When 'Buy and Hold' Works, And When It Doesn't

Imagine if you had invested in the S&P 500 in 1984 and held through the tech bubble and crash and then through the financial crisis and its recovery. How would you have done over those 30 years? As it turns out, very well. On a real basis (meaning, inflation-adjusted), your holdings would have appreciated by over 400%.  A $100,000 investment in 1984 would now be worth more than $500,000.

Now, imagine that you had made that same investment only 30 years earlier, in 1954. You probably imagine that you did even better. The economy was booming in the post-war/baby-booming 1950s and 1960s and was well into a new bull market by 1984. As it turns out, you barely broke even. Your $100,000 investment was worth about $120,000 a full 30 years later.

The chart below looks at the appreciation in the S&P over a rolling 30 year basis since 1900. The line at 1984 shows the appreciation of an investment made 30 years earlier, in 1954. The end of the line to the far right, at 2014, shows the appreciation if you had bought 30 years earlier, in 1984.

Are Low Rates Responsible For High Valuations

Interest rates are low, so stock valuations should be high.  After all, a lower discount rate means that company cash flows are worth more; hence, a higher stock price. And the higher yield offered by equities makes them more attractive than low yielding treasuries, another reason to pay up for stocks.

This is a very common view.  And its bolstered by the fact than interest rates have been falling for 30 years while stock valuations have mostly gone higher. These two seem to be inversely correlated. There must be a cause and effect reason behind it.

So, is this view correct? The short answer is no.

The chart below looks at valuations versus 10 year yields. Current yields (2.3%) have been associated with valuations over 20x and under 10x. Interest rates were higher in the 1990s and so were valuations (orange dots). Valuations have been under 10x when interest rates have been over 10% and under 3%.  There is no discernible correlation between rates and valuations at all (chart by Doug Short).

What Happens When SPY Trades Above Its Weekly Bollinger Band

Today, the PBOC and the ECB both promised to provide greater liquidity to combat disinflation. US markets have gapped nearly 1% higher overnight as a result.

Coming after 5 weeks of gains, this gap will push SPY above its weekly Bollinger Band (20,2). Above a Bollinger Band means that price is more than 2 standard deviations away from the mean. At least in theory, 95% of trading should occur within a Bollinger Band. Trading outside of the weekly band is usually significant.

Let's review recent instances. In the charts below, the arrow is a weekly close over the weekly Bollinger Band.

Since mid-2013, markets have been down the next week 5 of 6 times. In the one exception, markets gave back all subsequent gains and more in the next month.

Fund Managers' Current Asset Allocation - November

Every month, we review the latest BAML survey of global fund managers. Among the various ways of measuring investor sentiment, this is one of the better ones as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $700b in assets.

Here's a brief recap of the past several months:

In July, fund manager equity allocations reached a bullish extreme. At +61% overweight, it was the second highest since the survey began in 2001, a clear risk to near-term equity performance (post).

By August, the Euro 350 dropped 8% and SPX dropped 5%. In response, equity allocations fell and cash shot up to 5.1%, a high level associated with lows in equities (post).

In September, equities in the US hit new highs; Europe rallied, but fell short of new highs. Fund managers raised their global equity exposure and reduced their cash (post).

In October, equities worldwide fell more than 7-10%; most markets were, at least briefly, negative for 2014.  Bond yields made new lows. Fund managers raised their cash levels back to 4.9%. Equity allocations were dropped to their lowest levels in 2 years. On further weakness, a washout low would be set up (post).

Now, the strong recovery in equity prices (to new bull market highs in the US and Japan) has pushed cash levels down a bit and equity allocations up to near their prior highs. That's especially true for US and Japan equity exposure.

Let's review the highlights from November.

Fund managers have reduced their cash levels to 4.7%. This is still relatively high on a historical basis but note that cash levels haven't been below 4.5% in the past year. We consider current levels to be neutral. Instances are very low, but over 5% represents bearish sentiment: this is where bottoms in equities have formed in the past.  

What Happens To Open Gaps in SPY

From its mid-October low, SPY has left six large open gaps. These total to nearly $6. Three gaps are more than $1 each. In the charts below, open gaps are in blue; closed gaps are in yellow.

Weekly Market Summary

SPX, DJIA and RUT ended the week nearly unchanged from last week. NDX, which was unchanged last week, gained 1.5%.

It's hard to say trend is not bullish: SPX, DJIA and NDX all made new highs intra-week; RUT briefly traded above its early September high before closing lower.

Incredibly, SPY closed between 204.0 and 204.2 every day this week. Moreover, during the past 11 days, the open/close range in SPY has been just 0.13%. There has been limited movement for 2 weeks in a row.

The technical pattern coming into this week suggested that equities were set up for choppy trading, making the risk/reward of entering new longs uninteresting (read the post here). That seems to be validated by this week's trading. The outlook ahead hasn't changed.

By Friday, SPX had closed above its 5-dma 21 days in a row. The only other time it has done so was in 1996. That turned out to be the exact high over the next 3 months.

Zero Hedge Might Be The Smartest Financial Blog Around

We've been blocked by Zero Hedge for 4 years. Anyone who invests knows that equity markets have a far higher probability of rising over time than they do of declining. Pointing out that basic fact to the good folks at Zero Hedge is not appreciated.

But Zero Hedge might be the smartest financial blog around. Why?

Because anyone who writes in finance knows that bearish articles are the most popular. By far. In our experience, a bearish article attracts at least 5 times as many readers as a bullish article. People like to read about The End of Days. No one wants to hear that things are right in the world, even if that's more likely.

Which makes Zero Hedge a brilliant business concept. Write only bearish articles that collect the highest number of hits. Sell advertising. Collect revenues.

If writing in finance is viewed as purely a business endeavor, their model makes the most economic sense. Well done.

A Possible Set Up For Ex-US Markets To Outperform

While the US economy continues to repair, albeit slowly, the situation in the rest of the world looks more dire. As a result, the performance of SPX relative to ex-US stock markets has gone parabolic over the last two months.

November Macro Update: Growth Is Still Missing

In May we started a recurring monthly review of all the main economic data (prior posts are here). At the time, the consensus view was that growth in wages and employment were accelerating and that this would soon lead to a meaningful increase in inflation above the Fed's 2% target. So far, this has been wrong.

This post updates the story with the latest data from the past month. Highlights:

• The inflation rate continues to drop. It's well below the Fed's target of 2% yoy. PCE is now less than 1.5%. 
• Several measures of consumption continue to show demand growth of 2-2.5% yoy (real). A sustained improvement in growth remains elusive.
• A bright spot is employment: the 3Q14 employment cost index was the highest since the recession. 

Our key message has so far been that (a) growth is positive but modest, in the range of ~4% (nominal), and; (b) current growth is lower than in prior periods of economic expansion and a return to 1980s or 1990s style growth does not appear likely. This is germane to equity markets in that macro growth drives corporate revenue, profit expansion and valuation levels.

With the latest data, our overall message remains largely the same. Employment is growing at ~2%, inflation and wages are growing at ~2% and most measures of demand are growing at ~2.5% (real). None of these has seen a meaningful and sustained acceleration in the past 2-1/2 years. The economy is continuing to slowly repair after a major-financial crisis. This was the expected pattern and we expect it to continue.

We'll focus on four categories: labor market, inflation, end-demand and housing.


Employment and Wages
The October non-farm payroll (214,000 new employees) was in the middle of a 10-year range. (The past 12-month average of 220,000 was also in the middle of the range). This follows prints of 84,000 in December and 288,000 in June. Moving between extremes like these is nothing new: it has been a pattern during every bull market. Since 2004, NFP prints near 300,000 have been followed by ones near 100,000 (circles).

What Happens After SPX Streaks Above its 5-dma For 16 days?

SPX is currently adding to a 16 day streak of closes over its 5-dma. Since 1996, this has happened just 6 other times. It's a small sample but let's take a look at what happened next.

Most recently, SPX had similar streaks in July 2013 and August 2014. These may be the most relevant examples as both followed short falls in SPX and were part of a "-v-shaped" bounce.

The End of QE 3 Does Not Spell The End of The Bull Market

The Federal Reserve's third "quantitative easing" program officially ended last week. Many traders hold the view that equity markets have become addicted to central bank stimulus and that the end of QE 3 will therefore result in a significant fall in equities, just as the end of QE1 (2010) and QE2 (2011) corresponded with drops of 17-20% (chart from Nautilus).

Weekly Market Summary

It's hard to argue that the price action of US equities is not bullish. SPX and DJIA ended the week at new highs. NDX stayed near the new highs it made last week, apparently digesting its gains. NDX was flat for the week while SPX and DJIA added another 1%.

This is mostly reflected at the sector level as well. Financials, technology, industrials and transports are cyclical leaders all making new highs this week.

But what is curious is that the market is being led more by defensives. Staples, utilities and healthcare are also at new highs. Since the September 19 top, SPX has added 1%, but defensives have handily outperformed. Utilities is the sector star by a mile.

What Fund Flows Tell Us About Current Investor Psychology

It is true that "disbelief" is an important factor in driving equity prices higher. That is a large reason why powerful Year 3 Presidential rallies have followed recessions, bear markets and/or corrections larger than 20%; these events have had the effect of moving investors out of equities and into the relative safety of fixed income and cash (post).

The question now is whether the recent 10% correction in equities created enough disbelief among investors that they moved out of equities. If they did, a strong and sustainable rally lies ahead.

Lipper tracks fund flows into and out of both mutual funds and ETFs. The last 10% correction in SPX in mid-2012 caused a $20.6b equity outflow from the April top to the June low (left side of the chart below). Fund flows were negative for 8 of those 9 weeks. No doubt, this was significant in setting up the long rally that followed (chart from SentimenTrader).

Year 3 of The Presidential Cycle Is Unlikely To Go The Way Everyone Expects

If you even passively follow equity markets, chances are high you have already read a number of articles about "Year 3 of the Presidential Cycle". That period is starting right now, and it's incredibly bullish. In the chart below, we are entering the steep ascent where the SPX has risen 22% in a year on average (since 1950).

Weekly Market Summary

After dropping to a 6 month low in mid-October, SPX has since risen more than 10% in two weeks. The bounce has been at a torrid pace.

We had been expecting a more complex bottom to form at the low. Why? The market had risen 60% since it's last 10% correction in mid-2012.  A more typical basing at the low, to reset sentiment and breadth, seemed warranted before resuming the uptrend. This now appears to have been wrong.

Instead, SPX, DJIA and NDX all rose to new bull market highs this week. SPX has now completed its 9th "v-shaped bounce" since 2013. According to Dana Lyons, "v-shaped bounces" occurred once every 1.6 years from 1950 to 2012; since then, they have occurred every 2 months (post). To us, that reflects an unflinchingly bullish and aggressive investor psychology. The data supports that view.

This market is well-known for doing the unprecedented. According to SentimentTrader, SPX traded more than 0.5% above its 5-dma for 10 days in a row in the past two weeks. In the prior 75 years, this has only happened twice before, both at bear market lows (1982 and 2002). In other words, a rare rip higher, that has only happened after multi-year bear markets, just occurred after a mild, four week drop. It's incredible and completely unexpected.

Perhaps the most distinguishing characteristic of the current rally is this: SPX has made a series of 12 daily "higher lows" in a row. According to Paststat, there have been only 9 other instances in the past 20 years where SPX has made more than 10 "higher lows" in a row (post). This raises the question of what typically happens next.

We normally think of strength like this as initiating a broader move higher. But that was the case in just 2 of these 9 instances: December 2003 and July 2009. Both of these came within a few months of a new bull market, and in both cases, SPX continued higher. December 2003 is shown below (left side of chart).