by Lance Roberts, Clarity Financial
I have written over the last couple of months the market was likely to rally into the end of the year as portfolio managers, hedge, and pension funds chased performance and āwindow dressedā portfolios for year-end reporting purposes. As I noted inĀ this past weekendās missive:
āI still suspect there is enough bullish exuberance currently to push the Dow to 20,000 and the S&P to 2,300 by the end of the year. However, I am more concerned about what I believe may occur after the inauguration in January.
I have discussed previously the importance of āpriceāĀ as an indicator of the market āherdāĀ mentality. One of the major problems with the fundamental and macro-economic analysis is the psychology of the āherdā can defy logical analysis for quite some time. As Keynes once stated:
āThe markets can remain irrational longer than you can remain solvent.ā
Many an investor have learned that lesson the hard way over time and may be taught again in the not so distant future. As shown in the chart below, the momentum of the market has decidedly changed for the negative. Furthermore, these changes have only occurred near market peaks in the past. Some of these corrections were more minor; some were extremely negative. Given the current negative divergences in the markets from RSI to Momentum, the latter is rising possibility.ā
Despite this technical deterioration and excessive price extension, the ābullish vs. bearishā argument continues.
Letās examine both arguments.
The Bullish Bias
The bulls currently have the āwind at their backsā as the exuberance mounts the new administration will foster in an age of deregulation, infrastructure spending and tax cuts that will be boost corporate earnings in the future. As Jack Bouroudjian via CNBC wrote:
āLetās be clear, this market run up to the 20K level has a much more solid foundation for valuation. We are not looking at a P/E which has been stretched beyond historic norms as was the case in 1999, nor are we looking at a dot com bubble ready to implode. On the contrary, between digestible valuations and the prospects of real pro-growth policies, we have the foundation for a run up in equities over the course of the next few years which could leave 20K in the dust.
One of the great lessons in the market is that when āAnimal Spiritsā take control, one must simply go with it. Itās not easy to recognize a paradigm shift, in fact many can only realize the phenomenon after the fact. The Trump victory coupled with the sweep in congress makes this a classic paradigm shift and the financial world needs to embrace it.
The dark days of wasted revenue and liberal tax and spend policies is giving way to an era of fiscal stimulus and pro-growth legislation not seen in 30 years. All this is coming at a time when corporate America, sitting on mountains of cash both domestically and overseas, find itself on the brink of a digital revolution.
Over the course of the next few years, corporations should see top line growth and expanding operating margins. With the understanding that equity prices move on expectations, one must conclude that the rally we have experienced over the last few weeks might be the ātip of the icebergā when it comes to the move we will see in the coming years.ā
This, of course, is just the latest iteration of the ābull argument.ā Ā Previously it was Federal Reserve liquidity, low interest rates, and low inflation were good for stocks. Now, it is higher interest rates and inflation is good for stocks. In other words, there is apparently no environment that is bad for stocks. Right?
As shown below, the bullish trend has remained firmly intact since the onset of QE1 which brings two Wall Street axioms into play:
Since the primary goal of the Federal Reserveās monetary interventions was to boost asset prices, in order to stimulate economic growth, employment, inflationary pressures and consumer confidence, there is little argument the Fed achieved its goal of inflating asset prices. The ābullsāĀ drank deeply from the proverbial āpunch bowl.ā
The continuous and uninterrupted surge in asset prices has driven investors into an extreme state of complacency. The common mantra is the āFed will not let the markets fallāĀ has emboldened investors to take exceptional risks.Ā The chart of volatility shows again that bulls remain clearly in charge of the markets currently with the āfear of a correctionā at near historic lows.
We can see the same level of bullishness when looking at the levels of ābearishā ratio of Rydex funds.Ā (Bear Funds + Cash Funds / Bull Funds)
In other words, since investors have little fear of a correction, they have now gone āall inā following the election.
Lastly, since the election, investors confidence has soared as discussed by Evelyn Cheng via CNBC this week:
āIndividual investor optimism jumped to a nine-year high in November, according to the Wells Fargo/Gallup Investor and Retirement Optimism Index published Tuesday.
The last time the index approached the November level was before the financial crisis, in May 2007 with a read of 95, the report said. The index was at 103 in January 2007.ā
There is little doubt the āBulls are back.ā With the markets pushing all-time highs heading into the 9th year of a bull market, the belief is the momentum is set to continue.Ā In fact, there isnāt a ābearā in sight:
āThe unexpected election last month of Donald J. Trump as president has been a game changer for the 10 investment strategists whose market outlook Barronās solicits twice each year. As stocks took off on Nov. 9 and thereafter, fueled by investorsā enthusiasm for Trumpās expected pro-growth agenda, even our groupās bears turned bullish.ā
The Bearish Perspective
While the bulls are pushing a continuation of the market based on āhopesā and āexpectations,ā the bears are countering with a more rational and pragmatic basis.
Valuations, by all historical measures, are expensive. While high valuations can certainly get higher, it does suggest that future returns will be lower than in the past.
That statement of ālower future returnsā is very misunderstood. Based on current valuations the future return of the market over the next decade will be in the neighborhood of 2%. This DOES NOT meanĀ the average return of the market each year will be 2% but rather a volatile series of returns (such as 5%, 6%, 8%, -20%, 15%, 10%, 8%,6%,-20%) which equate to an average of 2%.
Of course, as discussed previously, investor behavior makes forward long-term returns evenĀ worse.
The bulls have continually argued that the āretailā investor is going to jump into the markets which will keep the bull market alive. The chart below supports the bearās case that they are already in. At 30% of total assets, households are committed to the markets at levels only seen near peaks of markets in 1968, 2000, and 2007. Ā I donāt really need to tell you what happened next.
The dearth of ābearsā is a significant problem. With virtually everyone on the ābuyā side of the market, there will be few people to eventually āsell to.ā The hidden danger is with much of the daily trading volume run by computerized trading, a surge in selling could exacerbate price declines as computers ārun wildā looking for vacant buyers.
This thought dovetails into the āhyperextensionā of the market currently. Since price is a reflection of investor sentiment, it is not surprising the recent surge in confidence is reflected by a symbiotic surge in asset prices.
The problem, as always, is sharp deviations from the long-term moving average always āreverts to the meanā at some point. The only questions are āwhenā andĀ āby how much?ā
Managing Past The Noise
There are obviously many more arguments for both camps depending on your personal bias. But there is the rub. YOUR personal biasĀ may be leading you astray as ācognitive biasesāĀ impair investor returns over time.
āConfirmation bias, also called my side bias, is the tendency to search for, interpret, and remember information in a way that confirms oneās preconceptions or working hypotheses. It is a systematic error of inductive reasoning.ā
Therefore, it is important to consider both sides of the current debate in order to make logical, rather than emotional, decisions about current portfolio allocations and risk management.
Currently, the ābullsā are still well in control of the markets which means keeping portfolios tilted towards equity exposure.Ā However, as David Rosenberg recently penned, the markets may be set up for disappointment. To wit:
āIn fact, despite base effects taking the year-over-year trends higher near-term, IĀ think we will close 2017 with consumer inflation, headline and core, below 1.5%Ā (though both will peak in the opening months of the year at 2.6% and 2.3%Ā respectively).
The question is what sort of growth we get, and as we saw with all the promisesĀ from āhope and changeā in 2008, what you see isnāt always what you get.
There are strong grounds to fade this current rally, which has more to do withĀ sentiment, market positioning and technicals than anything that can beĀ construed as real or fundamental.Ā There is perception, and then there is reality.ā
Currently, there is much āhopeāĀ things will āchangeā for the better. The problem facing President-elect Trump, is an aging economic cycle, $20 trillion in debt, an almost $700 billion deficit, unemployment at 4.6%, jobless claims at historical lows, and a tightening of monetary policy and 80% of households heavily leveraged with little free cash flow. Combined, Ā these issues will likely offset most of the positive effects of tax cuts and deregulations.
Furthermore, while the ābearsā concerns are often dismissed when markets are rising, it does not mean they arenāt valid. Unfortunately, by the time the āherdā is alerted to a shift in overall sentiment, the stampede for the exits will already be well underway.Ā
Importantly, when discussing the ābull/bearā case it is worth remembering that the financial markets only make ārecord new highsā roughly 5% of the time. In other words, most investors spend a bulk of their time making up lost ground.
The process of āgetting back to evenā is not an investment strategy that will work over the long term. This is why there are basic investment rules all great investors follow:
- Sell positions that simply are not working. If they are not working in a strongly rising market, they will hurt you more when the market falls. Investment Rule: Cut losers short.
- Trim winning positions back to original portfolio weightings. This allows you to harvest profits but remain invested in positions that are working. Investment Rule: Let winners run.
- Retain cash raised from sales for opportunities to purchase investments later at a better price. Investment Rule: Sell High, Buy Low
These rules are hard to follow because:
- The bulk of financial advice only tells you to ābuyā
- The vast majority of analysts ratings are ābuyā
- And Wall Street needs you to ābuyā so they have someone to sell their products to.
With everyone telling you to ābuyā it is easy to understand why individuals have a such a difficult and poor track record of managing their money.
As we head into 2017, trying to predict the markets is often quite pointless.Ā The risk for investors is āwillful blindnessāĀ that builds when complacency reaches extremes.Ā It is worth remembering that the bullish mantra we hear today is much the same as it was in both 1999 and 2007.
I donāt need to remind you what happened next.
Lance Roberts
Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of āThe Lance Roberts Showā and Chief Editor of the āReal Investment Adviceā website and author of āReal Investment Dailyā blog and āReal Investment Reportā. Follow Lance on Facebook, Twitter and Linked-In