Central Banks Are Not Going Away

Every once in a while someone summarizes the big picture in a simple way. Bill Gross of PIMCO noted the following in his most recent investment outlook:

Don't fight central banks, but be afraid.

Why is this statement so relevant? The market's pricing mechanism is driven by both fundamental and speculative forces. Speculators are not evil; in fact, they provide much needed liquidity for efficient pricing. A healthy market has a relatively even mix between fundamental forces and speculative forces.

Markets that have "excess liquidity" compliments of central banks become skewed toward the speculative end of the spectrum.

Speculative Markets Can Rise For Years

Many will say "I do not want to participate in speculative markets", which seems logical. However, if we told you the stock market was going to rise for two more years, would you want to participate? The logical answer is yes if there is money to be made. Those who lived through the dot-com and housing bubbles can attest to the accuracy of the statement "speculative markets can continue to rise much longer than rational people believe."

We Must Play The Hand We Have Been Dealt

The following statements are reasonable to those who are experienced in the financial markets:

1. Central banks have skewed the market, which means stocks carry higher speculative risk.
2. Markets with a speculative bent can continue to rise for years.
3. All speculative bull markets end with painful bear markets (20% to 50% losses).

Bull Market Could End Tomorrow Or In Two Years

If we know the statements above are true, then it seems logical that we need to account for the following:

1. We have no idea when the current bull market will end.
2. Stocks could rise for two or three more years.
3. When the bear market finally arrives, investors could lose 50%.

Therefore, we need a way to:

1. Monitor the health and sustainability of the bull market.
2. Identify when the odds have shifted to the bearish camp.
3. Migrate from a risk-on to risk-off portfolio as the odds shift.

Monitor and Migrate

Our market model is designed to address needs 1-3 above. When markets peak, it is logical to assume that investor demand for stocks begins to drop relative to (a) more conservative assets, such as bonds, or (b) risk-off assets, such as inverse stock ETFs (aka shorts). In a world where central banks have skewed the bond market, a fair argument is "your stock vs. bond charts won't work this time". While we all know "it is different this time" is a dangerous expression in the markets, let's assume the stock and bond charts will not be helpful this time around. The "it's different this time" argument does not hold water when we look at the relative performance of going long stocks vs. shorting stocks. It is mathematically impossible for a long vs. short ratio to "miss a bear market", regardless of what central banks have done.

Long vs. Short: Can It Help Capture Speculative Gains?

The charts below show how monitoring the demand for longs (SPY) vs. shorts (SH) can assist us with managing risk while attempting to profit from a rising, and even speculative, stock market. This video clip describes how the ratio of longs vs. shorts below helped identify the favorable risk-reward environment that existed in 2006 as the S&P 500 gained 17% between point A1 and B1. The short explanation is when the demand for longs is greater than the demand for shorts it indicates bullish economic conviction is greater than bearish economic conviction. During periods of bullish economic confidence, the ratio below rises, which it did in 2006 when the S&P 500 tacked on 17%.

Can The Ratio Help Us Spot Bearish Trouble?

This video clip describes how the ratio of longs vs. shorts below helped identify the unfavorable risk-reward environment that existed in 2008 as the S&P 500 experienced a 12% loss in June, and another 38% drop in Q4. Unlike 2006, bullish economic conviction in 2008 was clearly lagging economic fear during the periods where the S&P 500 dropped (the ratio was also in a bearish downtrend).

How Does The Ratio Look Today?

The present day version of long vs. short aligns with the bullish case for stocks and the economy. Prior to the onset of a bear market, the chart below would need to take on a "correction" look (see A & B). It should be noted the chart below includes the losses in stocks over the past three trading sessions.

Fiscal Stimulus Coming?

Freshly printed or borrowed dollars impact asset prices in the short-run. Central banks provide monetary stimulus. Governments can also "goose the system" with fiscal stimulus. According to Reuters, additional fiscal stimulus may be in the cards in late 2013 or early 2014:

Japan will craft an economic stimulus package this week worth about $53 billion to bolster the economy ahead of an increase in the national sales tax in April, people familiar with the process said on Tuesday. The size of the package, ordered in October by Prime Minister Shinzo Abe, will be between 5.4 trillion yen ($52.43 billion)and 5.6 trillion yen, the sources told Reuters on condition of anonymity. Government ministers have said the package needs to be at least 5 trillion yen to soften the economic blow of the tax hike - Japan's biggest step in decades toward curbing its enormous debt.

"Give Backs" Are A Normal Part Of Bull Markets

Since the October 9 low in the S&P 500, many have cited weakness in small caps as a reason to short stocks or remain in cash. Tweets like the one below have been common:

The author of the tweet (names removed to protect the innocent) makes a valid point; all things being equal stock market bulls would prefer to see strength in small caps. However, as shown in the charts below (S&P 500 top, small caps bottom), "give backs" or countertrend rallies are a normal and healthy part of sustainable bullish trends. For investors with longer time frames, the primary trend is what matters most; the countertrend moves represent volatility to ignore.

Central Banks Need Help From Economy

Markets cannot rise forever based on printed money. At some point, the economy needs to carry more weight. Tuesday brought some good news on the fundamental front. From The Wall Street Journal:

Chrysler Group LLC's November U.S. auto sales jumped 16% from a year ago as the auto maker reported strong demand for trucks, though car sales were lower. The company's latest sales gain was led by strong demand for Ram and Jeep branded vehicles, though growth was also reported for the namesake and Dodge divisions.

2008: Concepts Helped With Warning

If you think the charts shown above are a form of rear-view mirror analysis, we used the same concepts to post the following warning in February 2008:

"Based on recent technical breakdowns in many risk-based investments, the probability of investors incurring additional losses over an extended period of time has increased. Both the technical and fundamental outlook now favor bearish outcomes over bullish outcomes."

After the February 2008 statement above, the S&P 500 dropped from 1,367 to the March 2009 intraday low of 666 (a decline of 51%).

Investment Implications - Volatility & Flexibility

Since fear is not a strategy, nor can it manage risk, allow us to amend Mr. Gross' summary as follows:

Don't fight central banks, but have a specific exit strategy in place.

Our strategy is based on one of the most important and difficult tasks for long-term investors: discerning between "volatility to ignore" and "volatility that requires defensive action." If you look at the 2013 long vs. short chart above, it is easy to classify the last three trading days as volatility to ignore. Therefore, we will continue to hold our stakes in U.S. stocks (SPY), technology (QQQ), financials (XLF), energy (XLE), and foreign stocks (VEU). Since flexibility is a key tenet of investment success, we must be open to ongoing corrective activity and the possible need for a reduction in our exposure to stocks.