"No occurance is sole and solitary, but is merely a repetition of a thing which has happened before, and perhaps often." - Mark Twain
"If history repeats itself, and the unexpected always happens, how incapable must man be of learning from experience." - George Bernard Shaw
Many market observers have noted the ongoing correlation between the current market environment and that of 2008. The risk of a "Lehman moment" seems to be part of almost every analysis. With so many minds focused on that possibility - none more so than politicians and central bankers worldwide - it seems extremely unlikely that we'll get what everyone is watching for.
And yet, the ebbs of the flows of the 2011 market continue to play out in a manner very similar to what we saw in both 2000 and 2008 through the topping process. Notice in the chart below how the market seems to be experiencing similar cycle patterns.
click to enlarge
In the above chart, each of the following phases repeated in 2000, 2008 and 2011:
A. Warning sell-off. Warning sell-offs in 1998 and 1999 before the 2000 top. Significant weakness in 2006 prior to the 2008 top, and in 2010 the onset of the European crisis acted as a primer for 2011's topping action.
B. Topping. The 2000 top on the S&P wasn't anything particularly identifiable, though NASDAQ was an old fashioned climax top. Sloppy and Head-and-Shoulder patterns were formed on SPY in both 2008 and 2011.
C. Steep sell-off, and rally back to 200 day SMA. It's worth remembering that intense volatility - even the green kind - is far more likely to be found in the midst of a Bear market.
D. Sell-off to new lows, rally back to previous low. Rinse and repeat. This "D" phase can continue at great length, as was seen in the 1930s (see below). In 2000 and 2008, D occurred around the same level as A.
E. Final Capitulation. The steepest, nastiest part of the decline, when all hope has been cast aside.
I don't believe that history actually repeats, but as Mark Twain said, "it rhymes." There is always some variation. The behavior must be confusing enough to keep investors on both sides of the trade. Hope for a resolution of Europe's problems and continued global recovery has finally pushed the S&P back to its 200 day moving average four months after August's steep sell-off. In recent decades, deep multi-week incisions beneath the 200 day moving average (with the 50 day following to form a "death cross") have seldom been followed by reversals that re-instate the bull.
In this particular cycle, all eyes are on Europe as the Boogeyman that threatens to bring down the financial system. It's my suspicion that the danger lies somewhere else. The most obvious source is the U.S. economy, which seems to have been dismissed as a risk by most bulls. Recent economic data has supported this, and on Thursday initial claims for unemployment fell to the lowest levels since February of this year. So we're in the clear, right? Not so fast.
Two sources with strong track records are forecasting a recession in the U.S., and both recently confirmed that nothing has changed that forecast. John Hussman's collection of binary indicators is at a level that has coincided with a recession 7 times out of 7 since 1950. The ECRI's track record is much shorter, but they are 3 for 3 over the last two decades. On Thursday, Lakshman Acuthan appeared on Bloomberg and confirmed that in his view, recession is, indeed, on the way - or already underway. He noted that while GDP was recently reported at 2%, GDI (Gross Domestic Income) was 0.28% and has been trending downward for 6 quarters.
GDP and GDI should equal one another, but seldom do. When they don't, GDP is typically revised towards GDI. Moving away from economic indicators and towards market indicators, high yield bonds, which tend to be a good indication of market health and risk appetite, have seen demand dwindle relative to Treasuries. The ratio of high yield (JNK) divided by 30 year Treasuries (TLT) formed a bullish higher-low in March of 2009 and led the market high through this summer when it signalled a reversal for the first time since 2009.
It's possible that all of this is just a scare. Who cares about some stupid high yield ratio? Hussman and the ECRI could be wrong. Europe could solve its problems and the market could be off to the races. The point of this article isn't to convince you that the Apocolypse is here. It's to remind you that cycles repeat and we are thus far repeating a cycle that doesn't have a happy ending, so be careful. This is not the time to take big risks on the long side, in my humble opinion.
The easiest to way protect against a sell-off is to buy long-dated puts on SPY. They are still relatively cheap. You could also buy a short ETF like SH or SDS (2x short), but be aware that leveraged ETFs have decaying performance over time and are not designed to be held for the long term. It's also perfectly reasonable to just sit on cash awaiting better opportunities. I look forward to the day when I can take a more bullish view, but until I see the price action reflected in the SPY chart break the pattern that is currently playing out, I will remain extremely cautious.
Additional disclosure: I also hold long-dated puts on SPY.