Clouds and storms
By Daniel M. Ryan
Professors of economics rarely, if ever, offer market advice. Although this inhibition is easily made fun of, as "Prof refuses to get his/her hands dirty," there's a good reason for they refraining from doing so. Going out on limbs with forecasts means putting aside theoretical clarity and cultivating an intellectually pragmatic attitude. A different self-criticality is needed; ‘wrong' become redefined as "how did I miss that one?" Refutations and critiques become ancillary; getting the market's direction right, regardless of consistency, become primal.
Since there's no way to secure all the data needed for a theoretically sound forecast, as the crucial ‘data' are in people's choices made iteratively, any forecaster flies astigmatic. Consequently, good forecasters pile rules of thumb together; they don't model-build in ways that professors do. Any retired market forecaster who decides to take up theoretical economics as a second career soon discovers what a mish-mash his/her "model" is.
It really can't be helped. You can either be a systemizer or a discoverer; you can't be both without being out-competed by specialists in either. The division between theory and practice is just part of the specialization process. A master of theory, too, discovers how much of a tyro he/she is when on the other side of the fence.
If there's any analog to the theoretician's falling into basic error or self-contradiction, it would be the notorious "whipsaw." If you make a forecast, see the market go the opposite way for a time, get squeamish, reverse your earlier opinion, and then see you were right all along…you've been whipsawed. Everyone in the forecasting business bumps into it from time to time, because responsiveness is the mental skill that's needed – not rigor. Overly stubborn forecasters tend to become treated as cranks, no matter how right they are on fundamentals.
I myself was near-whipsawed because of a forecast I made about the American economy back in late January. In it, I said: a) there would be no recession; b) there would be a bear market. Because of the pessimism at that time, reflected now in somewhat face-saving attempts to redefine "recession," I put some care into justifying the no-recession forecast. My second forecast, about a bear market in the offing, was made more conversationally.
Now, I'm returning to it, with more care this time.
As the performance of the U.S. averages last week made clear, last spring's rally is beginning to look more and more like a sucker's rally for investors in U.S stocks. I have to admit that it came close to suckering me. The trouble with sucker rallies is that they look like the resumption of a bull market in a crucial way: sucker rallies and young bull rallies both climb the wall of worry. In the case of the latter, the worry comes from an acceptance of bad times as normal. When the news and data are bad day after day, we come habituated to more bad news. This normalization of pessimism is one of the main factors making investments undervalued at the end of a bear market. The bull phase begins with a surprise rally, widely disbelieved because bullishness at that time seems almost like "ignoring reality."
For the former, the wall of worry results from a different kind of surprise. The shock at seeing a seemingly permanent bull market fall apart makes for a purloined-letter effect. The negative data that's been in plain view, but ignored, is suddenly seen. This shock makes bearish rumors and scary forecasts credible once again. Ignored curmudgeons are then treated respectfully. So is what they've kept bottled up. The resultant nervousness is what forms the wall of worry that a sucker rally climbs out of.
The two look a lot alike, sad to say. When it comes down to the crunch, the only way to tell the two apart is a look at the five- or ten-year chart for the investment (or asset class) in question. Even then, distinguishing the two is somewhere between a judgment call and a guessing game.
The call I'm making now – that the spring rally was a sucker's rally that will turn into a resumed bear market – is counterintuitive given the most recent economic data, but there are other factors in play. As this article by Adam Hamilton points out, one of the overall factors is valuations. According to it, there exists a "long valuation wave" pattern in the Dow and S & P, which last about seventeen years for each phase. The primary bull wave takes valuations up, from a market P/E of less than ten to a P/E above twenty. As the second chart therein makes clear, there is no definite upper bound to the P/E ratio. So, this model can't predict the top of a primary bull, apart from vaguely timing it. The best it can do, in terms of bull tops, is to indicate a sucker's rally that should be sold into. Unfortunately, this limit is true of all models and systems. None of them can call the top of a bull – none of them.
What it's useful for is for staying the course. According to it, we're in the middle of a primary bear trend which began in 2001, though one that's been unusually mild. That's because the bear trend is in valuations. They've been shrinking largely because this decade's earnings for Dow and S & P 500 stocks have been catching up to 1999's price tops. Thanks to good earnings growth, a "valuation bear" has coexisted with a market that's been flat, if not up somewhat.
The question is, will earnings growth still accommodate a valuations shrinkage? Mr. Hamilton thinks "no," to the point where he calls for a ripping bear market like the one suffered in 1973-4. Unfortunately, the recent news is concurring with him.
The "blind spot" for this forecast is the current pullout from the near-recession earlier in the year. An economist-forecaster would consider the above call to be (at the very least) odd, because severe bear markets don't come with recoveries. It's too late in the downturn cycle for such a catastrophe to emerge, unless we're in for a "W'-type recession like the one suffered in 1980-82. There's nothing on the horizon to indicate such, unless something's been covered up in China.
As far as the money-supply situation is concerned, M1 year-over-year growth has gone to negative; M2 year-over-year growth has shrunk to 6.3%. Two months ago, year-over-year M1 growth was positive, and M2's was 7.0%. Now that the subprime credit crunch seemingly has faded away, the boost in the money supply is fading too. That moderation doesn't really bode well for the stock market. In addition, the otherwise-healthy steepening of the yield curve has seen the 3-month T-bond rate – and only that rate – fall back to last month's level. 3-month T-bills seem to be reaching safety-haven yields again.
I'll grant that predicting a bear market at this stage of the economic cycle is odd, but recent market action combined with rudimentary Fed-watching does indicate one. Unless a generally-unforeseen catastrophe emerges, I see no reason why it shouldn't be a relatively mild one.