Way back in the time when oil prices spiked to over $140, I started tracking the index performance now versus 1974. As it happens, the response of human psyche to turmoil has been remarkably similar during the two bears. No doubt our own bear is much more severe, and with good reason; we have had the financial crisis in addition to essential commodity price spike based turmoil.
My model comparing the two periods rebases the index values of the peak on SP500 Now, SP500 1974 and Sensex to 100. Subsequent daily values are stated with reference to the peak value of 100; so for example a value of 77 would mean that the index traded at 77% of the peak of the cycle. SP500 predictive values are input for February 2010 onwards; this effectively calculates an expected value based on the change in SP500 1974 adjusted for the beta characteristics shared between the SP500 now and the SP500 during the 1974 bear. Sensex predictive values are input for February 2010 onwards; this effectively calculates an expected value based on the change in the SP500 now, adjusted for the beta characteristics shared between the Sensex and SP500.
During 1974, after an exuberant post bottom rally following lows in March 1974, the market paused; it peaked on 15 July 1975 and fell 13% over the next 45 trading days ended 17 September 1975; then the post rally bottom was made. It would appear that the SP500 has made a peak on 19 January; 15 trading days are gone and so a bottom can be expected on 14 March 2010. The problem is that my predictor model puts the bottom at 14 February 2010 at 64.86% of peak value (i.e. 1,015 being 64.86% of 1,565). The predictor has worked pretty well so I am guessing the market will bottom at 1,015 sometime between 14 February and 14 March. For Sensex this translates to a bottom fisher target of 15,256. So far the model has worked with a 2.1% plus or minus range!
The model predicts a peak of 1,384 for the SP500 and 22,934 for the Sensex by very late this year following which the market is likely to be bearish for 9 months. This kind of makes sense; a rise on anticipation of rising employment and beyond, and then a fall 6 months later when the slow pace of growth (despite improved employment) on account of a deleveraging private and public economy is accepted. I do believe this global bear will be a meanie; it remains important to stick with strong secular trends (energy/basic materials/emerging markets) while underweighting other sectors in a weak secular trend (financials) for now. And to be honest, I think in the next several months it will be time to turn to treasuries, defensive sectors, yield and high quality balance sheets; I do not believe it is time just yet but in six to nine months, the time to go defensive may be upon us. The economics of this cycle is very difficult to understand; rising interest rates will kill a recovery; and with the reluctance to raise rates, it is equally likely that inflation and falling real incomes will kill the recovery. Keep eyes on the story being told by real interest rates because money interest rates are being influenced by unconventional intervention; it does look like sound policy but the risk of unintended adverse implications always rises when creativity enters policy. Watch out for the first rate rise, if long rates refuse to move higher it will be a bearish flattening of the yield curve; a bullish flattening would arise with an upward movement on the long end of the yield curve and a more than proportionate upward movement at the short end. Also watch the spread between treasuries and corporate bonds and the spread between high quality and low quality corporate bonds; a hint of widening following sharp recent contractions in spreads would be worrying. No need to act too soon, but keep watching exchange rates, inflation, interest rates and leading economic indicators; as always, these can give fairly clear hints of when a cycle is tiring.
The market should not be sold on forward fears; my guess of an ugly 9 months during late 2010 and 2011 is purely speculative; fear should only be sold after economic metrics (specifically yield curve inversions, interest, inflation & exchange rates and leading indicators) or value (over 75the percentile levels) & risk extremes (interest rate spreads) signal problems - in such situations reducing weightage to equity will make sense.
All of this is kind of meaningless, except that the human response to risk is surprisingly consistent over economic cycles; this time it may be similar; then again it might not. If you would like to have a look at the chart, visit http://sites.google.com/a/maxkapital.com/www/thequantreport and access the link SP500 Sensex Now Vs 1974 Bear.
