Markets always find a new way to make a fool out of you.  Sometimes that is when the market has done exceptionally well, and you have been too cautious.   That tends to be my error as well.  I’m too cautious in bull markets, but on the good side, I don’t panic in bear markets, even the most severe of them.

The bull market keeps hitting new highs.  It’s the second longest bull market in the last eighty years, and the third largest in terms of cumulative price gain.  Let me show you a graph that simultaneously shows how amazing it is, and how boring it is as well.

The amazing thing is how long the rally has been.  We are now past 3000 days.  What is kind of boring is this — once a rally gets past two years time, price return results fall into a range of around 1.1-2.0%/month for the rally as a whole, averaging around 1.4%/month, or 18.5% annualized.  (The figure for market falling more than 200 days is -3.3%/month, which is slightly more than double the rate at which it rises.  Once you throw in the shorter time frames, the ratio gets closer to double — presently around 2.18x.  Note that the market rises are 3.2x as long as the falls.  This is roughly similar to the time spans on the credit cycle.)

That price return rate of 1.4%/month isn’t boring, of course, and is close to where the stock market prediction model would have predicted back in March 2009, where it forecast total returns of around 16%/year for 10 years.  That would have implied a level a little north of 2500, which is only 3% away, with 21 months to go.

Have you missed the boat?

If you haven’t been invested during this rally, you’ve most like missed more than 80% of the gains of this rally.  So yes, you have missed it.

“The Moving Finger writes; and, having writ,
Moves on: nor all thy Piety nor Wit
Shall lure it back to cancel half a Line,
Nor all thy Tears wash out a Word of it.”

Omar Khayyám from The Rubaiyat

In other words, “If ya missed the last bus, ya missed the last bus.  Yer stuck.”

We can only manage assets for the future, and only our decrepit view of the future is of any use.  We might say, “I have no idea.” and maintain a relatively constant asset allocation policy.  That’s mostly what I do.  I limit my asset allocation changes because it is genuinely difficult to time the market.

If you are tempted to add more money now, I would tell you to wait for better levels.  If you can’t wait, then do half of what you want to do.

A wise person knows that the past is gone, and can’t be changed.  So aim for the best in the future, which at present means having at least your normal percentage of safe assets in your asset allocation.

(the closing graph shows the frequency and size of market gains since 1928)

This is the fourth article in this series, and is here because the S&P 500 is now in its second-longest bull market since 1928, having just passed the bull market that ended in 1956.    Yeah, who’da thunk it?

This post is a little different from the first three articles, because I got the data to extend the beginning of my study from 1950 to 1928, and I standardized my turning points using the standard bull and bear market definitions of a 20% rise or fall from the last turning point.  You can see my basic data to the left of this paragraph.

Before I go on, I want to show you two graphs dealing with bear markets:

As you can see from the first graph, small bear markets are much more common than large ones.  Really brutal bear markets like the biggest one in the Great Depression were so brutal that there is nothing to compare it to — financial leverage collapsed that had been encouraged by government policy, the Fed, and a speculative mania among greedy people.

The second graph tells the same story in a different way.  Bear markets are often short and sharp.  They don’t last long, but the intensity in term of the speed of declines is a little more than twice as fast as the rises of bull markets.  If it weren’t for the fact that bull markets last more than three times as long on average, the sharp drops in bear markets would be enough to keep everyone out of the stock market.

Instead, it just keeps many people out of the market, some entirely, but most to some degree that would benefit them.

Oh well, on to the gains:

Like bear markets, most bull markets are small.  The likelihood of a big bull market declines with size.  The current bull market is the fourth largest, and the one that it passed in duration was the second largest.  As an aside, each of the four largest bull markets came after a surprise:

  1. (1987-2000) 1987: We knew the prior bull market was bogus.  When will inflation return?  It has to, right?
  2. (1949-56) 1949: Hey, we’re not getting the inflation we expected, and virtually everyone is finding work post-WWII
  3. (1982-7) 1982: The economy is in horrible shape, and interest rates are way too high.  We will never recover.
  4. (2009-Present) 2009: The financial sector is in a shambles, government debt is out of control, and the central bank is panicking!  Everything is falling apart.
Sometimes you win, sometimes you lose...

Sometimes you win, sometimes you lose…

Note the two dots stuck on each other around 2800 days.  The arrow points to the lower current bull market, versus the higher-returning bull market 1949-1956.

Like bear markets, bull markets also can be short and sharp, but they can also be long and after the early sharp phase, meander upwards.  If you look through the earlier articles in this series, you would see that this bull market started as an incredibly sharp phenomenon, and has become rather average in its intensity of monthly returns.

Conclusion

It may be difficult to swallow, but this bull market that is one of the longest since 1928 is pretty average in terms of its monthly average returns for a long bull market.  It would be difficult for the cost of capital to go much lower from here.  It would be a little easier for corporate profits to rise from here, but that also doesn’t seem too likely.

Does that mean the bull is doomed?  Well, yes, eventually… but stranger things have happened, it could persist for some time longer if the right conditions come along.

But that’s not the way I would bet.  Be careful, and take opportunities to lower your risk level in stocks somewhat.

PS — one difference with the Bloomberg article linked to in the first paragraph, the longest bull market did not begin in 1990 but in 1987.  There was a correction in 1990 that fell just short of the -20% hurdle at -19.92%, as mentioned in this Barron’s article.  The money shot:

The historical analogue that matches well with these conditions is 1990. There was a 19.9% drop in the S&P 500, lasting a bit under three months. But the damage to foreign stocks, small-caps, cyclicals, and value stocks in that cycle was considerably more. Both the Russell and the Nasdaq were down 32% to 33%. You might remember United Airlines’ failed buyout bid; the transports were down 46%. Foreign stocks were down about 30%.

And then Saddam Hussein invaded Kuwait.

That might have been the final trigger. The broad market top was in the fall of 1989, and most stocks didn’t bottom until Oct. 11, 1990. In the record books, it was a shallow bear market that didn’t even officially meet the 20% definition. But it was a damaging one that created a lot of opportunity for the rest of the 1990s.

FWIW, I remember the fear that existed among many banks and insurance companies that had overlent on commercial properties in that era.  The fears led Alan Greenspan to encourage the FOMC to lower rates to… (drumroll) 3%!!!  And, that experiment together with the one in 2003, which went down to 1.25%, practically led to the idea that the FOMC could lower rates to get out of any ditch… which is now being proven wrong.

This is the third time I have written this article during this bull market.  Here are the other two times, with dates:

The first time, we had doubled since the bottom.  Second time, up 2.5x.  Now it is a triple since the bottom.  That doesn’t happen often, and this rally is getting increasingly unusual by historic standards.  That said, remember that every time a record gets broken, it shows that the prior maximum was not a limit.  If you think about that, after a bit you know that idea is obvious, but that isn’t the way that many people practically think about extreme statistics.

Let’s look at my table, which is the same as the last two times I published, except for the last line:

spx_31294_image002

Since the second piece, the gains have come slowly and steadily, though faster than between the first and second pieces.  As I said last time,

In long recoveries, gains first come quickly, then slowly, then near the end they often come quickly again.  Things are coming quickly again now, but who can tell how long it might persist.”

Indeed, and after the first piece, the market did nothing for about 16 months, after which the market started climbing again at a rate of about 1.5% per month for the last 27 months.  Though not as intense as the rally in the mid-’80s, this is now the third longest rally since 1950, and the third largest.  It is also the third most intense for rallies lasting 1000 calendar days or more.  This is a special rally.

 

spx_8180_image001

And now look at the cumulative gain:

spx_24509_image001

 

Does this special rally give us any clues to the future?  Sadly, no.  Or maybe, too much.  Let me spill my thoughts, and you can take them for what they are worth, because I encouraged caution the last two times, and that hasn’t been the winning idea so far.

  1. To top the rally of the ’90s for total size, we would have to see 2700 on the S&P 500.
  2. It is highly unlikely that this rally will top the intensity of that of the ’50s or ’80s.  Gains from here, if any, are likely to be below the 1.7%/month average so far.
  3. For this rally to set a length record, it would have to last until 12/14/16 (what a date).
  4. Record high profit margins should constrain further growth in the S&P 500, but that hasn’t worked so far.  As it is, there are very good reasons for profit margins to be high, because unskilled and semi-skilled labor in the capitalist world is not scarce.
  5. Rallies tend to persist longer when they go at gradual clips of between 1-2%/month.  Still, all of them eventually die.
  6. At present the market is priced to give 5.5%/year returns over the next 10 years.  That figure is roughly the 85th percentile of valuations.  Things are high now, but they have been higher, as in the dot-com bubble.  We are presently higher than the peak in 2007.
  7. On the negative side, it doesn’t look like the market is pricing in any war risk.
  8. On the positive side, I’m having a hard time finding too many industries that have over-borrowed.  Governments and US students show moderate credit risk, as do some industries in the finance and energy sectors.
  9. Finally, the most unusual aspect of this era is how little competition bonds are giving to stocks.  In my opinion, that idea is getting relied on too heavily for a relative value trade.  Instead, what we may find is that if bond yields rise, stocks, particularly dividend paying stocks, will get hit.  By relying on a relative yield judgment for stocks, it places them both subject to the same risks.

I still think that we are on borrowed time, but maybe you need to regard me as a stopped digital clock with a date field, which isn’t even right twice per day.  Historically, if the rally persists, stock prices should only appreciate at a 8-9% annual rate with the bull this old.

That’s all for now.  I’m not hedging my equity portfolio yet, but maybe my mind changes near 2300 on the S&P 500, should we get there.

PS — the title comes from the fact that markets move down twice as fast as they go up, so be ready for when the cycle turns.  The first article in the series focused on that.

A little more than two years ago, I wrote Goes Down Double-Speed.  I wrote it after the market had doubled from its lows two years earlier.  I want to update the piece and explain we have learned over the past 2+ years, and maybe discuss what could happen over the next 2+ years.  Anyway, here is the modified table of bull and bear markets:

spx_31294_image002

Since the last piece, the gains have come slowly, validating my comment, “But it would be unprecedented for the market to continue to advance at a 3% [per month] pace from here.”  In long recoveries, gains first come quickly, then slowly, then near the end they often come quickly again.  Things are coming quickly again now, but who can tell how long it might persist.

Maybe Goldman Sachs can tell us.  After all they increased their price targets for the S&P 500 yesterday.  Now let me republish my updated bull market graphs from the prior piece:

spx_8180_image001

And now look at the cumulative gain:

spx_24509_image001

The predictions of Goldman Sachs are both believable and unbelievable.  Believable: it’s not historically impossible for a rally to last that long, or for it to be so large.  That said the probability historically has been low.

Unbelievable: Unless revenue growth kicks in, that means the profit margin, already at record highs, will soar to an astounding record.  But won’t revenue growth begin again?  That’s hard to say, but if revenue growth starts in earnest, the Fed will start removing policy accommodation, because bank lending will be perking up.  At that point, it is anyone’s guess as to what will happen.  Therefore, I rule out Goldman Sachs’ forecast as a possibility.

The rally continues to get longer in the tooth, and its has been aggressive this year.  I repeat how I ended the original piece: “Consider trimming some of your hottest positions.”

Eddy Elfenbein wrote an interesting post on the market doubling from its bottom.  But given all of the odd things going on in the markets, and one of my mottoes is “Weird begets weird,” I asked how unusual the fall was  before the rise.  Over the last 61 years, it is unprecedented.  Here’s the table:

Return table

This table lists all of the major turning points as I see them.  The summary statistics are these: bull markets last 3.5x as long as bear markets on average.  Bear markets move at 1.9x the rate of bull markets. (double speed)

But now consider cumulative bear markets as I define them:

Cumulative Loasses

and the monthly losses versus the number of days for the loss.


The longer the losses go on, the less intense the losses are on an annualized basis.  But the loss level is higher per unit time than for gains — the amount of time spent in gains is 3.5x that of the losses.  Look at the cumulative gains:

Though the gains clump around doubling, there are two results in the triple to quadruple area — makes up for a lot of losses.

As one might expect, short rallies tend to be more intense than long rallies.  Normal rallies since 1950 tend to double the index value.  Abnormal falls cuts the index in half.

But for today that leaves us overextended.  Yes, levels have rapidly doubled versus the low.  That’s unusual; it undoes a harder than normal fall.  But it would be unprecedented for the market to continue to advance at a 3% pace from here.  That would be uncharted waters.

Consider trimming some of your hottest positions.

I’ve said this before, but I like it when research destroys a preconceived notion of mine.  Today’s post stems from an exchange that I had with Jackdamn (what a name) on Stocktwits, talking about a chart created by dshort.

S&P 500 Percent Off High Since March 9, 2009. Chart by Doug Short. $SPX $SPY $DIA

— Jack Damn (@jackdamn) Sep. 3 at 09:39 AM

I responded:

@jackdamn over a 7.5 year period, how frequently do you get 5-10%. 10-15%, 15-20%, 20%+ drawdowns? This graph looks tame to me. $$

— David Merkel (@AlephBlog) Sep. 5 at 02:52 PM

To which he responded: That’s a great question.  And it is a great question, but I’m not going to answer it directly here… because I think I am answering a better question.

Let me take you through my thought process, because I went through four different ways of trying to answer the question before settling on the better question, and getting the answer.

How do you summarize an area of a price graph in order to make comparisons of different periods?  How do you determine when the market has been near highs for a long time, or far away for a long time?  How does the intensity/distance below the high matter?  If you are looking at troughs, where does one begin and another end?

I started by trying to identify the troughs individually, and the difficulty was trying to establish that in a mechanical way that did not require interpretation.  I stumbled around playing with minimum periods between troughs, recovery levels before a new trough could start, moving averages to establish when a new trough was genuinely significant.  Sigh.

I tried a lot of different things, and I could create rules that mostly made the troughs look decent, but I could never get it to be fully mechanical or lack arbitrariness.  Why this trough and not that?  The same criticisms can be applied to dshort’s graph as well.

I finally pulled out of my mental gymnastics when I concluded: couldn’t I just take the area under the maximum line in percentage terms and use that as a measure, say over a 200-day period?  200 days is arbitrary, and so is the measure, but that is less than most of the measures that I considered, and at least this one corresponds to a relatively simple calculation.

So if you look at the red line in my graph above, you will note that it has dipped below 2.0 five times in the last 66 years, in 1954, 1959, 1964, 1995 and 2014.  These observations followed periods where the markets moved to new highs rather smartly and without a lot of downside volatility.  Then there were 3 times that the measure peaked higher than 64, in 1975, 2003 and 2009.  These times followed incredible market falls, and were great times to be putting money into the market.

Below you can see  a table of values for how often the measure is below a given threshold.  It’s only above 64 about 5% of the time, and below 2 about 3.5% of the time.  My main thought is this measure is this: high values of the measure probably are a “buy signal.”  Low values of the measure aren’t necessarily a “sell signal.”

That signals are asymmetric should not be surprising.  The largest factor in most long-term market moves, the credit cycle, is also asymmetric.  It’s like my continuing series, Goes Down Double Speed.  Bull markets have shallower moves and longer duration, the same way that the bull phase of the credit cycle goes.  Extend credit, extend credit, extend credit… loosen standards, loosen standards, loosen standards… tighten spreads, tighten spreads, tighten spreads, etc.  Then in the bear phase it is DENY CREDIT!! TIGHTEN STANDARDS!! SHEPHERD LIQUIDITY!! SURVIVE!!  Short and sharp.  Painful.  Prices are lower, and yields higher at the end.

To close this off, where is this indicator now?  It’s around 8, which is near the 40th percentile… kind of a blah figure, not saying much of anything… which is good in its own way.  The market meanders and hits a few new highs, sags a little, comes back, hits a few new highs, etc.  Not many people believe in it, but we are inches off the highs.  Odds are we go higher from here, but not aggressively higher.

One final note: we are in the fourth and final phase of the credit cycle now, so don’t get too aggressive.  Debt is getting higher inside nonfinancial corporations.  Be wary, and do your fundamental due diligence on balance sheets.

PercentileDFHI200MS
1%1.33
5%2.42
10%3.21
20%4.50
30%5.73
40%8.18
50%11.67
60%17.42
70%27.47
80%36.52
90%49.83
95%63.10
99%83.08

These articles appeared between February and April 2011:

On the Percentage of Market Cap held by Domestic Stock ETFs

Implications

  • Domestic stock ETFs tend to pick more volatile stocks.
  • Domestic stock ETFs tend to pick stocks held by major institutions.
  • Domestic stock ETFs tend to pick stocks less held by insiders.  (They tend to be more boring.)

Goes Down Double-Speed

Bear markets move at 1.9x the rate of bull markets. (double speed)

Consider the Boom in the Bust; Consider the Bust in the Boom

We would all be better off if policymakers thought at least half a cycle ahead in the credit cycle. Sadly, they are linear thinkers, and would be better off working at the county landfill, if they qualified for such authority.

Critical Analysis of Buffett’s Annual Letter

Critical Analysis of Buffett’s Annual Report

Analyzes Berkshire Hathaway in 2011.  Points at the growth in debt at BRK, and concentration risk in the subsidiaries.

Musings on Yield

Why you should not use yield as a criterion for investment.

On the Usefulness of Yield Spreads

So what does this tell us?

  • There is a credit factor that effects yields, and the effect on Baa bonds is roughly 1.5x that of Aaa bonds.
  • As Treasury yields get lower, Baa bond yields rise at roughly 45% of the rate.  There is the nominal yield need — even Baa bonds tend to need a certain nominal yield, particularly for 20+ year bonds.
  • Present yield levels are fair for long Baa bonds, to the extent that Moody’s measures them accurately.

On Con Men

So avoid complex investments.  Particularly avoid investments that you don’t understand.  At minimum, find a competent friend, or some neutral party that will look at the deal.  If you can’t find such a friend/party, don’t do the deal.  The friend is important, because he does not want you to come to harm, or lose you as a friend if things go bad.

Three Years from Now

There are real advantages to managing for the intermediate term.

Responding to a Bright Reader

Why I started a bond product.

Things are not as good as they look

Analyzing economic statistics when they don’t sound right.

Limits: Models, Governments, and Central Banks

Most writers say the governments and central banks are all-powerful.  I disagree, and I try to explain why.

Regarding David Sokol

Regarding David Sokol, Redux

Regarding David Sokol, Part 3

Regarding David Sokol, Part 4

The growing sentiment, though ahead of the crowd, that David Sokol should leave Berkshire Hathaway.

Everything Old is New Again in Bonds

On unconstrained mandates and managing for total returns with bonds.

When I was Young

What I went through in investing in my younger days.  Taught me a lot.

When Everything is Strong

When Everything is Strong, Redux

When the only thing weak is high quality bonds, what do you do?

It Would Have Happened Already, Redux

What do you do when all you hear are consensus opinions?

 

Don’t look at the left side of the chart on an empty stomach

==================

This will be a short post.  At present the expected 10-year rate of total return on the S&P 500 is around 4.05%/year.  We’re at the 94th percentile now.  The ovals on the graph above are 68% and 95% confidence intervals on what the actual return might be.  Truly, they should be two vertical lines, but this makes it easier to see.  One standard deviation is roughly equal to two percent.

But, at the left hand side of the graph, things get decidedly non-normal.  After the model gets to 2.5% projected returns, presently around 3100 on the S&P 500, returns in the past have been messy.  Of course, those were the periods from 1998-2000 to 2008-2010.  But aside from one stray period starting in 1968, that is the only time we have gotten to valuations like this.

My last piece hinted at this, but I want to make this a little plainer.  For sound effects while reading this, you could get your children or grandchildren to murmur behind you “We know it can’t. We know it can’t.” while you consider whether the market can deliver total returns of 7%/year over the next 10 years.

There are few if any things that remain permanently valid insights of finance.  Anything, even good strategies, can be overdone.  Even stable companies can be overlevered, until they are no longer stable.

In this case, it is buying the dips, buying a value-weighted cross section of the market, and putting your asset allocation on autopilot.  Set it and forget it.  Add in companies always using spare capital to buy back shares, and maxing out debts to fit the liberal edge of your preferred rating profile.

These have been good ideas for the past, but are likely to bite in the future.  Value is undervalued, safety is undervalued, and the US is overvalued.  A happy quiet momentum has brought us here, and for the most part it has been calm, not wild.  Individually prudent actions that have paid off in the past are likely to prove imprudent within three years, particularly if the S&P 500 rises 10-15% more in the next year.

People have bought into the idea that market timing never matters.  I agree with the idea that it usually doesn’t matter, and that it is usually is a fool’s game to time the market.  That changes when the 10-year forward forecast of market returns gets low, say, around 3%/year.

Remember, the market goes down double-speed.  Just because the 10-year returns don’t lose much, doesn’t mean that there might not be better opportunities 3-5 years out, when the market might offer returns of 6%/year or higher.

Also, remember that my data set begins in 1945.  I wish I had the values for the 1920s, because I expect they would be even further to the left, off the current graph, and well below the bottom of it.

This isn’t the most nuts that things can be.  In fact, it is very peaceful and steady — the cumulative effect of many rational decisions based off of what would have worked best in the past, in the short-run.

As a result, I am looking 10 years into the future, and slowly scaling back my risks as a result.  If the market moves higher, that will pick up speed.

Photo Credit: Frank N. Foode

Photo Credit: Frank N. Foode

==================================================

Moderator: Judy Shelton – Co-Director, Sound Money Project, Atlas Network

Gerald P. O’Driscoll Jr. – Senior Fellow, Cato Institute

Kevin Dowd – Professor of Finance and Economics, Durham University

Tyler Goodspeed – Junior Fellow in Economics, University of Oxford

==========================

O’Driscoll — What CBs can’t do? They aren’t prescient.  Policy discretion — results aren’t measured, and politicians blame the Fed when things go wrong, and take credit when things go right.

Politicians and Central bankers engage in “symbiotic rent-seeking.”

Fed reform would involve reducing the Fed’s scope, improving its performance and enhance its accountability.

Fed should let assets roll off the balance sheet and even sell off securities on the long.

Eliminate Fed 13.3 powers to eliminate lender of last resort powers.  Can’t implement a policy rule without that.

Wants to keep the regional Fed banks.

Dowd: “Money often costs too much” Ralph Waldo Emerson

John Law and money printing.  Sir Robert Giffen: “Governments, when they meddle with money, are so apt to make blunders.”

Allowing people to use their money freely is often viewed with scepticism.

ZIRP is not stimulative.  It is a trap.

QE/LSAP

QE — greatest Wall Street bailout of all time.

Argues that ZIRP causes productivity to drop.  Real Private Non-residential investment has only now come back.

Can’t calibrate hedges because markets are too stable.  In a crisis, that would shift.

QE has not worked in Japan.  Policy is increasingly delusional.

NIRP [negative rates] — doesn’t make sense.  If it makes your brain hurt you are sane.

Must abolish cash to do NIRP.  The most vulnerable people depend on cash.  Loss of cash is a loss of civil liberty.  Bad guys use every amenity, including cash.

Helicopter money is a form of redistribution, which should belong to Congress.  End of sound money. Hyperinflation.

The most costly money is the money that is free.

Goodspeed: We all ought to read more financial history: Those sympathetic to the elimination of large institutions today will learn.  Aids imagination.  Gives you kind of a “control group” to work with.

Prior to 1863, the US states had a wide number of approaches.  There was public, mutual, and no insurance for deposits.  He looks at contiguous counties in different states with different insurance regimes.

They had no effect on bank failure initially.  Over the long run, though, the more double liability resulted in less defaults. Public insurance —  More exposure to real estate and interbank lending, and other types of opaque lending.  Double liability took less risk prior to crises, but took more risk after crises, adding to system stability.

Seems to be that growth was the same across the counties with public vs double liability.

Scottish banks with unlimited liability.  During a balance of payments crisis — uses an extension option against British speculators.

Upshot: Socializing losses does not work well in the long-term.

Q&A

1) Benefit of QE?

Banking system bailout, nothing else

2) Ed Teryakin — what should Congress do to change the mandate of the central bank to get a better outcome?

O’Driscoll — long weak recovery; U-3 unemployment low because of people who have left the labor force

3) Walker Todd — lend in a panic only on collateral of recognizable value for lender of last resort powers?

O’Driscoll: Texas S&L crisis — collateral rules get fuddled.

4) Real purpose of stress tests?

To calm the public.  The tests are bad, particularly in Europe.

5) John Flanders, Central Methodist University — Canadian experience many fewer defaults.  Weren’t US banks over-regulated?

Unit banks less stable.  Law of small numbers in Canada.  But are fewer bank failures a good thing?

6) How did we end up with a central bank?  George and Martha Washington owned shares in the Bank of England.

Goodspeed: US banking has always had more failures. MD & VA tobacco planters defaulting on Scottish banks in 1772.

Dueling notions on the need for central banks with the Founding Fathers.  George Selgin tossed in a comment.

7) CPA — aren’t buybacks a waste of funds.  Bernanke said there would be a wealth effect, and then spending will rise.  Spending did not rise.  Wealth effect is not big.

8 ) Isn’t it a bad thing that there were no Canadian bank failures — not enough risk taking?  Morphed into a question on risk-based capital:

O’Driscoll: RBC is a disaster.

Goodspeed: Canada was not starved of capital.  Banks regulations can lead to their own set of problems. (DM: RBC creates its own weaknesses, but the one covering insurance in the US is pretty good.)

 

Rapid upward moves in volatility almost always presage a bounce rally.

Again, I am scraping the bottom of the barrel, but this is a common aspect of markets.  When things get tough, scaredy-cats buy put options.  That pushes up option implied volatilities.  The same doesn’t happen when prices are rising, because that happens slower.  Prices fall twice as fast as they rise in the stock market.

Emotions play a big role with options, and many do not use them rationally.  Rather than using them when the market is rising in order to hedge, more commonly they hedge after the market has fallen.

As implied volatility rises, the ability to make money from hedging falls, as the cost of insurance goes up.  As a result, hedging peters out, and the market will be receptive to positive news, given that most who want to hedge have hedged.  Their pseudo-selling is over, and a bounce rally will happen.

Volatility tends to mean-revert, and as the reversion from high levels of volatility happens, the value of stocks rise.  People buy equities as fears dissipate.

Volatility, both actual and implied, are tools to have in your arsenal to help you understand when markets might be overvalued (low volatility) or undervalued (very high volatility).  Use this knowledge to guide your portfolio positioning.  At present, it is more reliable then many other measures of the market.

Next time, I end this series.  Till then.