Sector Rotation: Short-term Rotation Charts - Part 4

Hello all, welcome back!

Given the impact sector rotation has on the outcome of investing, I will post a number of charts here detailing how the various sectors either had outperformed or underperformed the S&P500 over the last 13 years. From the charts, you will see how funds rotate during shorter phases of bull and bear market runs. Please bear in mind the charts here are shorter-term in focus (weeks and months) compared to the sector analysis done in earlier postings which generally delved into sector returns over medium to longer term. Shorter-term cycles are much more influenced by speculative moves in anticipation of and response to many factors such as government decisions on bail-out, intererest rate changes, bond purchases, wars, crisis, demand and supply of oil and commodities, strength of economies and even scandals rocking the markets. Often these serve as catalysts for an overbought sector to correct or for an oversold sector to rise, as evidenced in the following charts.

For the last decade or so, a significant part of the bull run was driven by asset inflationary pressures due to low rates for an extended period of time. There was expectation that countries like China would continue its unabated growth and hence, the demand for commodities and oil would continue to rise. There was a buoyant mood leading to Beijing Olympics 2008 despite soaring oil and and commodity prices exerting strains on global economic growth. 

In the following charts, note how similar sectors rise and fall (relative to S&P500) during bull and bear market runs over past decade. 

 

 

 



 

In summary, if you are a shorter-term investor or trader, it pays for you to understand the strongly trending sectors in a bullish market and the defensive sector positions you can take during a bearish market. Understanding sector rotation will keep you on the right side of the market and help reduce risks while improving profitability.

 

 

Sector Rotation : Achieving Diversification Benefits - Part 3

In the last two postings, you have seen how investing in the strong trending sectors can outperform the market by an average of 25% per year. A worst performing sector, on the other hand, would have generated an average of 15.5% lower returns than market. Understanding where institutional funds are flowing based on an understanding of economic cycles will give us a clue on what the leading sectors will be. I also shared how a longer-term strategy of selecting low-volatility (ie. low beta) sectors will generate the best sector returns. Going further, it is possible to select low-volatility (ie. low beta) stocks from low-volatility (ie. low beta) sectors but with nice earnings growth to boost longer-term returns.

This week, I will touch on how sector investing, with its many benefits, can achieve diversification that will especially help during this decade of turbulence as we ride out the remaining half of the 20-year secular bear market.

First, you see from the table T1 below that 52% of a stock price movement is attributable to company specific developments, with the remaining half impacted by prevailing market and sector conditions. While local market influence on a stock price movement is waning (from 23% in 1995 to 15% in 2008), we see global sector influence on a stock price movement increasing (from 7% in 1995 to 18% in 2008). 


T1 : Influences on stock performance

Second, as seen in table T2, the correlation of monthly returns between SP500 and international EAFE index has risen from 0.5 in the 70s to 0.82 in the past decade. International investing hence gives little diversification benefits now as markets become more inter-connected due to globalisation. 



T2 :Correlation of Monthly Returns : S&P500 vs EAFE

Third, this correlation is even stronger during bear markets than bull markets as seen in the table below. A panic in one market can easily spread across to another like wild fire. International investing does little to diversify risks during bear markets, when capital preservation and risk reduction are most critical. This is evidenced in table T3.

T3 : Bear and Bull Market Correlation of Monthly Returns

Fourth, table T4 reveals that sector investing can be more effective in achieving diversification in a portfolio as correlations between sectors and S&P500 can go as low as 0.40 over the past 10 years.

T4 : Correlations across sectors & S&P500

In summary, if you have a relatively large portfolio and see the need and benefits to diversify, you will do better by investing in multiple different sectors than just investing across international markets. Due to globalisation, few markets, if any, are spared from any global meltdown.

Sector Rotation : Volatility & Returns - Part 2

Hello, welcome back!

In the last posting, I highlighted how sector returns vary as funds flow across sectors in anticipation of changes to economic and business cycles. As these trends are likely to last from months to several years, investing in the best stocks in the favoured and strongly trending sectors can give you a sustenable edge in investing.

This week, I will touch on the relationship between sector volatility and returns. If you are into sector investing and you also take a longer-term view towards investing, you should understand the volatility effect as many investors tend to overpay for volatile stocks over the long haul, most dramatically during bear markets.

To start off, beta has been a statistical measure introduced in the 1970s to determine how the investment return of any asset moved compared to the overall market. With the beta of the S&P500 index set as 1.0, stocks (or sectors) that have tended to swing more than the market will have betas above 1.0, and those less will have betas below 1.0.

Below is a sector beta matrix of the various sectors. You will see high median betas (or volatility) for sectors like Technology, Materials, Industrials and Consumer Discretionary. Conversely, the noticeably less volatile sectors are the likes of Utilities and Health Care. If you recall from the last posting, these are sectors that are in favour as funds seek safe shelters when fears about impending economic recession increase.

As you can see from the matrix above, sectors which are less volatile tend to have more stocks within them that are also less volatile (betas less than 1.0). For the longer-term investors, this can be the key to achieving lower risk yet without lower returns.

It is a well-documented fact that high-beta portfolios tend to deliver weak long-term returns with well above average risk. Why is this so? Shouldn't higher risks and higher returns go hand-in-hand? Not necessarily so, especially in the longer-term.

Because studies have found that low-volatility stocks generally underperform the market during up months but they will outperform the market during down months. The critical consideration is the underperformance during up months being considerably smaller than the outperformance during down months. The opposite is true for high-volatility stocks. And this trend holds true at the sector level as well as across subperiods and for different intervals of historical volality.

What this volatility effect reveals, in essence, is that investors tend to overpay for volatile stocks over the long haul, most dramatically during bear markets.

Below is a chart comparing the annualised returns of high-beta and low-beta sectors with the S&P500 over a 25 year period.

As you can see, the commonly held theory that you can do no better than the market without taking on more risk is flawed. In the long haul, it is possible to generate superior returns by investing in low volatility or low beta (ie. low risk) sectors. This applies to stock investing too as it is possible to find low-beta stocks which can also generate nice earnings growth and hence stock price appreciation.

This revelation will present a viable sector investing strategy for those more passive, longer-term investors who may not be inclined or ready to take advantage of opportunities arising from the rhythm and flow brought about by shorter-term sector rotation.

Sector Rotation : Where the smart money flows - Part 1


Hi everyone, welcome back!

In the previous postings, we have made detailed observations and studies into the secular market cycles over the past century. This is important to successful investing because cyclical changes in market conditions often have a critical impact on assets allocation decisions and investing strategies and outcomes.

Successful investing requires understanding the movement of money and funds across asset classes, markets and critically, across sectors in the equity market (our focus today). Money flows from one sector to the next as price changes reflect varying degrees of growth and risk premiums in response to anticipated changes in macro conditions. Growth can relate to prospects of the companies or the economies while risk can relate to crisis unfolding in the industry, the companies themselves or the macro-economic and geopolitical uncertainties. In short, market prices will continuously seek to price in anticipated growth opportunities and risks.

As these trends are driven by some underlying fundamentals rather than technical considerations, they can last from months to even years. Hence sectors which are over-bought (over-sold) can remain over-bought (over-sold)for a long time.

In this posting, I will share with readers specifically the concept of Sector Rotation. To appreciate its importance, one only has to recognise that 50% of a stock's price movement can be attributed to its sector's price movement. If a sector is in favour (money pouring in), even mediocre stocks in this sector will perform well. As a rising tide lifts all boats. Conversely, if a sector is falling out of favour (money flowing out), even the best stocks in this sector will be hard pressed holding up their prices.

As different economic sectors are stronger at different points in the economic cycle, money will anticipate this and flow into different sectors at various points in time. Below is a Sector Rotation Model explaining which sectors may benefit at various points in the economic cycle. Note that the financial markets will always lead the physical economy by at least 6 months as investors collectively anticipate future developments. That is why you see stock markets bottoming out and rebounding when the physical economy may still be deep in recession and where maximum pessimism often prevails.

Source: Sam Stovall's S&P's guide to sector rotation.

The economy and stock market cycles go through four phases.

1. Economy in full recession. Stock Market often bottoms out.

In this phase, economy is contracting, Fed cuts rates, consumer expectations bottoming and yield curve steepening.

Best performing sectors are: Basic Materials, Technology, Industrials and Finance

2. Economy in early recovery. Stock Market is in a bull run.

In this phase, economy starts to expand (moving out of recession), consumer spending rising, industrial production growing, yield curve turned upward sloping.

Best performing sectors are: Industrials (peaking near beginning of this phase), Technology (peaking near beginning of this phase), Consumer Discretionary, Energy (beginning near end of this phase)

3. Economy in full recovery. Stock Market topping.

In this phase, as economy expands strongly, Fed raising rates to fight near-term inflation, yield curve flattening, consumer expectations beginning to decline, industrial production flattening or declining.

Best performing sectors are: Energy (peaking near the beginning of this phase), Consumer Staples (beginning near the end of this phase), Health Care (beginning near the end of this phase)

4. Economy in early recession. Stock Market in a bear run.

In this phase, waning GDP growth, consumer expectations in the pits, industrial production declining, intrest rates are high and peaking, yield curve is flat or inverted as uncertainties about the future impact on long-term corporate borrowing and investments.

Historically profitable sectors are: Health care, Consumer staples, Utilities.

Below is the actual performance of the best and worst performing sectors since 1999. As you can see, pursuing a sector strategy can proof very profitable. The best performing sectors out-perform the S&P500 by an average of 25% while worst performing sectors under-perform the S&P500 by an average of 15.5%.

By identifying the strong sectors and buying the best stocks in only those sectors while avoiding stocks from out-of-favour sectors, you will have given yourself a critical edge with improved odds of successful investing. What is encouraging to note is one can out-perform the market without necessarily taking on excessive risks by being invested in these strong trending sectors or the best stocks found there.

In the next few postings, I will talk about how sector investing is more effective than international investing to achieve diversification benefits and by studying sector volatilities, to suggest a low-risk investing strategy that can still generate superior returns riding on sector momentum.

I will then share with you ways to identify strong trending sectors as money move into these sectors, which always will last for months or years, giving the investors adequate time to respond and take advantage of these opportunities.

Stay tuned in two weeks' time!

Hi, thank you for visiting. I will be writing my next posting a week later. Going forward, I will post fortnightly given my tight travelling schedule. Thank you for reading.

Market History: Secular Cycles & Fundamental Valuations - Part 5


Hello everyone! We've spent the past couple of weeks identifying bull and bear secular cycles over the past 90 years. We've examined how these cyclical markets were formed as macro-economic policies taken in response to prevailing economic and geo-political conditions often have long lasting ramifications over the next decade or so that can swing the economy from one extreme to the other. Periods of contraction would led to expansion to inflation and as cooling measures took shape, the economy would contract once again sometimes leading to deflation. Likewise, investors can swing from feeling euphoric to great fear as market tops and bottoms are often formed during these extreme sentiments. And so the boom and bust cycles continue from one extreme to the next.

We've seen how interest rates, foreign exchange rates, budget deficits, taxes, fiscal policies, wars and crisis of different kinds have also unfolded to bring about many trends and counter-trends in the markets.

Today, I am going to share with you how valuations have also historically trended in cycles. This will have important implications for investors as I will explain later. 

From the chart below, you can see market trailing PEs oscillate between a low of 6.64 to a high of around 24 for most part of history. Historical average is around 16. Market PEs generally rise during secular bull markets and fall during bear markets. We saw big spikes in market valuations (PEs over 40) over the last decade that quickly led to a crash in prices following the sky-high valuations for internet companies and the subsequent boom in energy and commodity prices.

Because of the cyclical nature of prices and the expansion and contraction phases of EPS due to business cycles, it is critical for investors to realise that buying equities at different market PE levels will produce varying returns, even if held over the long-term like 10 years. This will have an important implication for asset-allocations.

To illustrate this, I have produced another chart below overlaying the 10-year subsequent returns (annualised) following each year's recorded market PE. You can see initiating purchases of equities during high market PE levels are unattractive as the coming 10-year returns could even be negative (-1.38%). In contrast, buying at lower market PE levels could yield over 20% annualised returns in the subsequent 10 years!

Hence, despite the well-known fact that long-term average return for equity investments is an annualised 9.37% (between 1930 and 2010), the actual disparity in returns for equity investors can be huge. The critical consideration is your point of entry.

Equity markets can only advance strongly through a combination of higher earnings and a low starting market PE ratio.

Given our current market PE is at long-term average of about 16, and Q ratio (measure of market value over book value) is currently above 1.2 (over-valued) and that we are currently in the midst of a secular bear market which may likely mean slowing EPS growth, probability of mean reversion is high.

In conclusion, from a fundamentals perspective using market valuation analysis, we have now arrived at a similar outlook on the equity market in line with the secular bear market trend we have observed earlier from the charts. Equity investments are likely to produce relatively sluggish returns below the historical market norms for the coming 8-10 years - the remaining span of this secular bear market we are currently in.

Hi, thanks for visiting this blog. I am travelling this week and am unable to write. Will be back next week. See you next Sunday.

Market History: Secular Cycles - Part 4

The start of the new millennium coincided with the beginning of the next secular market cycle. Ever since the end of World War 2, credit has expanded faster than GNP. Government debt expansion, an easy monetary environment and increased use of leverage by consumers and corporations further contributed to inflationary asset growth and a record economic boom since the early-80s.

# 2000 - 2020 : Secular Bear Market

The super bubble that formed, dating to its inception to 1980, inevitably led to a cycle of bust as prices must revert towards the equilibrium level at some point in time. Since year 2000 (a span of just 12 years), the equity markets already witnessed 2 severe crashes, one correction and another flash crash - a definitive characteristic of a secular bear market we are currently in.

The severe plunge of Nasdaq (and along with it, the Dow and S&P) in year 2000
saw a total of $8 trillion in wealth lost in the market decline. The internet euphoria led to the unfounded belief that in the new age economy of the new millennium, company valuations were less important or relevant in view of the limitless growth potential arising from this internet revolution and how the world could be transformed. By year 2000, stocks were trading in the hundreds and some in the thousands on a P/E basis. The IPO market even had new companies  losing tons of money with no hope of profit until many years down the road but trading at over 1 billion dollar market cap.

Stocks were certainly over-valued. At the same time, there were problems brewing in the market. Corporate fraud saw many companies like Worldcom and Enron inflated their profits by means of shady accounting practices to hide debts and inflate revenue and assets to mislead banks, investors and regulators. Corporate officers awarded themselves with outrageous stock options that diluted sharholders' value. Conflict of interests also arose as analysts and investment bankers worked closely together such that whenever a company was trying to raise capital, the investment bankers made sure their research  firms would put favourable ratings on stocks, misleading the investing public. In some cases, analysts had favorable ratings on stocks less than a month before the companies filed for chapter 11 (bankruptcy). The advent of the internet and online trading at around that time also gave many individuals a quick and cheap way to trade the markets. This led to millions of new traders hitting the markets with little or no experience, further driving up prices by these retail investors before reality returned and the market caved in.

In 2008, the stock market cratered as another financial crisis struck, one that would trigger what would be known as the Great Recession. Had it not been for the sustained and concerted government intervention to support the financial markets, the collapse would have much more disastrous consequences on a global scale that could surpass the Great Depression of 1929. While inflationary pressure such as from rising oil and commodity prices threatened global economic growth, it was the US housing meltdown that triggered the Great Crash of 2008.

The crisis could be traced back to the Government's desire and drive to promote home ownership amongst Americans as it became an important political agenda to win electoral votes. A robust construction sector also bode well for the economy. Unfortunately, the Federal Reserve supported this political objective by keeping interest rates artificially low for too long a period while encouraging banks to expand mortgage credit. Demand for mortgages rose rapidly as Americans not only borrowed to finance the house they lived in but also overleveraged to purchase more houses to flip in anticipation of a quick profit. As the mortgage market became very competitive, mortgage brokers proliferated and banks started to drastically drop underwriting standards in order to keep or grow their market shares. They dropped income requirement criteria and sold ARM (Adjustable Rate Mortgages) to make the new mortgages affordable in anticipation that home prices would continue to rise and that would allow borrowers to re-finance when higher rates kicked in later. Basic credit principles were cast away. Banks instead resorted to loan securitisation which effectively removed mortgage assets from their books, believing their credit risks were eliminated while freeing up capital to underwrite even more mortgages. All these while, regulators subscribed to the ideal of a free market economy from the Reagan years and scorned at over-regulation. Federal Reserve and the Congress continued to prefer a laissez-faire attitude towards supervising banks and the derivatives markets. The Federal Reserve also mistakenly believed that loan securitisation would indeed help remove risks from the US banking system as these securitised assets were sold to investors elsewhere and globally and the resultant risks would be effectively diversified. To make these mortgage-backed securities or Collateralised Debt Obligations (CDOs) more attractive to investors, insurance companies like AIG provided default insurance while rating agencies like S&P and Moodys accorded top credit ratings to these derivatives. To manage these risks, there were also many financial swap transactions involving various financial and non-financial institutions, that effectively created huge and highly complex counter-party risks when the crisis eventually unfolded.

The housing market collapse soon led to a collapse in the CDO and CDS markets as these derivatives were basically written on unsound sub-prime mortgages. Many banks, insurance companies and even pension funds were severely implicated as holders of these supposedly safe derivatives. The collapse of Lehman Brothers sparked off a panic and rapid loss of confidence in the entire banking system as the extent and magnitude of losses from counter-party obligations became too complex to determine. Banks became fearful of lending to each other which effectively froze the money markets. This led to the Federal Reserve stepping up its lending in the money markets and structuring TARP bailout of the major financial institutions whose capital base was decimated but deemed "too big to fail" like AIG, Citigroup, Bank of America and JP Morgan. Their collapse was thought to pose severe systemic risks to the global financial system. FDIC took steps to assure depositors to avert potential bank runs. Freddie Mac and Fannie Mae were re-consituted and so were companies like General Motors as the housing market collapse caused a widespread decline in economic activity in the US and across the world. The housing collapse was further exercabated by the glut of homes the developers built during the boom years creating a supply overhang currently. The volume of foreclosure added to the supply glut that would continue to keep US home prices depressed for a number more years to come (see my earlier post in this blog captioned "Future of the US" on how and when the economy and housing market would turn around).

The Federal Reserve expanded its balance sheet as part of its quantitative easing program to keep rates low to fight deflation and unemployment. It actively bought Treasuries and Mortgage-Backed securities to keep rates low so the housing market could stabilise and banks hopefully would be incentivised to lend more given the wide lending margin which in turn would enhance their earnings and help re-capitalise them.

Consequently, the US government ran into record budget deficits of around $1.4 trillion annually since 2009 or around 10% of GDP each year. Simply stated, $1.4 trillion is approximately the amount of debt the US accumulated from its founding until 1984. In a single year, the US government would outspend its income by as much as it did during two entire centuries of cross-continental expansion, civil war, depression, world wars and the implemenation of the modern social welfare state. Going forward, it is likely to add more than $900 billion a year to its national debt. The largely monetary policies so far have helped avert a deep-seated recession and yet inadequate to stimulate employment growth. The massive US budget deficit offered little hope for fiscal stimulus unless tax policy changes are made as well as government spending on social security and the military reformed.

The two major crashes in this secular bear market were violent and would take a longer time to recover.

(a) Dot-Com Crash of 2000

        - Nasdaq declined 79% (from peak of 5132) over 30 months
        - Nasdaq has not reclaimed its prior peak till today
        - SP500 declined 49% over 30 months
        - SP500's full recovery took 60 months

 
(b) Financial Crisis of 2008

        - Market declined 58% over 18 months
        - Market has not reclaimed its prior peak till today


Outlook

US economic growth is likely to muddle along over next few years till end of this decade unless external shocks like Eurozone became severe enough to derail its growth. Strong growth in foreign economies, especially those in Asia and China, pent-up consumer and business demand and an accomodative monetary policy are likely to support growth in the US in the near-term. Yet, there remains challenges such as a huge deficit, unemployment, tepid housing market, risk of inflation in future and policy uncertainties from the next administration(s).

Meanwhile, corporate earnings growth remain strong and resilient with record cash per share. Reinvestment will return when market clarity improves and that should further boost earnings growth justifying higher share prices.

By 2020 (end of this secular bear market), Dow should be trading between 15,000 and 18,000, S&P500 between 1,500 and 2,000 while Nasdaq should exceed 4,000 points.

Sluggish growth and volatilities are likely characteristics defining the equity market till 2020.

Hi everyone, please tune in again in two week's time. I am traveling and unable to write. Thanks for visiting.

Market History: Secular Cycles - Part 3

Hi, everyone. For many, the market volatility persisting over the past decade is disturbing. Will we see better times ahead? Let's get on with this part of the analysis on historical market cycles.

# 1980 - 1999 : Secular Bull Market

Since 1965 when President Johnson increased deficit spending to fund the Vietnam war, inflationary pressure began building. The collapse of the Bretton Woods system, the de-linking of USD to Gold in 1971 and the consequent oil crisis in 1974 and 1979 further fuelled inflationary pressures. Soaring oil prices compelled many American businesses to raise prices. Food harvest failures around the world at this time led to soaring prices on the world food market. High inflationary expectations led to a self-fulling cycle of higher prices.

By early 80s, runaway prices pushed inflation to 13.5% while unemployment rate reached 9.7%. US was experiencing stagflation. To wring inflationary expectations out of the system, Paul Volcker was nominated by President Carter as Chairman of Fed and he decided to put the nation through an intentional recession by raising rates. Fed's discount rate went to as high as 14 percent in 1981. Prime rate in the US hit a record 21.5% around that time.

By 1982, inflation abated. The war against inflation was won. Monetary policy was substantially eased and President Reagan introduced tax cuts and continued with deregulations. Within months, the economy roared to life and took off on an expansion that would last 7 years - the greatest peace time expansion in US history.

Geo-politically, the Cold War came to an end with the collapse of Soviet Union. In the middle-east, Iraq invaded Kuwait that led to a subsequent US invasion on Kuwait and attack on Iraq.

One notable market crash occured this period was The Black Monday crash. In a single day, the Dow fell 22.6%, wiping out $600billion in market capitalisation. The prior bull market had been fueled mostly by hostile takeovers, leveraged buyouts and "merger mania", a believe at that time that companies could grow exponentially simply by purchasing other companies. Consequently, there was a scramble to raise capital to finance these buyouts including issuing junk bonds to the public. Many shady IPOs were proliferating while investors were caught up in a contagious euphoria punting on these companies disregarding their true valuations. Insider trading was becoming rampant. Seeing a growing inflationary concern, the Fed began raising short-term interest rates to temper the economy and stock market. The barrage of SEC investigations and crack-down on insider trading further rattled investors who decided by October to exit what they now believed to be a rigged game and move into more stable fixed income securities (whose yields rose from just 7.4% at beginning of 1987 to over 10% in the summer before the crash). While some attested the crash to program trading, portfolio insurance, proliferation of derivatives, market illiquidity and over-valuation, these are really structural issues that would not trigger the panic selling. Rather the market was responding to failings in regulatory regime and congressional policies that undermined market integrity resulting in loss in investor confidence culminating in Black Monday.

The 1990s were also boon years for the economy. Helped by increased tax receipts as a consequence, President Clinton achieved a surplus budget which reduced the debt burden accumulated under the Reagan and Bush years. This helped keep interest rates low arising from reduced government borrowing which in turn spurred the economy. The economic boom of the 1990s was the longest sustained period of growth in American history. Unemployment and inflation fell to their lowest levels in 40 years. The stock market soared on the back of the dot-com boom, wages rose, crime rates fell, and the number of people on welfare declined.

Over this 20-year period, the US economy grew over 3.4 times larger, market EPS quadrupled and S&P soared from 140 to 1500 (over 10 times).

During this secular bull market, there were a few market corrections.

(a) Correction A - 1981 - Paul Volcker bitter medicine

      - Market declined 28% over 20 months
      - Full recovery took 3 months

(b) Correction B - 1983

      - Market declined 12% over 16 months
      - Full recovery took 6 months

(c) Correction C - 1987 (Black Monday crash)

      - Market declined 32% in 1 month
      - Full recovery took 22 months

(d) Correction D - 1991 - pre- Iraq / Kuwait war

      - Market declined 21% in over 3 months
      - Full recovery took 4 months

(e) Correction E - 1998

     - Market declined 25% in over 3 months
     - Full recovery took 2 months

Nonetheless, secular bull markets tend to be resilient with shallower corrections and generally shorter recovery periods. In the next posting, we will examine the most recent 10 years in this new millenium and postulate where we will go from here in the coming years.

Hi, I am travelling this weekend. Not able to write. Please tune in again next Sunday. Thank you.

Market History: Secular Cycles - Part 2

Hi, thanks for returning! I wrote about cycles last week and attempted to identify the secular cycles persisting since a century ago. Let's continue with our journey.

# 1940 - 1959 : Secular Bull Market

As US was drawn into World War 2, the US Federal government ran enormous deficits to fund the war against the Nazis in Europe and Japanese in Far East. Government spending % GDP rose to over 53% while debt % GDP exceeded over 110% during the war years. After the war, massive US investments and loans were made to re-build war-torn Europe and Japan. The war brought about rapid expansion to the sluggish US economy otherwise still in the throes of the Great Depression. Peace and prosperity returned for most Americans.

In an effort to free international trade and fund postwar reconstruction, nations began fixing their exchange rates by tying their currencies to the US dollar (Bretton Woods agreement) as the US government pledged a US dollar to 35 oz of gold bullion. The US dollar became a reserve currency for many nations and it began replacing the Sterling pound as the currency for international trade and commerce. The start of the Gold standard ushered in the golden age of the US dollar.

The end of WW2 also created heightend state of tension between the former Soviet Union and US as each fought for supremacy and over ideological differences. The fight against fascism and imperialism in WW2 had turned into a containment war against communism. This brought about the US invasion of Korea in the South in 1950 as fear escalated that Soviet Union would "export" communism to other Asian nations, following the fall of the Nationalist government in China to communist Mao.

Over this 2-decade period, corporate earnings rose strongly. Market EPS grew from $0.10 in 1940 to $0.35 by 1959 (3.5 times increase) buoying the S&P500  from 13 to 60 (4.6 times increase). US economy grew by 5 times over same period. This strong market performance, coupled with only shallow pullbacks, had all the makings of a secular bull market. This was the golden era for the US and Americans.

(a) World War 2 (1939-1945):

      - Market declined 38% over 30 months
      - Full recovery took 26 months

(b) Korean War (1950-1953):

       - Market actually moved higher by over 20% during this period.

# 1960 - 1979 : Secular Bear Market

While the US economy continued to grow strongly over the following 2 decades, the world was plagued by regional conflicts (such as in Middle East and the Vietnam War) and significant turbulences in the world's economic system. President Kennedy was also assassinated in 1963.

Apart from the Cold War rivalry between the former Soviet Union and the US which culminated into an arms race and a race into space (US Apollo landing on the moon in 1969), the collapse of the Bretton Woods system in 1971 created huge market turmoil when the US dollar was offically de-linked from gold and exchange rates were allowed to float. This transition to a fiat currency and managed float system was rocky and characterized by plummeting stock prices, skyrocketing oil prices, bank failures and severe inflation. This set off a decline of the US dollar and appreciation of gold prices, reaching $800 an oz by 1979.

In the midst of these turbulences, Nasdaq opened in 1971 and a few important technological innovations were achieved in the US. ARPANET, a predecessor of the Internet we know today, was set up in 1969 by the US Department of Defense in partnership with four universities. The first desktop computer (Altair) was developed in 1974. A powerful technological revolution that was taking shape in the US eventually led to a multi-decade run-up in Nasdaq, reaching a high of 5000 points in 2000 from low of 55 in 1974 (a 90-fold increase over a 25-year period). 

By end-1979, the US economy expanded by 4.9 times compared to where it was in 1960. Market EPS grew from $0.35 in 1960 to $1.50 by 1979 (4.3 times increase) but S&P was at around 140, just about 2.3 times higher than it was 20 years earlier. This period also witnessed 4 market corrections of at least 20%. This was a secular bear market for equities characterised by slower price growth, increased volatilities and more frequent and steeper corrections.

(a) Correction 1 (1962) - Cuban crisis

      - Market dropped 28% over 3 months
      - Full recovery over next 10 months

(b) Correction 2 (1966)

      - Market dropped 21% over 8 months
      - Full recovery over next 7 months

(c) Correction 3 (1969)

      - Market dropped 35% over 17 months
      - Full recovery over next 22 months

(d) Correction 4 (1973) - Oil crisis / Arab Oil Embargo / Nixon's resignation

      - Market dropped 46% over 21 months
      - Full recovery only 6 years later


Please tune in again next week.

We will conclude our market analysis and we will find out where we are now in the cycle and make an attempt to see where our future will head towards.

Market History: Secular Cycles - Part 1

Hi, welcome back. For this week and next, I will walk you through a brief journey back in time. A study on financial markets history is always instructive to understand how markets will behave.

Scientists are beginning to discover that the Universe manifests itself in countless observable cycles. From the smallest sub-atomic particles to the largest clusters of galaxies, they follow some kind of cyclic yin-yang order or rhythm. Likewise, societies progress, mature and decline before renewal sets off yet another cycle. What about the financial markets?

Prices may appear to move randomly, but with study show an underlying order and structure. Cycle analysis, Elliot waves, Kondratieve waves, Gann squares, angles, Fibonacci relationships and even postulations of planetary influences on financial markets are constructs and tools to help us uncover this underlying order. Psychologists and economists have also given a go at explaining the cycles of market boom and bust by attributing them to human behaviour through emotional cycles of extreme greed and fear, creating maximum energy at levels where turning points often happen. So, it seems, cycles are everywhere.

Recently, i purchased some data of the major US stock market indices over the past 100 years. When you have an opportunity to look at these vast amount of data plotted on a large chart, you will be amazed to see how the secular cycles (each lasting approximately 20 years) playing out in the stock market over the past century.

To many investors, the critical question is to know where we are now in the cycle so we can have some foreknowledge of what may be coming our way. Some call this forecasting.

In this and the next posting, I will share with you the secular cycles over the past century that I have identified from the charts. Whether to help you better prepare for the next looming crisis or just to pique your curiosity, I will outline the various crisis in each of these secular markets. I have also computed the exact magnitude the market moved and the time taken for a full recovery each time a crisis occured. You should find this information instructive. In each large secular cycle, there are usually one or more shorter counter-trend cycles.

So let's get started now! Back to the year 1906 we go.

# 1906-1919 : Reformative years

In the beginning of times, chaos reigned. Regulations and oversight in the financial markets were lacking and financial panics were rife. This was also the period where US continued to build on its industrial might having recently overtaken England as the world's largest economy. Ford Model T was introducted in 1908 and later that year, General Motors was formed. Technological feat led to the opening of the Panama Canal in 1914. War War 1 broke out later that year. The war actually accelerated growth for the US economy, bringing US GNP closer to $100 billion before the next decade arrived. The financial markets however remained flat over this period, as banking and currency reforms gradually took shape. Dow was at 110 points by end-1919, almost the same level as it was 13 years earlier.

(a) Panic of 1907:

      - Market dropped 45% over 9 months.
      - Full recovery 10 months later.

(b) World War 1 (1914-1918):

      - Market gapped down 33% when it was re-opened after closure.
      - Full recovery 9 months late, buoyed by growth from the war itself.

# 1920 - 1939 : Secular Bear Market

The 1920s was also known as the "Radio Age" where radio found its way into most American homes. This was also a dark age period for many Americans. The effects of Great Depression (1929) haunted the country for at least the next decade to come.

For the first 10 years during this secular bear market, the Dow actually rose from 110 points to almost 400 points. By 1929, with the onset of the Great Depression, the market not only gave back all its recent gains but turned into a steep loss. Such is the characteristic of a secular bear market where you expect to see wild swings and huge volatilities. The market collapse led to the formation of the Securities & Exchange Commission (SEC) in 1934. That year, Gold price was fixed at $35. By end-1939, Dow was back to a mere 150, closer to where it started two decades earlier. This was also a difficult time for the US economy. Its GNP recorded almost "zero" economic growth for a 20-year period. Literally, this secular bear market represented 2 lost decades for America and its people.

(a) Stock market crash of 1929:

      - Market plunged 90% over 36 months.
      - Full recovery took 25 years before Dow regained 400 points level.

Hope you had a fascinating read. Check in here again next week to find out where we are currently in the cycle and where we may go from here!

Future of the US - Part 2

Hi, thanks for tuning in again. Let’s continue this week with the second and final instalment on what the next decade or two will behold for the US:

5.  Technological Advancement.  US will continue to lead the world with its impressive prowess in innovation. Fast forward another decade or two, new businesses in forms we never can imagine today will sprout and transform the way we live and interact, just like how the internet, smartphones and Facebook have changed the world. The new smart home of the future will spell an entire new ecosystem of technological and lifestyle products that we can only dream of today. Consequently, new business models will emerge rendering existing business models obsolete, transforming industries, businesses and commerce. US will be central to these pivotal changes.  Medical advances of tomorrow will make serious diseases a thing of the past. Imagine someone diagnosed with cancer could just walk across the street to GNC or Wal-Mart to purchase over the counter cancer pills for treatment and in a week’s time, the cancer is eradicated, just like flu. Breakthrough in genetics, life sciences, pharmaceuticals and medical robotics will remain the domain of US supremacy in the next decade and two. Advancement in industrial engineering, agricultural technology and recycling capabilities will not only lift US economic productivity but will also contribute to sustainable long-term growth for the world as world population expands and continues to demand clean water, food and other resources adding continuous strains to our planet. The world will progress as the US innovates and exports high value-added products and services to the world, in process expanding its own economy. 

6.  Energy and the US dollar. Domestic US oil production will rise from 5.6 million barrels a day to 9.1 million by 2015, bringing about a leap in share of domestic oil production to consumption from 28% to 46% of the total 20 million barrels consumed by the US in a day. An extra 3.5 million barrels per day works out to $134 billion a year at current prices. This will drop US trade deficit by nearly 25% over next 3 years, a hugely positive for the US dollar. Breakthrough in technologies such as “fracking” will potentially help US to recover over 100 years’ of supply of natural gas. This can potentially replace coal and even oil when the technology is perfected in the coming decade. Power plant conversion from coal to natural gas is already accelerating at a dramatic pace, leaving China as remaining coal buyer in time to come. Many drivers will also disappear from gasoline pumps as electric cars become the norm.  Advancement in industrial manufacturing processes and nanotechnology will create new breakthrough in products that are less polluting and require less petrochemicals to make. All these will have a significant impact on oil and coal prices in the coming decade or two as supply increases and demand reduces. As US becomes less dependent on foreign oil, US balance of payments will significantly improve as it switches from a net importer of oil to a net exporter. Eliminating its largest import while adding an important export will be hugely positive for the US dollar. At $100 oil today, it was estimated that 30-40% of that comes from a fear premium that oil supplies are disrupted. A strong US dollar and reduced reliance on foreign oil import will help keep a lid on global runaway inflation in the coming decade. This will be a boon for corporate profits.

7.  Onshoring. Over the recent decades, US companies sought elsewhere to relocate their plants to places with lower wages, where unions and regulations are lacking and where there is a paucity of environmental controls. They opened plants in Singapore, Taiwan, Malaysia and more recently, in Mexico, Thailand and China. An estimate places the number of jobs lost in the US at 25 million from offshoring in the past decade alone. How long will this continue unabated? After 30 years of offshoring and falling real American wages and soaring Chinese wages, offshoring may not be that great a deal anymore for US companies. In 1977, average Chinese labourer earned about $100 a year. Today it is $3,500 and for the trained technicians, it is somewhere near $24,000 per annum, with total compensation rising 20 percent a year. At this rate, US and Chinese wages will reach parity in about 10 years. Offshoring also carries many risks.  Asian countries still lack infrastructure.  Natural disasters like earthquakes, fires, tidal waves can disrupt a highly tuned, incredibly complex manufacturing system. Not to mention political risks in the host countries and occasional hiccups in the relationship between US and China over trade and other issues that may disrupt commerce. Fast forward a decade or two, 20-30% of jobs lost to offshoring could return to the US. This could amount to 8 million jobs, cutting US employment rate by half, at least (by current unemployment numbers). This may add another $60 billion in GDP per year, boosting GDP growth by at least 0.5% per year. Onshoring will then lead to a stronger US dollar, rising stocks and lower bond prices. 

8.  Improving fiscal position. As the US economic engine resumes its growth in the longer-term, the macro backdrop as outlined here will help US reduce its budget deficit. US goods and services such as education continue to be sought after everywhere. Reforms on medi-care and retirement age issues will have taken place then.  As the world hopefully becomes safer through globalisation, it will become cheaper for the US to stay friendly than blowing someone else up. The US may cut its defence spending, triggering a global dis-armament race.  Hundreds of billions saved annually from reduced defence spending will help US to significantly narrow its budget deficit, improving its fiscal position and strength as a world economic superpower.

 

The world continues to move in phases, to the tune of the yin-yang interplay. The difficult times confronting the US today will give way to a more prosperous period ushering in the next golden era in the coming decade or two. The banking system collapse and bailout, deleveraging taking place across individuals and businesses, aging population, industries hollowing out from the country through offshoring, corporate America flushed with cash now but unwilling to invest due to uncertainties, high unemployment rate, huge budget deficit and a weakening US dollar may dominate today’s headlines but will in time fade into distant memory as US moves on to the next boom phase from the current bust.

If US GDP were to reclaim the 4% annual growth rate as seen in the 1990s, stock markets will resume a secular bull trend (by definition, lasting a 20 year period). Dow may climb to 20,000 by 2020. After that, anything like a fourfold increase seen during the Clinton administration, may propel the Dow to 80,000 on the back of a strong US economy and an expanding global economy bolstered by a growing world population.

American capitalism will regain its footing. Americans are positive, its society values innovation and free choices. These are America’s great strengths that make it a resilient and vibrant nation waiting to usher in her next golden era in the coming decades.

Next week, I will share with you some interesting research I have done looking at the oscillating cycles in the financial markets over the last 100 years. The capitalist boom and bust cycles manifest like the cyclic yin-yang. All things and all societies move in phases of growth, maturity and decline and the cycle will eventually repeat. We are in a secular bear market today. When will the next light shine on us?

Remember to tune in next week and find out where we stand in a brief history of time!

Future of the US - Part 1

After writing about China, I thought I should talk about the US this week as these two nations will collectively shape the century to come. This posting will be the first of two I will write on the US, with the second instalment coming next week.

Prior to the 19^th century, China boasted the world’s largest economy for most part of history till it was overtaken by England in early 1800s. England rose on the back of her successful Industrial Revolution which started in 1760 as well as her colonialist ambitions. By 1890, US overtook England as the world's largest economy and has since enjoyed a pre-eminent status as the world's sole surviving superpower. In 2000, China entered the WTO and the world’s manufacturing bases decidedly shifted from US, Mexico, Europe and other Asian nations to China.

Since then, the US economy continued to grow, but has done so at a slower pace in real terms than a decade earlier. Is this spelling the beginning of the end to US supremacy with the ascension of China? The US is already beleaguered by its own domestic problems and a huge budget deficit that effectively bankrupted its government. As superpowers rise and fall, will this new century’s power axis tilt and shift eastwards, relegating US to an inconsequential player on world affairs?

Despite many headwinds confronting the US today, we need to bear in mind the world does not move in a linear fashion. The natural law of yin-yang dictates the cyclic phases every society has to go through. The American society will likewise go through phases of prosperity, decline and a resumption of growth.

Fast forward a decade or two, you may once again see the US on the growth path. As the pendulum swings again, a new golden age may be awaiting Americans, and by extension for rest of the world since US will likely continue to be a net importer from the world and the world's largest economy after China.

A golden age may play out in the US because of shifts in demographics, economic and trade structures as well as advancement in technologies over coming decade or two. US greatest strengths have been innovations and freedom. These will help US stay resilient and re-invent itself as a new phase of prosperity emerge.

1.    Retiring population. One reason for the slowdown in the US in the coming decade is because 80 million baby boomers will be retiring followed by only 65 million Generation X-ers entering the workforce. Some 21% of 310 million Americans today are in retirement, and is expected to grow to 48% in 20 years’ time. More Americans in retirement mode means fewer buyers for real estate, home appliances and risky assets like equities. Instead, in the coming decade, there will be more relative demand for health care, assisted living facilities and safer assets like bonds. Slower economic growth, higher budget deficits (more resources being re-directed to support long lived senior citizens) and a weak currency are guaranteed outcomes for now and the coming decade at least. How then will a golden era emerge in the US?  

2.    US housing outlook. Retiring baby boomers are no longer purchasing additional properties. Many are looking at selling their homes as they raise cash for retirement. This supply glut will not be absorbed by enough Gen-Xers leading to a significant slowdown in construction activities in the US for the coming decade. Home prices may stabilise now but will remain low for most of the coming decade. Fast forward another decade or two, the US real-estate will look bright once again. After years of contraction in construction and as more Gen-Xers invest in properties, a scarcity in housing will result and this will set off the next real-estate and construction boom, underpinning the start of the next golden age for Americans.

3.     US wage outlook. The currently slowing US economy, together with the negative effects of globalisation, has brought down real wages in the US. Standard of living for the middle class will continue on a declining path. As US adjusts to the new structural role it will play in the new world economy, innovations in technology, life sciences, genetics, medical sciences, industrial applications, aeronautics and electronic commerce will create new growth focus and opportunities for Americans. US will continue to lead the world in innovation. To supplement natural population growth rates, US must ensure the right immigration policies are discerning enough to target and attract talented foreigners into these critical fields without depressing local wages across the board. As US continues to lead the world in expanding these strategic, value-added industries, it will continue to expand the global economic pie and its own share of this prosperity. As the baby boomers eventually exit the workforce, there will be labour shortages in the US that will once again lead to wage hikes and growing opportunities for the working Americans. The standard of living for the middle class will then reverse a two decade decline. 

4.      Return of the US consumers.  Today, private consumption accounts for about 80 percent of US GDP. A slowdown in real wages will mean a weakening in spending power. But with a weak housing market and little interests to invest in large big-ticket purchases such as houses or cars, Americans borrow less and they end up with more disposable income. I believe this explains why retail sector is currently booming despite talk about the death of the US consumers. Consumers end up splurging more on smaller-ticket purchases like smartphones, jewellery and accessories. In a decade’s time, higher consumer consumption will spread to all sectors as housing market recovers and Americans also start to trade their old automobiles for more fuel efficient cars. The US economy will grow at a more robust 4% like it did in the 1990s.

Stay tuned next week, as there are more reasons to believe how the world will change in the coming decade or two that will underpin America’s economic might ushering in her next golden era.

Future of China

Despite China's strong GDP growth relative to the West, its equity markets are likely to remain weak with downside bias. This is despite the Chinese government reversing its contractionary monetary policies to fight inflation as well as its readiness to deploy stimulus measures to keep the economy growing so as to provide continued employment for its massive population. Why then are the equity markets in the West rallying even with anemic economic growth while the Chinese equity markets are sliding as its economy expands?


A few concerns play out here:


1. Banking System under stress. China's economic and banking reforms slowed after it successfully cleaned up its state banks' balance sheets and launched their IPOs to strengthen their capital structure. The boom years of 2006, 2007 further lightened pressure on pace of reforms (complicated by bureaucraftic turf battles) as focus turned to the impact of an appreciating renminbi on exports instead. By 2008, at the onset of the financial crisis, it became concerned with how the global economic slowdown will impact on China exports. Given its huge production capacity and workforce, China may face massive unemployment and instability (especially a sizeable migrant population lives in its big cities, estimated at over 300 million). China then embarked on a massive stimulus program (relative to GDP, it far exceeded the bailout in the US) that forced banks to aggressively lend once again - just a few years after cleaning up their balance sheets. While this helped prop up the economy, this also led to much economic waste on financing un-economic projects and directly creating a real-estate bubble. Banks in the heat of lending could not perform proper due-diligence and they are now again riddled with assets of dubious quality. The concerns in the stability of its banking system and its ability to weather through an asset bubble burst are bearish enough for the equity markets.


2. Slower economic growth. With Eurozone likely to impact on China's growth in the near-term, Chinese government will be concerned about how best to further stimulate the economy without worsening the asset bubble as it has to keep a tight reign on food, energy and housing prices affecting many ordinary Chinese. Managing demand-side economics through stimulation of consumer domestic consumption will require time. Though the Chinese government is in a strong fiscal position to embark on aggressive expansionary policies, given the constraints outlined here, China may have to settle for a slower growth rate (7% region instead of 9%) as being sustainable for the country. Slower economic growth translates to slower earnings growth for companies in China, which will likely translate to lower stock prices ahead.


3. Limited liquidity participation from overseas. Over the past 3 years, much liquidity remained in the US system because it is still the "safest and most liquid" market to invest, despite its ballooning budget deficits and rating agency downgrades. The low interest rate environment and record high bond prices brought about by the US Quantitative Easing altered the risk-reward attractiveness for the US equity markets. Consequently, a US equity bull market ensued, surprising many. While there were some funds which did flow out of US in search of "higher growth elsewhere", they went largely to commodity and oil producing/exporting countries rather than to China (China also has capital controls). Australia, Canada, Mexico, Brazil, Malaysia, Indonesia, India and Russia benefited when funds flowed out of the US markets, but China did not. Capital controls in China effectively limited meaningful foreign participation in its markets and devoided its markets liquidity coming from overseas.


4. Fewer domestic growth opportunities. China, with its leninist-style Government and centrally-planned economic model, may be more responsive to a crisis, as shown in 2008. Today, there are plans to develop mega-cities in China as well as building more airports, rails and highways. However, longer-term, two factors will contribute to slowing economic growth for China. One is aging population exacerbated by its "one child only" policy and the other is the already substantial infrastructural build-up compared to other emerging countries like India. As economic growth plateau, so will corporate earnings and stock prices in the longer-term.


5. Lack of investor confidence. Investors are also concerned about the quality of earnings reported by corporate China. China is aggressively pushing for adopting GAAP accounting standards in its own PRC accounting codes. This will take time. Meanwhile, more accounting fraud continue to be uncovered. Quality of earnings is suspect. With SOEs consisting a large part of overall market capitalisation, private investors could be rightly concerned about the sustainability of corporate earnings growth independent of government support or participation. All these impact on investor confidence in Chinese companies and equities.


6. Alternative investments and reduced liquidity in equity markets. Consequently, Chinese would prefer to park their investible cash in real-estate or other forms of exotic investments like antiques, paintings, vintage wine and coin collections. Gold, as a store of value during inflationary times, is also diverting liquidity away from equity markets. With tightening economic policies of past years, and the reigning in on SOE, businesses and individuals taking borrowed money from banks to speculate in the stock and property markets, another important source of liquidity and leverage in the equity markets have been removed. This, together with competing asset classes for investible funds, have exerted further pressure on the Chinese equity markets, which have also been operating at a much higher PE than Western markets.


China is a huge and complex country to manage. Navigating through the headwinds has its difficulties and challenges.  China has a long history, its feudalistic mindset is deeply entrenched. Decades of centrally planned economy also added bureaucratic complexity. These pose definite challenges to necessary reforms ahead. But the resilience, determination and commitment of the Chinese people and its government to modernise China and propel it into the forefront shaping the new world order will be China's great strength.


The global economy will expand as world population grows and technology and innovation will continue to help boost productivity, boost living standards and sustain an ever larger world population living on limited resources. China understands this must be the best time for it to re-invent itself for the new century. The collective leadership in Beijing knows reforms are needed and they must not miss such a golden opportunity to re-establish China's rightful place on the world stage. The future for China is bright. It will weather the headwinds and eventually cruise in a safer plane on to much greater heights.