Telltale signs for a correction

There are four basic negatives for a sharemarket – a pullback, a correction, a crash and a prolonged slump.

A pullback is when the market index falls from its previous peak by under 10%. Minor pullbacks are less than 5%.

A correction involves the market index falling by between 10% and 20%, and usually takes a few weeks or months. 

A crash is when the fall exceeds 20%. This is also called a primary bear market and may last for a few years.

A prolonged slump can last several years (usually five to 20 years, though in Japan it has now been 24 years). This is also called a secular bear market. It’s marked by a combination of primary bull and bear market swings that broadly stay within a horizontal channel. Secular bear markets end when there is a decisive and sustained breakout from this channel.

The history of secular bear markets since 1900 is shown in the following chart using America’s Dow Jones Industrial Average Share Index, the oldest share index in the world.  The Dow represents the average share prices of America’s largest 30 listed companies without any weighting for their capitalisation.

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Bears in hibernation

The good news is that most technical analysts now think the secular bear market that started in the year 2000 ended in 2013. That is illustrated by the following chart of the S&P 500 index, which represents the combined share prices of America’s top 500 listed companies weighted by their capitalisation.

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But Robert Dillon of stockmarkettiming.com in the USA says that until the market’s breakout is more pronounced there is still a risk of it falling back within its previous sideways pattern, which would signal that the secular bear market has longer to run. As evidence, he points to what happened in 1920 when the market jumped above its previous channel ceiling only to relapse again in a shock crash.

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Dillon also makes the point that every sideways secular bear market in the last century was marked midway by a sharp dip. See the first slide above. If that pattern is repeated again then the secular bear market may have another two to three years to run before it can be declared over. In the meantime, it could experience another crash.

Nasdaq vs the Great Depression

But Dillon thinks the key to understanding the current market is what happened after the Great Depression. He notes that the pattern of the US Nasdaq Share Index (which represents mainly hi-tech companies) in the last 14 years is similar to that of the Dow Jones index from 1930 to 1949.

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The Dow Jones index originally represented the dynamic giants of the industrial revolution just as the Nasdaq now represents the leading companies of the information revolution.

If the Nasdaq keeps following the path of the Dow Jones in the 1930s and 40s the worst should be over, except for a delayed correction which Dillon expects this year. Also, the Nasdaq could take until 2017 before it matches the dizzy heights it reached in 2000.

Finally, the party-pooper in technical analysis is Robert Prechter, founder and head of Elliott Wave International. Prechter, who believes markets move in cycles (five waves up and three waves down) made his reputation accurately predicting the start of the secular bull market in 1982 and the flash crash of October 1987.

He lost clients in the 1990s because he told them to short the market from 1995 when instead it kept booming until 2000. In his 2002 book, “Conquer the Crash”, he accurately foresaw the bust of 2007, but since then he has wrongly forecast every major pullback as the start of another crash. So his record is patchy.

Prechter’s big theme is that the sharemarket is at the end of a 300-year super-cycle that is on the cusp of breaking, and when it does all hell will break loose. In his view the 2008 crash was just a preview of worse to come. Here is how he depicts it in a chart.

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PER and Irrational Exuberance

But what does the market tell us on fundamental rather than technical analysis? The most common measure of whether the stockmarket is over or undervalued is its overall price to earnings ratio (PER), which divides the S&P 500 index by the trailing-12-month earnings of its constituent companies. As you can see this ratio at present is 19, which is above its historic mean of 15.8, but not alarmingly so.

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But there is another way of looking at the PER popularised by Nobel Laureate Professor Robert Shiller, whose 2007 book “Irrational Exuberance” came out just before the financial meltdown.  He divides the S&P 500 index by its annual earnings over the past 10 years adjusted for inflation. This has the advantage of eliminating fluctuation of the ratio caused by the variation of profit margins during business cycles. This is similar to Warren Buffet’s favourite measure of market valuation, which divides total market capitalisation by GDP, where the variation of profit margins does not play a role either (see http://www.gurufocus.com/stock-market-valuations.php).

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Shiller’s cyclically-adjusted price-earnings (CAPE) ratio at 25.5 is not as high as it got in 2000, but it’s almost back to the “irrationally exuberant” level of 2007. Shiller also makes the point that every secular bear market in the last century did not end until the CAPE ratio fell below 10. If history repeats itself then either share prices have to crash and/or earnings have to soar for the CAPE ratio to return to its historic average, though historically it has undershot this level before stabilising.

Does Shiller’s work suggest the S&P 500 can’t go higher? Absolutely not, since the CAPE reached greater heights in 1929 and 2000. But my view is that anyone who thinks the US stockmarket from hereon will defy gravity is not an investor but a speculator. Also, any shake-out in America would be especially felt in Australia given the economic headwinds we face with the end to our mining construction boom.

How to safeguard against a crash

So how can one safeguard against a future market crash (based on Shiller’s fundamental analysis), but still enjoy a protracted sharemarket boom (based on Dillon’s technical forecast)? My advice is to hold at least a large chunk of your share portfolio in the form of an exchange- traded fund (ETF) with ASX codes STW, VAS, IOZ or SFY and then slow trend-trade it to ride booms and sidestep busts.

Here’s what to do. When the All Ords index’s 50-day trend line (red) overtakes its 250-day trend line (blue), as it did in September 2012, buy units in one of these exchange-traded funds. When the shorter trend line falls below the longer one sell the units and put the proceeds in a cash management account until it’s safe to rebuy the units.

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Note that such trading is very slow (only seven transactions in 12 years), yet it rode the bull market from 2003 to 2007, avoided most of the 2008 bear market, caught the rally of 2009, sidestepped most of the 2011 correction, and resumed the rally of 2012. Admittedly there were two small whipsaws between 2010 and 2011, but the gains and savings from the other trades more than offset these modest losses.

I prefer a more sophisticated market timing model that combines trend and momentum indicators to allow earlier entry in a rally and earlier exit in a crash. I am a market timer because I never want to experience another 2008 market crash.

Over an economic cycle I want sharemarket returns without sharemarket volatility, and that’s only possible by smoothing the rollercoaster ride associated with a buy and hold approach to share ownership.

Percy Allan is a director of MarketTiming.com.au For a free three week trial of its newsletter and trend-trading strategies for listed ETF funds, see www.markettiming.com.au.