By Mark Hulbert, MarketWatch
In recent days, a chart featuring two lines like the ones shown below has been circulating among trading desks, according to hedge-fund manager Douglas Kass. It certainly looks scary, pointing as it does to a 1929-magnitude crash in January.
But there isn’t any need to run for the hills just yet. The chart’s statistical validity is questionable, at best. Even many of those who insist it is worth paying attention to aren’t predicting a crash.
The chart shows the performance of the stock market over the past 18 months alongside the path the Dow Jones Industrial Average DJIA +1.26% traveled in 1928 and 1929. In emailing it to his clients, Kass, president of Seabreeze Partners Management Inc., called the similarity “eerie.” Read: Ghost of 1929 crash reappears.
According to Tom McClellan, editor of the McClellan Report, an investment newsletter, the Sept. 3, 1929, stock market top equates to this coming Jan. 14 — just five weeks from now.
David Leinweber, founder of the Center for Innovative Financial Technology at the Lawrence Berkeley National Laboratory, isn’t impressed. In an email, he said that “if you looked at enough periods of the same length, you’d find all sorts of very similar pictures, most without a crash at the end.”
Leinweber views charts such as this one as an example of a potentially dangerous practice known as “data mining”— endlessly analyzing a database until you “discover” a pattern. The result of this practice is “the analytical equivalent of finding bunnies in the clouds. If you did enough poring, you would be bound to find that bunny sooner or later, but it would be no more real than the one that blows over the horizon,” he said.
Kass, who has been outspokenly bearish on the U.S. stock market during a rally that has pushed the S&P 500 index SPX +1.12% up 26% this year, said he sent the chart out to his clients merely as “interesting food for thought.” He said that, while he believes stocks are likely to produce below-average returns in coming years, he doesn’t think there will be a crash.
McClellan said that finding chart correlations is risky, since they “all break down eventually — it’s just a matter of time.” Unfortunately, “they usually break down the moment you are most counting on it.”
Nevertheless, he said he will be closely watching whether the stock market in coming weeks continues to follow the pre-1929-crash script. If it does, and he concedes that this is a “big if,” then his confidence will grow that the stock market’s direction will turn down in January.
To be sure, a bear market could happen at any time, and drawing the analogy between now and the late 1920s can serve a helpful purpose: If you don’t think you can stick with your stock holdings through a market decline, you should reduce them now to whatever level you would be comfortable holding through that decline.
There is another reason to consider selling some shares: The bull market has led equity positions to become a bigger part of overall portfolio values. That in turn means portfolios might be riskier than is appropriate. The end of the year is an ideal time to tweak portfolio allocations.
In this rebalancing, you would normally invest the proceeds of sales into asset classes that have performed poorly. That might mean buying bonds, however, since bonds have lost ground this year as the stock market has soared. That may seem hard to swallow if you expect the Federal Reserve to start pulling back on its bond purchases, which some think could push bond yields higher and prices lower.
Jason Hsu, chief investment officer at Research Affiliates, a money management firm based in Newport Beach, Calif., recommends looking at “absolute-return strategies” as you rebalance your portfolio. These strategies aim to produce consistent returns in all kinds of markets.
In theory, absolute-return strategies tend to march to the beats of their own drummers rather than rise and fall in lock step with either stocks or bonds. That could make them attractive if you, like Hsu, are unenthusiastic about the prospects for either stocks or bonds in coming years.
David Nadig, chief investment officer at IndexUniverse, a research firm, says there are several exchange-traded funds that offer absolute-return strategies. He said in an email that his firm’s recommendations are based on a number of factors, including expenses, liquidity, and how closely the fund tracks the market to which it is benchmarked.
His firm’s top pick among “absolute-return ETFs” is the IQ Hedge Multi-Strategy Tracker [ticker: QAI], with a 0.94% expense ratio, or $94 per $10,000 invested. The fund aims to match the average performance of a wide variety of hedge funds.
Another is the PowerShares DB G10 Currency Harvest fund [ticker: DBV], with a 0.75% expense ratio, which invests in the currencies of leading industrialized nations. A third ETF that Nadig’s firm recommends is the WisdomTree Managed Futures Strategy fundWDTI +0.51% , with a 0.96% expense ratio; it bets on the directions of currencies, interest rates, and physical commodities.
Hsu also suggested diversifying equity holdings outside the U.S. He believes that three regions offer equity markets that are cheaper than the U.S.: Japan, Europe and emerging markets.
The ETFs linked to these respective regions that Mr. Nadig’s firm favors are the iShares MSCI Japan fund EWJ +1.27% , with a 0.53% expense ratio; the iShares MSCI EMU Index fund EZJ +2.17% , also with a 0.53% expense ratio; and the iShares Core MSCI Emerging Markets fund IEMG +1.98% , with a 0.18% expense ratio.
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