Saturday, October 29, 2011

All Ords - A Below Average Recovery

The Australian All Ords recovery since the 6 March 2009 bottom is below average, but in the recovery from the 1987 crash it got a lot worse from here.

See the bottom of the page for methodology and disclaimers.

Recent Position
As can be seen from the chart below, the current recovery from the 2009 bottom after the 2007 peak was the lowest percentage recovery of all since 1984 for a few days around mid September this year, 2011, or about days 645 to 648 on the graph which is about 2.5 years after the bottom. It was significantly below Average and below Average - 2003.

Currently (Friday 28 October 2011) after 671 trading days, or about 2.5 years since the 2009 bottom, we are at a 41.6% recovery, compared to an average of 54.9% or an average not including 2003 of 52.3%.

This does not mean that the recovery will automatically revert to the mean/average or that any reversion that does occur will be before any further significant falls. I am not pretending to forecast the market close at some point in the future.

In the chart below, which only covers trading days 471 to 810 since the bottoms, bold bright blue is the current recovery, the average is the orange line around the middle of the chart and 1987 is the pink line dipping towards trading day 800. 


There are several possible explanations for this position.
1. The European debt crisis caused a secondary crash - the fall from the April highs to September lows was a median major fall of the Australian All Ords.
2. Austerity to reduce government debt resulting from stimulus and bank bailouts is reducing GDP/GDP growth whereas there was no Western debt crisis other than for highly geared corporates in most previous recoveries.
3. The imbalances that grew during the artificially induced "Great Moderation" of 2003 to 2007 and the size of the 2007/8/9 crash were of such magnitude that they will continue to work through the global economy for some years, much as was the case after the 1987 crash and so 1987 is as likely a guide to the future as the average of past recoveries.

The Megaphone of Likely Possible Futures
 We can think of the chart from Day 671 forward as a megaphone (or sideways cone if you like) of  likely future possibilities - it might not be correct, there could be worse outcomes eg Japan from 1990 to 2011, or maybe even better outcomes than the recovery from 2003, although personally I don't give that a snowballs chance in hell. I regard these latter outcomes as very remote, highly unlikely possibilities.

Our Attitude And Approach From Here - Invested but respecting the possibility of 1987/1991.
While we might hope for reversion to the mean and possibly above from time to time, we should not lose sight of the 1987 possibility (I heavily discount a Japanese possibility because of the resource demand from China and India and our better demographics), which is that we could fall from being a 41.5% recovery now to being only a 4.6% recovery over the next say 130 trading days, just like what happened to the recovery from the 1987 crash in 1991.

So while we might be heavily invested now after the September bottom, we should set our stop loss limits now (one off  "risk off" disinvestment or staggered risk/investment reductions to avoid the possibility of being totally whips sawn). Personally I will reconsider what will, after this Monday, be my almost fully invested position if there is a drop of 5% from my buy price on Monday.

Methodology and Disclaimers
I keep a number of charts of recoveries, all with the bottom as zero and measuring the percent improvement since the bottom for all crashes from 1987. I follow each recovery for 1100 trading days which allows us to see how this recovery compares to others. That period of time normally includes at least 1 other fall of more than 20%, but not in the case of 2003 to 2007. I include 2 averages, one of all recoveries and one of all recoveries other than from 2003 given it seems unlikely to be repeated any time soon given the various private, public, foreign and foreign currency debt crises that still exist.

As always this is not financial advice or a forecast and the past does not foretell the future. Ask any Japanese stock market investor about time in the market and the possibility of markets being lower even after 20 years after a bubble peak. Read widely and make your own decision after getting whatever specific advice you might need.

Tuesday, October 25, 2011

Market Cycles in the Australian All Ordinaries

What have the market cycles in the Australian All Ordinaries looked like in the modern era (post 1984)?

While I have previously posted on market Tops and Bottoms as separate entities, this post shows the cycles of tops and bottoms in one table in chronological order.

Explanation of the use of the lengths of cycles and rates of growth over different time periods have been given in the last post about the Characteristics of Market Bottoms and very similar principles apply to market tops.

The only additional word of caution is regarding the possibility that we are in a long term secular bear market and so falls might be longer lasting and bigger and bull rallies shorter and lesser, but this is just a caution about a real possibility, not a prediction.

The last line is today's results and it will not be a major turning point (famous last words?) unless Europe falls apart over the next few days.

The greens and blues are buys, the pink, yellow and orange are sells. you will see from the last two columns that tops are all large rises (because we are adding together the growth for 2 or 3 periods) and the bottoms are all large falls (for the same reason).

You will see that all bottoms have falls for 2 months and 1 year and generally for 2 years also, while almost all tops have positive growth for all periodicities with only a few exceptions, including in April 2011. Only 2 tops out of 7 have any negative growth period. It is uncommon to see a top without all periodicities showing positive growth.

The median lengths of complete cycles, rises and falls are at the bottom of the table as are the median results of adding each of :
a) 2 month and 1 year, and
b) 2 months and 1 and 2 years growth
for tops and separately for bottoms.

Median cycle is 3.2 years, median rise is 2.1 years, median fall is 1.0 years.

In about 1974 Austin Donnelly's book on Charting for Profit indicated that cycles averaged about 4 years, so things haven't changed that much, particularly if my 2 sub 20% fall bottoms were excluded, as most people would do in an article on market cycles.

Because of the occasional fast dramatic fall like 1987's 50% in 50 days with some trend indicating strategies failing to initiate a SELL until most of the loss was over, you may wish to have a stop loss at say 7 to 8% fall from the current bull market high. A tighter loss will result in more whipsawing and resultant losses over the round trip (Sell/Buy)

 When looking at market bottoms, you may also like to consider the likely maximum fall in terms of the previous 1 or two rises. The largest falls often occur after the most extraordinary rises like the 1987 and 2007 tops.

Should I "pick the bottom"?
You may choose to to invest at a time when the market:
a) is grossly oversold compared to eg its 200 SMA,
b) has had a fall of say 9% over the last 2 months (all bottoms except 1995 met this criteria), and
c) has fallen more than say 114%
on the basis that you will lose recovery of say 10% of the value at the top when the market turns up while you await the emergence of an apparently sustainable uptrend and so will get in closer to the bottom with this bottom picking strategy than by waiting for the uptrend to establish. You would likely be more cautious and adjust the above parameters if the preceding bull market was longer than usual, had a higher percentage rise than most bull markets and a higher rise in percent per annum terms.

For those interested in avoiding major falls but participating in major rises, this information should be helpful.

I add my usual cautions about the Japanese possibility which would change all these things and also of the dangers and costs of being whipsawn.

Characteristics of Market Bottoms for Aussie All Ords

Since 1984 (based on the free data from Yahoo Finance), the Australian All Ordinaries has experienced 9 major market bottoms of 14% or more, 7 of which were 20% or more and 2 were 50% and 54%. So while no one rings a bell at a market bottom, we ought be able to observe some characteristics of market bottoms that may help inform decision making now and in the future.

The table below summarises some of the indicators I believe are relevant to determining whether a market bottom is likely to have occurred. This should be read in conjunction with market trends so that you don't pick a bottom while the market is still trending down. In the case of very large sudden falls you might try bottom picking on the basis that if you are a bit early it is likely not worse than you would have been being a bit late while you waited to be sure a sustained upswing was emerging.

The main indicators are growth/fall rates over various time periods, and the length of a rise and fall. From past major bottoms and these indicators are derived Average, Median, Maximum and Minimum of each indicator.

From the table below
Please note that the last normal row is as at today which can't be a major bottom, but including it lets us see it is not too dissimilar to 2 previous major bottoms so could still be good buying.

If it is more than 1.5 years since a prior bottom you are getting into the range where one has occurred previously. The range however extends out from 1.5 to 6 years so this measure alone is not sufficient.

Falls can be surprisingly rapid - 1987 was 50% in 50 days, so you may want to sell after a fall of 7 to 8% no matter how quick the fall. A smaller fall is unlikely to be part of a major fall and if you sell after a fall of 3 or 4 % you will be whipsawn frequently, much to your detriment.

Assuming the fall is at least 8% already, the bottom could be in at as little as 14% total fall but the median is 22% and the average is 28%. As a guesstimate, if you buy in after a 20% fall you may still do as well as if you waited for a 30% actual bottom and then a 12 to 15% recovery while you waited to be sure that any emerging uptrend was likely to be sustained.  If you buy at 20% down and the actual bottom is at 25% down you might have done better buying in at the 20% as it might recover to being only down 15% before you otherwise are convinced to buy. The chances of picking an absolute bottom are virtually nil.

Major bottoms have only occurred when there has been a fall over both 2 months and over 1 year. It is also not uncommon for there to have been falls over longer periods, but rarely for there to have been a fall over 5 years except in the very worst of falls. The very worst of falls normally occur after the very best of rises!

As in the last few columns on the right of the table, you can look at cumulative falls from the 2 or 3 shortest periods of growth I monitor as a further indication and look at the Average, Median, Minimum and Maximum for them also.

While it would have been misleading in the Japanese market since 1990 and I assume in any other crash of a huge bubble you can look at the rate of growth since say 3 bottoms ago compared to the median to see whether the rate of growth seems to be about the rate of growth in the economy over that extended period. It is highly unlikely that there will have been exceptional growth compared to the economy as a whole over the term of 3 bottoms.

From this exercise we can see that there was an almost median bottom of a fall of 22% on 26 Sept 2011. This is not to say that the market can't fall further, possibly resulting in whipsawing losses if you buy back in/increase exposure and the market falls.

Note of Caution
"Time in the market" and "Buy and Hold" have been disastrous for the Japanese since 1990. Given the global debt crises (public, private, external and FX denominated) it is possible that we may be in a Japanese situation and that should be kept in mind. In the Japanese post 1990 bubble the market has shown a further loss (and negative return over the last 3 bottoms) at each new, lower bottom until now (assuming September was a major bottom). the percentile amount of time in loss approached 50% compared to 30% in the Australian market since 1984 to date. our percentiles in loss could increase given the long, high growth we had from 2002 to 2007.

All Ords Dashboard Update - 25 Oct 2011

(See earlier article for a detailed explanation of this Dashboard. Essentially the top section is about timing signals and the bottom section about whether it is a likely top  or bottom in the market)

From the Dashboard it appears that a possibly sustained up trend is emerging from an approximately median market bottom on 26 Sept 2011. (See recent post on characteristics of market tops and bottoms.)

While the market is up 9% from the low it is still 15% below the April 2011 high and a sustained up trend could be reasonably expected to have a total rise of 20 to 50% or more.

From the short term chart included in the Dashboard below you can see a possible trading range of 3900 to 4400 and a longer term chart shows strong resistance at 5100. (I use Incredible Charts free version and the free data since 1984 from Yahoo Finance.)

From the Dashboard
The market is presently above its 10, 30 and 50 day simple moving averages, but below the 100 and 200 SMA's.

The 10, 30 and 50 day SMA's (as I calculate them which uses two lots of 3 days with a 2 day delay) have all turned up, but the 100 and 200 are still trending down.

The 10 has crossed above the 30 and 50 but there are no other crosses (30/50, 30/100, 50/100 and 50/200).

The market is still heavily oversold against the 200 SMA being in the 13th worst percentile since 1984. The 2 month rate of growth is not at either extreme. The market remains extremely volatile based on my calculations, being in the 95th percentile of most volatile periods.

The 1, 2, 4 and 5 year growths are all in the bottom 20 percentiles. Over 80% of the time the market shows better growth for these periods than currently.

While Japan is a cautionary tale for many of these indicators, the market has since 1984 been closer to its then all time high 92 per cent of the days. I am not very persuaded by this as the 2007 top was quite and extreme and we could be in a secular bear market with another 10 or 15 years to run so medium term cycles might be more helpful indicators than relativity to the 2007 high.

My overall conclusion is that on a break above the 4400 mark or perhaps on earlier favourable crosses of moving averages I will increase exposure to stock markets, probably in Australia.

Macro Analysis
Uncertainty in Europe looks like being resolved, at least in the short to medium term, later this week. (In the absence of full union or individual currencies it is impossible to expect that trade and performance imbalances can be resolved - Europe is on a "gold like" standard which means all adjustments are internalised, not through a floating exchange rate and/or inflation.). Even temporary resolution will likely assist market confidence globally. A Euro breakdown would be a Lehman like event, while a time delay would be a likely negative.

The US has some indicators showing that the recession forecast by ECRI and John Hussman might be avoided, although others claim that the favourable indicators are lagging or their positive performance is statistically insignificant noise.

China continues to be of some concern and this is not positive for Australia, but falls in commodity prices and the mining sector may ease the AUD and assist local manufacturers and tourism operators and any interest rate cut would provide cash to most mortgaged households and could lead to increased spending and profits.

A fall in interest rates because of slowing construction approvals (12 month average), falling house prices in some mainly regional markets and core inflation probably moving back into target range is now regarded as quite possible/likely, particularly after recent IMF growth warnings.