Tuesday, July 16, 2013
Saving the least predictive cycle model for last, here is the update for the DJIA. I probably should preface this particular model with some comments about what it represents. The inputs to the cycle models rely on historical data. History rhymes and sometimes even repeats itself. However, the Fed asset buying and bailouts over the past four years are unprecedented in scope, so the model falls apart because there is no way to predict future Fed actions, and right ow the market is focused on Fed actions, rather than underlying business cycle fundamentals like credit, international capital flows, industrial production, etc. And the market rules.
So why continue to run this model? Well, one way to interpret the prediction is that while on a historical basis there is very strong downward pressure on prices, the Fed has successfully, at least for now, inflated equity prices with enough liquidity to push back on seasonal, yearly and decadal patterns of business cycles, all of which have been pointing down for 4 years. Nevertheless, the model might give some quantitative indication of the amount of "pressure" the Fed has to exert to prevent the normal business cycles from re-exerting themselves. If you look carefully at the Z-score charts, you will see that negative divergences in the Z-score coincide with Fed bailouts and QE (n+1) announcements. So, if this hypothesis is correct, we should see the Fed announcing a creative way to continue to add liquidity to the banking system without spooking bond holders, probably in the next few weeks. If the Fed does inject enough liquidity, and the bond markets do not get spooked, then it will provide another point of divergence for the model predictions. However, if the Fed does nothing, or even thinks about removing liquidity by setting a timeline, the downward pressure on equity prices will reassert itself.
For those not familiar with Z-scores, it is a way to look at how much variance there is between the predictions and the actual prices over time. A positive Z-score of 2 or 3 indicates that the predictions have exceeded actual prices by that margin 2.2 % of the time and 0.13% respectively. The reverse operating for negative scores. The Wiki page is good for a refresher course. The blue line on the second chart shows where we are with the Z-score at the moment, and you can see that on a historical basis it is quite remarkable. But does it mean an equity meltdown is coming up? I don't know, I guess I'll keep my eye on the Fed, like everyone else.