Diary of a Financier

Bull v. Bear

In Capital Markets on Thu 15 May 2014 at 10:51

I’ve spent considerable time synthesizing all of the information I’ve consumed since my last “Bull v. Bear” entry, and enough has changed for me to render a new, timely, cogent market opinion.  The following signals-through-the-noise attempt to substantiate an objective, data-driven narrative that can guide me through the equity market over the coming days, weeks, months, and quarter…


  1. Secular bull market evidence (+)
    The quantitative data not only suggests we’re in a secular bull market, but also we’re barely at halftime.
    First, contrary to conventional memes, buying at alltime highs like today’s has historically been a good strategy, because the frequency of new alltime closing highs since 2013 is a signal of a secular bull market that’s just getting started.SPX inflation-adjusted secular highs & lows (1871-2014)
    In addition, the Great Recession’s bear market that bottomed in 3/2009 (-59% in real terms) was quantitatively commensurate with predecessors, but the recovery-to-date hasn’t fully matured per the same history.  SPX +122% (inflation-adjusted) over 5 years is mid-stride compared to the 5 prior, secular bull market precedents, which averaged +424% (+396% median & 131.6% standard deviation) over 15.9 years (18.1 median & 8.8 year σ).
  2. Momentum (+)
    Between 6/2013 – 4/2014, $SPX  hit a higher-high in all 10 consecutive months. Since 1950, there have been 22 such occurrences, and the subsequent average (mean) returns suggest an overwhelming probability that $SPX will post meaningful gains over the coming months — especially 3-12 months hence (7/2014 – 5/2015).
  3. Pent-up demand (+)
    Coming into 2014, we expected strong GDP growth, starting the year as high as 4% & settling into a 3% FY clip, but bad winter weather disrupted economic expansion.  As I’ve maintained throughout, per the data, Q2 should exhibit a spike in pent-up demand if we were to return to trend growth, and recent data (e.g. railtraffic & PMIs) have continued to affirm that deduction.
  4. Household releveraging (PUSH)
    5 years after the credit crisis, US household deleveraging seems to have bottomed with 3 consecutive quarters of debt increases and healthy consumer balance sheets starting a releveraging trend.

    • Counterpoint: On net, private sector credit may not materially releverage, since corporations seem to have engorged themselves on corporate debt during ZIRP, with their mean reversion likely offsetting any expansion in individuals’ balance sheets.
  5. Retail investor sentiment (PUSH)
    After their absence provided almost 5 years’ worth of contrarian buy signals, individual investors have now returned to the stock market excessive bullishness at the start of the year has waned in the wake of January/February’s market drawdown:
    While the bull/bear ratio is low, investors seem to expect a sideways market over the coming quarters, which is frankly inconclusive noise, but retail asset allocations to stock are almost at extreme levels, with cash and bond allocations near their own historical lower bounds.


  1. SPX long term regression ()
    The SPX long term regression- mean & standard deviation (1870-2013)market is currently +80% above its mean (almost 2 sigmas) vs. prior highs of +85% before the Panic of 1907, +81% Great Depression, +150% Tech Bubble, and +89% Great Recession.  While we’re approaching both 2 standard deviations and those prior high-water marks from the Great Moderation era, there may remain a little meat left on this bone, but this indicator suggests we tread lightly.
  2. Margin debt ()
    Every data permutation (nominal/real & gross/net) indicates that margin levels remain at extreme levels despite the choppy start to the year.

    • Counterpoint: Due to reporting latency, latest available data is from March, which did show a -3.3% reduction in outstanding margin debt.  While that’s miniscule relative to the multiyear increase we’ve experienced, April and May data should show more substantial retrenchment alongside the small cap and momo correction.
  3. Rising rates (PUSH)
    Amidst the rising rate regime associated with the QE taper (and now a feared Fed Funds tightening with the end of ZIRP potentially closer than consensus had assumed), earnings yields should rise with any volatile shifts up in the risk free rate.
    At best, a risk-on environment should see a compression in the historic arb spread between the SPX E/P ratio (6.34%) and Baa bond yields (5.10%), as bond yields catch-up to earnings yields and eliminate risk’s relative value advantage.  This would occur if both interest rates rise steadily, and real economic growth resumes, manifest in corporations by top-line (revenue) growth.
    At worst, stocks should revalue, given a thin equity risk premium (ERP).
    Empirically, there’s an analogue to 1994′s bond massacre, in which SPX saw significant multiple contraction (ttm PE from 17.6 to 14.7) in a broad revaluation amidst rising base rates.  SPX then ended 1q94 -4% after a -10% drawdown, managing to end the full year only -2%.
  4. Fundamentals (PUSH)
    A refresh of my valuation multiple analysis shows Street consensus resuming its annual, habitual walk-of-shame:SPX valuation analysis 2014.05.09
    Analysts have already walked-down SPX FY14 EPS growth by 35% ytd. 
    While valuations are fair on a historical basis, the lower earnings growth means PEs will have to expand from current 15.76x (Fw) to ~16.7x if market performance will give investors at least 5% byYE14 — and that’s assuming that FY EPS actually hit that lowered-bar for consensus expectations.
    Finally,SPX’s PEG ratio has reached 1.7x, which exceeds its 10 and 15-year average.

    • SPX returns after fair value (1963-2014)Counterpoint: Secular bull markets never end at fair value; they always ride momentum’s wave and overshoot.  In the postwar-era, the average SPX return after hitting fair value¹ is +28.14% mean (+16% median) across 7 occurences, with only 2002’s market reversing without material gain.
  5. Size divergence ()
    If you’re immersed in the markets and punditry today, you have a bearish mouthfeel attributable to the carnage in small caps ($IWM/$RUT) and momentum names ($QQQ and $IBB).  The former have undergone a proper correction (-10% drawdown so far), and the latter a full-blown bear market (-40 – 60%).   However, the broad reality is a lot different, because large cap blue chips ($SPY) and dividend stocks ($HDV) remain near alltime highs.
    Some onlookers have called such “internal corrections” or “size divergences” bearish harbingers.  In fact, Small Caps ($RUT) have undergone 36 corrections since 2000, all accompanied by a simultaneous large cap correction.  So far today, $SPY is +0.12% during the -10% $IWM drawdown.

    • Counterpoint: Given multiyear $IWM outperformance, valuation may be the reason for recoupling — suggesting IWM may just be catching-down to SPY and IWB, rather than us awaiting the opposite:
      “Looking at averages since 2000, small-caps are trading at a 24% premium based on price/sales, and a 42% premium based on EV/EBITDA. Conversely, large-caps are trading at just a 14% premium based on price/sales and are actually at a slight discount based on EV/EBITDA.”
    • Counterpoint: Frankly, this kind of bifurcation among Small Caps and Large Caps happens all the time.  Instead of focusing on instances when this amounted to a correction, I also counted the occurrences when “SPY made a higher-high without IWM echoing it, then IWM made a lower-low without SPY doing the same”; the results say this kind of discrepancy clearly doesn’t always spell doom (e.g. 10/2009, 3/2012, 7/2012, 4/2013, 5/2014).
  6. Credit spreads ()
    High Yield ($HYG) and Investment Grade ($LQD) spreads have been whittled down to almost nothing:
    HY absolute spreads at 379bps have reached another new postcrisis low in the 2004-07 and late-1990s range (low ~250bps), but more importantly, relative spreads are still right there at alltime lows.
    IG absolute remain at 68bps – their own postcrisis low in the 2004-07 range – but relative have at least floated a bit higher since hitting a alltime record low in 1q13.
    I’m changing my tune on this, rating it a “negative” (previously a “push”).  First, spreads have continued to tighten, despite contributing +9.4% to junk bonds’ performance attribution in 2013 (+3.0% for IG).  Second and more troubling, the Street is citing debt as a growth catalyst in recommending the stocks of alotofleveraged SMid cap companies.  “Refinancing credit facilities,” “floating-to-fixedrecapitalizations,” and “increase Debt/EBITDA”arebecoming prevalant in analysts’ research reports.  That’s become part of forward growth consensus for shareholders, so now I expect the widening of credit spreads to actually impact broad market equities.

    • CounterpointAgain, the deleveraged household sector can now releverage, taking the handoff from an overleveraged corporate sector.  At this point in the greater credit cycle, these spread corrections are merely the undulations of a “short term debt cycle” — not the kind of systemic defaults associated with larger credit booms.
  7. Technicals (PUSH)
    IWV & SPY daily- bearish setupsI’ve harped-on the bearish pattern developments and indicators’ divergences across broad equity indices, and we’re now seeing the follow-through. 

  8. Mean reversion (PUSH)
    Despite a lot of debate citing overfitted data, SPX typically mean reverts after big years like 2013. After >25% CY performance, SPX’s subsequent mean return is only 5.47 vs 11.5% historical average, but with an 18.27% standard deviation, we can’t expect 2014 to be the same, since past data shows high variability.
    1946 (-11%) may be the best analogue for 2014, given the pattern of preceding annual returns (through 1945), the ending war, and the demographic trough.


I count 3 positives (+), 4 negatives (), and 6 pushes (PUSH).  Quantitatively, that amounts to net -1 — a bearish tilt.  Qualitatively, I think there’s a discrepancy in the timeframe of the positive/negative datapoints, as the overarching secular bull market is at odds with the shorter-term excesses.  Thus, that’s the conclusion here: remain benchmark-weight for continued softness in the short term, but deploy cash to return to overweight as singlenames cheapen and the technicals signal a market bottom. 

Five years ago, the US economy was supposed to hit escape-velocity in the years 2014/15.  It appears GDP growth is returning to the US economy — albeit with predictable choppiness and moderation that underwhelm early CBO and Fed forecasts.

Intuitively, SPX should enjoy nice multiple expansion during economic expansions… However, “the extension of monetary policy at the zero-bound” changed the game.  Not only did extraordinary postcrisis intervention produce garden-variety countercyclical stimulus (from eased Fed Funds Rate), but it also created unique opportunities for corporate buybacks and margin expansion (from the hunt for yield caused by QE’s risk-free supply shortage).

Paired with a prolonged federal deficit and some fiscal stimulus, QE and ZIRP were bridges to literally breach the output gap.  Such measures borrow from the future.  Although 2012/13 featured substantial fiscal drags, more countercyclical dragging remains as policy normalizes.  The next drag will eventually come from corporate credit: spread-widenings, margin/EBITDA headwinds (for y/y comp at very least), etc.  We’re seeing the preview in the aforementioned “size divergence” we’re currently undergoing.

Valuations are the key to avoiding a bear market disruption in the middle of this secular run.  The market’s taking a healthy pause here — hopefully throughout CY14 — allowing fundamentals to catch-up with valuations.  Beware “price compression,” in which valuation multiples hyper-extrapolate, pulling-forward rosier, longer term factors than are probabilistically insignificant or unfeasible.


As always, my default setting should be bullish optimism 80% of the time.  In part of that balance, a mere 10% SPX correction (~5% drawdown for a diversified 60/40 allocation) is peanuts within the big picture context of a bull market.

With that in mind, the trade activity I’ve been reporting since February has our allocation back up to slightly overweight risk, after we reduced to benchmark-weight earlier in the year.  The portfolio’s asset allocation is 61/31/8 vs 60/40 benchmark (stocks/bonds/cash), with beta at 0.76 vs 0.76 benchmark, and sigma 0.90 vs 0.77.

We have eliminated our broad, high beta, small cap exposure ($IWM) to pare risk in one fell swoop, although much of the position was closed in the latter-half of this correction.  Now we have cash-enough to buy further equity corrections, and I’ll likely start with punished, individual singlenames like Criteo ($CRTO), $CREE, and $GNC.


¹Fair value = average real earning yield (postwar, 1963-2014) = +2.5%

  1. […] end at fair value; they always ride momentum’s wave and overshoot.  In the postwar-era, the average SPX return after hitting fair value is +28.14% mean (+16% median) across 7 occurrences, with only 2002′s market reversing without […]

  2. […] end at fair value; they always ride momentum’s wave and overshoot.  In the postwar-era, the average SPX return after hitting fair value is +28.14% mean (+16% median) across 7 occurrences, with only 2002′s market reversing without […]


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