Diary of a Financier

Bull v. Bear

In Capital Markets on Wed 16 Jul 2014 at 15:57

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 (+)
    The quantitative data not only suggests we’re in a secular bull market, but also we’re barely at halftime:

    • Alltime closing highs: 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)
    • Average secular bull: 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 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).
    • Winning streak: SPX has gone 32 months without a correction, which is still below the average of 36.3 among all 10 postwar bull markets — despite bears’ repeated claims that “the rally is long-in-the-tooth.”
  2. Fundamentals (+)
    Valuations are average, which is a good sign in the midst of a bull market:
    SPX valuation metrics 2014q3

    • Fair value: SPX fundamentals have just reached their long term (20-year) averages and aren’t even close to multiple-sigma premia that’re indicative of extremes.
    • Relative value: Equity earnings yields are still +170bp spread over corporate credit (Baa bond yields) vs -100bp historical average.
    • Return after fair value: Secular bull markets never end at fair value;SPX returns after fair value (1963-2014) 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 material gain.
  3. Macro (+)
    Growth is looking-up, manifesting pent-up demand after aweak Q1 (attributable in part to the weather):

    • PMIs: US ISM -0.1 @ 55.3; global manufacturing PMI +0.6 @ 52.7
    • Railtraffic: +4.6% y/y
    • Commercial bank lending: +4.86% y/y
    • Consumer indebtedness: +3.7% y/y
    • Retail sales: +4.3% headline; +2.8% core y/y
    • Durable & capital goods: orders +10% qtd annualized; shipments +3 – 4% y/y
      • Counterpoint: Inventories have been accumulating rapidly, so shipments need to redouble their growth rates to sustain a healthy balance. 
  4. Internal correction (+)
    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 $IBB).  The former have resumed losses after a recovery from a proper correction (-10% drawdown between March and May), and the latter had undergone a full-blown bear market (-40 – 60%).   However, the broad reality is a lot different, because large cap blue chips ($SPY) and dividend stocks ($HDV) remain near alltime highs.
    Some onlookers have called such “internal corrections” or “size divergences” bearish harbingers, but the data suggest otherwise:

    • Valuation: Perhaps the best thing that came from the internal correction was multiple compression.  During the correction, Street consensus estimates were revised higher, leaving FwPEs at cheaper valuations even after share prices had fully recovered.
    • Quantitative outcomes: 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, but rather risk-on (e.g. 10/2009, 3/2012, 7/2012, 4/2013, 5/2014).  In fact, IWM historically outperforms in subsequent periods, averaging +4%outperformance over 12 months (+10% excluding Tech Bubble)
      • Counterpoint: 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.
  5. 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).
  6. Opportunity cost (+)
    There is no alternative (“TINA”) to equities at this point in time, which is fine within context of fair valuations and normalized sentiment (see above & below, respectively):

    • Bonds: $TNX @ 2.5% despite 3 – 4% trend nominal growth (2% inflation plus 1 – 2% real GDP); credit spreads at alltime lows.
    • Cash: ZIRP.
  7. 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.
  8. Sentiment (PUSH)
    Investor sentiment is almost unanimously average:

    • Individuals/retail: Both asset allocations and sentiment are still around historical norms.
    • Institutional: Fund managers’ equity allocations are average, but bonds and cash are below extreme lower bounds
    • Strategists: BAML’s sell-side consensus is still flashing a contrarian buy signal, with the average equity allocation @ 51.3%, which is below its extreme lower bound @ 54.5 and its historical average @ 60.3.


  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. Credit ()
    While credit availability to the real economy is finally increasing to normalized levels, pockets of credit excess threaten to offset the healthy gains elsewhere:

    • Traditional bank lending: Again, commercial credit outstanding is growing +4.86% y/y — a healthy velocity of credit expansion that will boost GDP growth.  More granularly, loans to the real economy (C&I loans) are in an upswing after years of weak demand; lending to households is cooling-off after the postcrisis refinancing scramble; CRE loans are moderating after a multiyear boom.
    • Margin debt: Every data permutation (nominal/real & gross/net) indicates that margin levels remain at extreme levels despite the stock market’s choppy start to the year.
    • Leveraged loans:  Junk issuance and valuations at exuberant levels, including floaters like institutional bank loans and PIK toggles for M&A/LBOs.
    • Credit spreads: notHY spreads & defaults (1988-2014) only are high yield ($HYG) and Investment Grade ($LQD) spreads atalltime lows,butHY default rates are extraordinarily low too @ 0.6% vs 4.0% average — on par with exuberant stretches across 1995-99 and 2005-08.  More troubling, the Street is citing debt as a growth catalyst in recommending the stocks of alot of leveraged SMid cap companies.  “Refinancing credit facilities,” “floating-to-fixed recapitalizations,” and “increase Debt/EBITDA” are becoming prevalent in analysts’ research reports and hence being incorporated in forward growth consensus for shareholders.  Thus, I now expect the widening of credit spreads to actually impact broad market equities
      • Counterpoint: Again, 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.
  3. Complacency ()
    Historically, indicators of complacency — when at today’s levels — are poor timing mechanisms in spotting the tops of bubbles; many more indications of Delusion must be manifest before some kind of bear market crash draws near:

    • Volatility: The $VIX hit a postcrisis low @ 10.18, still remaining persistently below its extreme low threshold @ 15 and its long term average @ 20.1.
    • Short interest: Across developed markets, short interest @ 1 – 2% has plummeted to the lowest levels since the dataset began in 2006.
  4. 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:

    • Best case scenario: Corporate revenues and economic growth steadily increase up to potential; the risk-on environment will redouble, with the historic inversion between SPX earnings yield (6.4%) and Baa bond yields (4.7%) reverting to its normalized equity premium over time; indicative of PE multiple expansion.
    • Base case scenario: Revenue and GDP remain below trend; an increase in bond yields (cost of debt/liabilities) and a decrease in present value of assets in response to higher rates will erode the margin expansion that’s aided EPS throughout much of this recovery; indicative of PE multiple stagnation.
    • Worst case scenario: Revenue and GDP decline due to the withdrawal of stimulus; debt has to be rolled into a higher-rate environment, and ROAs slip to negative returns; everything will revalue due to razor-thin credit spreads and equity risk premiums (ERP).
    • Historical correlations:SPX/TNX correlations (weekly, 1963-2014) Historically, from this low of a rate environment (ZIRP), equity returns are positively correlated with rising interest rates; I would add the caveat that the pace or volatility of rising rates is a very important determinant.
      • Analogue: As an extreme example, 1994′s bond massacre saw significant SPX multiple contraction (ttm PE from 17.6 to 14.7) in a broad revaluation amidst rising base rates.  Nevertheless, SPX ended 1q94 -4% after a full -10% drawdown, then managed to end the full year only -2%.
  5. Technicals ()
    SPY daily/weekly 2014.07.14

    • $SPY: daily LT rising wedge & ST bull channel at trendline support; weekly bull reversal.
    • $IWM: daily IWM daily/weekly 2014.07.14H&S top with weekly 4xbear divergence and $SPY (risingwedge withbear divergence) are both bearish.
  6. Mean reversion (PUSH)
    Despite a lot of debate citing overfitted data, SPX typically mean reverts after big years like 2013:

    • Quantitative outcomes: 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.


I count 6 positives (+), 4 negatives (), and 4 pushes (PUSH).  Quantitatively, that amounts to net +2 — bullish by a narrowing margin.  Thus, my conclusion: remain slightly overweight to benchmark-weight.

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 “internal correction” we’re currently overcoming.

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.


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

  1. […] historical analysis of relative returns gauges my expectations for IWM’s future path.  The period of Small Cap underperformance […]

  2. […] of all multiples less 10y Treasury yield e.g. earnings yield – bond yield) [Previously: SPX’s substantial return after fair value & CAPE and valuations in context] #Bullish #There Is No Alternative $SPY $IWM […]

  3. […] a deleveraging corporate sector is handing-off to a releveraging household sector/real economy (as expected). Surveys net respondents’ qoq change in credit demand, spreads, and lending standards: – […]

  4. […] since 1990, using the most statistically significant fundamental metrics. [Previously: SPX +28% average return after fair value] […]


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