US Stock Markets and 2009 by David Kotok
David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).
There are signs that the 2008 year-end stock market rally may continue into 2009. Internal market dynamics have changed since the November 20 low. In order to grasp these new dynamics it is important to study three key dates and the transitions in between them.
The first date is October 10, when the US stock market appeared to show signs of a selling climax. Subsequently, the market tested those October 10 trading lows several times.
The second key date is November 20. This is the day that the market retested the lows of the climax in October and established an even lower reference point.
The third key date is December 15, when the Federal Reserve’s most recent policy action established a zero-bound low target for the Fed Funds rate. In the same action, the Fed articulated a complete commitment to liquidity provision in whatever amount and by whatever means is necessary to liquefy the economy and unfreeze credit markets. The Fed’s commitment to avoid deflation and depression is now certain and clear.
October 10 appeared to be the selling climax of the post-Lehman failure waterfall. The accelerating global downturn actually started in earnest in mid-July during the Fannie-Freddie crisis, and the depressing accelerator hit the floor with the failure of Lehman Brothers. Between Lehman’s mid-September demise and the mid-October climax, all stock markets of the world fell in a highly correlated manner. The correlation among global markets had been rising since mid-July. After Lehman it became a single global contagion-driven waterfall. Credit markets seized; raw panic ensued.
After the October 10 climax, markets experienced a tug –of war between those who forecast a multi-year period of gloom and doom and those who expected governments and central banks to intervene powerfully to avoid that fate. The movement of stock markets worldwide between October 10 and November 20 was much less correlated than in the immediate period following Lehman’s failure.
In order to believe that the stock market lows were reached in the autumn of 2008, we need to observe transitional changes during and after that time frame. The first transitional change is observable when market behavior begins to relax after the peaking of highly correlated movements. In other words, when markets are selling off worldwide with the intensity of raw panic, one must look for signs that the panic has reached its extreme peak. This can only be done after the fact. This peaking point determination is necessary in order to set the stage for the next observation.
Panic selling was at its extreme between Lehman’s mid-September failure and October 10. Panic selling was still very intense after October 10 but not as extreme between October 10 and November 20. We conclude that observation because we can measure the correlation of the selloff in global markets. That correlation peaked between September 15 and October 10.
Signs of panic selling intensity include outperformance by the very large-capitalization stocks. In other words, lesser-cap, smaller- and mid-cap stocks get hammered more than the largest-cap stocks because the largest-cap stocks are viewed as being safer. Remember, this is during a period when all stocks, large- and small-cap, are falling. This is a relative performance comparison.
Between October 10 and November 20, the capitalization-weighted S&P 500 index fell 16%. The reference exchange-traded fund (ETF) is the “Spider,” symbol SPY. SPY’s total return was negative 14.75% between October 10 and November 20. SPY tracks the index closely. The numbers are not exact, due to tracking error and internal ETF costs and also due to the fact that the total return of the ETF includes dividends. The raw price change of the index ignores dividends and has no internal attributable costs.
During the same October 10-November 20 period of time, the Rydex equal-weighted S&P 500 ETF (RSP) declined by 22.5%. In other words, we are measuring the same 500 stocks by two methods: capitalization weight and equal weight. Capitalization weight went down but not as much as equal weight. This demonstrates the observation that large-caps didn’t decline as much as small- and mid-caps during the October 10-November 20 market waterfall.
Let’s now examine the period between November 20 and December 15. We are looking for evidence to confirm the assumption that November 20 was the bottom. SPY rose by 16.3% between November 20 and December 15. RSP rose by 18.2% during the same time frame. In other words, the equal-weighted S&P 500 reference outperformed the capitalization-weighted index reference by about 2%. The implication is that the market recovery since the November 20 low is broadening beyond the very large caps.
Let’s examine this issue of broadening to see if there’s more evidence to support our observation. To do this, we will compare the S&P 400 mid-cap index ETF (symbol MDY) and the S&P 600 small-cap index ETF (symbol IJR). Between November 20 and December 15, MDY achieved a total return of 18.5%. In the same period, IJR achieved a positive total return of 17.3%. The conclusion is that between November 20 and December 15, SPY performed the worst. RSP outperformed SPY. MDY outperformed RSP and IJR outperformed SPY. Note that we have just examined the relative performance of the components of the S&P 1500 stock index with four different reference index ETFs.
Let’s examine what happened after the Federal Reserve policy action and statement issued on December 15. Between December 15 and December 31, SPY delivered a total return performance of 3.7%. RSP resulted in 5.9%. MDY delivered 8.3%, and IJR derived 9.8%. Notice how the transitional trend that began on November 20 and continued through December 15 became even more robust after December 15. Notice how the market broadened and extended to smaller- and mid-caps. In the US, stock markets have interpreted the Federal Reserve policy statement on December 15 with a positive response.
Disclosure: Cumberland’s US ETF accounts now hold more RSP than SPY in the broad ETF category. In addition we are now overweighted in MDY and IJR
As we enter 2009, we are looking for additional affirmations that November 20 was the low for the stock market and that the post-Lehman failure period of September 15 through October 10, and then to November 20, represented the most acute degree of panic. In addition to broadening markets we also see margin debt as a percentage of GDP reaching the historic low range that corresponds to bottoms. We see insiders buying. We see the VIX Volatility Index falling; it still has a long way to go to return to the levels that have corresponded with complacency. And finally we see $3.8 trillion in money market funds earning zero interest.
Of special note is the Ned Davis Research Multi-Cap Institutional Equity Series Absolute Index. This complex and relatively obscure measure has an 85% successful batting average. It logged great buy signals in 1982, 1987, and 2002. Last month, it logged a record value and reversal.
Our outlook is positive. We expect the central banks and governments of the world to continue aggressive monetary and fiscal stimulus. We anticipate credit markets will improve in 2009. Spreads will narrow. Tax-free Munis and taxable corporate bonds will rally in price. We are avoiding US Treasury notes and bonds.
Our current allocation is 50% bonds, fully invested with long duration (both tax-free and taxable), and 50% stocks using ETFs. Cash is currently allocated at zero.
As markets improve, we would expect the stock market allocation to rise over time and the bond allocation to fall commensurately. This adjustment process may occur during the entire year of 2009.
A normal allocation over strategic time periods would have 70% in the stock market and 30% in bonds. These are very uncertain times as we enter 2009. While we expect central banks and governments to succeed, we acknowledge that risks are very high. Therefore, our present allocation to the stock market is below normal and allocation to bonds is higher than normal.
We’re flying to Paris for two days of discussions about European markets, the dollar-euro exchange rates, and the fallout in Europe from the Madoff scandal. For those who rise early, we will be the guest host of CNBC’s Worldwide Exchange from the Paris studio on January 5 between 10am and noon Paris time (that’s 4am to 6am NY time).
We wish our clients, their consultants, our friends, and all of our readers a happy and healthy 2009.
David R. Kotok, Chairman and Chief Investment Officer, email: david.kotok-at-cumber-dot-com
Copyright 2008, Cumberland Advisors. All rights reserved.
The preceding was provided by Cumberland Advisors, 614 Landis Ave, Vineland, NJ 08360 856-692-6690. This report has been derived from information considered reliable but it cannot be guaranteed as to its accuracy or completeness.
Cumberland Advisors supervises approximately $1 billion in separate account assets for individuals, institutions, retirement plans, government entities, and cash management portfolios. Cumberland manages portfolios for clients in 42 states, the District of Columbia, and in countries outside the U.S. Cumberland Advisors is an SEC registered investment adviser. For further information about Cumberland Advisors, please visit our website at www.cumber.com.