Leon Tuey on the
Markets
There is a common belief that timing is not important and
that no one can time the market. I beg to differ. Those who hold such beliefs
are ignorant of the market’s logic. Also, it may well be just propaganda by the
fund industry for if investors can identify a bull market top and pull their
money out, what would the funds do for a living?
If investors understand the market’s logic, they can divine
the future direction of the market (long-term, or shorter term). It is not
rocket science. Understanding the market’s long-term direction is of primary
importance. If investors had bought the following blue-chip stocks at the top
in 2007 - Berkshire Hathaway, 3M, Microsoft, Royal Bank of Canada, United
Technologies and hundreds ofothers, they would have lost 50% or more at the end
of the bear market in March 2009 and they didn’t get even until early 2013.
To understand how a bull market begins and how it
ends demands a deep understanding of the economic cause/effect relationships
that drive the markets. The following must be clearly understood and
appreciated.
The U.S. Federal Reserve System was created in 1913 to
perform all roles monetary. It’s an independent body. One of its key statutory
mandates is “To maintain orderly economic growth and price stability” (unlike
the European model, which is primarily concerned with price stability). The most powerful tools at the Fed’s
disposal to effect monetary policy changes are the basic monetary policy
variables, bank reserve requirements, margin requirements, and the discount
rate. Changes in the Bank Reserve Requirement and the Margin Requirement
are infrequent; the discount rate changes the most frequently. When the Fed raises/lowers the Bank Reserve
Requirement, however, investors should pay close attention as when it happens,
it signals monetary tightening/easing. The
single most bullish indicator for the stock market is when the Fed lowers the
Bank Reserve Requirement; it’s a clear signal of monetary easing. To encourage
investments, or to dampen speculation, the Fed will lower or raise the Margin
Requirement. The Discount Rate is the only policy variable that changes
frequently. Monetary tightening is when the Fed raises the Discount Rate many
times in succession; drains liquidity from the system (contraction in the
year-over-year rate of growth in the Adjusted Monetary Base, MZM, and M2. Data
are available in U.S. Financial Data, reported every Thursday evening by the
Federal Reserve Bank of St. Louis); and inversion of the Classic Yield Curve
(13-week T-Bill yield vs. 30-year T-Bond yield).
The Fed’s mandate
must be clearly understood and appreciated. Failure to do so will leave
investors in a state of perpetual confusion and at the mercy of the “noise.”
To divine the market’s long-term trend, I monitor six
factors to help me detect how a bull market begins and how it ends. These are the monetary (the most important
and the real drivers of the market’s long-term trend), economic, valuation,
sentiment, supply/demand, and momentum/internal/technical. The valuation and
supply/demand factors are imprecise in terms of timing. Nevertheless, they must
be closely monitored. The
momentum/internal/technical factors don’t drive the market; they tell investors
about the health of the market.
As mentioned on numerous occasions, if nothing else, if
investors only understand and appreciate the following, they will always be on
the right side of the market and will never be influenced by others’ opinions
or news headlines:
1) Investors must
understand the role of the U.S.
central bank (the Fed). The U.S. Federal Reserve System was created in 1913
to perform all roles monetary, but one of their key statutory (written in law)
mandates is to “To maintain orderly economic growth and price stability.” This
agency has more and better information on the economy than anyone in the world.
It was not created to promote hyperinflation or to create depressions. The
Fed’s key mandate must be clearly understood and appreciated.
2) The stock market
is a leading economic indicator. The economy does not lead the stock
market. Hence, once these two points are clearly understood and remembered, the
market’s logic becomes apparent. Hence, when the economy slows and heads into a
recession, the Fed will ease and will keep easing until the economy responds
(remember, that’s their mandate). The stock market, being a leading economic
indicator, will have bottomed 6-9 months before the recovery begins, not after.
For example, "the market" bottomed in October, 2008 and the recession
ended at the end of June, 2009 and a [market] recovery commenced, eight months
ahead of the [economic] recovery. Conversely, when the economy overheats;
inflation surges; and speculation is rampant, the Fed will tighten by draining
liquidity from the system and raise interest rates in an attempt to cool the
economy. The stock market, being a leading economic indicator, will head south
long before the onset of a slowdown or recession, not after. This chain of
logic is so simple that anyone with an IQ slightly above room temperature would
understand it. Yet, most on Wall Street with umpteen degrees and decades of
experience can’t figure it out.
IDENTIFYING A MAJOR MARKET BOTTOM
1) The economy is in
bad shape; jobs are hard to find; and headlines are black. Capacity
utilization plunges. Talk of depression is widespread. The talking heads will
declare “this time is different. They (the Fed) has lost control.”
2) Investors are
crying the blues as their portfolios are showing huge losses. Worldwide,
investors panic and a sense of despair and hopelessness prevails. Brokers are
sleeping like babies; theywake up every hour and cry.
3) The Fed eases by
injecting liquidity into the system and lowers the Discount rate three or
more times in succession and will keep easing until the economy responds.
4) The Classic Yield
Curve (13-week T-bill Yield vs. 30-year T-bond Yield) starts to steepen
(short rates below the long rates).
5) The
interest-sensitive sectors such financials, bonds, preferred shares, utilities
bottom and start to head north while the major market averages continue to
head south. Mesmerized by the decline in the market indices, investors are
unaware that a “rolling” bottom has begun.
6) As the Fed eases
further, the growth and consumer discretionary issues bottom while the
major market averages move yet to new lows.
7) The market becomes
grossly undervalued.
8) Investors are
sitting on a mountain of cash and hold little equities. They have no
appetite for stocks.
9) A selling climax
occurs as investors panic. Seized by fear, investors “throw the baby out
with the bathwater” as they can’t bear the loss anymore and are convinced the
world will end. An emotional catharsis occurs and stocks move from weak hands
into strong hands.
The bear market ends and a bull market begins.
IDENTIFYING A MAJOR MARKET TOP
1) The economy is
booming; workers are hard to find; and headlines are glowing. Capacity
utilization is running full tilt.
2) Investors are
euphoric and the stock market becomes topic du jour at cocktail and dinner
parties. Waiters, taxi drivers, bartenders, and shoeshine boys are giving
clients hot tips; they think they are market mavens. Everyone is a genius and
have the keys to Fort
Knox.
3) Euphoria reins.
Investors are heavily invested in equities and hold little cash.
4) Stock brokers,
confusing their own genius with a bull market, buy Ferraris and
Lamborghinis and dine in uber expensive restaurants.
5) The economy
overheats, inflation surges; and speculation is rampant. Consequently, in
their attempt to cool the economy, the Fed tightens meaningfully by draining
liquidity from the system and raises interest rates numerous times.
6) The market becomes
grossly overvalued.
7) After a long
period of flattening, the Classic Yield Curve is inverted (short rates
higher than long rates). Then, as the economy deteriorates, the yield curve
starts to steepen (short rates start to move below the long rates).
8) Interest–sensitive
sectors such as financials, bonds, preferred shares, utilities along with
consumer discretionary, start to head south. Meanwhile, dragged up by the
late-cycle issues, the major market averages keep moving to new highs.
Investors are lulled by the new highs in the market indices, not realizing the
broad market is already heading into a bear market. Not surprisingly, the
various Advance-Decline Lines start to head south 3-6 months before the major
market averages. New Highs start to contract and New Lows expand.
9) Finally, the major
market averages top and join the rank and file by heading in a southeasterly
direction.
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