12/31/11 Expect The Unexpected

Hidden inside both commentaries below is food for thought. As port points out, writing things down allows us to clarify our thinking. In fact, were I asked for an opinion on psychotherapy, the so-called 'talking cure,' I would suggest that even greater benefits might be possible by tweaking it into a 'writing cure.'

Sure, I may be guilty of latching on to articles that resonate with my current bearish outlook. However:

(a) Note that the second commentary sports a very bullish-sounding byline, and in fact leans bullish in the short term.

(b) It cannot be ruled out that I was led to read both articles in a karmic 'when the student is ready, the teacher will appear' frame of mind.

http://www.marketwatch.com/story/in-2012-somethings-gotta-give-2011-12-30?link=MW_story_popular

It’s nothing new for the stock market and bond market to disagree, but watching the bond market argue with itself is another matter. While regular U.S. Treasury bonds are priced for a sluggish economy with steady or even falling prices, inflation-protected Treasurys — so-called TIPS bonds — are braced for inflation. These bonds have now locked in negative “real” yields — in other words, yields adjusted for inflation — over the next decade. Historically, these TIPS bonds have tended to yield inflation plus about 1 to 2% a year. Bonds with negative real yields almost guarantee instead that investors will lose purchasing power.

The prices of these bonds most make sense if investors expect to see stagflation — poor growth and quickly rising prices. For very technical reasons, they might also make sense if investors expected a total, 1930s-style economic collapse, with plummeting prices.

The markets can’t all be right. In 2012 we can’t see a good old-fashioned boom with rising employment and falling spare capacity (which is what the stock market wants), a slump with tons of spare capacity and flat prices (which is what the regular bond market wants) and either a slump with no spare capacity and surging inflation or a 1930s meltdown (which is what TIPS seem to want).

Oh, and then there is the small matter of China. The locomotive of the global economy is relying on a housing mania and a gigantic capital investment boom that currently soaks up nearly half the entire gross domestic product.

Maybe that goes on indefinitely, until every inch of China is paved in concrete, every Chinese peasant lives in a luxury condo with valet parking provided by other Chinese peasants, and every town there has high-speed WiFi connections and bullet trains and monorails.

Maybe it’ll all work out.

http://www.marketwatch.com/story/sp-500-returns-to-critical-1260-level-2011-12-30?link=MW_story_popular

In fact, it seems to me that there is already a very “crowded” trade out there (i.e., one in which “everyone” is taking a similar position) and that is traders wanting to “own” volatility. Since we prefer to think along contrarian lines, that would indicate to me that all these traders who have buying protection (and thus forcing up the price of VIX derivatives while they do so) are going to be proven wrong — at least in the short term. In fact, a purchase of the inverse VIX index XIV might be in order, if you agree.

There is another bullish factor at work: the Santa Claus rally. While it is common for the media to term any rally in December as the Santa Claus rally, it really pertains to a very specific period of time, identified by Yale Hirsch and published in The Stock Market Almanac years ago.

This typically bullish period extends over just seven trading days: the last five trading days of one year and the first two trading days of the next year. Thus, we are currently right in the middle of that period. So far, it has risen rather weakly, from 1,254 to 1,263, as measured by SPX. But there are still three more trading days left in this bullish seasonal period. So if it can persist for three more days of bullishness, that will almost certainly necessitate an SPX breakout over the 1,270 level.

To summarize this short-term outlook, then: the bulls have everything going their way. If they can’t get the clear upside breakout soon, that would be very bearish.

Longer-term outlook

Since it is the end of the year, it is a time for assessment and planning, and thus many longer-term forecasts are offered. Even if the market does break out on the upside in the near term, we expect to see another large bear market emerge sometime in the next 15 months. There are two scenarios that we have been following, both of which quite closely parallel the path of the stock market for the past several years.

One scenario is the 1937-1942 time period, in which the market tried to rally back to its 1940 high, but couldn’t do so. Eventually, the lows of 1940 were broken, and the market traded all the way back down below the lows of 1938. In modern terms, this would play out as an attempt to rally back to the highs of 2011 (near 1370), but fail to do so. Eventually the lows of 2011 (near 1080) would be broken and the market would fall to the lows of 2009 (near 670).

The other scenario starts more bullish, but ends pretty much the same way. From 1962 through 1974, there were three bull markets and three bear markets. Each bull market carried all the way back to the all-time highs (near Dow Jones Industrial Average of 1,000 in those days), only to see ever-more-fearsome bear markets take place. Eventually, the third bear market — in 1973-74 — took the Dow Industrials down to lower prices than either of the previous two bear markets.

In current terms, we saw the bull market of the 1990’s die near SPX 1,550 before a fierce bear market ensued in 2001-2002. Then a second bull market again rallied back to SPX 1,550, before the 2007-2008 bear market fell to lower lows than the previous bear market. Now we are in another bull market, one which started in 2009. Could it extend all the way to SPX 1,550? Why not? But then the third bear would strike, and it would be very severe, taking out the 670 lows of 2009. The irony is that the latter scenario is much more bullish at first because it contains an SPX rally to 1,550, but results in a much nastier and volatile bear market than does the 1937-1942 scenario.

In any case, we expect that a bear market lies in the intermediate-term future and one should not plan on a buy-and-hold strategy — or should at least plan on collaring positions or employing other portfolio protection strategies.