Commentary | October 1, 2014 |
What a dramatic week!
For context, the dramatic action in the U.S. and global stock markets this week – and the flash-crash in Treasuries at the open on Wednesday – came well into the months-long deterioration in economic data from both Europe and China, and ominous downtrends in oil and copper. And growing global worries that have been reflected in a strong, months-long rise in the dollar and in Treasury prices.
At Sierra, we’ve been expecting a major cyclical market top in the U.S. stock market for a long time – and we’ve been way too early, since the Fed has been so successful in heading off any normal cyclical decline.
Now, one visible sign of an important top is the record high in margin balances – significantly surpassing the multi-year buildups that presaged the cyclical tops in 2000 and 2007.
The exceptional day-to-day volatility that began on October 8 was another indication that something unusual was brewing, and this week saw a massive spike in new 52-week lows on the NYSE, even while the Dow and S&P 500 were still close to their all-time highs of September 19.
Most other global markets peaked months ago, and in the U.S. only complacency about Fed support has held up the large-cap indices, while the small-cap Russell 2000 has been in decline since July.
We are in the camp that believes that September 19 marked the final cyclical high in the Dow and S&P, and that the major trend is now down.
The rising cycle in stock prices that began in March 2009 is now a record 67 months old. Significantly, the Fed launched massive QE programs in response to the last two significant stock selloffs, successfully fending off a “normal” cyclical decline. Now, unless the Fed intervenes again with a massive new program, we think September’s high may stand for at least several years, and that stocks could have many months of downside ahead. Short term, we see today’s uptick as a relief rally that is likely to fizzle within a few days, followed by one more downleg before a stronger rally that may last more than a week.
But then, look out below! After any such second rally, we expect the larger downtrend to resume, with a strong selloff lasting several weeks, taking the major indices to levels near 20% off their highs – with further downlegs well into 2015.
Guesstimating downside targets is not our strength, but historically the stock market tends to overshoot in both directions on its major cyclical moves, so it would not surprise us to see the P/E ratio fall below 10, as it did during most past secular bear markets.
We are pleased that our risk-mitigation disciplines once again protected our two mutual funds and our separate accounts from any significant drawdowns during the early phase of this downturn. (Yes, having the same lead portfolio managers for over 27 years is beneficial!)
Some of our modest risk-on holdings have already hit their Sell stops, so our portfolios currently are now even less exposed to stock market risk, although rallies (as is typical during any downtrend) will result in modest down days. But over the coming months we are positioned to profit from the environment we expect.