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Per Stirling Capital Outlook – June

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There is an old Wall Street proverb that “nobody rings a bell at market tops and bottoms”.  At first glance, this adage seems both self-evident and reasonable, as it simply points out the obvious fact that market timing is, at best, both highly challenging and very difficult to do successfully on a consistent basis.  Indeed, many wealth management experts and numerous academic studies maintain that it is useless, and even counter-productive, to attempt to time the twists and turns in the markets.

After all, while no guarantee of future results, with bear market losses since the late 1960s averaging less than 20% of bull market gains, and the average bull market lasting five times as long as the average bear market, history has shown that time strongly favors equity investors who are long-term-oriented, and who stick to their strategic investment plan investment plan(1).

Greatly complicating any attempt at market timing is the incredibly counterintuitive nature of investing, where market timing success often requires an investor to sell when the markets are euphoric, when investing seems easy and gains are plentiful, and to add to their investments when the markets are dominated by panic-selling and investor despair, both of which require a very strong constitution.

As such, many investors who try to time the markets end up doing the exact wrong thing at the exact wrong time, by ramping up the risk in their portfolios during the euphoria generally associated with market peaks, and panic-selling during the capitulation and abject fear normally associated with a market bottom.

Even worse, many investors who sell near the market lows end up being either too scared or too convinced that the market will just end up falling again if they get back in, and end up missing the rebound.

History suggests that the consequences of such panic-selling become particularly dire once the S&P 500 crosses below the -20% bear market threshold, as it just did on June 16th.  According to Barron’s, in 75% of all bear markets since 1950, the S&P 500 has been higher by an average of 6.4% just three months after first crossing below the -20% threshold, and a year after first breaking below that threshold, the S&P 500 has been up 75% of the time, and by an average of 17% (2).

Indeed, for some inexplicable reason, numerous significant declines in the S&P 500 have exhibited a tendency to end right around that -20% mark.  That includes the declines in 1990, 1998, 2011, and 2018, each of which ultimately declined by between -18.6% and -19.4%.

Moreover, even when the full -20% bear market requisite is achieved, a new bull market has often started in relatively short order.

According to research from Charles Schwab (3), the time from the initial crossing of the    -20% level to the start of the next bull market spanned only “39 days in 1966; six days in 1987; 36 days in 1990; the same day in 1998; 12 days in 2011; the same day in 2018; and 11 days in 2020”.

The Schwab report continued, the “four exceptions to these brief periods were: the start of the 1970s when it took 117 days; the end of the inflation era in the early 1980s when it took 157 days; the early 2000s Tech Wreck where it took 595 days to bottom; and the 2008-09 Great Financial Crisis, which took 241 days.”

Obviously, the past is not necessarily prologue, and there is little doubt that the equity markets are currently confronted with an unusually large number of negative influences and catalysts.  That said, it may be wise to remember the advice of Warren Buffet to “be fearful when others are greedy and greedy when others are fearful”, and the insight from Sir John Templeton who noted: “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”   Today’s environment seems to have surpassed pessimism, and has arguably ventured well into the realm of despair.

None of the above is to advocate a purely laissez-faire and/or passive approach to investing, or to suggest that one should not adjust portfolio risk in light of the level of risk in the macroeconomic environment.  Indeed, we believe that such an approach, which we view as very different from market timing, can be highly rewarding.

Under such a tactic, an investor would maintain a level of risk near the lower end of their “risk spectrum” when inflation is high, the economy is slowing, corporate profits are under pressure, and interest rates are high and/or rising, as examples, and adopt allocations closer to the upper end of their risk spectrum when the opposite conditions prevail.

Among other things, when done properly, such a strategy can help to limit losses and reduce volatility during market declines, while creating at least a modest allocation to cash that can be put to work once there is evidence that a sustainable bottom is in place.

One would be correct to note that this last statement certainly insinuates certain elements of market timing, which we acknowledge is challenging and potentially counter-productive in the midst of a sustained uptrend or downtrend, largely because there are so many different factors influencing the markets in the middle of the cycle, and because you can never tell with any degree of certainty which of those influences will have the biggest impact.

However, when markets are reaching extremes in euphoria or despair, and are thus likely within range of a market top or bottom, then the emotions of greed and fear tend to overwhelm everything else.  In such environments, we believe that the ability to analyze and quantify these powerful emotions can provide valuable insight into the markets.  Indeed, we believe that, at these extremes in euphoria and despair, markets can indeed “ring the bell”, thus signifying a major and sustainable reversal in market trend.

Our experience is that this is particularly true regarding the measures of despair and capitulation that often accompany bear market bottoms, as investors tend to have a much more visceral and emotional reaction to losses than they do to gains.

If you combine this premise with our belief that large groups of people (i.e., a majority of market participants) tend to be subject to the oddities of crowd psychology, and thus will tend to respond to fear and greed in a similar and reasonably predictable way, then the idea of identifying major market tops and bottoms (or at least getting close) does not seem so farfetched.

Some of those gauges of fear measure what investors say, while others measure what they do in their portfolios.  That said, one important anomaly that seems to be rather unique to this particular bear market is that these measures currently contradict one another.

While current measures of investor sentiment illustrate the kind of extreme bearishness that often accompanies market bottoms, actual investor positioning still seems to reflect a belief that the Fed, as they have so often done in the past, will ultimately come riding to the market’s rescue, once the decline gets severe enough, so all that you need to do is just hold on until the “cavalry” arrives.

As we have emphasized over recent months, we think that this opinion is misplaced, as anything that the Fed could do to aid the stock market would simultaneously exacerbate inflation, the reduction of which is the Fed’s overwhelming priority.

Indeed, we suspect that markets are unlikely to see signs of broad capitulation, which we believe will ultimately be necessary for an end to this bear market, until investors (many of whom have never known an environment where the Fed did not act as a de facto safety net for the markets) recognize that the Fed is very unlikely to come to their rescue this time.

We think that it is this belief in the so-called “Fed put” that explains this divergence between the attitudinal sentiment measures, which are showing indications of capitulation, and the positioning and behavioral indicators, like the put/call ratio and VIX Index, which show that investor fear has yet to reach a point where most investors feel a need to hedge their risk or buy portfolio protection.

Indeed, from our perspective, these indicators of investor positioning (what are they doing versus what they are saying) continue to indicate an excess of optimism, a persistent and misguided belief in the “Fed Put”, and a shortage of the kind of investor panic and/or capitulation that traditionally indicate a significant bottom.

Importantly, while capitulation occurs at most major bear market lows, there are certainly exceptions, although they suggest a very different type of bear market bottom, and one that demands a different investment strategy.

To explain, market tops and bottoms are effectively a tug-of-war between bulls and bears, as each camp battles for control of the market trend.  In those relatively rare major market lows without a definitive signal of capitulation, the bottoming process can last many weeks, if not months, until bulls finally regain the upper hand.  This is commonly referred to as a “saucer bottom” and, due to the lack of a definitive capitulation low, investors might be best served deploying any cash back into the equity markets over time and in stages, instead of trying to time the bottom.

In sharp contrast, when capitulation does take place, battle for control of the market trend is normally resolved in very short order, as the last potential sellers get washed out of the markets all at once in the final emotional decline, thus leaving the bulls in full control.  With all of the potential sellers out of the way, it opens the door for a “V-Shaped” bottom and a powerful first leg of a new bull market.  In such an instance, investors may be well served buying the market at or around the initial panic lows.

From our perspective, most signs support the idea that this bear market is growing very long-in-the-tooth and is already very technically oversold.  The S&P 500 is also approaching a couple of areas of significant technical support, which we suspect will help to keep the market above its pre-pandemic highs.

In the meantime, we are still looking for signs of capitulation, and believe that, once it arrives, a market bottom could be “as clear as a bell”.

 

Disclosures
Advisory services offered through Per Stirling Capital Management, LLC. Brokerage services and securities offered through B. B. Graham & Co., Inc., member of FINRA/SIPC. Per Stirling Capital Management, LLC, and B. B. Graham & Co., Inc., are separate and otherwise unrelated companies.
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Nothing contained herein is to be considered a solicitation, research material, an investment recommendation or advice of any kind. The information contained herein may contain information that is subject to change without notice.  Any investments or strategies referenced herein do not take into account the investment objectives, financial situation or particular needs of any specific person. Product suitability must be independently determined for each individual investor.
This document may contain forward-looking statements based on Per Stirling Capital Management, LLC’s (hereafter PSCM) expectations and projections about the methods by which it expects to invest.  Those statements are sometimes indicated by words such as “expects,” “believes,” “will” and similar expressions.  In addition, any statements that refer to expectations, projections or characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements.  Such statements are not guarantying future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict.  Therefore, actual returns could differ materially and adversely from those expressed or implied in any forward-looking statements as a result of various factors. The views and opinions expressed in this article are those of the authors and do not necessarily reflect the views of PSCM’s Investment Advisor Representatives.
Neither asset allocation nor diversification guarantee a profit or protect against a loss in a declining market.  They are methods that can be used to help manage investment risk.
Past performance is no guarantee of future results.  The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance quoted.
Definitions
The Standard & Poor’s 500 (S&P 500) is a market-capitalization-weighted index of the 500 largest publicly-traded companies in the U.S with each stock’s weight in the index proportionate to its market. It is not an exact list of the top 500 U.S. companies by market capitalization because there are other criteria to be included in the index.
The VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPX℠) call and put options. On a global basis, it is one of the most recognized measures of volatility — widely reported by financial media and closely followed by a variety of market participants as a daily market indicator.
The CNN Fear and Greed Index (FGI) was developed by CNNMoney to measure two of the primary emotions that influence how much investors are willing to pay for stocks. It is based on the premise that excessive fear can result in stocks trading well below their intrinsic values, and that unbridled greed can result in stocks being bid up far above what they should be worth. CNN examines seven different factors to establish how much fear and greed there is in the market, scoring investor sentiment on a scale of 0 to 100.
The put-call ratio (PCR) is an indicator used by investors to gauge the outlook of the market. The ratio uses the volume of puts and calls over a determined time period on a market index to determine market sentiment. It can additionally be used for individual securities by looking at the volume of puts and calls on a security over a determined time period. A high PCR is indicative of bearish sentiment while a low PCR is indicative of bullish sentiment.
Citations
1. “Stock Market Volatility: Recession Worries Return”, Charles Schwab, Posted 06/16/2022 https://www.schwabassetmanagement.com/content/market-volatility?render=print
2. “The Bear Market Is Officially Here. What Comes Next, According to History.”, Nicholas Jasinski, Posted 06-13-2022. https://www.barrons.com/amp/articles/bear-market-stocks-whats-next-51655150790
3. “The Three Bears?”, Jeffrey Kleintop, Posted 05/23/2022. https://www.schwab.com/learn/story/three-bears
Image #2: “A Long-Term Perspective on Market Downturns” https://www.amgfunds.com/research-and-insights/keep-calm-and-remain-diversified/longterm_perspective_on_market_downturns/
Image #4: “What Happens After A Bear Market Starts? Four Things To Know”, Ryan Detrick, Posted 05/23/2022, https://lplresearch.com/2022/05/23/what-happens-after-a-bear-market-starts-four-things-to-know/
Image #5: “A Closer Look at Historical Bear Markets” https://www.amgfunds.com/research-and-insights/keep-calm-and-remain-diversified/a_closer_look_at_historical_bear_markets/
Image #6: “Fear & Greed Index”, CNN, 06/23/2022, https://www.cnn.com/markets/fear-and-greed
Image #7: “What Direction Do AAII Members Feel The Stock Market Will Be In The Next 6 Months?”  www.aaii.com/sentimentsurvey
Image #8: “Weekly Sentiment Report”, Willie Delwiche, 06/01/2022, https://allstarcharts.com/sentiment-report/