Markets – “A Bottom” vs. “The Bottom”

Are we there yet?

I am writing this article on 28th June. We have just seen a sharp 7% bounce in the S&P 500 over the last few trading days.

A common question that both Pai and I have been getting is similar to the question that those of you old enough to have kids would have heard many times. “Are we there yet?”. Essentially the question is about the bottom in the stock market. Is the “bottom” in?

If you scan the news, you will find enough articles predicting both ways. “Yes, the bottom is in….new bull market” to “Bottom is still months away….we are in for a few more months of doom and gloom”. Sometimes both these articles are from the same analyst or investment banking firm.

There is a newsletter scam that I read about a few years back. You start by sending 100,000 newsletters out predicting the market will go up. You send another 100,000 predicting the market will go down. In a few months, if the market does go up, you send out 50,000 newsletters predicting that the market will go down and another 50,000 predicting market will go up, but you send it only to the prospects that you sent out the first prediction that the market will go up. In a few months, repeat the same thing. Keep doing this a few times, and in a few cycles, you will have 12,500 prospects who have seen your prediction being correct 4 times. Ideal candidates for subscribing to the newsletter, aren’t they??

It is somewhat similar with a number of analysts who try and predict the stock market. You can write articles predicting both ways and then keep posting links to the ones that got the prediction right. I know, because back in 2017-2018, I was exploring a predictive model based on the collective opinion of analysts who got it consistently right.


As an investor, it is easier to predict risk than predicting returns

In developing my own models, I found that it is easier to predict risk than predicting returns. The caveat is in the word “Investor” though. A “Trader” does predict returns, but also has the discipline to exit a trade when the trade is not going in the direction he predicted.

An investor on the other hand is investing for the long term. Most of the people who invest in the market are confused about whether their strategies are “investing” strategies or “trading” strategies. Mixing the two or switching strategies in response to a trade going bad is dangerous. One individual can do both, but a trade should ideally fall into one category.

As an investor, prediction accuracy needs to be high, since the number of trades are lower. As a trader, prediction accuracy can be low, since the number of trades are higher; but risk management in terms of recognizing a “bad” trade is paramount.

Predicting risk than predicting return is the equivalent of not driving when the chances of a thunderstorm is high. Sure, the thunderstorm may never happen, but as an investor, you are managing risk.


“A Bottom” vs. “The Bottom”

This particular write-up is from the viewpoint of an investor. In a subsequent write-up, I will write from the viewpoint of a trader.

So is the “bottom” in or is “the bottom” still a few months/ years away? In order to answer this question, let us look at the few variables that I found significant in predicting “risk”.

Valuations

There are multiple ways of measuring valuations. Shiller PE Ratio, Buffet Indicator and others, but the principle is the same. Is the collective valuation of all the companies the market justified by the price that you are willing to pay for it?

The Shiller PE ratio also called the CAPE ratio is currently at 30. Mathematically if one were to invest based on a model, where you have 80% of your money in stocks when the Shiller PE ratio is below 14 and reduce it to 40% when the PE ratio is above 22, you will get around the same returns as the stock market on an annualized basis, but would have reduced your risk by more than 50%. What that means is that when the market drops by 50%, your portfolio would have dropped only by around 20%. Here is a link to the model.

A similar indicator is the Buffet indicator, the ratio of market capitalization to GDP. You can get similar results where your stock allocation is high when the indicator is less than 85 and reduce it when the indicator is above 100. Right now we are at 116….which is the “modestly overvalued” range. Here is a link that explains it better.

Both of these indicators currently are predicting that the risk of being in the market continues to be high and that your allocation to stocks should still be on the lower side. The problem with both of these indicators however is their prediction time-frame is months and years. They don’t predict the next few weeks; they predict next few months and years.

The way we use these indicators in our fund and client portfolios is slightly different, we use them to predict agility required in our models. If the valuations are high, the allocation of funds in our models is towards more “agile” strategies; strategies that have the discipline and the agility to get out when the market does go down.

Yield Curve

Without getting into too much detail, the yield curve is another statistically significant indicator of recessions. There are two timeframes that are normally monitored. 10 year minus 2 year and the 10 year minus 3 months. I have found the 10 year minus 3 month to be more statistically relevant. Essentially whenever the yield curve turns negative, the odds of there being a recession in the next 6 months goes up significantly. When you click through the links, change the timeframe to “max” to see what I mean. The 10 year minus 2 year turned negative a few months back, but the 10 year minus 3 month is still positive, but trending down.

My interpretation of this would be that the risk of a recession is high, but it is probably a few months away – maybe end of 2022 or beginning of 2023.

200 day Moving Average of the S&P 500

This one is less of a risk predictor and more to enforce discipline in the monthly timeframes. When combined with the above two indicators the results are pretty impressive.

The reason why I think this particular moving average is relevant is because of the “trodden” path effect. In essence when enough analysts and algorithms use the 200 day moving average line as a firm line in the sand, its relevance increases.

Consider a model where you invest in stocks as long as it is above the 200 day moving average on a monthly basis and move to cash when it drops below the 200 day moving average. You would have made a higher return than the stock market and at less than 1/3rd the risk. When the stock market dropped by 50%, your portfolio would have dropped only by 16%. Simple but effective.

The key here is discipline though, not very easy if you are susceptible to FOMO, MOMO, FOMOMO, SLOMO or any of the other emotions that go through when you listen to your neighbors, analysts, rickshaw drivers. Yes, Rickshaw drivers…see this story.

Right now the stock market is approximately 13% below the 200 day moving average. Not the time to be getting in.


Stop avoiding the question – Is the “bottom” in?

As an investor – unlikely. As a trader – likely. How is that for an answer? My “bottom” is firmly on the fence!!

Kidding aside, as a trader, the market is highly oversold, so a bounce is overdue; but since the valuations are still considerably high, my bets would on this being “a bottom” as opposed to “the bottom”.

Our models are still very much in the “agile” camp; it may change when we cross the 200 day moving average; but given the past few months, it is more important than ever to be agile. If you can’t be agile, stay away…..”bottoms” can get burnt.


P.S. If you combine the indicators I talked about in this article, it is possible to beat most financial advisors in terms of return over risk. The only thing that stands in your way are your own emotions.

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