Recent escalated market volatility was a signal to sell—now. In nautical terms, that spike in volatility was a ‘shot across the bow’. Ken Norquay, a regular contributor to The MoneyLetter and author of the behavioural finance book, Beyond the Bull, says that dramatic warning shot was a signal that the stock market outlook has changed to a downtrend.
The ‘shot across the bow’ is an old navy term: when a Royal Navy vessel wanted to board some ship, it would fire one shot in front of that ship as a warning of what would happen if that ship’s captain did not cooperate. The sudden extreme in stock market volatility experienced in the last two weeks of August was ‘the shot across the bow’ for investors: a dramatic warning of the stock market outlook for what lies ahead. The long-term trend of the U.S. stock market has changed from an uptrend (March 2009 to August 2015) to a downtrend. The bear market has begun.
The bear’s begun
The great American investment writer, Richard Russell, once said: “In a bear market, whoever sells first wins.” In other words, in a bear market, winning means losing less. Investors should change their expectations of market returns now. We should expect our stock market returns to be negative for a year or two. Those whose financial plans call for selling should sell now. Those whose investment plans call for holding and never selling should re-think those investment plans now. The stock market has warned us. The ‘shot across the bow’ has been fired. Now it’s up to us to get our investment portfolios shipshape.
Investment GPS: How we got here
Let’s review the sequence of financial events that preceded the August 2015 warning shot.
1. The financial crisis of 2007–2009 set up the stock market bottom of March 2009. From there, the U.S. stock market rose in a series of zigzags until May 2015, a six-year-plus bull market.
2. In winter 2015, long-term U.S. interest rates bottomed—in other words, the U.S. long-term bond market topped.
3. In the six months from June to December 2014, the price of a barrel of oil dropped by more than half, sending the world’s petro-economies into tailspins (including our own Canadian economy). Oil prices are still half what they were a year ago.
4. The economic expansion of September 2009 to December 2014 was weak through all Western economies. The year 2015 has brought talk of recession in Europe, Canada and the United States.
The normal topping sequence
In my investment book, Beyond the Bull, I discuss The Counter-cyclical Model, which explains the relationship between the bond market (i.e., long-term interest rates), the stock market and the economy. The normal long-term topping sequence is this:
1. First interest rates go from a downtrend to an uptrend. (In this current cycle, that trend change occurred at the end of January 2015.)
2. Then the stock market reaches its cyclical high. (That occurred in September 2014 in Canada and May 2015 for the U.S.A.)
3. Then the economy slips into the contraction phase. (Canadian and American economies, damaged by the sudden and dramatic drop in oil prices, have been weaker than expected.)
To repeat, the topping sequence is: 1. Long-term interest rates reverse; 2. The stock market reverses; 3. The economy reverses.
Why the warning shot’s more worrying for Canada’s market outlook
Note that the sequence is not unfolding normally for Canada in this cycle. Because the Canadian stock market has so much exposure to energy prices, the S&P/TSX Composite Index reached its high several months before interest rates reversed. Because of the dramatic impact of oil prices on our economy, the Canadian economy appears to have slipped into recession already. The extreme drop in oil prices has made our situation more dangerous than in previous cycles. The volatility ‘warning shot’ we received in August is more ominous for Canadian investors.
The American bear
Based on this evidence, my article in the second issue of The MoneyLetter in June 2015 predicted that the U.S. stock market would peak this summer. As you can see, I was wrong. At that time, the American stock market had already reached the peak for this cycle, a reading of 2,134 for the S&P 500 Composite Index in the month of May. The bear market had already begun.
The events of this summer remind me of the market at the top of the bull market that ran from October 2002 to November 2007. In summer 2007, a whiff of volatility stuck: from its high in July 2007 to its low in August 2007, the S&P 500 dropped 11.9 per cent. Last month the S&P 500 dropped 12.5 per cent from high to low.
In 2007, the S&P 500 rose to its ultimate high of 1,576 in November. During the following 16 months, it dropped 57.7 per cent!
Heed the warning shot
If history repeats, the market outlook calls for a rise for the next three months before the serious losses start. The market may not repeat the 2007 pattern because the economic background in 2015 is quite different from 2007. I mention the events of 2007 to illustrate the importance of heeding the warning that the market just gave us. The risk of owning stocks or equity mutual funds now is as great as it was eight years ago, in September 2007.
Market tops: 2015 versus 2007
Let’s review the financial background of the stock market now, at the 2015 top, and compare it to the 2007 top.
1. The Canadian dollar is worth about US$0.75 now, and its currency market outlook is in a downtrend. In November 2007, the loonie peaked at US$1.11 after a long uptrend.
2. A barrel of oil was about US$80 in September 2007 and was in an uptrend. Today it is about US$45 and is in a downtrend.
3. In 2007, U.S. residential real estate was hot, hot, hot. Today, Canadian residential real estate is hot, hot, hot.
4. In 2007 the American and Canadian economies were in the expansion phase. Today these economies are weak, perhaps in recession.
5. In autumn 2007, the U.S. dollar had been weak, in a downtrend for over a year, when measured against a basket of non-U.S. currencies. Now the greenback is strong, in an uptrend for over a year.
6. In 2007, the incumbent president of the United States was nearing the end of his eight years in office. That’s also the case in 2015.
Keep economic data in perspective
It is important not to focus too much on all this economic knowledge. The economic world consists of the collective economic activity of all the participants. It is very difficult to predict how the various participants will act in the context of their own financial point of view.
For example, we know that the price of oil has dropped in half—operations like the tar sands are no longer profitable. The layoffs have started. Certain pipeline projects are no longer necessary. The Canadian dollar is declining. Lower fuel prices help consumers and should result in more consumer spending. This helps the retail sector. But a lower Canadian dollar means wholesale Chinese imports will cost more, squeezing Canadian retailers’ profit margins. Will retail stores thrive or flop?
Who can forecast what all these economic cross-currents might mean? It is important to remain humble when we make these observations and not pretend we can solve this magnificent monetary puzzle.
There may be some financial genius who can sort out all the factors and make an accurate investment forecast. But will we be competent enough to recognize which economists are the geniuses who get it right and which are the ordinary ones who fake it ‘til they make it’? In the investment business, all professionals represent that they are the ones who have the right answers and we should have faith in them because we are not capable of accuracy in the complex inter-connected world of finance. As investors, should our quest be to find the one wonderful financial guru whose market outlook is right all the time? Impossible! The complexity of the financial world is the wrong place for us to be focusing our attention.
What we should focus on
Our attention should remain focused on our personal financial world and the risks associated with our portfolio. Our decisions relate to our holdings—not to the details of the world economy. The stock market outlook has become very risky, the opposite of what it was six and a half years ago. Our personal investment policy should relate to that increase in risk.
What we should do
Furthermore, as one approaches retirement, one’s overall investing should become more conservative. Twice this century, the stock market has dropped in half. Can your investment portfolio handle a third such drop? Now is a good time to review the overall level of risk in your investment portfolio with an eye to becoming more prudent.
Those with a propensity for speculation should learn about selling short and about put options. Making money requires different skills now that the bear market has begun. When volatility heats up again, as it did last month, both profits and losses will come fast.
The MoneyLetter, MPL Communications Inc.
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