Predicting major correction in 2013 as contrary indicators are mostly bearish

Last year, I was bullish on European shares and this proved the right call as they modestly outperformed. As this year begins, I am doing a lot of thinking about my much-delayed “Ten Surprises for 2011” post. And as I compile list items, it’s clear I want to be bullish again, this time both on the economy and global markets. But there are a few things holding me back.

Politics is the only thing holding me back on the economic front, frankly. If you look at Ireland, Britain and the US, three of the four big housing bubble markets, house prices have levelled off and are showing modest gains in many respects. Only Spain lags here. And clearly, this has everything to do with politics. The post on the eurozone crisis yesterday showed how much the politics of austerity has affected growth trajectories. One need only look at the chart on Italy versus Germany to see how stark the differences are. If you get the politics right, I think we could see sustainable growth. But that’s another post.

I want to talk about markets here. And this is where I am worried. I am a contrarian. And without looking up what that word means in a dictionary, I can tell you what it means to me off the cuff. It means having the odd predisposition to buck the trend when everyone else is following the crowd. There’s a whole psychology to contrarianism when it comes to social issues since most people feel deeply uncomfortable going it alone when everyone else is moving in a different direction. And while that same psychology carries over to markets, it has some serious implications at market turning points because that’s when everything is going up the most and things look wonderful.

Right now, things look pretty good. In the US, we have had an 85% run-up in shares. Market volatility is multi-year lows. Banks are flush with cash. Mortgage rates are at historic lows. House prices are rising. GDP growth is positive. Junk bonds are the highest flying bond asset class. And even government bonds are doing well, with ten year yields under 2 percent. You look at Europe and once you forget about the economy, things look pretty good too. The ECB is backstopping pretty much everyone except Greece in the euro zone. We had a good run in shares last year. Peripheral sovereign bonds have been monster winners. Ireland and Portugal have joined Spain and Italy on the public bond markets. Spain’s banks are being recapitalised. Irish and Spanish banks are now tapping the public markets at much lower yields. What’s not to like?

There’s plenty not to like if you are a masochistic contrarian sort like me. It’s when I see blue skies and easy sailing that I start to get worried and then I start looking at all the contrarian indicators telling me this is a sign of a market reversal.

Let me concentrate on the US here since that’s where my next prediction for 2013 is going to be. I think US shares will see a major correction of 15% sometime in 2013, potentially entering a 20% down bear market phase. And this is largely because the shares are overvalued on a secular basis in the midst of what I believe is still a secular bear market. I believe that what was margin compression in 2012 will become earnings shortfalls and share reversals in 2013.

Let me turn to John Hussman for some insight into the secular nature of this. Here’s what he had to say two weeks ago.

Generally speaking, the very best times to be long are when a market decline to reasonable or depressed valuations is followed by an early improvement in market internals (breadth, leadership, positive divergences, price-volume behavior, and so forth). This is a version of a general principle: bullish investors should look for uniformly positive trends to be coupled with an absence of particularly hostile features such as overvalued, overbought, overbullish conditions. Put simply, we are looking for the good without the awful.

To illustrate this principle, let’s put together a slightly crude model, but one that will serve well enough for instructional purposes. I’ll preface this by saying that this is not a model we use in practice, that past performance does not ensure future results, and that this model is for illustration only.

For “The Good” criteria, we’ll use some simple indicators we’ve used before in other market discussions. Give one point to each of the following:

  1. S&P 500 dividend yield below its level of 6 months earlier (a trend-following measure)
  2. Dow Utility average above its level of 6 months earlier (a multi-purpose indicator that has trend-following, divergence, and interest-sensitive functions)
  3. 10-year Treasury yield below its level of 6 months earlier (an interest-rate trend measure)

Let’s call 2-3 points “The Good” and only 0-1 points “Not Good.”

As for “The Awful” criteria, we’ll require a syndrome including all three of the following:

  1. Shiller P/E above 18
  2. Investment advisors (Investors Intelligence) bullish sentiment > 45%
  3. S&P 500 more than 50% above its 4-year low

Clunky, simplistic, but enough to get some useful results. Most importantly for our purposes, if we look since 1960 at periods that couple the Good without the Awful, we find that 41% of history falls into that bucket. Assuming one was invested each week based on the previous week’s signal, this subset of periods produced a 21.4% annual total return, or 15.3% in excess of Treasury bill yields, on average.

In contrast, once the Good was joined by the Awful, the resulting 10% of market history featured market losses at a -1.3% annual rate (-4.8% short of Treasury bill yields). Indeed, of the 59% of periods not among the “The Good without The Awful”, the S&P 500 achieved an average annual total return of just 2.0%, and a shortfall of -3.1% versus Treasury bill yields, on average. If an investor does not seek to closely track market fluctuations – and we don’t – the optimal strategy is to accept market risk only when the expected market return exceeds the risk-free rate.

Translation: contrarian indicators are the best ex-ante technical signals for anticipating stock market returns. When sentiment is bullish, P/E ratios are high and market volatility is low, you have the makings of a market reversal. Hussman backs up his specific contrarian indicators which shows one investor making three times the market over a 50-year lifetime of investing by investing when the contrarian signals are good.

Contrarian signal investing versus market

That is a big difference.

And right now the contrarian indicators are mostly bearish.

  • The Shiller P/E is 22
  • The VIX is 12.5
  • Junk bonds have broken below 6% yields
  • American Association of Individual Investors bullish sentiment is 44%
  • The S&P500 is 114% above its 4-year closing low of 683
  • New highs to lows for NYSE, AMEX and NASDAQ stocks is 1188/257 year-to-date

So, here we are going into a period in which government is trying to cut its net deficit, something that translates into a net savings cut in the private sector and earnings misses as government deficits are the biggest driver of elevated corporate margins. And yet, the markets are going from strength to strength. And banks and home builders, the epicenters of the boom and bust are leading the charge. In my view, we have an unusually high level of market peaks that suggest greater risk for a sharp market reversal, especially in the context of anticipated fiscal retrenchment. I believe this sets the market up for a large correction at some point this year.

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