But 2010 will be different. We’ve all been hearing a steady drumbeat of “equities markets are loosing upward momentum” for months now. We’ve heard some of the most respected names in the investment world opine that the rally off the lows of last March has come too far, too fast. Some suggest that the capital markets’ valuation of risk is irrationally exuberant at the moment. Others suggest the potential for a next wave of the credit crisis – maybe downgrading of sovereign debt, perhaps an even larger collapse in commercial real estate lending. Still others point to the flagging impact of stimulus spending on the global economy, and the prospects for growing inflation and a concomitant need for central bankers worldwide to raise interest rates. The theme of de-leveraging has played out throughout 2008 and 2009, and will likely continue for the immediate future. I have no prediction about what will happen in January, but I am prepared to issue a firm prediction that if (that is, “IF”) we see a January sell off, many commentators will seize upon it as evidence of one or more of these explanatory themes.

 

The problem with explanatory themes is that the global financial market, in all of its multifaceted glory, is really too complicated to explain. To attempt to do so is likely hubris, which in investment land can be one costly sin to indulge in. And at the risk of sounding too cavalier, who really cares WHY a market is tanking – all you need to know is WHETHER it is, in fact, tanking. The most useful “themes” for an investor to focus on are not explanations for a bear market, but rather, descriptions of  a bear market. There are three descriptive themes that are worth holding in focus: (1) Fear and Loathing, (2) Abandonment of Risk Appetite and (3) A New Love of Safety.  If you see those themes start to develop (which occurs over time, rather than as the consequence of a single event), you know you are in a bear market and that probably, these themes will take on a life of their own, momentum being what it is.

 

 (1)       Fear and Loathing. The Chicago Volatility Index (or “VIX”) has been trending lower throughout the latter half of this year, and remains comfortably under its 30, 65 and 200 day exponential moving averages (or “EMAs”). If we see a massive January meltdown, the question to ask is can the VIX vault above its longer-term EMA? If so, we should get nervous. If the shorter-term momentum, such as the 30 day EMA, overtakes the medium-term 65 day EMA or longer-term 200 day EMA, it could be a great time to start freaking out. But unless and until we see this sort of technical confirmation, any sell off in January might be viewed with skepticism.

 

(2)        Abandonment of Risk Appetite. Vanguard total market vipers (VTI) is one of the broadest equities ETFs out there. Since March, it illustrates a clear trend of higher highs and higher lows. It currently trades above the downward price trend line spanning the 2007 peak through each of the peaks in previous bear market rallies we have observed since 2007. VTI also rests above its short, medium and long-term EMAs, in a relatively clear pattern of upward momentum.

 

Looks good? Not so fast! As VTI has rallied, volume has ground lower and lower. To some, this signals flagging conviction on the part of bulls. So, let’s see whether we get a very high volume sell off in this security come January, and more importantly, let’s see whether this sell off (should we get one) take VTI below its medium-term or longer-term EMA. We should also be watching to see whether the 30 day EMA drops below the 65 day EMA as well, a sign of short-term selling momentum overwhelming longer-term buying momentum, which generally accompanies and exacerbates falling prices.

 

(3)        A New Love of Safety.

 

Nothing says safety like a ten year US Treasury. When people buy a ten year US Treasury at a yield that hovers around the rate of inflation, it tells you they are starry-eyed in love with safety. This is the classic stuff of bear markets.

 

At the moment, yields are rather low, but seemingly heading higher. The matter is complicated by several factors, not least of which being the Federal Reserve’s efforts to pin yields lower in hopes of spurring the nascent economic recovery. More complicated is the fact that both long-term and medium-term buying momentum are almost the same as long-term and medium-term selling momentum. For instance, the 65 day and 200 day EMA for the yen-year US Treasury yield are almost equal. We are on a knife’s edge at the moment, when it comes to the direction in the price of US Treasuries. If we see the 65 day EMA start to head into a downward sloping line that is trending below the 200 day EMA, we could see yields start to get tugged lower by trading momentum. Generally, investors fund a flight to US Treasuries by dumping risky assets. By the same token, a spike in yield can rapidly inflate the real price of stocks, raising the applicable discount rate for measuring the worth of future cash flows. That’s not so hot for equities prices either. Trends in the price of US Treasuries is something we should watch like a hawk throughout 2010, but particularly in the face of a major catalyst – like an equities sell off.

 

Another harbinger of starry-eyed love of safety is the US Dollar. Again, this is a toughie thanks to government policy which intervenes in the price of US Dollars at least as much as private sector investment behavior does. At the moment, the US Dollar has been in a downward trend of lower lows and still lower higher, but recently staged an impressive rally beyond the 65 day EMA. Will the 65 day EMA provide trading support for the US Dollar on the next pullback? If so, the US Dollar may go higher yet. And if the 30 day EMA (which is now upward sloping and indicative of short term buying momentum) should overshoot the 65 day EMA? This too would indicate that short term buying momentum has subsumed medium term selling momentum. The real test for the US Dollar for 2010 is not “can it rally from here” but rather, how far can it rally? If the US Dollar breaks above its long term 200 day EMA, it may be an indication that the US Dollar has farther to go. If so, would that be a love affair with safety? Perhaps – if interest rates in the US are still negative relative to inflation. Or, perhaps, a higher US Dollar would indicate something else all together. The question would be whether investors are willing to pay for the privilege of owning a low yield currency, rather than being paid for the risk of doing so. If so, it wouldn’t look like risk appetite was all that robust, and it would be hard to get all that excited about risky assets such as equities.

 

Last of all, what about gold? Traditionally, this is the stuff of bears, the ultimate store of safety for value. It’s in a confirmed bull market at the moment, but flies are buzzing in the ointment. The price of gold has fallen below its 30 day EMA and observed that area (an erstwhile zone of trading support) as trading resistance. The CBOE Gold Index hovers at the 65 day EMA, sniffing it out as either support or resistance. If support, Gold could likely go higher still, signaling a love of safety. If the 65 day EMA is resistance, on the other hand, one of the most publicly adored investment vehicles of the past couple of years could be trolling significantly lower from here, indicating that safety is looking a little withered in the eyes of investors.

 

Other asset classes will add to the pastiche of whatever market themes erupt or seep into early 2010. It will be helpful to avoid chalking up too much significance to any one event, but instead, to watch key technical levels in assets that, themselves, signify attributes of bear markets of years gone past.

 

Happy new years in advance to the SeekingAlpha community.

 

There are a few arguments that support the end of the sucker rally story. First, technically speaking, a bunch of the broadest equities ETFs (for example, Vanguard Total Stock Index – ticker VTI) established a price “gap” last year – an area in the price of a security where nobody would purchase it at any price. Having hit those same price areas only recently, these ETFs have stalled and, indeed, reversed. The gap, the argument goes, is technical trading resistance – a ceiling, a cap on any further gains.

 

Perhaps, but the counter to that argument is that the short-term moving averages are still well above the long-term moving averages for ETFs like VTI, having crossed over one another merely months ago. To some market technical analysts, VTI will continue to be in a long term bullish trend until the 50 day simple or exponential moving average drops below the 200 day simple or exponential moving average. That hasn’t happened, and there is no way to guess ahead of time whether it will. Until it does, the technical story is patchy and unreliable.

 

On a fundamental level, some experts suggest that expensive, hard-to-come-by credit, coupled with lower consumption and higher savings by the American consumer, destines equities prices to a lost decade or worse. Intuitively, that makes sense. People are buying less, so profits are lower, and thus, stock prices drop. 

 

Yeah, well, except for the fact that during an entire decade or more of nearly free and always easy credit, negative savings and frantic levels of extreme consumption by American consumers, equities prices in the US markets are down in real terms (and far down in currency adjusted terms). In fact, cheap and available credit and over-consumption seems to hurt, not help, equities prices. So, perhaps higher interest rates, restrictive credit availability and parsimony on the part of American consumers will actually help, or at least, not hurt, equities prices. Just think, if Americans decided to invest money, rather than fritter it.  Lower credit availability equates to lower leverage, and lower leverage equates to lower systemic financial risk, and all things being equal, people pay more for assets when there’s lower systemic financial risk. The argument that lower consumption, higher savings, and less credit shall doom equities prices just doesn’t jibe with history.

 

Another angle is the carry trade/ liquidity argument. Many respected experts argue that the flood of liquidity generated by central banks around the Earth has pretty much poured into risky assets, and so, when that liquidity is withdrawn by central banks, it will get pulled out of risky assets, and thus, cause the price for risky assets to drop. Again, an intuitive argument, except for the fact that it is focused on the volume, rather than velocity, of liquidity. And on an even more basic level, the argument is premised on a misconception of what liquidity actually IS.

Money is not the stuff printed by a central bank. Instead, money is nothing more than a collective belief that we are better off. True, maybe some hot printing presses at the U.S. Treasury can contribute to a sense that we are better off, but probably not. Real liquidity will come when businesses and individuals simply believe in the system more, believe in their futures more, believe that investments and transactions will pay off more. THAT belief is the stuff that lifts asset prices, not pieces of paper pumped into the banking system. And that belief is, if anything, in short supply, rather than over-supply, at the moment.  The real price for assets will go up only  when this belief is increasing on average, and the printing campaign going on across the worlds’ central banks will have only a tangential impact at best. People will pay more for risky assets if they feel better about the future, and will pay less for risky assets if they don’t – and that is irrespective of the volume paper sloshing around the system. Accordingly, it does not necessarily have to follow that when this printing campaign ends (and who can say when that will be), it will trigger a wholesale regurgitation of risk onto the capital markets.

 

So are we at the end of the great sucker’s rally? I can’t say, but at least some of the arguments suggesting that we are don’t hold water.

Disclaimer:  The author owns long positions in VTI

 

 

 

 

 

The second change was less subtle - the global financial system practically collapsed, and in the process came close to creating a pandemic global depression of nearly epic proportions. Stock prices on global equities indexes were handsomely slashed by 50% or more, which had an interesting impact on many retirement and fiduciary accounts. For one thing, if you were a retiree or trust beneficiary, that 4% draw you thought you could take each year was cut in half, and if your expenses weren’t cut accordingly, you had a problem. And another thing, to eat 4% of a portfolio, you have to sell stuff. But selling into weakness is anathema to asset managers, who quickly groped around for a new management model (including frantic phone calls to beneficiaries asking them to forego distributions temporarily) that wouldn’t require them to sell assets at bargain basement prices as markets swooned.

 

The biggest impact of the credit crisis, though, may have been the sudden realization that there is a fundamental weakness of a Monte Carlo simulation.  By design, it doesn’t “hedge” for Black Swans. A Monte Carlo simulation weights outcomes within the bell curve of statistical probability, and outlying outcomes are discounted according to their unlikelihood. A good Monte Carlo simulation will virtually ignore the effect that an Earth killing asteroid impact would have on your portfolio. Likewise, pandemic global depressions and collapses of the planetary banking system are given little weight in a Monte Carlo simulation because these events are just way outside of the bell curve. But as many people learned, unlikely, unexpected and rare as they may be, a Black Swan will gobble up 50% of your portfolio within a few short months. It seems foolish to ignore them now.

 

Conditions have changed, and with these changes, we need a new conceptual framework when it comes to financial management. One of the main conditions of change we see is that now, yields on some assets are, well, huge. According to ETFConnect.com, SPDR Barclays Capital High Yield Bond Fund (JNK) yields over 13% currently. Ishares MSCI Taiwan Index Fund (EWT) is churning out over 10%.  PowerShares Preferred Stock Portfolio (PFF) is yielding close to 8%.  The list goes on.  I’m not suggesting readers invest in these assets, per se, but only that low yield environment pervading the capital markets over the last fifteen years has shifted.  It no longer makes any sense to plan a retirement, or manage a fiduciary account, in a way that doesn’t focus a great deal of attention on yield.  If a client can’t get by eating 3% of the portfolio capital each year, then perhaps leaving capital in place and eating an 8% cash flow will suffice?  

 

Another condition that has changed is our appreciation of unexpected and dire events, which can snuff out principal values on assets with stunning speed.  While the share price of a stock or bond index can get whacked rapidly, dividend and interest payments tend to change far more slowly – if at all. In that sense, focusing on portfolio yield as a basis for a retirement plan or for managing a fiduciary account offers a great hedge against Black Swans.  Meaning, the value of a portfolio can change, but that doesn’t need to impact a retirement plan or trust account much if the cash pouring out of the portfolio remains relatively constant. 

 

I remember when bell bottoms made an unwelcome comeback a few years back. When it comes to the rules governing personal finance, I’m thinking we should go back a few decades, too.

Disclosures:  The author owns positions in JNK, PFF and, soon, EWT.