Alex Trias'  Instablog

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It has been pointed out that stock markets tend to move in cycles, where boom periods (think 1920s, 1950s, 1990s) are followed by sharp busts (1930s) or lengthy, agonizing, drawn-out flat periods where inflation consumes most of the gains from the prior period (like 1965 to 1982). We know that the past years have represented a terrible bear cycle, but the question on many folk's minds is where do we stand in this cycle now?

It's easy enough to see from a chart that the Dow Jones Industrial Average hasn't budged much in the past ten years, so it's already looking a bit like we are well into a 1970s-esque investment epoch. Many have concluded that if the 1970s is the proper analogy, we only have six or seven more years of famine to go. Hurray!

But dig a little deeper. Let us assume that inflation rates have clocked in around 3% on average for the last decade or so. In fact, I'd think the rate of inflation is probably somewhat higher, but take 3% as a conservative estimate. Let's also look at the real purchasing power of the dollar. When first introduced, the Euro traded close to parity with the dollar, dipped down to about 90 cents at one point, and then began an epic climb towards where it is today - which I'll peg at $1.44 just for illustration's sake. Using the Euro as an baseline for comparison, let us assume the dollar today is worth about one third what it was worth during the prior decade. Again, this is  a hypothetical figure just for illustration's sake, because ideally, we'd want to use a far broader basket of currencies.

Today, the Dow Jones Industrial Average trades at around 9,300. Adjust that for inflation and the demise of the dollar, and what we find is that in fact, the last time the Dow Jones hit this level in real terms was when the Dow Jones traded around 4,000 back in 1994 to 1995.  In real terms, the U.S. markets haven't actually moved anywhere for nearly 15 years. 

Does that mean we've come to the end of a 1970s-like stretch? Not necessarily.  The 1970s was a period characterized by runaway inflation rates, far higher than what we've experienced in the last ten years. The true wealth destruction from 1965 to 1982 was far more dramatic than what we have seen to date - perhaps in the range of 60% or more.  

So, let's look at it another way. Starting at the top of 1990s bull cycle. The last great bull market cycle probably  ended in 2000 when the Dow hit 12,000. True, the Dow Jones did vault above 14,000 very briefly in 2007, but in inflation adjusted terms, that's lower than the 12,000 peak in 2000. If you assume 12,000 was the peak, then adjusted for inflation, the Dow Jones stood at about 15,700 in today's dollars. And adjusted for the deterioration of the buying power of the U.S. Dollar verses the Euro (again, assuming about $1.44 buys one Euro today), the Dow Jones would now stand at about 22,500 - nearly 13,200 points higher than today. Look at it that way, and we've already seen a real loss of 60% in the U.S. markets off their true highs at the top of the last bull cycle. That is starting to look very much like the wealth destruction during wrought by the 1970s.

I don't know where we stand in the bear market cycle, and nobody else does either. What we can know, however, is that the current bear market cycle has been almost as bad as some of the others we've seen in history. And we can also know that after a really bad stretch in the market, usually a really good stretch follows. For those with patience and a stomach for eating more losses that may or may not materialize over the next few months or years, the future should look brighter than it may at first blush.

 

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My model portfolio remains comprised by the following:

MDY
QQQQ
VTI
VT
EEM
FXI
ILF
EPP
EFA
IFN
EWH
TYY
HYG
JNK
AGG
BND
PFF
PGF
GS
BRKA

I remain heavily weighted in international equities,  with only about 20% to 30% US exposure - mainly in midcaps (MDY), preferred shares (PGF and PFF), master limited partnerships (TYY) and high yield junk bonds (JNK and HYG). I am overweighting US assets with high yield because, frankly, getting 10% yield at reasonable risk levels, plus some upside that correlates somewhat to the S&P 500, is an investment opportunity of a lifetime.  My reasoning for limiting US exposure is twofold.  First, from various perspectives, it appears that the global equities markets have entered long-term bull markets.  I hold many non-US ETFs because these have a higher beta than the broadest US equities ETFs, and should outperform for that reason. Second, the US dollar is in a bear market. For instance, it has sold off repeatedly from it's 30 day exponential moving average on each and every failed approach. This will continue until it stops, and until it stops, whenever that may be, I will overweight into non-US assets which, on a dollar adjusted basis, ought to outperform US assets.

One area of reasoning I absolutely do NOT have is the economic prospects of the US.  For one thing, local equities markets have nothing to do with domestic economic conditions. US firms will generate profits regardless of our GDP, and will likely grow their profits at impressive rates as they have for the past few centuries.  Add to that fact that valuation for equities here is reasonable to attractive, and the reasons for being bullish on America overwhelm the reasons not to be.

Unfortunately, that has nothing to do with the US dollar or the beta coefficient of non-US equities indexes. If the US dollar reverses direction, or if past statistical correlations deteriorate, changes to this portfolio allocation will be appropriate and, in my case, welcome. 

Various segments of the domestic equities markets, particularly mid-caps and certain segments like technology, are now past an important inflection point, where short-term trading momentum has overpowered long-term investment momentum, as indicated by the fact that the 50 day exponential moving average has crossed above the 200 day exponential moving average for a number of domestic equities indexes.  Abroad, this technical posture is already old news, and it's more or less universal across major markets - (you can take a quick snapshot by following global equities exchange traded funds like GWL).  In a few days, barring a 20% selloff, we'll probably see the same technical posture develop within broader US equities indexes as well. For many traders, that signals an "all clear ahead" long-term bullish trend. It will be widely reported when this happens, and there will be euphoria, conviction and optimism extraordinaire.  It may last a week before the inevitable disappointment comes, or it could be five years. There is absolutely no way to know without taking hallucinogens.  

Three points on this. First, if you wanted to unload some serious equity, and you had sufficient fire power, you might want to nudge markets to a point where traders just blithely go long. I mean, it would be like herding cattle to the slaughter. Mooo mooooo moooooo! Everyone going long without so much as a second thought, ignoring stuff like, oh, I dunno, global recessions, cratering earnings around the Earth, little stuff like that. I'm not one for arguing with the market, and if it is saying bull market, okay. I mean, I guess. I just don't trust it. Too many clanking cow bells and strange looking men with thick rubber gloves and aprons, with metal objects.

Second, one thing some technical trading guys forget is that many times, you see a moving average cross such as the one unfolding now, and the first thing the markets like to do is to sell off. Test moving averages like the 200 day simple moving average as support. My guess is that ought to happen this time around. But it is only a guess because I have no idea. Anyhow, if it does happen, expect much wailing and gnashing of teeth. Breathless news stories about the new "long term technical uptrend" will go up in smoke, the weak shall be killed and eaten, and once they are, the market can go on about it's business climbing the great wall of worry. 

Third, the news about the exponential moving averages obfuscates a more interesting technical development that gets very little attention.  I call this "The Big Squeeze".  What is The Big Squeeze? The Big Squeeze comes when short sellers take their best shot, and come up... well... short. This can be measured with charts, in fact. What happens is you see a super short-term moving average get close, maybe even skirt along, an intermediate-term moving average. For example, a 30 day simple moving average might come into contact with, or get flirtatiously close to, a 50 day simple moving average.  It looks for a while like the two will cross paths and the market will plunge lower as the hyper short-term traders (which the 30 day simple moving average sort of tracks) feast on the nervous, timid sort of want to be long-term investors but we're too scared types of folks (I'm looking at the 50 day simple moving average when I think about these guys). It gets tight, uncomfortably so. 

But they never really do cross. In fact, the 30 day simple moving average starts to lift again off the 50 day simple moving average, and now you have the shorts getting their shorts squeezed. They cover, moaning with disgust, and on cue, the markets blasts higher. 

This story is unfolding across virtually all equities markets around the world. Many ETFs tell the story - EEM, ILF, EPP, EFA, GWL, SPY, DIA.  The list just goes on and on. The homogeneity of this technical posture on all these global equities markets is unusual. Lots of flashing green lights here, and it appears to be a massive tide, indeed.

Do you hear some mooing? Yes, oh yes, too much mooing, in fact, but the cows aren't focused on The Big Squeeze. I think some technical traders are drooling with greed at the moment, but maybe for the wrong reasons.   

Disclosures:  The author is plodding along, cowbell clanking, holding long positions in ILF, EEM, EPP, and EFA, trying not to be nervous about those guys with meat hooks, aprons and heavy rubber boots standing right around the corner. 

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