The following is a break from my usual weekly review/preview pieces
Ok, we know things are getting worse before they get better. You’ve heard it before. There’s the global slowdown, the EU crisis threatening to become a global one, etc.
So the big question on everyone’s mind is, how bad can it get? How low will it go?
Conceivably a lot lower than most believe, even if we just look at a few very basic bits of technical and fundamental evidence.
There are long term technical and fundamental indicators that the current downturn is part of a much longer term move lower. The following is far from a conclusive, thesis. Rather, it’s a starting point for both further study and formation of long term view of where markets are headed.
Some Technical Evidence
Chart 1 below shows a nearly 20% drop since recent May 2011(C) high, which has provided a distinct lower high that confirms the bearish double top pattern formed by the highs in 2000 (A) and 2007(B).
Chart 1: S&P 500 MONTHLY CHART DECEMBER 1999 – SEPTEMBER 2011 04 oct 08 2054
Points to note:
1. We have additional confirmation of a long term downward momentum from the index having broken below strong support in the 1200-1144 range which included:
- The 50% fib retracement level (not shown in order to keep the chart from being too cluttered)
- The 20 (yellow), 50 (red), 100, (purple) and 200 (pink) month EMAs.
Again, those are MONTHLY EMAs that should provide strong support, and the uptrend on which that Fib retracement was based was formed over 6 years. These are serious long term support levels. Gone.
A valid bearish double top reversal pattern needs to be preceded by a long uptrend. We’ve got that too.
In Chart 2 below, of the S&P 500 dating back to 1950, we see that long prior uptrend. You could measure it from around, 1990, 1987, or around 1975. The point is, the double top was preceded by a long uptrend, which in turn was part of an even longer term uptrend over the course of the entire period covered.
Chart 2: S&P 500 04 1950 – 30 SEPTEMBER 2011 oct 06 1637
This 60+ year perspective highlights how prominent the 2000 – 2007 double top is, how clearly it stands out compared to earlier topping patterns.
Here’s the scary part. The general rule of thumb for Head and Shoulders patterns is that the potential pullback is double the distance from the tops to the neckline. The tops (A and B in chart 1) were at about 1500, the neckline was at about 800, a 700 point drop or 46%! Another 700 point drop from that neckline at 800 would bring the S&P 500 to 100, a 93% drop!
Obviously you wouldn’t base your long term portfolio strategy on this one indicator, though.
The Fundamental Case For A Prolonged Down Cycle
Still, there is significant fundamental evidence that markets are in a multi-year downtrend. See two of the most popular financial books in recent years:
- This Time It’s Different: Eight Centuries of Financial Folly, Reinhart & Rogoff, 2009, Princeton University Press
- Endgame: The End of the Debt Supercycle and How It Changes Everything Mauldin & Tepper, Wiley & Sons, 2011
Both suggest the fundamental outlook for the coming years are likely to be bleak as a “global debt super cycle” (per Mauldin & Tepper) requires years to work off even if policy makers do a good job and are able to manage a controlled descent. If they fail, that steady glide lower becomes a crash landing, with all the panic selling overreaction implied. If they fail over the long term, we get a series of plunges, each leaving markets with refreshed memories of losses and thus more inclined to selloffs. If that happens, then over a matter of years, possibly decades, the S&P at 100 (adjusted for what could be considerable inflation) is not inconceivable. Panics by nature lead to extreme selloffs.
Augmenting the case for a long slide lower:
1. Demographics Of The Leading Economies: The case for a long term downturn in risk assets is strong when we consider the demographic picture in the US and the rest of the developed world, where populations are ageing. That means a shrinking proportion of asset buyers to prop up prices and a larger proportion of asset sellers who need cash to fund retirements or semi-retirements. The threat posed by a shrinking population of investors and rising population of retirees liquidating assets is perhaps most dangerous in Japan, where already about 25% of the population is over 65. Consider:
- Japan has the highest debt/GDP in the developed world, around 200%
- Yet its 10 year bonds yield only about 1%, because of strong domestic demand.
- Even with those low borrowing costs, Japan’s debt service expense consumes about 25% of its national budget. We’re not even looking at local or municipal debt.
- Japan’s demographic time bomb means it’s a matter of when, not if, Japan needs to sell more bonds in the international market at higher cost. Even if it could sell 10 year bonds at only 2% (US 10 year bonds pays over 3%) that would put debt service expenses at over 50% of the national budget, bankrupting the world’s 3rd largest economy.
None of this is new. Japan’s ongoing slow motion train wreck widely noted, but as with Europe’s debt crisis, there’s no solution thus far.
2. The very real threat of severe downturn in Europe at some point in the coming years, possibly months or weeks, is by now well known. It seems as if a week doesn’t pass without some figure of importance warning of Europe’s imminent collapse. See here for just one from the past week from IMF advisor Robert Shapiro, who told a BBC interviewer:
If they can not address [the financial crisis] in a credible way I believe within perhaps 2 to 3 weeks we will have a meltdown in sovereign debt which will produce a meltdown across the European banking system.
We are not just talking about a relatively small Belgian bank, we are talking about the largest banks in the world, the largest banks in Germany, the largest banks in France, that will spread to the United Kingdom, it will spread everywhere because the global financial system is so interconnected. All those banks are counterparties to every significant bank in the United States, and in Britain, and in Japan, and around the world.
This would be a crisis that would be in my view more serious than the crisis in 2008….
Before you dismiss him as just another doom-and-gloom type, as the article’s author so eloquently puts it:
And Shapiro is not just some random guy living with his girlfriend.
Aside from being an advisor to the IMF, Shapiro is the co-founder and chairman of Sonecon, LLC, and was formerly the U.S. Undersecretary of Commerce. He has a Ph.D. from Harvard, among other degrees, oversaw the Census Bureau, and has been a Fellow at Harvard, Brookings, and the National Bureau of Economic Research.
If either Europe of Japan hit an economic collapse, the risks for more of the same elsewhere rise as supply chains and consumer demand is disrupted.
3. Kondratiev Wave Theory: In essence argues for the existence of 40-60 year economic super cycles.
So our long term bias is to seek strategies that will benefit from a bear market. In other words, it should involve shorting risk assets and being long safe haven assets. Of course there will be intervening bull markets over the coming years, but these are more for trades most likely held for playing shorter term counter moves lasting a matter of months or a few years.
DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING DECISIONS LIES SOLELY WITH THE READER. IF WE REALLY KNEW WHAT WOULD HAPPEN, WE WOULDN’T BE TELLING YOU FOR FREE, NOW WOULD WE?