Perspectives

Fall Summary Report Excerpt – Seasonal Investing

I am often asked for examples of my reports.  Our Fall and Spring Summary Reports are provided to all membership levels.  Since this Fall’s summary discusses the seasonal strategy at length and touches on why we have seen strong summer performances this market cycle, I have decided to post an excerpt. Not all the objectives are covered in this excerpt.


 

Fall Summary Report Excerpt

 

Sitting down to start a Summary Report is often difficult because I cannot simply cover everything I would love to. Of course, I realize many members do not want me to cover everything – just let us know how and when to invest.  But during this market cycle we have seen a few Summers/Falls with decent gains that our seasonal strategies have missed. So questions arise, including for me.

I decided what better way to start this report than by summarizing the primary objectives of this report.

  1.  Understand how the current unfavorable season stacks up with the past.
  2.  Understand we are in the largest financial bubble in history in order to prepare for when it ends.
  3.  Understand why the markets have been propelled higher than the economy or profits justify.
  4.  Understand that bubbles do not pop.  They grow and grow especially when they are created by central banks who can print money out-of-thin-air to buy into the markets and stop the free markets from real price discovery.
  5.  Understand bonds (fixed income funds, TSP F fund) have been in a secular bull market since Paul Volcker saved the dollar from 12%+ inflation by inducing two recessions with 18% interest rates in 1982.  The bond bull market began when he started lowering interest rates in 1982.
  6.  Understand past performance of bond funds includes capital gains which are generated by dropping interest rates. If interest rates flatten, then all you get is the current low yield.  If rates rise, capital losses subtract from low yields.
  7.  Understand that the seasonal influences are always present, but can be overcome by larger influences in the short term such as monetary policy or market resets (bear markets).
  8.  Understand seasonal investing increases our winning trades and mitigates losses, but it is not designed to beat buy & hold every year. It is designed to win over the full market cycle of bull and bear markets.
  9.  Understand that our primary risk indicator does not care about the economy, profits or monetary policy.  It simply tells us when the most risk-sensitive bond investors start to head for the exits so we can exit equity funds.

 

How this unfavorable season stacks up

First we need a frame of reference prior to looking at the *unfavorable* season performance charts.  And our reference is how the *favorable* season for equities has fared since 1980.  The returns are shown in order of highest to lowest. The years are denoted at the bottom of the chart.  The 1980 return means from the Fall of 1980 until the Spring of 1981.

What is most impressive about the favorable seasons are how few have negative returns.  In the six negative years shown, two are from the most recent bear markets which lost over 50% each total.  The favorable season during these bear markets lost only 10% and 4%.  This means the bulk of the losses occurred during the *unfavorable* season as we will see.  The early 80’s were a time of extremely high inflation and interest rates and a transition period from a secular bear market to secular bull market that lasted from 1980 until 2007.

Which brings up an important point – we are looking mainly at returns in a secular (long-term) bull market which will not be repeated during the next 20 years. But the *difference* in performance of the favorable season and unfavorable should.

Summer sp500 favorable season

The next chart shows what our objective seasonal model missed over the Summer and Falls (the unfavorable season).  Two of the largest three gains were due to the bear market ending and bouncing back during the summer.  If we identify the bear market is over, we could capture some of these gains too.  But it is important to understand that the 20% gain in the summer of 2009 did not come close to recouping the bear market losses.  The 38% loss missed in the summer of 2008 required a 60% gain to break-even.  The entire bear market loss required a 120% gain to break-even.

Summer SP500 minus Tbills

The “QE rallies” point to three years during the present market cycle that occurred when the central banks were engaged in QE programs (created money to buy financial assets).  The largest summer QE rally this cycle was 2013 at close to 10%, the other two were around 5%.  Missing the 1987 crash more than made up for missing the 1988 bounce back.

Historically the small cap indexes have exhibited much stronger seasonal tendencies as we see next.  Our favorite small company index includes all of the stocks not in the SP500 index, so we simply call it the non-sp500 index.  The TSP S fund tracks this index as does the Vanguard VXF ETF.  This index started in 1987. 

Again we see the best performing summers include the markets bouncing back from major bear markets and recent years when central bank QE programs were in effect.  The seasonal strategy has paid off handsomely during bear markets and years with large market corrections or crashes.  It has also paid off near market tops.  

Summer S fund Returns Chart

 

What all of this translates into over the time frame seen above is seen in the next chart from July 4th 1987 until December 31, 2016.  Losses matter more than missing summer gains in the long run.

 

 

But how about the current bull market (half cycle) after the bounce back in 2009 with all the QE summer rallies?  The next chart looks at 2010 through 2016. Outside of bear markets, our seasonal strategy makes money during years of large corrections like 2011 and 2015.  I actually believe 2015 was a market top thwarted by 4 trillion dollars being dumped into the financial markets in 2016 by global central banks (QE) and it is still on-going in 2017.  Which is one of the reasons this unfavorable season will close the gap since 2010 a little more.

 

 

Before deciding that the central bankers have captured the markets and we can rest easy as buy and hold investors, we need to look at what price level we are now paying to buy a very small stream of future earnings after corporations pay interest on record setting debt levels and deal with under-funded pensions…

 

…In theory, the valuation of stocks would be based on a future stream of income generated and the expected growth rate of those dividends.  While in the long run this rule is loosely followed, in the short run the markets move from high valuations relative to this expected stream of income to low valuations.  During secular bull markets these valuations move higher at each market top and bottom.

If the stock market today was valued at the same relative level as the start of the secular bull market in 1980, it would be 75% lower!  Meaning you are paying four times the net present value of expected guesses for future earnings.

 

Black Swan Events

Which brings me to another point.  If a global disaster occurs over any weekend (eg. start of war in Korea), the stock market could lose 50% overnight in investor eyes.  There are circuit breakers in place, but it could jolt its way to this new level over the course of a few trading days with little chance retail investors would be at the front of the exit line.

 

The question is if the markets were to lose 50% overnight (or week) where did the “wealth” go?

The answer may surprise you in that 8 trillion dollars of “wealth” can disappear in aggregate overnight.  For the most part, no one gains other than a few short sellers.  But they only made a few percentage of the aggregate losses.  Which brings us back to the true wealth of investments – its stream of payments expected in the future (not its current price)…

 

…Today, we need to understand what might impact our retirement balances over the course of 10 – 20 years and why valuations matter.  I want you to have that larger balance to draw from when you retire and throughout retirement.  In order to do so, we need to stop chasing past returns and focus on future returns…

 


 

There is much more in the report, but hopefully you get the picture on the history of seasonal investing. This market cycle has seen atypical positive summer gains primarily due to recent monetary policy which may reverse in the future.

While rare, the favorable season (as defined by our objective strategy) has had few down seasons and they are typically associated with bear markets.  We do track and report on a separate indicator that has led stock market sell offs the last 20 years. If you follow the flip side of this indicator, you would have remained invested over the summer.  

At present, I am concerned about a Black Swan landing during the favorable season. Historically high valuation and corporate debt-to-earnings levels could lead to some pain and panic.  By definition, there would be little to no warning for a landing black swan – North Korea comes to mind. Because of this, I am recommending members go light on stocks even if we miss some of the terminal phase of the melt-up. The Titanic was breaking records too.

Michael Bond

 

Black Swan Event – rare events that are beyond the realm of normal expectations in history, science, finance and technology due to psychological biases that people, blind both individually and collectively, to uncertainty and to a rare event’s massive role in historical affairs.

 

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