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In October of 1987 I was only 17, but already very interested in trading and the markets. As a result, when the Crash happened I was very interested, and impacted. I may not have yet had my own trading account, but I did have money in a Dow Chemical dividend reinvestment program (DRIP) my mother had made me contribute into out of my paper route money when I was younger. I watched the value of my shares get cut in half that one day, something I’m sure a lot of people who were in the market then (and none too few who have experienced the two major bear markets since) can relate to on some level. That had a major impact on me, as it did on many, many others.

Here’s the rub, though. The Crash of ’87 didn’t send me running away from the market the way it did for a great many investors (and they didn’t come back until the middle to latter 90s). It actually motivated me to try to understand the markets and could easily be pointed to as a major factor in my eventual move into the ranks of professional market analysts.

More importantly, though, the Crash taught me a major lesson that I think too many traders and investors fail to learn until it’s too late. This is that the markets can do just about anything at any time.

There is the old saying that generals fight the last war, meaning instead of thinking forward they are caught up with trying to avoid past errors. Traders and investors are the same in many ways. It relates to recency bias. This works both in positive and negative times, and in both cases it keeps us from realizing the markets will do new and surprising things in the future.

Whether you are trading or investing your own money, or putting that money to work with others through alternative investing, managed accounts, or autotrading you need to always have that “anything can happen” mentality. It needs to always be a part of your decision-making. That way, though the market may throw the occasional surprise twists your way, you’ll never be overly damaged by them.



It is almost four years since central banks in the Western world first adopted near-zero interest-rate policies – alongside the implementation of substantial quantitative easing measures – intended to halt the sharp and swift decline in economic activity that followed the acute myocardial infarction that struck at the heart of the global financial system.  The prescribed medicine successfully revived the ailing advanced economies, but failed to restore the patient to full health, as the deterioration in vital signs in the years leading up to the crisis, precluded a rapid and robust recovery, no matter how high the dosage.

The lacklustre recovery – characterised by persistently elevated levels of unemployment, and subpar business investment rates – has seen central bankers reaffirm their commitment to do “whatever it takes,” in the words of the European Central Bank’s President, Mario Draghi, to return the industrialised world to a more familiar growth-setting.  The rhetoric has been followed by action, as monetary policymakers in Frankfurt and Washington have reached into their medicine chest, and upped the dosage in an effort to remove negative fat-tail risks, and keep their economies afloat.

Return-starved investors’ anticipation of further monetary stimulus fuelled an unseasonal rally in the world’s major stock market averages during the summer that has seen prices advance to within touching distance of multi-year highs.  Surprisingly, the robust double-digit, percentage-point gain in equity values has taken place in spite of mounting evidence that suggests global economic growth has slowed to stall-speed, which is often a prelude to recession.

Further, stock market indices have moved higher on economic data, both ‘good’ and ‘bad,’ which means investors must believe central bank action will ultimately, result in a significant improvement in economic activity.  The conviction is difficult to fathom, given that the ambitious monetary policies pursued in both Europe and the U.S. post-crisis, have already failed in igniting anything like a standard economic recovery, and that further life-support operations are required simply to sustain economic growth not too far below trend.

The evidence of the past four years is virtually a carbon copy of the Japanese experience following the collapse of its twin property and stock market bubbles in the early-1990s.  The Bank of Japan reduced short-term policy rates somewhat belatedly to zero in 1996, and launched the first in a series of quantitative easing programmes early in the new millennium.

However, the unconventional policies adopted in Japan did not produce any real traction in the economy, and the nation’s economic output is now forty to fifty per cent below the level that reasonable forecasters would have projected it to be way back in 1991.  Ultra-accommodative monetary policy was unable to prevent two decades of economic stagnation, as the banking crisis and private sector deleveraging that followed the implosion of the credit-fuelled asset bubbles, seriously curtailed its potency.

Investors refuse to acknowledge the possibility that the Western world might succumb to a more than decade-long, Japanese-style stagnation, even though the starting points were much the same, and the recovery to date has followed a similar path in the presence of equally expansive monetary policies.  The notion that the advanced economies in the West merely skipped a heartbeat, and did not suffer a cardiac arrest, does not stand up to serious scrutiny.

The euro-zone, the U.S., and the U.K. all entered the current episode with non-financial private sector debt ratios that were close to those of Japan two decades ago, and well above the thresholds that have been shown empirically to retard economic growth.  Not surprisingly, the slump in property prices, alongside a severe decline in equity values, prompted a sharp drop in the private sector’s demand for credit, as both the household and corporate sectors attempted to rehabilitate their weakened balance sheets.

Just like Japan, private sector deleveraging continues in spite of historically low interest rates, as subdued growth in disposable income means prospective borrowers are in no hurry to add to their already difficult-to-manage debt burdens, while capital-constrained banks are reluctant to lend to all but the highest-quality debtors.

Further, the Japanese experience demonstrates that the continued suppression of long-term interest rates via quantitative easing, risks undermining the availability of credit even further, as the potential rewards from incremental lending fail to compensate for the risks attached.

Troublingly, years of private sector deleveraging in Japan did not prevent the combined government and non-financial private sector debt ratio from moving higher, as the improvement in corporate and household balance sheets was more than offset by the steady deterioration in public finances.

The same phenomenon has been apparent throughout the advanced economies of the Western world in recent years, as declining tax revenues, increasing unemployment benefits, not to mention sizable bank recapitalisation costs, caused fiscal deficits to skyrocket during the recession, and the subsequent recovery has not been sufficiently robust to stabilise public debt ratios.

Aggregate debt ratios remain close to or at record levels throughout the Western world, and as in Japan, the right-sizing of balance sheets is set to become even more difficult, due to an unfavourable demographic picture that is certain to lower potential growth.  The task could prove even more onerous should elevated unemployment rates and subdued investment in the capital stock, result in lower productivity.

Stock prices have staged an impressive rally on the belief that monetary stimulus will produce a self-sustaining economic recovery any day now, but round after round of unconventional programmes suggests the Western world is edging ever closer to Japanese-style stagnation.  Investors should take note.





Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

The world’s major stock price averages have registered robust double-digit gains, since early-summer, to within touching distance of multi-year highs, a somewhat puzzling development given that virtually all of the most recent data confirms that global economic growth has slowed to the most sluggish pace since the ‘Great Recession’ came to an end three years ago.

A troubling slowdown in economic activity is detectable almost everywhere, with stagnation or outright contraction evident across much of the developed world, while several emerging market economies have struck a nasty speed-bump.  The deterioration in the global economic outlook is beyond dispute, and reflected in rising unemployment, falling investment rates, as well as the volume of world trade, which has slowed to a standstill.

Hope continues to trump reason however, as investors continue to demonstrate blind faith in policymakers’ ability to deliver stimulus measures that will lift the global economy from its current soft patch.  It is staggering to observe that many seasoned market players persist with such a belief, given that all the evidence suggests that the various growth models responsible for the robust expansion in economic activity, in the years that preceded the global financial crisis, are now exhausted.

The debt-driven model that underpinned economic growth throughout most of the Western world, for at least the past two decades, is undoubtedly beyond rescue at this juncture.  The rate of increase in non-financial private sector debt outpaced GDP growth by more than three percentage points a year on average through the 1990s, and the gap widened to almost six percentage points a year in the early years of the new millennium, which inevitably pushed debt ratios to dangerous levels.

The unsustainable private sector borrowing spree duly came to an end once the ‘Great Recession’ struck in 2008, and the resulting plunge in economic activity required fiscal and monetary stimulus on an unprecedented scale to prevent a worldwide depression.  The unthinkable did not happen of course, but policymakers’ efforts to promote a self-sustaining economic expansion have been less than impressive.

The U.S. economy for example, is experiencing the weakest recovery in post-war history, with annualized economic growth, quarter-on-quarter, averaging little more than two per cent since the downturn ended, or less than half the pace recorded over a comparable time period, following the previous ten recessions.  Additionally, although real output has reached new highs, not one of the four indicators that the National Bureau of Economic Research employs to date business cycles, has exceeded their pre-recession peaks.

Meanwhile, European economic performance has been even less inspiring, with activity failing to recover its pre-recession peak in both the euro-zone and the U.K., such that GDP-per-capita is still roughly two per cent below its 2007 level in the former, and six per cent below in the latter.  Further, the post-recession experience in both economic regions trails the Japanese record following the deflation of its twin property and stock market bubbles more than two decades ago.

Three years have passed since the advanced economies of the Western world reached their nadir, and economic growth continues to disappoint, while aggregate debt ratios remain close to record levels, as the deleveraging of private sector balance sheets has been offset by the deterioration in public finances.  Further, persistently elevated unemployment rates, alongside relatively subdued investment in the productive capital stock, threatens to lower potential growth rates that are already pressured by an unfavorable demographic picture.

The debt-driven model apparent in most of the developed world is bankrupt, but troubling, the growth models applied in emerging market economies can no longer be relied upon to drive the global economy forward.  This is true not only in India, where persistently large fiscal deficits, a deteriorating external position, and stubbornly high inflation have undermined the sub-continent’s status as emerging-market darling, but also in China, where an unprecedented investment boom has limited the central government’s scope to offset the sharp slowdown in economic growth via a fiscal stimulus package centered on infrastructure spending.

The Middle Kingdom’s economy is already in desperate need of rebalancing towards household consumption, which at less than 35 per cent of GDP is well below that of countries at a similar level of in income.  Additional infrastructure spending at this juncture may well ease cyclical pressures, but would undoubtedly result in greater economic turbulence later.

China’s policy response to the global financial crisis precipitated a nine percentage point increase in the investment share of GDP to close to 50 per cent between 2007 and 2011.  However, the investment boom has been accompanied by an increase in the incremental capital/output ratio – the quantity of new capital required to generate an additional unit of growth – to levels comparable to its East Asian neighbors just before crisis struck in 1997.

Further, central government and corporate debt ratios are not far removed from Japanese levels just before its economic miracle came to an end in 1989.  Rebalancing, and not fiscal stimulus, is what the Chinese economy requires, and simple arithmetic suggests that this is not possible without a significant drop in the economy’s long-term growth rate.

Investors continue to push stock prices higher on hopes that stimulus measures will return the world economy to a more familiar growth trajectory.  Cyclical solutions cannot solve structural problems however, and it is troubling to note that there are no growth engines available to push the world economy forward.


Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Modern Portfolio Theory remains a major part of many investment portfolio allocation processes. Basically, the idea of MPT is that one can combine a collection of securities into a portfolio which offers comparable return prospects with reduced risk. This is done by mixing together stocks and other assets which are not well correlated, or perhaps are negatively correlated.

Sounds good, right?

The problem is, as has been discussed, that individual stocks have become extremely highly correlated to the market in recent years. This, by definition, means they have become increasingly correlated to each other as well, reducing the opportunity for diversification in portfolios using the old methods.

Another issue with MPT-based portfolio development is the fact that correlations change over time and in different time frames. The chart below from Oanda shows a recent set of correlations between EUR/USD and other currency pairs (as well as gold and silver).

Notice in the AUD/USD column how the correlations to EUR/USD are strongly positive (darkest red) in the hour, day, and week time frames, but then are uncorrelated in the longer time frames, and even negatively correlated at 3 months. In the case of USD/JPY we can see the correlations are very time frame depended, running the full spectrum over the time frames. Even with silver and gold (XAG/USD and XAU/USD) the correlations aren’t consistently strongly positive.

All this correlation variation creates considerable challenges to standard asset allocation and portfolio development methods and approaches. Imagine creating a portfolio of stocks that have been properly minimally correlated only to have them all become highly correlated? It would totally change the portfolio’s risk dynamics, and likely at the worst possible time.

This is where the importance of considering diversification not just in terms of markets and securities, but also in terms of trading/investing approach becomes clear. This is the approach of fund-of-fund investors. They seek out uncorrelated money managers, exactly the same sort of thing you can do by taking part in the Trade Leaders program.

Labour Day has come and gone, which means the US summer season is officially over.  Wall Street brokers have made their way back from the Hamptons, and returned to their desks to prepare for the final stretch of 2012, a year that has been kind to the owners of common stocks so far, with the Dow Jones Industrial Average delivering solid, double-digit percentage-point gains during the first eight months of the year, while the S&P 500 has returned to the levels that prevailed just before stock prices descended into free-fall in the autumn of 2008.

It is often said that bull markets climb a wall of worry, and the old, nineteenth-century adage has certainly proved true in the year-to-date.  Indeed, investors’ asset allocations appear to have been swayed more by the potential for further unconventional central bank action, rather than the myriad threats – from the persistent turbulence in the euro-zone to a rapid slowdown in Chinese economic activity – that would have been expected to keep risk appetites in check.

Long-term investors are undoubtedly cheerful, but they would be wrong to take comfort from the stock market’s relatively tranquil price action in recent months, as the latest upward move has been accompanied by a marked deterioration in technical indicators, and a growing air of complacency among the professional investment community.

The major market averages’ risk/reward profile is decidedly asymmetric at this juncture, with the potential downside far outweighing any possible upside.  As a result, a nasty surprise could well lie in wait for the increasing army of bulls, who display uncritical satisfaction with their current allocation to risk assets.

The ‘Dow Theory’ is a useful place to start given its long and rich history as a staple for wannabe technical analysts, and it reveals some discomforting divergences that question the true health of the stock market’s present condition.  Far from confirming the optimism of the diehard bulls, the study of recent price action and trading volume, suggests that the upturn in the major stock market averages has become increasingly fragile, and when some of the financial world’s savviest short-term traders hint that are they are positioning for an impending downside shock, perhaps it would be wise to take notice.

For those unfamiliar with Dow Theory, it was derived from a series of Wall Street Journal articles penned by the newspaper’s founding editor, Charles Henry Dow, from 1900 until his untimely death, aged just 51 years, in 1902.  The journalist assembled the Industrial Average in 1896 and the Railroad Average one year later, which meant that he had only a limited sample of historical data from which to develop a cohesive theory.

Dow’s failing health meant that he had little time to put all his thoughts on paper, but William Peter Hamilton, his successor at the financial newspaper, used his predecessor’s theory as the basis for the market predictions he made in more than 250 articles from 1903 until his own death in 1929.

Hamilton clarified the basic outlines of the theory in the 1922 classic, “The Stock Market Barometer,” and the study of stock price movements was further refined by Robert Rhea, who reduced the analysis to a set of theorems that an ordinary investor could understand, in 1932’s timeless, “The Dow Theory.”

Dow believed that both stock averages must confirm a trend, and Rhea noted in his text that, “The movement of both the railroad and industrial averages should be considered together…Conclusions based upon the movement of one average, unconfirmed by the other, are almost certain to prove misleading.”

In this regard, it is interesting to note that the recent cyclical high in the Industrials has not been confirmed by the Transports.  Indeed, the Transportation Average reached a cyclical peak during the summer of 2011, and registered a lower high earlier this year.  Rhea warned that, “A wise man lets the market alone when the averages disagree.”

Dow argued that trading volume should confirm price trends, and Rhea believed that investing in a market that had become “dull on rallies and active on declines” was foolhardy.  The entire advance off the crisis-induced lows during the spring of 2009 stands out in this regard, as trading volume has been consistently higher on weakness.  Indeed, the coefficient of correlation between the ninety-day average of trading volume and stock prices has been a disturbing –0.84 since the cyclical bull market began, as compared with a positive correlation of 0.88 during the early years of the great 1980s bull market.

Not only has trading activity collapsed, with volume at the recent cyclical high in stock prices almost sixty per cent below the figure recorded at the 2009 bottom, but daily price changes have also declined into insignificance.  Since the crisis-induced low, stock prices have registered a percentage point move of more than two per cent once every nine trading sessions, and a more than three per cent change once every 28 sessions.  Recently however, the daily fluctuations have been miniscule; there has been just a single two per cent change in almost fifty trading sessions, and the market has not registered a daily move of more than three per cent in nine months.

Dick Arms, a respected figure in the world of technical analysis, observes that, “There are times when the market gives the impression it is fading into nothingness.  Volume becomes very low, trading ranges become very small, volatility becomes very low.  Also, there is very little change in market levels, and day-to-day fluctuations are minimal.  Looking back at history, when that happens, it is almost always a sign of a market high point.”

Investors have been warned.



Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

US stock prices have been unusually buoyant through the lazy-days of summer, and have jumped almost ten per cent since the end of May, to within just two per cent of the levels that prevailed immediately before the financial crisis entered its most dangerous phase during the summer of 2008.

The most recent turnaround in the stock market’s fortunes has been somewhat surprising, given that virtually all of the latest economic data points to nothing better than sub-trend growth, while ‘Corporate America’ has just completed its most disappointing quarterly-earnings season –  at least, versus bottom-up expectations – since the current upturn in equity values began more than forty months ago.

The major market averages’ resilience against what would appear, on the surface, to be bad news, almost certainly reflects investors’ blind faith in the Federal Reserve’s ability – and willingness – to deliver infinite rounds of emergency stimulus in the face of sagging growth, that should, in the bulls’ eyes, not only prevent the realisation of unfavourable outcomes, but perhaps, even return the economy to a more robust growth trajectory.

The close to God-like status afforded to the inhabitants of the Marriner S.  Eccles Federal Reserve Board Building in Washington D.C. is warranted, or at least the bulls argue, by the fact that the monetary authority delivered the ‘Great Moderation’ through the mid-1980s and beyond, and managed to prevent a repeat of the ‘Great Contraction’ of the 1930s, in the face of the largest systemic crisis in generations.  It is clear that the ‘Greenspan Put’ has simply evolved into the ‘Bernanke Put’ – but, investors’ increasing dependence upon central bankers’ continued wizardry could well be nothing more than wishful thinking.

It is beyond dispute that the ‘Great Moderation’ was a very real phenomenon, whereby a broad-based decline in macroeconomic volatility began during Paul Volcker’s second term as Chairman of the Federal Reserve, and persisted throughout the Greenspan era.  Indeed, the volatility of quarterly real GDP growth more than halved in the period from the final quarter of 1983 to the end of 2007, as compared with the previous quarter century.  Further, the dramatic decline in macroeconomic uncertainty was not confined to quarterly output, and extended to a multitude of variables including inflation, employment, and exchange rates.

The ‘Great Moderation’ was well-known to investors for several years, but captured the public imagination in the spring of 2004, when Ben Bernanke delivered a speech given to the Eastern Economic Association, which concluded that, “improvements in monetary policy…have probably been an important source of the Great Moderation.”  Various central bankers have put forward the same view, which has been dubbed ‘enlightened discretion,’ but numerous academic studies have poured scorn on this hypothesis.

Indeed, a paper by James Stock and Mark Watson finds that monetary policy had little to do with the substantial drop in output volatility, and everything to do with good luck.  The authors attribute as much as ninety per cent of the economy’s improved stability to good luck – or the absence of large adverse shocks – rather than the economy’s dynamic response to these disturbances.  The very same conclusion has been reached by various respected academics, which undermines central bankers’ current God-like status.

Those who remain unconvinced, and continue to believe that central bankers are miracle-workers and not ordinary mortals, should take a close look at the rhetoric emanating from the higher echelons of the Federal Reserve before the crisis struck.  They championed the financial innovations that precipitated the crisis, and were blind to structured finance’s soft underbelly.  Further, once the crisis struck, they consistently underestimated the potential size of the shock.

The Federal Reserve did prevent a repeat of the 1930s, but the monetary policymakers have been consistently surprised by the economy’s underwhelming response to unconventional stimulus.  Indeed, the Fed wizards believed in the summer of 2010 that economic growth would be between 2.9 and 3.8 per cent for the full calendar year, and between 2.9 and 4.5 per cent in 2011.  The actual outcomes were a disappointing 2.4 and 1.8 per cent respectively.

Investors need to appreciate that in spite of extraordinary monetary stimulus, the current economic upturn is the most uninspiring in post-war history.  Indeed, output growth has averaged just 2.2 per cent over the twelve quarters since the recession’s nadir in the summer of 2009 – or less than half the average pace of growth registered during the three-year periods that immediately followed the previous ten post-1945 recessions – while the current unemployment rate is still above all but three of the prior recession peaks.

The economy’s good luck ran out when the financial crisis struck, and the Federal Reserve is not a miracle-worker, and simply does not have a silver bullet that will return the economy to a more robust growth trajectory.  Meanwhile, the structural headwinds behind the lacklustre growth performance, exposes the economy to adverse shocks.  Welcome to the ‘Great Stagnation.’




Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

That’s the question I see popping up frequently of late. The argument is a fundamental one focused primarily on the debt crisis going on in Europe at the moment and the seeming lack of ability of anyone in power to deal with it. Even Federal Reserve member Bullard expressed pessimism about the prospects on a recent CNBC stint. So why isn’t the euro coming unglued?

First of all, as the following charts show, the single currency has been weakening pretty steadily against all the major currencies over the last year.

EUR/JPY is down about 20%. EUR/USD is currently down about 15% from its high, and the other pairs are down a comparable amount. That’s a sizeable devaluation for a major currency in that period of time. So to say the euro hasn’t fallen apart is a bit off.

Could it be worse off? Sure. There are reasons why it isn’t, though.

The biggest reason is what we saw on Wednesday after the release of the minutes of the last FOMC meeting. It indicated the prospect for further QE, or at least further monetary accommodation. This potentiality is present in many of the major economies, while the ECB has dragged its feet being as aggressive as the likes of the Fed and Bank of Japan. We always have to remember that exchange rates are reflections of relative value, not absolute. If the Fed is acting in a fashion which weakens the dollar, then issues with the euro will not be reflected so sharply in EUR/USD.

Those looking at currency valuations also need to realize that unlike stocks and bonds, which are mainly priced in terms of the value of future events, currencies themselves cannot be priced that way. With a stock we look at future earnings and whatnot to figure out what it’s worth today. With bonds we discount back all the future cash flows. In both cases expected future inflation is a factor. Inflation is also a factor in currency valuation, but unto itself a currency has no cash flows to be discounted. As a result, a currency – in spot terms – is a more immediate asset.

The immediacy element means we need to look at the euro more in terms of what it’s being used to buy and sell. The Eurozone as a whole has been running a strong positive current account balance of late, meaning more money coming in than going out. That indicates increased demand for euros, with both trade and investment flows a factor. This is supportive for the euro.

Lastly, also keep in mind the so-called risk trade. The euro has been a primary beneficiary of periods when the markets were more positive about things like economic prospects. As the chart below shows, EUR/USD has been largely well-correlated to the S&P 500.

You may not buy into the euro rallying with stocks, but if that’s what the market does then it’s the reality we have to face at the moment. Regardless, it comes down to making sure we factor in all aspects of the multidimensional forex puzzle, and don’t get caught just looking at one side of any exchange rate equation.

The ‘risk-on’ trade is back in vogue, as less bad economic data alongside investors’ blind faith in central bankers’ ability to implement the necessary policies to prevent unfavourable outcomes, has pushed the major stock market averages upward by as much as ten per cent since early-June.  The bulls are back in charge for now, but the antiquated views of the world that underpin their investment strategies, are unlikely to generate superior performance for return-starved clients.

It goes without saying that the recent turnaround in the stock market’s fortunes has seen the traditional long-only bulls applaud themselves for their seemingly prescient views.  The song remains the same for this particular breed of investor – stocks are the most appropriate vehicle for long-term investors, and investors should stand firm in the face of sporadic weakness.  The ‘buy-and-hold’ mantra persists, even though the major market averages have made no discernible headway in more than thirteen years.

Unfortunately, the continued complacency has seen few if any of the diehard bulls question why the frequent pullbacks during the three-year old cyclical upturn in stock prices, have ranged between ten to twenty per cent – or more than twice the magnitude of the typical correction in the years before the global financial crisis.  The oversight could well prove costly, as the reasons behind the equity market’s outsized moves, suggest the secular downturn that began more than twelve years ago, is not over.

The double-digit percentage point moves in stock prices, both upwards and downwards, reflects the equity market’s increased sensitivity to the economy’s underlying momentum.  In fact, macroeconomic developments explain more than three-quarters of the stock market’s performance in recent years, much to the frustration of bottom-up investors, who champion the sharp, albeit low-quality, improvement in corporate fundamentals.

The increased importance of macro as an explanatory factor behind the stock market’s fluctuations in recent times stands in sharp contrast to the extended upturns in equity values from the summer of 1949 to the winter of 1968, and from the autumn of 1982 to the spring of 2000.  During these periods, cyclical developments were typically overwhelmed by powerful secular forces that allowed for private sector credit expansion, such that bear market declines of more than twenty per cent were few and far between.

The secular bull market that began in the summer of 1949 encountered three recessions during its first eleven years, yet the stock market did not register a cyclical bear market decline on any of these occasions. In fact, equity investors did not endure one single recession-induced decline of more than twenty per cent during this nineteen-year long secular upturn, and suffered the first major setback only when President Kennedy’s took on the steel industry in 1962 over ill-advised price hikes, which triggered a valuation correction that paved the way for further gains.

Similarly, common stock investors did not suffer one single recession-induced bear market during the period that extended from the autumn of 1982 to the spring of 2000; the record-breaking bull market was notable for the fact that the economy spent just eight months or less than four per cent of the time in recession.  The only major setback that investors endured during this almost eighteen-year long stretch was a nasty valuation correction in 1987, which was precipitated by a confluence of negative factors.

It is fair to say that the more than three-year old upturn in stock prices that began during the spring of 2009 looks nothing like these former periods, as the major market averages have already suffered several percentage point declines of more than ten per cent, while the macro-driven fluctuations in stock prices are symptomatic of an ongoing secular bear market.  Thoughtful investors need to appreciate what lies behind the stock market’s increased economic sensitivity.

Several commentators who have detected this particular feature of the current cyclical upturn typically trace its origin to globalisation, but it is far more likely that the macro-driven market is a function of the regime in which the economy currently resides.  Equity investors enjoyed a disinflationary boom from 1982 onwards, as powerful secular tailwinds combined to precipitate a sustained decline in macroeconomic volatility and an improvement in potential future growth, but the so-called ‘Great Moderation’ came to an abrupt end, once the global financial crisis unleashed dangerous deflationary forces.

Common stock investors are now facing a tug-of-war between destructive debt deflation and successful policy-induced reflation with the probability of each moving in sync with the economy’s underlying momentum.  Negative macro surprises increase the chances of the former and reduce the probability of the latter, while positive surprises have the opposite effect.  It is hardly surprising in this context that seemingly small changes in economic momentum have an outsized impact on market performance.

The risk-on/risk-off trade has characterised stock price behaviour ever since the global financial crisis struck four years ago.  The volatility reflects the ongoing tussle between deflation and reflation – ultra-bearish and bullish outcomes respectively.  Top-down investing is king for now.



Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.