Unveiling a New (Bullish) Framework for 2016
I generally believe the name of the game when it comes to my investment process is to idea-generate objective, fact-based historical frameworks – be they statistical, technical, analog or all of the above – that help map out various contingencies of how the future might unfold.
Some of these frameworks have lower probabilities of playing out when generated, others much higher; some of the lower-probability frameworks actually come to fruition, some of the higher-probability ones fail to materialize.
Regardless, I don’t present any framework on the site for activity’s sake alone; they all have a purpose and even the ones with more remote chances of occurring at one point in time can act as fall-backs to quickly understand a world that has deviated vs. an expected outcome in the event that our higher-probability theses fail us. It’s all about triangulating and being able to quickly assess – and reassess – the world’s general tendency across a myriad of assets as they act both independently and in unison, generating chain reactions among each other.
With the above out of the way, I’d like to unveil a new framework for assessing 2016.
Believe it or not considering the copious amounts of “bear market” category work I’ve posted in recent weeks with titles that include words like ‘deflationary’ and ‘collapse’, this framework is of the more bullish variety, suggesting the potential for a sizable 2016 rally beginning in the early or middle of the year, likely resembling the type of +20-30% bullish year we suggested in our working thesis for 2013.
I was reading yesterday about the producer price index for commodities and its rapid descent over the past year (ticker = PCAC on Bloomberg). I used that conversation as a starting point of curiosity for deeper research and idea generation. In doing so I noticed that Bloomberg has PCAC data dating back to the early 1900s, or much farther than the CRB data I’ve found which begins in the 1960s. This presented a great opportunity to tee up a very long-term ratio chart b/t the value of U.S. stocks, via the DJI, and the PCAC index, using the latter as a proxy for the CRB. In doing this we would hopefully get a very long-term view of how stocks and commodities generally out or under-perform one another across cycles.
As a refresher, we touched on this very topic in 2012 when we began making the case for stocks out-performing commodities for a sustained period of time and how this would assist in airlines out-performing other equity sectors; as of now I’m simply updating the thematic after three years of our original thesis playing out as expected.
Regardless, below you’ll see the DJI in the top panel and a ratio chart of the DJI vs. the PCAC index into the early 1900s in the bottom panel. There are four red arrows and four red horizontal lines across this ratio. Each red arrow marks a major, seminal, all-time high cycle peak in the DJI vs. PCAC. There have been four such peaks in history if we qualify our filter by demanding that the ratio fell by least 50% from an all-time high – 1915, 1929, 1966 and 2000. Naturally, these basically form most of the biggest equity tops in history.
If you follow the horizontal red lines that are drawn off each of these arrows/peaks you’ll notice many years, often decades-worth of time, of equities under-performing and/or trading below their all-time highs vs. commodities on a relative basis until you ultimately come to the green shades at points (A), (B) and (C). These points represent the time at which the original peaks in the ratio of the DJI vs. PCAC are finally eclipsed to the upside and include 1926, 1963 and 1994. As of 2015 we have yet another year to add to the latter three as the flattish performance in the DJI vs. the carnage in commodities resulted in the ratio b/t the two finally eclipsing the high it put in place in 2000, a full 15 years later, as can be seen at (D). Thus, as of this year the DJI has fully retraced the 54% peak/trough decline it generated from 2000-2009 vs. commodities (via the PCAC index).
This is an important distinction to make – although U.S. stocks are and have been well above their 2000 highs (ex Nasdaq) on an absolute basis for some time, they are only now eclipsing those highs on a relative basis vs. commodities.
This may not seem important, but if an asset is technically breaking above a ~15-20 year high on an absolute basis, why shouldn’t it also matter if it does the same vs. another, competing asset class?
There are a few things about (A)-(C) in the chart above that are both very interesting and similar to what has occurred at (D) in 2015.
For instance, if we look at each of (A)-(C) on a daily chart basis below, we find that these signals have tended to occur as the DJI was entering a ~12-24 month pause in which it peaks, grinds sideways-to-down, experiences a temporary VOL shock/correction of decent, but not massive size and then finally, emerges from that correction/trading range and enters a fairly aggressive bull phase (including history’s two best bull runs ever), lasting some period.
Specifically, initial peaks in 1926 and 1994 were pauses that lasted only 8-12 months, while the initial peak in 1961 lasted 24 mo. To reiterate, we are looking at these cycle pause peaks because they coincided with the ratio of the DJI vs. PCAC eclipsing a former all-time cycle high. Moving along, as these pause peaks emerged, the 1926 and 1994 signals generated bullish ascending triangle patterns.
Thus far, 2015 seems to be playing out much more like 1926 and 1994 and less like 1961’s initial peak in that the initial corrective decline in August was less severe, the time to reclaim those losses shorter and the overall pattern looking once again like a bullish ascending triangle.
2015’s similarity to 1926 and 1994 is reinforced by the analog below. In that analog we anchor each cycle to 100% at its peak price that ultimately led to an ensuing cycle pause. The move off 2015’s high is very much in-line with the latter two periods and not the move off the 1961 high whose correction was much deeper and long-lasting. Don’t put too much focus on this first analog above and beyond 2015 looking much more like 1926 and 1994 vs. 1961.
Let’s now strip out 1961 and focus on the remaining two that most resemble 2015. Three very important points to make:
- Per the dotted blue line, when the DJI eclipsed its initial swing high, or the 100% mark, both the 1926 and 1994 moves basically begin an unabated vertical ascent, producing the juiciest parts of the Roaring 20s and 90s tech boom (note: analog shows two years of trading after pause peak and therefore does not include entirety of rallies into 1929 and 2000 highs, respectively).
- On a day count, the rallies mentioned above begin at 175 days off the 1926 high and 265 days off the 1994 high; we are now 155 days off the 2015 high.
- The latter day counts coincide with technical break-outs from the bullish ascending triangle patterns highlighted earlier in this post.
What are the implications of all of the above for commodities on an absolute basis?
That question is answered in the chart below. In the top panel I plot the PCAC index alone. In the bottom panel I’ve once again plotted the ratio of the DJI vs. PCAC and have annotated it with the four aforementioned all-time highs from the initial chart in this post; I’ve also included peak/trough draw-downs off each of those highs that the ratio put in place before it started climbing again. In addition, we once again label the green shades of (A)-(C) again to show you how commodities acted on an absolute basis once the ratio of the DJI vs. PCAC broke a previous all-time high.
Historically, when the DJI vs. the PCAC index has broken out to fresh all-time highs it has generally marked a period of losses or flattish performance for commodities on an absolute basis; this can be seen with the red and orange arrows. However, there is a big caveat to this statement. Flattish or down absolute performance has ended if and when the index declined enough to reach line (1) support. Per the green arrows, if and when line (1) support has been reached, the PCAC index has tended to enjoy large, sustained absolute price gains.
As of this month the index’s current print of ~186 is a stone’s throw – only ~700-800 bps – down to line (1) support in the low ~170s.
Thus, in addition to our CRB vs. USD ratio chart from a recent post, we really want to pay attention to how the PCAC index acts if and when it touches line (1) support on a go forward basis. That support may be the only trigger the EM complex needs to ignite a very massive rally considering what is about to be four-five years of relentless under-performance vs. the SPX.
In concluding, my findings above are simply the result of the research I’ve been doing this week. The framework seems very sound and objective in that I’ve canvassed history to find cycle environments that are factually and demonstrably identical/similar to today (i.e., ratio of DJI vs. PCAC reaches and eclipsed a former all-time high as it is in 2015) and then analoged the moves the market has taken off of what have historically been temporary cycle pause highs as those cycle environments emerged/became evident.
To execute this post’s suggested plan of action we need to wait for some combo of 1) either day count 175 or 265 to arrive, 2) the DJI’s (or SPX for that matter) 2015 high to be eclipsed on a daily or weekly closing basis and 3) the DJI to break out from its bullish ascending triangle pattern. As it stands, all three are very close to occurring. From a simple timing standpoint, we have only 20-90 days left, or ~one-five months, coinciding with Jan-Jun-16 and are a mere ~200 bps below the summer-15 highs.
Again, one more framework to keep in our back pocket and assess as time elapses.
If the market can break above the 2015 highs and its ascending triangle pattern as we enter 2016, I will be long. Until then I default bearish.