October 2006

Pop Cycles

Pop Cycles...So here we find ourselves at the end of what has historically been one of the poorest months of the year for stock market performance - September.  Not this year.  In fact, with all the liquidity floating around the system these days, liquidity clearly no longer rushing headlong into residential real estate, many an equity index put on its best third quarter price performance in half a decade.  And we also find ourselves in a period where there is more than a good bit of division regarding directional outlook to come for both the economy and financial markets.  Theoretically, over the next month or so we're facing the convergence of a number of popular equity market cycles.  The fabled four year cycle is set to bottom sometime directly ahead.  Of course the proper question being when considering this particular cycle, bottom from what?  There has been no point to point downturn to speak of year to date.  The second issue at hand is the powerful calendar seasonal cycle for equities.  You know the drill, sell in May and go away.  But come the late October/early November period, it's again time to step up to the proverbial equity plate and play ball, so to speak, as the "good calendar period for equities" begins its run into next April.  Have fourth quarter rallies become self fulfilling prophecies in the modern world?  To be honest, at least over this decade, investors have been "taught" to get long in the last ten weeks of the year, whether the total year has been good or bad up to that point.  Simply for drill and perspective, here's the price only S&P return from October 15 of each year to the respective year end.

As is more than clear, many an institutional investor would have gotten down on their hands and knees to have achieved total year performance as was seen only in the last ten weeks of each year during 2000-2002.  In fact, in the clarity of hindsight, going on vacation from January 1 through October 14 in each of those years would have been the proper thing to have done.  Also, in 2004 and last year, more than total year price performance was achieved in just the last ten weeks of the year.  Powerful stuff and lesson learned.  Suffice it to say, at least to us, this type of record has "taught" equity investors to "be there" in the fourth quarter, regardless of their fundamentally driven hopes or fears.  You don't need us to tell you that this period now lies dead ahead and is sure to get a lot of headline press and attention (think CNBC) regardless of the state of real world fundamental facts and figures.  And this year it should be accompanied by the dreams of "new highs" for the Dow, which in our minds is relatively meaningless, but we don't drive broad market perceptions.  What this says to us as we move into the last part of the year is that we need to remain very flexible.  Remember, it's not what you personally think should be correct that counts, it's what markets perceive at any point in time and how they react to those perceptions in pricing securities that is all that matters over the short term.  We plan on parking our egos firmly at the door as we enter the period ahead.  Especially now as visions of lower interest rates, lower energy prices and excess liquidity dance in the heads of the hotter money on the Street.  And we already know that more staid institutional capital has no choice but to follow shorter term price movements given today's chief institutional investment motivation factor - performance anxiety.

And last, but very certainly not least in terms of cycles, we also face a potentially important change in the presidential cycle of historical equity market performance in concert with the prior cycles mentioned.  It's been a while since we have dredged this up, but now is the time to again consider the cycle.  Not because it is necessarily going to be correct, but more importantly because the crowd will certainly be treated to this same information in the broader mass financial media in the months ahead.  Forewarned is forearmed?  Let's hope so.  First, a quick retrospective by month of equity market performance in the second year of each presidential cycle over the last 55 years.  We've also put 2006 monthly performance so far alongside for comparison.  As you'll see, we're using the Dow as an equity proxy.
        

Has September been a tough month historically?  Sure.  But look what happens afterward.  Interestingly, up until August, the monthly pattern of positive or negative price performance of the Dow this year followed historical monthly average directional performance almost to a tee.  But that changed dramatically in August and September.  The chart below is the same long term average monthly performance data above simply put in cumulative monthly rate of return fashion.  Please remember, importantly as we have warned in the past, the following chart is not to be relied upon for potential rate of return magnitude, but rather for directional movement during the seasonal calendar period.  
       

And as we step back just a bit further, we need to remember that the historical turn in equity prices that has begun in the late third to early fourth quarter of the second year of presidential cycles past has also been the beginning of the best period for equities over the entire four year presidential cycle.  Here's one we've shown you in the past updated with numbers through September of this year.  
         

Again, remember that whether macro economic or corporate earnings fundamentals would support such a potential movement over the next twelve months as per the message of presidential cycle history is not the point.  It's whether investors believe it can happen and act upon that belief that's at issue.  As we have written about many times over the past years, we are absolutely convinced that the complexion of the market today is much different than has been the case in decades.  Hedge, prop desk, momentum and technically driven money cares about one thing and one thing only - the direction of price action.  This type of money is much less concerned with "why" as opposed to "when" and "how much".  And as we've discussed many a time recently, we're convinced this type of money is very important to shorter term price movements at the margin.  So we need to realize that and act accordingly in terms of short term investment flexibility.  

One last perspective on the presidential cycle for equities so we don't simply dismiss this as yet another pop cycle theory.  Here are the numbers that go with the charts above in terms of the 55 year average of Dow performance.  Along side is the prior presidential cycle from 2001-2004 as well as 2005 and 2006YTD experience.

At least so far, 2005 and 2006 look a whole lot like the average presidential cycle experience.  We have another quarter to go in 2006 at this point, so we'll see what happens.  Moreover, despite the equity bubble pop in 2000-2002, the 2003 and 2004 Dow price experience fell right back into directional line with average presidential cycle rhythm - a big third year and more modest fourth year return.  Do we believe that based on the facts at hand right here and right now that a fundamental case can be made for a 20+% run in aggregate equity prices into the latter part of 2007 as Presidential cycle rhythm would imply?  Of course not, but as we stated, our gut is telling us it's time to firmly check our egos and remain open to any number of alternative outcomes over the remainder of this year and into next.  Politics and monetary reflation are sure to make guest appearances at the table of equity market perceptions.  In fact, August and September price performance suggest these two party animals have already arrived at the door.  We're guessing it's simply nothing but a sheer coincidence that Goldman decided to significantly drop the weighting of unleaded gasoline in their commodity index (GSCI), prompting more than a few traders to blow out of unleaded gas futures and so heavily influence real world prices as of late.  We're sure it's simply fate that has allowed us to witness one of the largest eight week drops in crude oil prices in years, literally months in front of the election.  Additionally, for those watching, the Fed coupon passes and temporary open market operations just keep a comin' at this point.  How convenient, just the right things at just the right time.  So too, we now also find a confluence of what have been historically important aggregate equity market cycles lying directly in front of us.  To us, trying to be aware of our surroundings at all points in time is more than half the battle in the investment game.

The Cast Of Characters...So what do we watch in trying to determine whether these dreams of presidential cycles, four year cycle lows, and the "good part of the year" calendar seasonality are about to come true in terms of a potentially bullish equity market outcome for a time?  At least as far as the presidential cycle is concerned, if indeed past is prologue, we have to believe investors would be anticipating more than just modest gains.  And we'd suggest that something more than just modest gains would mean growth and high beta assets would provide the real juice for some type of sustained move upward.  It's a bit hard to believe that the AT&T's and Verizon's of the world would lead any type of sustainable rally charge from here, as has been the case recently.  In other words, any chance for a real simultaneous cycle upturn, or multiple cycle upturn, in the months ahead, at least from our viewpoint, would not be led by defensive sectors.  It would be led by growth and beta.

As a quick exercise let's again look back at equity market performance from mid-October of each year through year end as we did with the S&P table at the beginning of this discussion.  But this go around we'll include high beta favorites the NASDAQ composite and the Russell 2000.  Have a peek.  Remember, this covers both the bubble pop period as well as the 2003-present recovery.

At least in terms of year end equity rally periods, the message is pretty darn clear.  Higher beta assets on average have been the place to be, excluding the 2000 experience for the NASDAQ of course (which is more than understandable).  Once again, we firmly believe that given the character change in the equity markets, as hedge, prop desk and assorted algorithmic trading has come to dominate short term NYSE volume, high beta has become more of a commoditized asset class of choice during uptrends or rallies.  After all, hedge managers don't get paid to buy large cap blue chip issues.  Quite the opposite.  If indeed we're anywhere close to the mark in terms of this line of reasoning, we need to closely monitor sector performance and ongoing changes in sector leadership.  It's absolutely clear that post the May highs in really the global equity markets, high beta gave way to the greatest price extent relative to other broad asset classes, whether those be foreign or domestic high beta sectors.  In the following table, we've gone back to the as of now June 13 low in the S&P and tracked both its performance through September month end along with the S&P Sector Spiders.  Same deal for price only performance during the singular month of September.  For drill we've also included the NDX.  In other words, what is the character of the current post June price low rally in the major equity averages and sectors?  Let's have a look.  Of course, all of these indices or sectors did not bottom simultaneously.  We're simply trying to get a sense for what is outperforming the broad market as characterized by the S&P.

There you have it.  Although we're not showing you these numbers, through the beginning of September, it was really defensive issues that were leading the charge.  The leaders from the June SPX lows through late August were Telecom, Energy, Health Care and Staples.  Almost classic defensive exposure.  But that changed in September.  Up goes tech, up goes the discretionary consumer issues, and up goes the NDX relative to the SPX.  Of course the interest sensitives have also come alive on the seemingly never ending Fed is done theme on the Street.  In other words, higher beta and procyclical issues led the charge in the more momentum driven September period.  So what happens now?  Although no one has the answer to this important question, we suggest it will be more than important to continue monitoring relative equity sector performance characteristics in an effort to listen to what the markets are telling us and trying to decipher exactly what the markets are discounting.

As you'd guess, we have a few macro charts we hope worthwhile in guiding us ahead in terms of relative asset class and sector performance, to say nothing of longer term seasonal calendar and presidential cycles.  First the very simplistic relationship between the NDX and the S&P.  As you can see below, relative NDX outperformance of the S&P has led or been coincident with every major absolute price rally in the S&P since 2002 at least.  And what is extremely noticeable is the fact that just recently, the NDX/SPX relationship slipped to a new three year low before attempting to recover.  For us to even begin to believe in a meaningful or sustained broad equity market rally to come, the NDX is going to have to sustainably retake the relative performance channel that is more than clear in the chart below.
          

For now, the Russell as yet another high beta sector is in a bit better shape than the NDX relative to the S&P.  It has barely fallen out of its long term relative outperformance channel and is struggling a bit relative to past swoons to regain performance leadership.  It goes without saying that getting back into the long term channel from here is an absolute must do exercise if indeed high beta is to retake relative defensive sector out performance.  If we are to "believe" in any type of beta/growth led rally from here, the chart above and below are simple and bear watching.  
         

With all of the hoopla and focus on the potential new all-time high in the Dow as of late, the equity market has a lot of proving to do if indeed the favorable influence of the historic presidential cycle and favorable seasonal cycles are to take us to meaningfully higher equity ground.  Although a new high on the Dow would be symbolic, the NDX, Russell, Transports, etc. have a lot of catching up to do from here to validate what may end up being a record Dow close to come.  

Taking Stock...So why all of this discussion regarding cycle possibilities that lie in front of us?  More than anything, we just want to remind ourselves to remain flexible.  We need to continually remain open to all investment possibilities and outcomes, no matter what our personal theoretically logical reasoning may dictate.  We can give you a million intellectual reasons why real world fundamental deterioration argues for softer equity prices moving forward.  But intellectual reasoning and financial market activity can be two different worlds, especially over the short term.  As we have written about many a time over the past year, and is now more than clear in the mainstream press, the very important residential real estate cycle has turned.  Important in that household asset inflation and monetization (through the credit cycle) has been extremely meaningful to the US economy really over the last decade plus.  So as we look ahead, we see little choice for the Fed except to attempt yet another reflation campaign if indeed residential real estate continues on its southern asset class price journey, dragging the macro economy along with it (as it sure as heck seems to be doing).  And if that reflation campaign lies ahead, we need to ask ourselves just where yet another round of newly created liquidity will flow. Although we nor anyone else has any idea what's to come ahead, we need to at least remain open to the idea that a serious reflation campaign would find its near term outlet in stock prices.  And here's why we believe the Fed would not exactly be heartbroken if that were to transpire.          

A very notable wrinkle in the recently released 2Q Flow of Funds report concerns growth in household net worth, or more correctly lack thereof in the current quarter.  We won’t lead you through some huge diatribe about how important asset inflation has been to US households over the last half decade, especially in light of the fact that real wage growth has not really made an appearance on the scene in the current cycle.  You already know all of that.  To suggest that 2Q growth in household net worth was a bit of an anomaly is probably the understatement of the moment.  Believe us, US households certainly are not used to this.
       

How did this happen?  Here are the quarter over quarter numbers.

First, it’s clear that despite a slowing residential housing market, a 2Q climb in real estate values accounted for more than 2Q period growth in total household assets.  So what else is new, right?  It’s the 2Q drop in household equity values that shot household net worth growth out of the sky for the period.  But even if household equity values were flat, the change in household net worth would have remained the lowest of any period you see in the chart above.  We already know that 2Q is old news.  From the end of 2Q until the close last Friday, the S&P is up 5.2% in price.  That’s about $250 billion plus or minus in terms of a potential pro forma increase in household equity values for 3Q on price alone.  So, clearly household net worth will grow ahead and 2Q was a bit unusual.  But what we believe this shows us is that absent continued meaningful gains in real estate values, stocks take center stage as the primary swing factor in household net worth changes looking ahead.  A little bit of back to the future here relative to what was also the experience of the late 1990’s, now isn’t it?  And if the Fed again attempts a reflation campaign to save the economy, guess which asset class they probably would not mind to see moving higher?  Do you need a minute to think about it?

Again, this discussion is not about fortune telling as it applies to the financial markets.  It's about being aware of and accepting of historical seasonal tendencies and longer term equity market cycles that may indeed have meaning for what lies directly in front of us.  It's about maintaining balance and flexibility.  Because at this point in the economic, financial market and household asset inflation cycles, we believe the Fed has very little flexibility.  As we mentioned, if the residential real estate cycle continues to deteriorate, which is a much better than even money bet in our eyes, the Fed will have little choice except to pull the same reflation rabbit out of the hat once again.  And in that case, following the macro movement of liquidity will be an exercise of critical importance for investors.  We'll see how it all turns out, now won't we?