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| | The Speculator
Four in a row? The odds are against it
Based on what happened in 2002, it looks unlikely to us that bonds will post another strong year. But we'd bet that stocks won't suffer a fourth down year in a row.
By Victor Niederhoffer and Laurel Kenner
We began 2002 with one of our most pessimistic assessments ever:- The CBOE Volatility Index ($VIX.X) and the stock/bond ratio are relatively bearish right now, as are monthly trading patterns.
- The optimal time to jump into the market is not after two up months such as weve experienced in November and December.
- We live in a time of staff cuts, reduced bonuses, smaller retirement-fund contributions from many corporations and a general reluctance of investors to throw new money at the stock market, which, after all, has lost two years in a row.
- While we like low-priced stocks, we hesitate to recommend another basket of them now. Last years 60% gain for companies whose shares were in the bottom fifth of price may have used up all the extra chips that the mistress of markets can throw at the group.
Our misgivings were amply confirmed. The market declined for the third year in a row, for the first time in 60 years. We strayed from our pessimism subsequently, expecting after many of the bearish squalls that the market and individual stocks would reverse. They didnt. We and the bulls got hurt, particularly during the summer.
All the more reason for that strategy to work in the coming year.
As we begin 2003, we are feeling pragmatic, rather than bullish or bearish. We have two trades to suggest: short bonds and long stocks.
The first is a statistical trade, based on the correlation between bond returns and stock returns. The data, using continuous futures contracts, appear in the table below.
| Winners and losers | | Year | Bond futures % chg* | S&P 500 futures % chg | | 2002 (est) | 10 | -21.9 | | 2001 | -2.5 | -13.9 | | 2000 | 12.3 | -10.1 | | 1999 | -13.2 | 19.2 | | 1998 | 6.1 | 27.2 | | 1997 | 7.0 | 31.5 | | 1996 | -7.3 | 20.4 | | 1995 | 22.5 | 34.1 | | 1994 | -13.4 | -1.2 | | 1993 | 9.4 | 6.7 | | 1992 | -0.1 | 4.7 | | 1991 | 9.4 | 26.5 | | 1990 | -3.0 | -7.2 | | 1989 | 10.7 | 27.1 | | 1988 | 1.3 | 13.6 | | 1987 | -10.4 | 1.9 | | 1986 | 15.2 | 14.0 | | 1985 | 19.9 | 24.8 | | 1984 | 1.5 | 1.7 | | 1983 | -8.6 | 18.0 | | | | | Average return | 3.3% | 14% | | Bonds vs. stocks | | | | Buy the winner | 10.6% | | | Buy the loser | 5.3% | |
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*adjusted by Niederhoffer Investments
We studied various combinations of lags and combinations. The best we could come up with is that bond returns are correlated about -0.30 between consecutive years.
After the seven years that bonds were up 9% or more, the average change in bonds in the next year was -3%. After the other 12 years, the bonds returned some 8%.
In 2002, bond futures returned about 10%. That would mean that the best prediction for bonds in 2003 is about -3%. Well go with that as our best statistical trade for the coming year.
(We note in passing that there is one market where a continuation strategy rather than a reversal strategy seems indicated. That is gold, where the correlation between consecutive years is about 25%. Gold was up 23% in 2002. Thus, the best prediction for gold in 2003 is up 6%. However, we are not going to be buying gold. Vic had enough of that in 1980, when he bought gold at $300, pyramided it up to a 200-fold gain and then lost a fast 80% of that before he stopped himself out the next year.)
Our qualitative trade: stocks
Our other trade is qualitative, based largely on our feeling that there is too much negativism out there. We think its a good time to buy stocks with a horizon of a few months or more.
After all, how many times has the market gone down four years in a row? (Answer: Just once during the past 100 years, from 1929-1932).
Assume that the market, like a coin toss, has a 50% chance of a rise. (The market is very far from being a coin toss, but bear with us for a moment.) We would expect that four declines in a row would occur about 1 in 16 times. That would mean there should have been about six occasions in the last 100 years when stocks declined four years in a row.
The chance of obtaining one or no four-year down streaks in a situation like this turns out to be about 0.04. So we can say that a four-year decline occurs less frequently than it should by chance alone.
The market, as we said, is not a coin toss. Its a bazaar where the shoppers are sometimes overly gloomy and sometimes overly enthusiastic. In time, those swings tend to correct themselves.
After all, the market has to go up sometime. The U.S. stock market, as measured by both the S&P 500 ($INX) and the all-inclusive Wilshire 5000 ($TMW.X), lost half its value in the 2 years between its March 2000 high and its October 2002 low. Note that even after the 15% rally since Oct. 9, the S&P 500 is still below its August high.
Admittedly, 2002 was not a good year for reversion-to-mean strategies. However, weve often placed statistical bets that dont work on the predicted day but work with a vengeance on the day after.
Final note
Canes are the rage among collectors these days. We spotted a window display of antique canes in the high-end East Side stationery and gift shop Sui Generis the other day and stopped in for a look. We had to wait, because the well-dressed woman ahead of us was playing with a 19th-century sword cane. Store manager Stephen Vanilio said shoppers and passers-by have been dropping in continuously to look at the canes. His canes, decorated with mermaids, crocodile heads and other fantastic carvings, come with research notes and are priced at several thousand dollars apiece.
Maybe the baby boomers are getting old. But wed prefer to think that the fashion for canes relates more to a passage weve written about now and then from a 1887 book by Henry Clews called "Twenty-Eight Years in Wall Street":
"But few gain sufficient experience in Wall Street to command success until they reach that period of life in which they have one foot in the grave. When this time comes, these old veterans of the Street usually spend long intervals of repose at their comfortable homes, and in times of panic, which recur sometimes oftener than once a year, these old fellows will be seen in Wall Street, hobbling down on their canes to their brokers offices. Then they always buy good stocks to the extent of their bank balances, which they have been permitted to accumulate for just such an emergency. The panic usually rages until enough of these cash purchases of stock are made to afford a big 'rake in.'
Final note II
With all the malfeasance coming to light in 2002, we developed new indicators. The 5 genuine buys on a Street of impostors we wrote about on Oct. 24 are up 3.7%, vs. 2% for the S&P 500. These picks relied on a triple combination of cash indicators: a buyback announcement, a big decrease in inventory and a big decrease in accounts receivable. We believe systems based on cash will continue to work well.
We wish all of our readers a happy and prosperous New Year. Thanks to all who sent their thoughts, critiques and praise to us in 2002. Please write us through our Web site, at request@dailyspeculations.com. Well be updating all our pieces there, along with extensions and current readings on our new volatility prediction system, the VIC.
Current VIC reading: Bearish.
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