two Times Was Convincing; Five, Maybe Six Times Cannot Be Coincidence:

In 2007, the year following the top in the housing bubble (really eurodollar bubble), both the economy and financial system started in very familiar fashion (to today’s world). GDP plunged to (current estimates after many revisions and benchmarks) barely positive in Q1; liquidity had deteriorated in wholesale channels, particularly CDS and related ABX pricing to the point that two hedge funds run by Bear Stearns had to be “rescued.” Despite the rough start to the year, by midyear things looked much, much better. GDP rebounded to 3% by Q2, and markets were seemingly shaking off any deeper concerns though wariness remained. At the end of March, Ben Bernanke told the world (via Congressional testimony) that subprime was contained and for a few months in the spring it looked like he might have been right.

Just after the start of Q3, however, fissures again appeared, culminating in the systemic break of August 9. That unleashed a rising tide of illiquidity and disorder that would characterize the entire rest of the year (even stocks couldn’t ignore it beyond October). The monetary “tightness” of the wholesale system would spill over into the start of 2008, another weak annual beginning, with a crescendo in mid-March and the failure of Bear Stearns.

Then, just like the year before, the seasonal turn to spring seemed to bring about a stunning rebound, increasing, on the surface, the potential for maybe even complete escape from the whole affair. GDP, which had contracted in Q1, jumped in Q2 alongside fiscal “stimulus” from the Bush administration. By June, Bernanke was in Massachusetts claiming, “the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.” Like his 2007 statement, for a time it appeared to be very possible.

Once again, however, everything changed in the growing heat of summer. Indymac shockingly failed on July 11, 2008, followed two weeks later by sudden interest from the SEC in short selling of GSE’s and primary dealer banks (leading to a ban of it). The rest was, as they say, history.

What was it about each midyear that seemed to perform an almost unbelievable inflection? To be completely fair, that wasn’t necessarily the case, as illiquidity and systemic disruption remained consistent underneath even the spring rebounds, but there is no arguing that monetary “tightness” broke out into the open each summer in sharp contrast to mainstream hope that prevailed just months or weeks before. Illiquidity was prevalent throughout, but at each midyear that seemed to somehow alter in behavior and even fuller context.

ABOOK July 2016 Seasonality 2007

ABOOK July 2016 Seasonality 2008

ABOOK July 2016 Seasonality 2011

ABOOK July 2016 Seasonality 2014

ABOOK July 2016 Seasonality 2015

Two times is a very compelling argument for illiquidity exposing underlying seasonality, but five times is a pattern (with 2016 so far acting a sixth to this point).

These are obviously incomplete catalogs of all events that took place in each respective year, but they are, I believe, a representative sample of this repeating template: weak start, spring rebound, summer “tightness” that takes up the remainder of the year and spills into the next. The prevalence of changes in especially financial behavior each July and August is striking, giving a new “dollar” spin to “sell in May and go away.”

We are conditioned to look at things in straight lines; we are even told that history is linear. This is simply not the case, as cyclicality is encoded in our DNA by the most basic processes of astrophysics and planetary motion. I have to believe what you see here is quite a bit more than ancient biases protruding into modern life, but overall it makes perfect sense to find drastic seasonality; especially under conditions of monetary illiquidity and tightness that has the effect of amplifying even natural pressure points.

While this iterating behavior had a direct impact on the mistakes of the Great Recession, it may be even more important in the years after it. In other words, economists and policymakers are looking in straight lines for straight-line events like recession. These seasonal patterns, however, argue instead for a far different kind of analysis. By virtue of all the ups and downs, there is an unevenness to them that looks like nothing but noise from the linear perspective; economists can’t understand or define the seemingly random swings between weakness and strength. So abhorrent is it to the mainstream assumptions, they have even reacted by attempting to adjust basic statistics like GDP to try to erase it (residual seasonality).

From the monetary perspective joined to the calendar, however, we find a single process wound up in all the repetitions. Again, it was compelling the first two times; three or maybe even four more cannot be coincidence.

Enjoy your summer.

 

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