May 28th, 2014
by Lance Roberts, Streetalk Live
The markets rose this past week to once again test the upper boundaries of the trading range that has existed since February. As Jeff Saut wrote earlier this week:
"Markets that go straight up are easy. Markets that go straight down, while painful, can be managed. It's the back-and-forth fluctuations that drive all but the most short-term traders and long-term investors crazy."
2014, so far, has been the year of the churn. The last time that we saw relative market action like this was in 2011 as the Federal Reserve's second "QE" program was winding down. The chart below shows January through August of 2011 versus February to the current period.
"Over the past 14 weeks, the S&P 500 has traded in a very narrow range of around 4%, with some false breakouts and breakdowns thrown in just to further frustrate its fickle followers."
Overall last week market action was very dull. While the markets advanced it did so against a backdrop of extremely light trading volume and declining volatility. More importantly, a bulk of the action last week was primarily due to short covering as some of the beaten down sectors of late recovered mildly. The chart below shows performance of other major markets as compared to the S&P 500 over the last 5 days.
While the S&P 500 rose 0.82% over the last 5 trading days, the Nasdaq outperformed that advance by 0.63% and with the Russell 2000 outperforming by 0.24%. Bonds, US Dollar and Gold lagged.
You can also see the rush to cover shorts in the most beaten up sectors of the S&P 500 - Technology and Cyclicals.
Whether or not the markets can break of out the current trading range with conviction next week remains to be seen. However, as I stated last week, I do suspect that the current sideways consolidation will be resolved soon.
Signs Of An Aging Bull
Since this is a holiday weekend, I thought a pictorial review of the markets might be appropriate to allow you to draw your own conclusions.
"Are we closer to the end of the current bull market cycle or is there is still much more to go?"
How you answer that question should have a significant impact on your investment outlook as financial markets tend to lose roughly 30% on average during recessionary periods as shown in the chart below.
The current bull market cycle is now extremely long by historical measures. The chart below shows the historical length of economic recoveries (number of months) which drives bull market cycles, as compared to the subsequent market drawdown (percent decline) during the following recession.
There are only 5 economic recoveries that have lasted longer than the current "muddle through" growth cycle. The first was the economic recovery driven by massive government make-work projects during the Great Depression. The next was during the space race of the 60's and the final three all occurred in the 80's and 90's as inflation and interest rates fell sharply following their peaks in the late 70's.
Is it possible that the current economic cycle can continue longer? Absolutely. However, considering that we have none of the ingredients seen in the previous extended recoveries, combined with the Federal Reserve extracting their liquidity support, there is a high degree of risk that will not be the case.
There is currently a debate being waged on Wall Street. On one side of the argument are individuals who believe that we have entered into the next "secular bull market" and that the markets have only just begun what is an expected multi-year advance from current levels. The other side of the argument reiterates that the current market advance is predicated on artificial stimulus and that the "secular bear market" remains intact, and the next major reversion is just a function of time.
The series of charts below is designed to allow you to draw your own conclusions. I have only included commentary where necessary to clarify chart construction or analysis.
But when it comes to investing, "exuberance" can always outlast fundamentals.
Investors are once again reverting back to their old habits of rushing in to buy market peaks. This is never a sign of a "new bull market" but rather one that is well aged. As I quoted in Friday's missive:
"Despite talk of flagging investor confidence and increased scrutiny of market participants, data from retail brokers show that the retail crowd is more engaged than ever," Avramovic wrote in a report last week.
Combined daily average revenue trades at E*Trade Financial Corp., Charles Schwab Corp. and TD Ameritrade Holding Corp. rose 24 percent in the first quarter from the previous year and reached the highest level ever, according to Raymond James Financial Inc. analyst Patrick O'Shaughnessy.
All of this could conjure up the old Wall Street trope that retail investors are always late to the bull-market party and their exuberance is a sign that the keg is almost kicked. Not to mention that U.S. equity mutual funds are winning net inflows for a second year after six years of withdrawals."
Also, if there was ever a sign of irrational investor exuberance it is this:
"Investors are piling into the shares of small, risky companies at the fastest clip on record, in search of investments that promise a chance of outsize returns.
The investors are buying up so-called penny stocks-shares of mostly tiny companies that aren't listed on major U.S. exchanges-at a pace that far eclipses the tech boom of the late 1990s. "
It should not be surprising that now six years into the current market boom that individuals are now jumping into the stock market. After all, the media has continually berated them for the last six years for "missing out."
This exuberance can also be seen in the two following charts of excessive bullish sentiment and extreme lows in bearish sentiment.
The following chart of the Volatility Index as compared to the S&P 500 is another case of excessive investor complacency. The volatility index is now at the lowest levels since the last financial crisis as the "fear" of a market correction is virtually non-existent.
Credit Market Froth
Yves Smith wrote a great piece this weekend entitled "Widespread Signs Of Credit Market Froth."
"In the runup to the crisis, all it took was reasonably attentive reading of the Financial Times to discern that Things Were Going to End Badly.
It is important to understand that financial crises are credit crises. The dot-com bubble was enormous, and margin debt was at a high level before it imploded. But the amount of borrowing related to equities simply wasn't that large relative to the economy.
I'm getting a bad case of déjà vu from reading the Financial Times over the last week. And remember, this comes against a backdrop of a rise in investors willing to take on more credit risk out of desperation for yield.
Now that central banks have improves their rescue playbooks, a September-October 2008 outcome seems unlikely. But the diversion of resources and profits from potentially productive real economy to the credit market casino has only become more deeply institutionalized. It's hard to see how this resolves, but the ending is unlikely to be happy for ordinary citizens."
Historically, it has not been the increase in margin debt that was a cause of concern. Rather, it is the unwinding of that leverage that weighs on asset prices. The decline in asset prices triggers a waterfall of selling as liquidations to meet margin calls are met by more liquidations to meet more margin calls.
It is important to understand that a "crisis" isn't necessary to create a leverage fueled market liquidation cycle. Just an "event" that spurs enough selling to trigger the first margin calls.
Last week, I visited with the portfolio manager of a major global equity income fund who was making his case as to why Europe still had "legs" from an investment standpoint. It was at this point that he directed my attention to the recovery in M&A activity as support for his point.
With margin debt just off record levels and complacency near historic highs, I was more concerned about the surge in domestic M&A activity. Such activity is generally focused near the ends of economic cycles as other investment opportunities wane. Of course, the last time the U.S. was at these levels was in 2006.
Stretching The Rubber Band
The last chart in our picture book series is one I have shown you many times before. It is the deviation in price from a very long term (36 month) moving average. Market prices, in many respects, are controlled by "gravity." The only way that there can be an average price is because prices have traded both above and below that level in the past.
Therefore, these moving averages exert a "gravitational pull" on current asset price levels. The further from the average that prices deviate the stronger the gravitational pull. The chart below shows that current price levels are now extended to levels only witnessed four previous times in the past. None of them ended well for investors.
Don't Panic - Just Pay Attention
None of this analysis is to suggest that you should immediately sell everything and move to cash. Currently, the bull market trends remain intact and our portfolio model remains fully allocated.
However, it is important that we continue to keep an eye on the rising risks in the market. The markets will eventually crack and we will strongly advise raising cash and moving to the sidelines. This is why it is important to continue paying attention to your money.
There are very important differences between your investment portfolio and a benchmark index which I covered in "Revisting Why Benchmarking Is A Bad Investment Strategy"
- The index contains no cash
- It has no life expectancy requirements - but you do.
- It does not have to compensate for distributions to meet living requirements - but you do.
- It requires you to take on excess risk (potential for loss) in order to obtain equivalent performance - this is fine on the way up, but not on the way down.
- It has no taxes, costs or other expenses associated with it - but you do.
- It has the ability to substitute at no penalty - but you don't.
- It benefits from share buybacks - but you don't.
For all of these reasons, and more, the act of comparing your portfolio to that of a "benchmark index" will ultimately lead you to taking on excessive risk, making emotionally based investment decisions and losing capital and time. The index is a mythical creature, like the Unicorn, and chasing it takes your focus off of what is most important - your specific goals, time horizon and investment discipline.
Investing is not a competition and, as history shows, there are horrid consequences for treating it as such. In the long run, achieving your own personal investment goals is why you invested in the first place.
Ope you had a safe and happy Memorial Day weekend.