Let's start with the following:
An important market top was likely made in the first half of this year
A test towards the recent lows and then a resting period is my baseline expectation
Projected S&P "Fair Market Value" is lowered by 5%, from 1995 to 1890
"Fair Market Value" is 1% below yesterday's close
"Praise by name and criticize by category." --Warren Buffett
Today I want to start with a continued warning and some more lessons learned.
I have frequently warned about the self-confident views (both bullish and bearish) of glib talking heads. This statement might be the single most important lesson taught from the last five weeks.
Too many talk fast, are often three miles wide and an inch deep, rarely manage real money (they are usually virtual), are not rigorous in their analytical process or have none at all, never say "I don't know," talk with authority through sound bytes and are usually trying to sell you something. They are "Hoovers" who too often quickly forget their investment boners and/or act like deer in headlights when losses quickly mount.
I also remain ever critical of those talking heads who are rigorous in their approach but deliver their bombastic investment messages with self-confidence. There are simply too many adverse outcomes possible for such a delivery without qualification.
If I ever conduct myself in that manner I want you to chastise me and slap me around silly in the Comments Section.
Keep those commentators far away from your children and from your investment portfolio. Instead, weigh all opinions, read as much as possible, keep your losses under control, stay independent in view and always evaluate reward versus risk in every investment or trade.
Remember as well that, at inflection points, the consensus fails -- sometimes spectacularly.
It is fine to listen to talking heads (I include myself and our contributors in this class), but make sure you understand their investment process and weigh their value and integrity of analysis on an objective basis.
Above all, always define and understand your risk profile and timeframes; never stray from them, despite the protestations and assurance of others.
It is your capital to make or lose, not theirs.
At the same time we all must take responsibility for our own investment actions.
After getting that off of my chest, here are some of my tentative conclusions from observing the market over the last few weeks:
An important market top was likely put in during the first six months of this year
We likely saw a selling climax a week ago Tuesday, but further tests may occur
Liquidity is not what it used to be as the character of the market's participants has changed
I would like to split up today's opener into a brief discussion of Fundamentals and Technicals.
I am changing the probabilities (I am upping "muddle along" and reducing the odds of a reacceleration/maintenance of domestic economic growth) and price and price-earnings multiple targets associated with my five scenarios that support the calculation of the S&P's "Fair Market Value."
When I combined the revised scenarios' probabilities against my S&P targets for each scenario, I come to a "Fair Market Value" for the S&P at about 1890 compared to Tuesday's close of 1915 (and down from my previous estimate of 1995) -- or about 1% lower than yesterday's close. (Precision is not intended!)
Here is the basis of the new calculation:
Scenario #1: Economic Acceleration Above Consensus (Probability down from 10% to 5%) -- 3% Real U.S. GDP growth, 2.0% to 3.0% inflation and 8% to 12% profit growth. Stocks climb by 12.5% over the next 12 months. S&P target is 2150.
Scenario #2: Status Quo (Probability down from 25% to 20%) -- 2% to 3% Real U.S. GDP growth, 1.5% to 2.0% inflation and 5% to 9% profit growth. Stocks climb by 8% to 10% over the next 12 months. S&P target is 2085.
Scenario #3: Muddle Along (Probability up from 25% to 35%) -- 2% Real U.S. GDP growth, 1.5% inflation and 3% to 5% profit growth. Stocks climb by 5% over the next 12 months. S&P target is 2010.
Scenario #4: A Garden Variety Recession (Probability stays at 25%) -- Negative Real U.S. GDP growth, less than 0.5% inflation and a decline in profits. Stocks drop by 10% to 15% over the next 12 months. S&P target is 1675.
Scenario #5: A Deep Recession (Probability stays at 15%) – Negative Real US GDP growth, deflation and a large drop in profits: Stocks drop by more than 15% over the next 12 months. S&P target is 1590.
One of the most important factors that contributed to the August market setup, which still gets very little discussion, was the deterioration and narrowing in market breadth and leadership.
Sectors such as cyclicals and commodities were already experiencing their own bear markets, but complacency -- measured by an abnormally low volatility index, was a conspicuous feature of the January-through-June period.
This is a subject I dwelled on repeatedly throughout the first half of 2015. It was, to me, the most important technical tell that presaged the August and early September market massacre.
Last week's capitulation – in which the Dow Jones Industrial Average dropped by more than 1,100 points in five minutes (more than in the May 2010 "Flash Crash") -- came unexpectedly and violently as it was born out of new highs only a few days before.
Technically, this could make the recent drop even more consequential, particularly as it uncovered structural market breakdowns, or what I term a fundamental breakdown in the market mechanism.
The market's culprits, which likely stressed and exacerbated the recent meltdown, were gamma hedgers, levered exchange traded funds that rebalance their portfolios during the trading day, opaque dark pools and spoofing quants whose computerized trading knows not about balance sheets and income statements. As well, as I discussed in Barron's over the weekend, the pendulum of regulatory actions (Volcker Rule, Dodd-Frank and Basel III) created a vacuum of lost liquidity in which market makers were no longer there to provide liquidity and orderly markets.
These disruptive factors have evolved over the last two decades and remain a constant source of future risk. It also might make it hard to return to normalcy and it even makes it hard for technicians to analyze the market's action and behavior in a market dominated by players that are far different in character and methodology than past market participants.
One of my conclusions at the beginning of today's opening missive was that a capitulation low occurred a week ago. I still subscribe to this notion.
As I wrote last week, two consecutive down 90% days are typically followed by a few days of recovery (my pal Bob Farrell says that near 80% of a post-climax rally occurs in the first few days following the drop), then a fall back to or near the old lows is to be expected.
The recent volatility could lead, as I have suggested, to the potential "Death of the Retail Investor." Last week individuals sold out of nearly $30 billion in domestic equity, high-yield and emerging-debt funds; Merrill Lynch claims that this is the largest weekly withdrawal in 13 years.
The good news is that it is likely this week will be greeted with more large outflows as well, potentially setting up for an extreme move in negative sentiment as weak holders exit.
Bianco Research has done some excellent work on market volatility that I wanted to share.
Drops of 10%-plus in only four trading days is a rare phenomenon. A 10% drop occurred Aug. 21-25; that's only the ninth time since The Great Depression. As seen below, these events are typically an outgrowth of major economic or corporate failures.
The other eight periods of 10%-plus drops were seen in August 2011 (US lost its AAA credit rating), October 2008 (financial crisis), July 2002 (Worldcom defaulted), August 1998 (Long Term Capital failed), October 1987 (portfolio insurance causes a stock market crash), May 1962 (President Kennedy introduces steel tariffs), May 1940 (Battle of Britain) and March 1938 (Fed policy error).
Importantly, according to Bob Farrell, "all these drops were followed by retests or lower lows in the weeks or months later, whether in bear or bull markets."
Only two of these drawdowns occurred in bull markets – in 1998 and 2011 (Jim "El Capitan" Cramer discussed August 2011 on "Mad Money"). Accordingly, if you think the recent drop is within the context of a bull market sell-off, those two years might be instructive. Bob mentioned to me that:
"In 1998, the volatile four-day crash established the low for the reaction in late August which was tested in early October. New highs were reached four months after the low. In 2011, the lows were made in mid-August and were tested three times with a slightly lower final low made in early October. It took five months to rebuild and get back to new highs."
Bob calls these "best case" scenarios.
"In the case of the 2010 'flash crash' which did not make the four-day 10% down list, it was the beginning of a two-month, 16% correction and took over six months to reach new highs again."
The question is whether the first half of 2015 was a more important top than in the past 10%-plus drops. This is my baseline expectation. If so, significant resistance lies above current levels.
Predictions are like noses (anatomical part has been changed to get through my editor!) – everyone has one! That said, I am here to forecast and forecast I will; but because any projection over a year is more a statement of religion or philosophy, I will stick to the next six months or so.
My "Fair Market Value" for the S&P index has been reduced to 1890, some 1% below the current level of the index. So, fundamentally (using this methodology), the market doesn't appear materially overvalued or undervalued.
Technically, I currently subscribe to the notion that over the next two or three months a further retest towards the recent low could develop and then the market might just lay dormant for a while in a relatively narrow trading range.
At the core of this expectation are several cushioning factors, including the absence of participation by individual investors, deteriorating investor sentiment readings (Investors Intelligence bulls are the lowest in five years and the correction camp at over 45% -- the highest level since last October, which was the highest in 19 years) and the emergence of fear, which is a necessary reagent to a more durable market turn.
If this is the case, long-term investment opportunities will emerge.
If I am wrong -- and it certainly is not impossible given high historic valuations, especially in the face of profit margins at several standard deviations above historical averages -- then a cyclical bear market will emerge.
Regardless of view, the ride ahead will likely be wild.
