Why This Time Could Be DifferentAugust 28, 2015

by Lance Robertsof Streettalk Live

In yesterday's post, I discussed the current correction within the context of previous "bull market"corrections. Specifically, the corrections in 1987, 1998, 2010 and 2011.

However, today, I want to look at the current correction in the context of previous starts to"bearmarkets" and subsequent recessions.

As I said previously, we never truly know for sure where we are within a given market cycle. This iswhy it is often fruitless to try and predict future outcomes as you will often be wrong more than right.However, by analyzing past market behavior we can often develop an understanding of what to expectso that appropriate, and timely, reactions can be made.

Currently, the "bulls" are "hopeful" that the worst is now behind us and that the meager rate ofeconomic growth in the U.S. will be enough to sustain the bull market through at least the rest of thisyear. They could be right, particularly given support by the Federal Reserve of not hiking interest ratesin September and potentially discussing more accommodative policy actions if needed. While it hascertainly been beneficial over the last few years to give sway to the "bullish" view, it has historicallybeen disastrous to become blinded by it.

As I will discuss today, from both a fundamental and technical perspective, there is mounting evidencethat this correction may not be just a "bump in the bullish road," but rather something more important.While I am not suggesting that we are about to enter into the next great "financial crisis," I amsuggesting that investors carrying excess levels of portfolio risk may wind up being ratherdisappointed.

Fundamentally SpeakingValuations

As I stated yesterday, earnings growth is deteriorating, and valuation expansion has ceased. As Iaddressed in "Shiller's CAPE - Is There A Better Measure:"

"The need to smooth earnings volatility is necessary to get a better understanding of what theunderlying trend of valuations actually is. For investor's periods of 'valuation expansion' arewhere the bulk of the gains in the financial markets have been made over the last 114 years.History shows, that during periods of 'valuation compression' returns are much moremuted and volatile.

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muted and volatile.

Therefore, in order to compensate for the potential 'duration mismatch' of a fastermoving market environment, I recalculated the CAPE ratio using a 5-year average asshown in the chart below."

"There is a high correlation between the movements of the CAPE-5 and the S&P 500 index.However, you will notice that prior to 1950 the movements of valuations were more coincidentwith the overall index as price movement was a primary driver of the valuation metric. Asearnings growth began to advance much more quickly post-1950, price movement becameless of a dominating factor. Therefore, you can see that the CAPE-5 ratio began to lead overallprice changes.

As I stated in yesterday's missive, a key 'warning' for investors, since 1950, has been adecline in the CAPE-5 ratio which has tended to lead price declines in the overallmarket."

Economic Growth

Just recently the Congressional Budget Office (CBO) downwardly revised their always over-inflatedeconomic forecast. (As an aside, this is the same organization that has never gotten any of theirforecasts correct. In 2000, they projected a $1 Trillion budget surplus in 2010 versus a $1 Trillion

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deficit reality.) To wit:

"Federal budget analysts dropped their estimates for U.S. economic growth after anotherdisappointing first quarter, extending a string of downward revisions to initial forecasts thathave been a hallmark of the current expansion.

U.S. gross domestic product is now expected to increase 2% this year, down from aJanuary estimate of 2.9%, the Congressional Budget Office said on Tuesday. The reportrevised up slightly the GDP forecasts for 2016 to 3.1% from 2.9%, and for 2017 to 2.7% from2.5%."

Well, at least hope springs eternal at the CBO.

However, the importance of the downward revision to economic growth is market crashes combinedwith declining economic growth rates have historically marked the beginning of more substantial bearmarkets.

Breakeven Inflation Rates

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In a strongly growing economy, that would support sustained earnings growth and higher valuations,expectations of rising inflation would be found. There is historically a strong link between inflationexpectations and the S&P 500. That was until the start of QE-3 in December of 2012 which floodedthe financial markets with liquidity sending asset prices surging without a subsequent pickup ineconomic growth.

As shown in the chart below, the decline in inflation expectations suggests that the economy is runningat a far slower pace than headline statistics suggest. As a consequence, the detachment of thefinancial markets from economic realities leaves investors at risk of a more substantialcorrection.

Technically SpeakingFrom a technical viewpoint, the markets are currently behaving in a manner that has been more closelyassociated with the beginning of previous bear market declines.

The chart below shows only two moving averages of the S&P 500 index. The short term two-weekmoving average is in blue as opposed to the one-year moving average in red. Historically, when thesetwo moving averages have crossed it has been representative of a more severe market correction orbear market. This is with the exception of the 2011 correction which was halted by theintervention of the Federal Reserve's second round of quantitative easing.

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While the moving averages have not crossed as of yet, there WILL do so in the next few days. Verylikely, the only thing that would stop a bigger correction from that point would be the onset of anotherFederal Reserve intervention.

Momentum

As I discussed previously in "Think Like A Bear, Invest Like A Bull:"

"The effect of momentum is arguably one of the most pervasive forces in the financial markets.Throughout history, there are episodes where markets rise, or fall, further and faster than logicwould dictate. However, this is the effect of the psychological, or behavioral, forces at work as"greed" and "fear" overtake logical analysis."

Currently, momentum has clearly broken in the market as shown below. The break in momentum hasnot only been a good signal to reduce equity risk exposure during bull markets, but also a warningsignal of impeding bear markets.

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The Elephant In The RoomFrom both and fundamental and technical viewpoint, there is mounting evidence that the currentdecline might just be sending a signal that there is more going on here than just an "overdue correctionin a bull market." While it is too soon to know for sure, there seems to be little risk in being moreconservative within portfolio allocations currently until the market environment clears.

However, the proverbial "elephant" is margin debt. As I have stated previously:

"While 'this time could certainly be different,' the reality is that leverage of this magnitude is'gasoline waiting on a match.' When an event eventually occurs, that creates a rush to sell inthe markets, the decline in prices will reach a point that triggers an initial round of margin calls.Since margin debt is a function of the value of the underlying "collateral," the forcedsale of assets will reduce the value of the collateral further triggering further margincalls. Those margin calls will trigger more selling forcing more margin calls, so forthand so on.

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Notice in the chart that margin debt reductions begins innocently enough before acceleratingsharply to the downside."

No one knows for sure where how far the market needs to fall before "margin calls" are triggered.However, if that point is eventually reached, there will be very little investors can do to shieldthemselves from the decline.

Yes, if you become more conservative now, you might just miss some of the recovery if the market canregain its bullish stance. Of course, it is relatively easy to re-enter the markets when the picturebecome clearer. However, those that refuse to accept the notion that it is possible the bull market justended will once again see irreparable damage done to their retirement savings once again.

While it is correct that given enough "time" the markets will eventually recover previous losses, the"time" lost to save, invest and grow funds to meet your retirement goals will not.

Just something to think about.

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Lance Roberts

Lance Roberts is the General Partner and Chief Portfolio Strategist for STA Wealth Management. He is also the hostof "Street Talk with Lance Roberts", Chief Editor of "The X-Factor" Investment Newsletter and the Streettalklive dailyblog.

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