 |
|
Volume 1 - Issue 32
April 25, 2005
State of the Markets:
A Minsky Review
By Ed Easterling
| |
|
This week's letter is from my good friend Ed Easterling of Crestmont Research in Dallas. Ed helped co-author a couple of Chapters in my book "Bull's Eye Investing" and that inspired him to write his own book. Ed's recently published, a must read book in my opinion, is called "Unexpected Returns: Understanding Secular Stock Market Cycles."
This article uses some of the insightful research in the book to examine current market conditions and why Ed thinks the "Four Categories" are pointing to a bear market decline in the near future.
Successful investing is all about recognizing and managing risk and not looking for the next home run. It is a lesson we all need to understand. I hope you enjoy this week's edition of Outside the Box.
- John Mauldin
|
| |
|
|
|
 |
State of the Markets: A Minsky Review
By Ed Easterling |
 | |
|
Judging from the level of complacency in the stock market, some of you may not
care to make it to the second paragraph of this article--Hyman Minsky warned us
about times like this! Those of you that stay until the end will find a
compelling case that four indicators portend a significant decline in the stock
market and a rise in volatility before the end of next year. For those with
financial exposure to the stock market today, you may be compelled to act. For
those of you that have already hedged your positions, this article will provide
the insights to know when to increase your exposure again. And for the
complacent readers, save this for later reference to explain "why."
MINSKY'S INSIGHTS
Professor Hyman P. Minsky (1919-1996) studied at the University of Chicago and
Harvard. He became a leading economist and advanced our understanding of the
linkages between the financial markets and the economy. His work was influenced
by the wisdom of John Maynard Keynes, Irving Fisher, Henry Simons, and other
prominent economists and scholars. Among his many achievements is the Financial
Instability Hypothesis (FIH): that stability is destabilizing.
Minsky found that financial systems naturally evolve from a position of
stability to a vulnerable position of instability. Financial positions within
the system evolve from "hedge" to "speculation" and finally to "Ponzi," a
bubble-like stage. This evolution occurs when participants become increasingly
optimistic about the future and complacent to risk. The resulting stability
generates a false confidence, ultimately leading to financial positions that are
increasingly vulnerable to conditions or events that do not meet expectations.
In the first stage, investors in pursuit of returns remain always cautious to
the risks around them. The approach is vigilant against unwarranted risky
exposure. Investors hedge by buying protection, actively diversifying, and
maintaining cash reserves. In the second stage, during periods of low
volatility and generally rising markets, investors become desensitized to
potential risks and begin to increase their risk profile in order to enhance
returns. This can be done by taking positions that are more concentrated,
investing in high-risk securities, adding leverage through margin, and selling
options. At times, yet not very often, investors disengage from rational
investment thinking and make decisions based upon the expectation that someone
else will buy their overvalued securities at even higher prices--this is stage
three, the Ponzi phase...remember the recent bubble of the late 1990s?
Most cycles never reach the Ponzi stage. Markets more often remind investors of
this cycle during the "speculation" stage and restore balance in advance of the
carnage from a bursting bubble. Today, spring 2005, we are well into the
"speculation" stage and the conditions are ripe for realignment. Let's explore
the indicators.
VULNERABLE MARKET CONDITIONS
Background
For this analysis, principles from my recent book, Unexpected Returns:
Understanding Secular Stock Market Cycles, will be employed. The following
article will include all of the charts and information needed to assess the
current vulnerability and impending decline. For more information about the
book, please visit www.UnexpectedReturns.com or Amazon.com for a direct link to
information about the book. Unexpected Returns was developed to explore the
messages of research published on the Crestmont Research website, and includes
more than 60 full-color graphics as well as new material developed to highlight
key issues. It is written in a style that is directed to casual investors as
well as sophisticated scholars. Unexpected Returns is a unique combination of
investment art and investment science that enables the reader to differentiate
between irrational hope and a rational view of current market conditions.
Four Categories
There are four categories of indicators that signal an impending decline (bulls
will call it a "pullback") in the stock market. Because we are currently in a
secular bear market (a bear-in-hibernation at the least), the market can be
expected to act as it has during the past secular bear markets. Keep in mind:
the market conditions are not positioned to provide another secular bull market
at this time--it is not a sleeping bull. The current conditions reflect a secular
bear or a bear-in-hibernation because the price/earnings ratio ("P/E") is well
above its historical average and cannot rationally be expected to rise from
current levels. Without a rising P/E, future returns will be below average. For
more information about secular cycles, chapter 5 of Unexpected Returns is titled
"Secular Stock Market Cycles" and provides an in depth discussion of their
characteristics and causes.
The four categories include: (1) Secular Bear Market Profile, (2) Volatility,
(3) Valuation, and (4) Anecdotal Evidence. Each will represent a piece of
evidence that will build the case that the market is likely to experience a
decline during 2005 or 2006.
Secular Bear Market Profile
The first, Secular Bear Market Profile, relates to the characteristics of the
stock market during periods when P/E ratios start at relatively high levels and
remain flat or decline. Figure 1, Selected Secular Market Profile Measures,
compares the current secular bear market period (2000-2004) to the average
historical secular bear market. For a more complete profile chart, you can visit www.CrestmontResearch.com or see Figure 5.1 in Unexpected Returns.
Figure 1: Selected Secular Market Profile Measures
Thus far, the current secular cycle has experienced a near-average profile of
positive and negative years. In addition, the current cycle has a near-average
profile of positive and negative years in a row. The average secular bear has
42% of its years in positive territory and 58% in the red. The current period
has presented 40% and 60% respectively. For years-in-a-row, the typical secular
bear has an average trend of 2.1 positive years and 2.7 negative years; the
current period is a very close 2.0 and 3.0 thus far. The divergence from the
average secular bear market profile occurs in the magnitude measures--the average
gains and average losses are well below average.
This is further evident in Figure 2, Annual Dispersion of Market Changes, which
presents the frequency that annual changes in the market occur either within or
outside of key ranges. This figure is described in more detail in Unexpected
Returns. For this article, note the general consistency between secular periods
for the frequency inside both ranges. Historically, almost 30% of the years have
annual changes between -10% and +10%. Further, almost 50% of the years have
annual changes between -16% and +16%. Most notably, these frequencies occur
during secular bull and secular bear periods as well as occurring in the
aggregate. Yes, the inside-range occurrences are remarkably consistent. The
differences occur outside the range--secular bull markets have a strong bias to
upside occurrences and secular bear markets have a notable bias to downside
occurrences.
Figure 2: Annual Dispersion of Market Changes
So far in this secular bear market cycle, the past five years have been
atypically concentrated toward the center. More concerning, however, the
frequency of large declines (more than -16%) is unusually low. Based upon the
typical secular bear market profile, we appear susceptible to double digit
moves, especially large declines.
Volatility
Volatility relates to the choppiness of the market and tends to cycle over time.
The cycles are erratic and often violent. The level of volatility rarely remains
constant for very long. There are a number of ways to measure volatility; two of
which include (a) the statistic known as standard deviation and (b) the daily
range from high to low measured as a percentage. Figure 3, S&P 500 Volatility,
presents the rolling twelve-month standard deviation of the S&P 500 since 1951.
It is obviously quite erratic, yet with defined cycles and extremes of low and
high levels. It is noteworthy that extreme lows (near 5%) are generally followed
by spikes to near 20% or more. Further, the current level of volatility
(approximately 8%) is near historical cycle lows.
Figure 3: S&P 500 Volatility
Presenting the second measure in Figure 4, Average Daily Range: S&P 500 Index
(since 1962, when range data was readily available) also reflects cycles, highs
and lows, and a current condition near the bottom of the range. This volatility
measure is similar to the measure presented in Figure 3 and reflects the general
level of volatility in the stock market.
Figure 4: Average Daily Range: S&P 500 Index
Why does volatility matter? As reflected in Figure 5, Volatility & Market
Returns, there is a strong relationship between the level of volatility and the
performance of the market. As volatility rises, there is a greater propensity
for the stock market to experience losses. Volatility tends to decline as the
stock market rises and tends to increase as the stock market falls. For example,
in the top half of Figure 5, the average daily range for each month is grouped
into four sets, known as quartiles, which are ranked from least volatile to most
volatile.
You will notice that the least volatile periods have the lowest frequency of
down months. As the volatility increases across the quartiles, the frequency of
down months consistently increases. Further, as the volatility increases, the
magnitude of the loss during down months consistently increases. Higher
volatility brings not only a greater chance of loss, but greater losses as they
occur.
The column on the right provides a summary measure of the expected return during
each period. The expected return is determined by multiplying the chance of a
gain times the average gain and subtracting the product of the chance of a loss
times the average loss. As you can see in the table, the expected return
consistently declines and becomes an expected loss in the most volatile markets.
A similar analysis using annual data is provided on the bottom half of the table
reflecting the same conclusions.
Figure 5: Volatility & Market Returns
Further, when the concepts of volatility are assessed in secular bull and
secular bear markets, the characteristics that we saw in Figure 2 are apparent.
In secular bull markets, the more volatile periods tend to occur on the upside.
In secular bear markets, however, there is a higher percentage of downside
volatility than upside volatility. As a result, the negative effects of
volatility surges in secular bull markets can be overcome by strong market
performance and the stock market can experience gains amidst the volatility. In
secular bear markets, the downside volatility and negative effects of volatility
create adverse market conditions.
Figure 6, Volatility in Secular Bull and Bear Cycles, reflects the performance
of the stock market during the volatility cycles presented earlier in Figure 3.
Green shading has been added to reflect periods of secular bull markets and
yellow shading reflects periods of secular bear markets. This will help to show
that volatility surges have different effects on the market during secular bull
periods and secular bear periods.
As measured by the rolling standard deviation, there have been five surges in
volatility from extreme low levels since 1951. Each of these volatility surges
is noted on Figure 6 with black circles, lines, and arrows. In addition, a
percentage value is presented next to each black line representing the
annualized rate of change in the S&P 500 Index from the bottom to the top of the
move in volatility. The average change in the stock market during volatility
spikes is positive during secular bull periods and negative during secular bear
periods, yet the gains and losses can be much more extreme at times within the
period. Time, totals, and averages have the tendency to blur the magnitude of
intra-cycle swings.
Figure 6: Volatility in Secular Bull and Bear Cycles
Therefore, volatility represents the second indicator of an upcoming sharp stock
market decline based upon (i) the currently low level of volatility, (ii) the
tendency for upward spikes to follow extreme low volatility, (iii) the
relationship of market direction to volatility trends, and (iv) the propensity
for downside volatility during secular bear markets. Volatility could decline
further and could remain low for some time longer; however, based upon history,
it has not stayed low without subsequently spiking and, as it goes lower, the
likelihood of a spike increases significantly.
Valuation
Generally, when valuations are relatively high, there is a greater propensity
for a decline in value than a rise in value since there is a typical range of
values and, in some cases, a natural limit to values. Two of the indicators of
valuation in the financial markets include (a) price/earnings ratios (P/E) and
(b) bond market credit spreads.
As reflected in Figure 7, P/E Ratio: S&P 500 (1900-2004), the current level of
the general market P/E is well above the average and near past cycle tops
(excluding the bubble of the late 1990s). Clearly, the P/E is above the
historical average. As a result, the market may be more vulnerable to a decline
in valuation than it is susceptible to an increase in valuation.
Figure 7: P/E Ratio: S&P 500 (1900-2004)
Beyond the stock market, the bond market also reflects a relatively high level
of valuation. Further, the bond market is indicating a low perception of risk.
One measure of valuation and risk assessment is credit spreads--the additional
return available to an investor for owning a bond from a company with higher
credit risk compared to a company with lower credit risk. As reflected in Figure
8, Historical Credit Spreads, we are near or below levels of the past decade.
Keep in mind that the spread should never go below zero and, as it approaches
zero, at some point no longer compensates the bondholder for the additional risk
(some experts are saying that we are at that point now).
Figure 8: Historical Credit Spreads
 Also: Hartford Investment Management
Regardless of whether we are at extreme levels or simply levels that reflect
relatively high valuations in the financial markets, the third indicator of
vulnerability and potential stock market decline is the relatively high level of
valuation in the financial markets.
Anecdotal Evidence
There is plenty of evidence in the traditional press and offered from the
traditional pundits that the current level of valuation is reasonable, that
conditions are different this time, and that we are positioned for a strong bull
market in stocks. The purpose of this subsection is to offer a few balancing
anecdotal indicators as the intangible part of this article. Although the
strength of the case could be made with the first three indicators alone, the
following snippets further confirm that vulnerabilities and attitudes that
Professor Minsky identified in his Financial Instability Hypothesis.
As the financial market volatility has continued to decline, managers of hedge
fund portfolios initially experienced the decline in volatility and then began
to increase their risk profile and volatility (see Figure 9). As Minsky
postulated, this essentially reflects the shift from the hedged stage to the
speculative stage. Further, some investors and hedge fund managers have
increased leverage to maintain returns in more stable environment.
Figure 9: Typical Hedge Fund Portfolio Volatility
Over the past year as volatility has continued to decline, substantial capital
has left certain "long-volatility" styles of investing and shifted to certain
"short-volatility" styles. For example, substantial capital has been withdrawn
from convertible arbitrage, a strategy that is highly dependent upon stock
market volatility, and shifted to distressed debt hedge funds (which has
profited handsomely as credit spreads have moved to historically low levels).
Because the insurance of investing in "long-volatility" strategies has not paid
off, investors have shifted to selling insurance by shifting to "short-
volatility" strategies. Essentially, as market volatility has declined,
investors have shifted from risk-averse positions to risk-accepting positions.
Contrarians would say that this is a sign of upcoming market losses.
Using the Lemmings Rule, indicating that investors--like furry little lemmings--
tend to herd together and ignore disaster, we can look to Merrill Lynch's recent
survey of investors as reported in the Financial Times on March 16, 2005.
Christopher Brown-Humes and Jennifer Hughes reported: "The latest monthly
Merrill Lynch survey of fund managers shows a net 59 percent of participants are
over-weighted in equities--the highest figure since Merrill began the survey in
1999." This overly-aggressive bias for bullishness is another time-tested sign
that the market may be vulnerable to a decline.
A wise and experienced hedge fund manager with more than $3 billion under
management recently wrote to his investors: "The last time arbitrage strategies
were declared dead was in 1998, just before the Long Term Capital fiasco. The
next two years produced great returns for those who managed their risk well
during the market turmoil. The mindset that arbitrage and highly-hedged (or
lower-risk) strategies are unattractive is potentially dangerous. Hedge funds
are clearly taking more risk to maintain their returns both in the form of more
market risk and more liquidity risk, and they have received a lot of
encouragement from investors to do so. A fund manager takes a lot of business
risk to follow the crowd down that path. We do not think adding risk is
appropriate at this juncture and are willing to accept the business risk. We
want to be around for the great years. This means focusing on investment risk
when the crowd is focused on return.{emphasis added}"
Using Professor Minsky's concepts, once investors become complacent to risk and
become overly-focus on return, the markets shift from a state of "hedged" to a
state of "speculation" (before potentially moving to "Ponzi"). Such a shift
creates a condition of vulnerability when stability can be destabilizing (the
Financial Instability Hypothesis).
Further evidence from other economic and financial indicators suggest that the
tectonic-pressures in the financial markets are rising includes: (a) declines in
the U.S. dollar, (b) rising commodity prices, (c) U.S. trade deficit, (d) U.S.
budget deficit, (e) the VIX, a measure of expected stock market volatility, is
at low levels, (f) earnings growth has peaked following the last recession, (g)
oil prices have reached a plateau above $50 per barrel, and (h) for the
superstitious, January's loss in the stock market is believed to be a harbinger
for the year.
IMF REPORT
The International Monetary Fund (IMF) assesses global financial market
developments with the view to identifying potential systemic weaknesses and
publishes a semi-annual Global Financial Stability Report. The most recent
report, published in April 2005, received a fair amount of attention for its
stark warnings of potential instability in the global financial markets. Quoting
from the report:
"If history is any guide, the single most important risk factor for financial
markets in good times is complacency...current risk premiums for inflation and
credit risks leave little or no margin for error in term of financial asset
valuation." (pg 1)
Further, "Low short-term interest rates and low volatility are encouraging
investors to move out along the risk spectrum in their search for relative
value. The incentive to use leverage to boost returns is still strong. The
premiums for inflation and credit risk appear compressed. There is little
cushion for bad news regarding asset valuations if expectations for continued
favorable fundamentals change." (pg 8)
Additionally, "Financial risk taking encouraged by a prolonged period of
abundant liquidity may have created unsustainable valuations and pushed
volatility across a wide range of markets to artificially low levels. Past
tightening cycles have revealed hidden vulnerabilities as the incentive to reach
for yield was withdrawn. The locus of such vulnerabilities has typically become
fully apparent only after the fact." (pg 9)
Why are so few concerned about the vulnerabilities and bias toward disruptions
in the financial markets? Minsky and the IMF agree: Complacency.
CONCLUSION
Four of the indicators that the stock market is vulnerable to a volatile and
significant decline include: - The Secular Market Profile is underweighted with significant downside years
- Volatility is near historical lows; spikes upward tend to accompany market
declines
- Valuation in the financial markets is high and vulnerable to decline
- Anecdotal evidence reinforces the vulnerabilities
The message from the indicators is reinforced by the extensive analysis included
in the IMF's recent report on global financial markets. Based upon history,
these factors do not indicate that the decline will occur in 2005. It does
indicate, however, that the current conditions are becoming increasingly
vulnerable. If the increase in volatility and market decline does not occur in
2005, the probabilities of a market decline increase significantly for 2006. Be
forewarned, just because it could occur in 2006 does not mean that it will not
occur in 2005.
These conditions are not unusual for periods that have relatively high stock
market valuations and low interest rates--these conditions are the norm rather
than the exception. It is as typical as winter following summer; it is a time
for the superior, above-average period of the 1980s and 1990s to return to the
average. Periods that start with above-average valuations (i.e. high P/Es and
low interest rates) result in below-average returns, just as periods like the
1980s and 1990s that started with below-average valuations have produced above-
average returns.
For a more detailed explanation of these and other factors as well perspectives
on investment strategies to address secular bear market conditions, please see Unexpected Returns: Understanding Secular Stock Market Cycles (www.UnexpectedReturns.com). The book is available internationally online or
locally at a bookseller near you.
Ed Easterling is the author of recently released Unexpected Returns, President
of an investment management firm, a member of the adjunct faculty in the Cox
School of Business at SMU, and publisher of provocative research on the
financial markets at www.CrestmontResearch.com.
|
 | |
|
| |
|
|
|
|
Reproductions. If you would
like to reproduce any of John Mauldin's E-Letters or
commentary, you must include the source of your quote and the
following email address: JohnMauldin@InvestorsInsight.com.
Please write to Reproductions@InvestorsInsight.com
and inform us of any reproductions including where and when
the copy will be reproduced.
John Mauldin is president of Millennium Wave Advisors, LLC, a
registered investment advisor. All material presented herein
is believed to be reliable but we cannot attest to its
accuracy. Investment recommendations may change and readers
are urged to check with their investment counselors before
making any investment decisions.
Opinions expressed in
these reports may change without prior notice. John Mauldin
and/or the staffs at Millennium Wave Advisors, LLC and
InvestorsInsight Publishing, Inc. ("InvestorsInsight") may or
may not have investments in any funds cited above.
PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS.
THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN
INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE
INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER
VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN
ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT
PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN
BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR
VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX
STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX
INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY
REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN
MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND
ARE KNOWN ONLY TO THE INVESTMENT
MANAGER.
Communications from InvestorsInsight are
intended solely for informational purposes. Statements made by
various authors, advertisers, sponsors and other contributors
do not necessarily reflect the opinions of InvestorsInsight,
and should not be construed as an endorsement by
InvestorsInsight, either expressed or implied.
InvestorsInsight is not responsible for typographic errors or
other inaccuracies in the content. We believe the information
contained herein to be accurate and reliable. However, errors
may occasionally occur. Therefore, all information and
materials are provided "AS IS" without any warranty of any
kind. Past results are not indicative of future
results.
We encourage readers to review our complete
legal and privacy statements on our home
page.
InvestorsInsight Publishing, Inc. -- 14900
Landmark Blvd #350, Dallas, Texas 75254
©
InvestorsInsight Publishing, Inc. 2005 ALL RIGHTS RESERVED
|
| | |
|
Printer Friendly Version
Email this Article
