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The Confidence Roller-Coaster…

Posted by: Brian Dennehy
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…brought to you by various central banks. In the blog on recessions (“Awaited policy error”) I highlighted that confidence (or lack of it) is the one indispensable requirement for both a recession (major or otherwise) and a bear market. For most, lack of confidence is a condition stretching back decades – but not for the few.
 
For much of the population of the indebted Western world the evidence of confidence failing has been around for a lot of years, and this preceded Trump and 2008 and Brexit. Most of the Western world has not enjoyed the wealth creation of the few.  This has merely become more obvious with “surprise” reactions by voters, throughout the West.
 
We showed four charts illustrating the longer-term nature of this problem in “Historian 0-4 Facts”. 
 
In contrast, stock markets have not suffered from a lack of confidence. Why? Central banks, in particular central bank action, and extraordinarily low “emergency” interest rates and quantitative easing (QE) being held in place long after the emergency was over – the emergency was 11 years ago, it ended 10 years ago.
 
But this central bank largesse simply didn’t extend to the wider economy. What it did encourage was companies to borrow very cheaply. And they did.
 
But they did not spend it on new capital, or research, or better trained staff, or even pay increases, at least not in scale. What they did was buy back their own shares. This meant, as if by magic, that earnings per share went up – the company itself made no more money by this mechanism, but the earnings per share did.
 
Guess who benefits from a higher earnings per share, even if overall company profitability is unmoved?
 
You guessed it. The major beneficiaries were the company executives who made the decision to buy back their own company shares – because their bumper remuneration is typically based on increases in earnings per share.
 
Politely it’s called financial engineering.
 
No wonder the stock market kept going up (as confident company execs kept buying back their own shares), which benefitted the top 1%. Meanwhile the 99% (excuse the shorthand) were increasingly feeling less well-off and less confident (and more anti-establishment – just saying).
 
The result was that the already entrenched trend, the growing wealth gap, became bigger, and more obvious.
 
The funny thing about the 1% is that they hang out with the politicians and the central bankers. 
 
This isn’t me being conspiratorial or tabloid-ish. Just look at Davos… The photo below shows a banker, an “establishment” journalist, a central banker, an investment banker, a tech biz CEO. 
 
 
So, it was no surprise after the stock markets fell very quickly from October to Christmas, that the central bankers appeared to panic. First the US central bank. And last week it was the European Central Bank that appeared to hit the panic button, announcing more stimulus for the banks, as it slashed its growth forecast for the eurozone.
 
Of course, debt is part of the problem. Mountains of debt require torrents of interest payments. And these interest payments are money which might otherwise have gone into new capital, or research, or better trained staff, or pay increases. 
 
Let’s think about the central banks reversing their reversal of their emergency response to an emergency which finished 10 years ago.
 
Clearly very low interest rates and QE were great news for stock markets. Then the US Federal Reserve started raising interest rates back in 2015. But markets didn’t get into a panic then. The idea of central banks was that if they acted very slowly they could let air out of the market and debt bubble slowly and without incident – perhaps they thought no one would notice. But there is no precedent for that – no bubble has done anything other than burst in a messy fashion.
 
What seemed more likely to most of us was that eventually the rate increases and QE withdrawal would trigger a reaction, even a panic, but no one knew when.
 
To guide us through this huge central bank experiment, and its impact on the stock market (our primary concern) we turned to a bit of basic Elliott Wave Theory. (As an aside, remember that next week in a blog we are going to link back to blogs and teleconferences and downloads which go through the detail on this analysis).
 
Here is an idealised version of a bull market of 5 waves in total, 3 up and 2 down. Then underneath that is how we fitted the US stock market into this analysis, which developed in textbook fashion following our analysis in January 2018. 
 
 
 
A bull market of 7-10 years in the making does not end with a correction of three months e.g. last October to December.
 
To recap, markets fell fast from early October to Christmas eve:
 
·         The US fell 17.6% from its peak.
·         The UK fell 9.8% over the same period…
·         …and 13.2% from its peak back in May 2018.
 
Steve Blumenthal highlighted interesting data. He asked, what happens after a typical waterfall-like decline, such as that which occurred in late 2018? The answer:
 
·         In 19 post-war examples of 15% uninterrupted decline
·         After a bounce the low was retested…
·         …in every instance.
 
Since Christmas Eve we have had a bounce for sure. As we see it there are now three possibilities, represented by the three coloured lines on this chart:
 
 
But you might ask why all three lines ultimately point down from some point soon? Interest rate lows supported the stock market for 10 years, and now central banks have stopped increasing rates (and in the case of the ECB re-commenced more stimulus), so surely the market will go on another tear upwards?
 
Let's have a glance at history.
 
September 1929
Rates were cut ten times, from 6% to under 2%.
Irrespective, the bear market lasted 34 months, and the market fell 89%.
 
December 1999
Rates were cut 13 times, to less than 1%.
Irrespective, the bear market lasted 3 years, and the market declined 51%.
 
Lesson? You’ve got to stop believing in the central bank fairy.
 
John Kenneth Galbraith had something to say about bull market fairies…
 
During every speculative episode, investors come to believe that past experience is the “primitive refuge of those who don’t have the insight to appreciate the incredible wonders of the present” …
 
…and that somehow, we can avoid the disappointments of the past.
 
Then over to John Hussman, who asks “what is normal?”
 
From valuations at current levels “normal” is falls of about 60%.
 
It’s that simple. The numbers don’t lie and John has crunched them like no other.
 
There is always room for the unprecedented – there has been a lot of that in recent years. But for now, John’s historical analysis is your best guide.
 
Of course, we don’t know when those falls will begin. That is why our approach has always been not to try and “spot the top” or market timing.
 
Rather, we believe your focus should be on applying a clear stop-loss strategy when these levels are breached e.g. a 10% fall below your purchase price.
 
I stress, a stop-loss is not applied in an attempt to market-time. A stop-loss is applied to protect your capital value. 
 
What about those of you who didn’t apply a stop-loss in the Autumn?
 
·         Perhaps you didn’t intend to do so?
·         Or found it difficult when it came to it?
·         Perhaps there were lots of “siren calls” in the media?
·         Or life just had too many other distractions!
 
Do not let the Christmas bounce lull you into a false sense of security. The John Hussman-style facts have not gone away.
 
A number of measures highlight renewed complacency. But YOU don’t need to get suckered in the same way…
 
…be ready to act.
 
If you didn’t have or didn’t apply a stop-loss, you have been given another chance.
 
I have no idea if John Hussman will be proved right, or when. But don’t ignore his analysis just because it makes you feel uncomfortable. Feeling a bit uncomfortable should be a perpetual state for a successful investor. Be prepared.
Topic: Market commentary


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