Gloom and doom became the norm in 2011, ahead of the year when the world is supposed to end. Inspiring the disaster movie that started filming around the time of the Lehman implosion, the doomsday prophecies for 2012 have included everything from a meteor strike, to a geomagnetic reversal, to a visit by aliens. And the latest take on apocalypse is the death of the euro and the after-shock of hyperinflation or economic depression – take your pick.
The Armageddon chatter and contagion talk has continued to weigh down consumer confidence globally, in the eurozone as well as in the UK, US, Japan, China, and other countries. And worried investors have continued to seek the comfort of the herd, acting in unison.
The result has been an unprecedented number of one-sided trading sessions since August. The vast majority of shares and stock prices have been moving in the same direction, with the daily gyrations unusually high, as reflected by the S&P 500’s mean daily change over the past 100 days.
At the same time, correlations remain higher than ever, with the risk-on beneficiaries outperforming together on rallies and the risk-off indices outperforming together on sell-offs.
There is a high correlation between the MSCI All Country World Index and the ratio of the NDR Risk-On Index (comprising markets, sectors and currencies that outperform on market strength) to the NDR Risk-Off Index (containing indices that outperform on market weakness). The risk-on/risk-off dynamic is the strongest since 1980-81, another period when worry ruled the day.
Believers in the doomsday prophecies would argue that fear is justified, that global market and economic deterioration will be reminiscent of 2008, or even worse.
But the flaw with that argument is that the 2008 experience, together with the widespread awareness of the carnage that a euro break-up would bring, virtually ensures that the world’s main policymaking bodies will do whatever they can to prevent it.
Political feuding and global coordination hurdles are likely to draw out the process and make it more of a muddling process of repair than a quick fix. But the eurozone should hold together, at least through 2012.
And to the extent that the process will continue to include monetary accommodation, the markets will stand to benefit from the increased liquidity, if and when the gloom gives way to rising confidence that the outlook for Europe and the global economy are not as dire as the markets had thought. When pessimism has been at such high levels, equity investors have been susceptible to positive surprises.
Among the unusual developments of late 2011 was the market’s November-December zigzag, reflecting a momentum thrust from an oversold condition. By itself, the late November streak of seven straight down days was a positive omen.
The market has usually been higher over the three-, six-, and 12-month periods following past streaks of seven straight down days. And it has been especially encouraging to see that streak followed by a five-day gain of more than 7% on the S&P 500.
Before 2011, there were four other cases when a seven-day losing streak was followed by a five-day gain of at least 5% during the next two weeks: in 1942, 1962, 1974 and 1982. Each case occurred within four months of a cyclical market bottom.
Despite the rarity of such reversals, the latest case was actually the second in four months, following a similar reversal after the selling climax in August. The back-to-back cases exemplify the market’s gyrating tendency, and they are in keeping with the other signs of a market that has reached the extreme of worry.
Smoothing out the daily fluctuations, indicators based on moving averages will confirm the arrival of a new bull market. With more than 70% of 45 markets above rising 200-day moving averages, the global trend would clearly be pointed upward.
If contagion from the eurozone debt crisis is in fact contained to Europe, then comparisons with 1998, when Asian contagion stopped, will remain more relevant than comparisons with 2008, when US contagion did not.
In 1997-98, the US stood at the outskirts as the Thai baht devaluation led to currency meltdowns, collapsing markets, a liquidity crisis, and economic contraction throughout Southeast Asia, leading to an oil-price drop that triggered the 1998 Russian default and in turn the demise of Long-Term Capital Management. The period included a series of IMF bailouts and ultimately a Federal Reserve bailout to stop the contagion, with successful results.
Ten years later, the US stood at the centre of an escalating financial collapse that spread globally. The US-driven financial contagion produced a global bear market with the worst declines since the 1930s. The market carnage anticipated the longest recession since the 1930s and the biggest earnings collapse on record. With the world’s largest economy and market cap, the US dragged down markets and economies around the world.
With a doomsday scenario unfolding in Europe, the credit crunch would spread globally, and so too would the probable European recession. Currently, however, recessions do not appear likely beyond Europe. Keeping in mind that the stock market leads the economy, the relative market performance suggests that the European economy will underperform.
But that doesn’t means that a global contraction lies ahead. In 1997-98, the MSCI Pacific ex Japan Index underperformed decisively as the US outperformed. Likewise in 2010-11, the MSCI Europe ex UK Index underperformed decisively as the US outperformed.
NDR has been positioned for US relative strength and eurozone weakness, remaining overweight the US since early 2011 and underweight Europe ex UK for most of the year.
With confidence picking up in a cyclical bull market next year, it’s quite possible that the US will be a market-performer, or even an underperformer, as Europe ex UK performs better on mean reversion and lessening fear. But we doubt that overweight allocation will be warranted with the eurozone muddling process continuing and major solvency questions unresolved.
We would expect more from the region’s non-euro markets, a group that has consistently outperformed eurozone markets since euro notes and coins started changing hands in 2002. The second chart illustrates the persistent slide of an index based on eur0zone markets relative to an index based on non-euro European markets.
Also entering 2012, we are marketweight the UK, expecting the UK as well as the non-euro Scandinavian markets to hold up better than most of the region’s other markets during a global economic pick-up.
The same can be said of the region’s emerging markets, which have been weighed down by their exposure to eurozone banks. Increased economic confidence, improving bank stock performance and a continuing decline in most yields would be especially beneficial to the emerging markets of eastern Europe.
As an asset class, emerging markets tend to perform well during the first year of a cyclical bull market, when risk appetite is rising. After the past five cyclical bottoms, the relative strength of the MSCI Emerging Markets Index has been up by medians of 4% after three months, 11% after six months, and 34% after a year, in each case exceeding the median relative strength of the five other regional indices.
Emerging markets were the best performers in two of five cases after 63 days, four of five cases after 126 days, and all five cases after a year. With narrowing credit spreads, more aggressive easing in Bric countries, a persistent advance in the risk-on/risk-off ratio, emerging markets would be likely to beat out the other indices as the performance winner next year.
We have been overweight emerging markets since November 4, which is also when we returned Japan to underweight. Japan has had its own debt and currency issues, in its case excessive currency strength, with economic implications that have prevented the country from climbing out of its 22-year secular bear market.
While the main markets of Europe ex UK, the US and the UK also remain in secular bears, secular bulls have persisted in the markets of the Pacific ex Japan region. We are currently marketweight the Pacific region, but an upgrade to overweight will be supported if those markets regain relative strength in tandem with re-assertive commodity demand.
As long as correlations remain elevated, and as long as our indicators describe a risk-on environment, the risk-on beneficiaries can be expected to outperform in 2012. The US market could be expected to rise toward a test of the 2007 highs in the range of 1500 to 1560 on the S&P 500, while the MSCI World Index would rise toward the equivalent range of 1615 to 1680.
What if we’re wrong, and the 2012 doomsayers are vindicated, at least about the stock market? In that case, our indicators and models will warn of trouble, and we will cut exposure in response. But their current message is that the world as we know it will survive in 2012, and markets will recover on the receding gloom.
Tim Hayes is chief investment strategist at Ned Davis Research, a leading independent research group.
This article, with accompanying data, will be published in the January edition of Euromoney.
For more information of Ned Davis Research, visit ndr.com