CAPITAL IDEAS: Bad movie night

Dalton — Ever have a designated “Bad Movie Night” with your friends? It’s been a while for me. One day per month, a member of the group would go to Blockbuster and find the absolute worst movie they could find. Overacting, campy plots, special effects with a budget that matched my third-grade allowance—think “Sharknado,” “Roadhouse” or “Plan 9 From Outer Space.” These movies were so bad, they were good. They were examples of “good bad” as opposed to “bad bad.”

The last few months have been bad for the stock market. Investors have been liquidating their securities in anticipation that the bad will get worse. However, breadth of the young, two-week rally suggests that it was so bad it’s good. Tracking market breadth is a technique used to gauge the direction of the overall market. It involves comparing the ratio of advancing stocks versus declining stocks in terms of both price and volume. When a certain percentage of prices and volume move in the same direction, say 90 percent, then it’s referred to as a 90 percent up day or 90 percent down day.

In the world of So Bad It’s Good, you want capitulation; you want investors throwing in the towel as they’ve hit their threshold for pain. A precipitous drop in prices in a short period of time, referred to as a “waterfall decline,” often marks that moment of capitulation. The 16 percent decline stock prices experienced in the three weeks up to Dec. 24, 2018, was an example of this. Christmas Eve was nearly a 90 percent down day (88.97 percent), and that day was preceded by two consecutive 80 percent down days.

But capitulation alone is not the sign of a bottom. You also need investors to feverishly buy up stocks, exhibiting renewed demand. Both Dec. 26, 2018, and Jan. 4, 2019, were 90 percent up days, the first in about two years. That’s renewed demand.

However, caveat emptor. Waterfall declines are typically not the final low; the Dec. 24 low might need to be retested—might. We’ll watch the breadth over the next few weeks to assess if the rally is sustainable or if portfolios need to get more conservative to defend against a retest.

That January 4 90 percent up day was sparked by a strong employment report as well as dovish comments from Federal Reserve Chairman Jay Powell. Payrolls surged by 321,000 in December, far surpassing the expectation of 176,000. Not too long ago, payroll numbers that came in above consensus caused the stock market to go down because it emboldened the Fed to raise rates. However, this number was so good, it couldn’t be bad. Additionally, prior months’ numbers were revised upward, which was comforting to investors who had worried the markets were deteriorating due to weakening economic conditions. It turns out that while the market was tanking in the fourth quarter of 2018, the economy was at least good enough to average 254,000 new jobs per month.

Image courtesy tradingeconomics.com/U.S. Bureau of Labor Statistics

Later in the day, Powell indicated willingness to proceed more slowly with monetary policy normalization in order to avoid a disruptive slump in asset prices. Markets were already on the upswing when he said they “will be patient as we watch to see how the economy evolves,” that they are “listening very carefully” to the market and that the Fed no longer has a “preset path.” Actually, what he said was “as always, there is no preset path for policy.” However, not too long, ago he used language to the contrary. That prior comment was later considered a mistake, but it was a costly one for stocks as it drove prices down. Correcting his comment as well as addressing the predictive nature of the stock market rejuvenated hope for investors as it seemingly reduced the probability of a policy mistake.

That’s the short term and, in the short term, I have confidence that, even with a retest, the bulk of the damage has already been done. In the very long term, I’m even more optimistic. Statistics indicate that, over time, there is nearly always a reversion to the mean. Mean reversion is a financial theory suggesting that asset prices and returns eventually revert back to the long-run mean, or average, of the entire dataset.

The last couple of decades have been bad, relatively speaking. According to DataTrek Research, since 1928, the average of rate of return for all 20-year periods has been 10.7 percent. However, due to the two bear markets of 2002 and 2008, the return of the last 20 years has been only 5.52 percent. At some point, maybe after the next recession, that reversion to the mean will actualize. It’s nearly a statistical certainty.

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Allen Harris’ forecasts and opinions are purely his own. None of the information presented here should be construed as individualized investment advice, an endorsement of Berkshire Money Management or a solicitation to become a client of Berkshire Money Management. Direct inquiries to aharris@berkshiremm.com.