Thursday, October 29, 2009
ECRI weekly leading index turns down
One of the key conclusions from our late-1996 Ice Age thesis was that once the bubble burst, the close 35-year positive correlation between equity and bond yields would break down. This relationship had persisted for so long that it had become ingrained in investor psychology.
The 35-year period could be divided into two phases. The 1982-2000 equity bull market had largely been driven by PE expansion (not profits), which in turn had been driven by lower bond yields and lower inflation. Conversely, in the dismal years, the Dow went sideways for 17 years between 1965-82 as profits growth was wholly offset by multiple compression - driven this time by higher bond yields and higher inflation. Indeed, throughout this 35-year period, "bad" economic news was generally good for equities as it drove bond yields lower and PEs higher. Equities had only a very loose relationship with the profits cycle.
We knew though from Japan that in a post-bubble world, once bonds and equities had decoupled, that the equity market would mirror the economic and profits cycle. And so, despite Japan's structural equity bear market, one could enjoy numerous 50%+ rallies if one invested as the cyclical lead indicators bottomed out. Conversely one should have ALWAYS sold when these same lead indicators peaked out. After recent massive cyclical gains in equities, that extremely dangerous topping out phase looks as if it has begun.
We have long advocated that in a post-bubble world, investors could participate in explosive upside equity rallies driven by decent economic data and an underlying improvement of profits. We saw many of these rallies in the Nikkei over Japan's lost decade. And even if one believed, correctly as it turned out, that each 50% rally would wither away, it would be simply daft not to participate in these policy-induced cyclical rallies.
UPDATE: pragmatic capitalist picks up the news as well.