September 15th, 2014
by Lance Roberts, StreetTalk Live
In December of last year, as expectations rose that the Federal Reserve would begin to exit from the current quantitative easing programs, I begin publishing predictions of the value of the S&P 500.
The following exert is from "FOMC Asset Purchases And The S&P 500:"
"This is something that I discussed previously. The chart below shows the historical correlation between increases in the Federal Reserve's balance sheet and the S&P 500. I have also projected the theoretical conclusion of the Fed's program by assuming a continued reduction in purchases of $10 billion at each of the future FOMC meetings.
If the current pace of reductions continues, it is reasonable to assume that the Fed will terminate the current QE program by the October meeting. If we assume the current correlation remains intact, it projects an advance of the S&P 500 to roughly 2000 by the end of the year. That would imply an 8% advance for the market for the entirety of 2014."
That was in March. Today, as the Federal Reserve concludes its last month of programmed purchases, the market has struggled exceeding that target of 2000 since its first attempt in late August.
The chart below is a daily chart of the S&P 500 which shows the short term topping process that appears to be in play.
Importantly, the first level of support is the 50 day moving average that is currently hovering around 1975. Below that is a bullish trend line from the beginning of this year that is holding at 1950.
As long as the market remains above 1950, there is no need to make any changes currently to portfolios. However, any violation below that level and we could be starting to discuss a correction of magnitude of as much as 24%. Such a correction would fall well within the norms of a standard 38.2% correction. However, such a correction would surprise the majority of market commentators who currently believe such an event could only occur within the confines of a recession. Normally, I would agree, but current conditions are far from normal.
That thought also shows how far the markets have deviated from normal historical tendencies. The near straight line advance in the market over the last 23 months has created a risk-profile in the markets that is far in excess of what most advisors, analysts and portfolio managers currently believe.
What Are You Going To Do?
While I am not suggesting that a reversion is on the cusp of occurring, I am stating that when it begins the responses by investors and advisors alike will be to:
- Buy the dip.
- Buy the second dip.
- Rotate into defensive securities
- Hold on
This is simply the psychology of market players as few truly understand the dynamics at play. The number of portfolio managers that both understand and incorporate the behavioral and emotional biases into portfolio management can be counted on one hand with fingers left over.
The major problem is that the majority of advisors/managers are still playing by the same set of rules fostered by the very flawed theory that markets are efficient. Yves Smith recently concurred with this point stating:
"Yet the Efficient Markets Hypothesis and the Capital Assets Pricing Model are still almost universally taught and used despite serious (and in the case of CAPM, fundamental) flaws. People apparently would rather have bad heuristics than none at all. The Efficient Markets Hypothesis (EMH) is wrong. It has been proved wrong. Do you think you've heard this before? You likely have, but the proof that you've heard that the EMH is wrong probably has not done the damage that you thought it had."
The two charts below show the sectors of the S&P 500 on a price basis from 2000-present.
Do you see the problem here?
If your portfolio strategy is based on fundamental analysis, sector rotation and asset allocation you are likely going to have issues. With correlations between all asset classes tightly wound, volatility extremely low and leverage high; when the markets do eventually break the rush for "cash" will swamp those trying to manage the plunge selectively. Their intentions and philosophies will be understandable and well documented; it just won't compensate for the psychological upheaval.
John Hussman this past week summed up this issue extremely well stating:
"There's no question that the absence of consequences - to date - has led investors to believe that those consequences simply will not emerge. Once the consequences arrive, the preceding bubble seems obvious, but it's a regularity of history that speculative episodes are only completely clear in hindsight. The following chart is a reminder of where we stand. The index is the S&P 500."
"History teaches clear lessons about how this episode will end - namely with a decline that wipes out years and years of prior market returns. The fact that few investors - in aggregate - will get out is simply a matter of arithmetic and equilibrium. The best that investors can hope for is that someone else will be found to hold the bag, but that requires success at what I'll call the Exit Rule for Bubbles: you only get out if you panic before everyone else does. Look at it as a game of musical chairs with a progressively contracting number of greater fools.
Why won't most investors get out? The answer is that in equilibrium, they can't. On any given trading day, only a fraction of 1% of total market capitalization changes hands, and the vast majority of that is high-frequency trading and portfolio reallocation between existing equity holders.Think about it - the only way for an investor to get out of stocks without someone else getting in is for the stock to be literally removed from the market.
That source of net removal of stock is corporate repurchase activity, which recently hit a year-over-year pace of about $500 billion. That's still less than 4% of total market cap in an entire year, and it's a fairly good upper limit on the percentage of investors who will successfully get out of this bubble without the appearance of a miraculous multitude of greater fools at the very moment existing holders decide to sell.
Notably, the heaviest repurchase activity is associated with market peaks - repurchases actually dwindle at market lows. As our friend Albert Edwards across the pond in England points out, corporate cash flow alone is not enough to finance buybacks and other corporate expenditures, so buybacks are instead typically funded primarily through debt issuance. When you recognize that most corporate debt has a maturity of less than 8 years and that market valuations presently imply negative total returns for the S&P 500 over this horizon by our estimates, we believe that corporate repurchases are doing violence, not good, to investors. Moreover, a good chunk of repurchases are used to offset dilution from stock and option grants to corporate insiders. This is like someone saying, "Hey! I made you a pizza!" and then eating that pizza right in front of you.
Notice that heavy equity buybacks (negative values on the red line below) are regularly financed by the issuance of corporate debt (a mirror image of positive values on the black line). Those debt-financed equity buybacks have been heaviest at market peaks like 1999-2000, 2007, and today. Put simply, the history of corporate stock buybacks is a chronicle of corporations buying stock with borrowed money at market tops, and retreating from buybacks at the very points that stocks are most reasonably valued.
In any event, the reason most investors won't get out of this bubble is that it will require other investors to get in by taking the stock off their hands - and with bearishness running at the lowest level in 27 years, those potential buyers increasingly represent value-conscious investors like us whose demand is likely to emerge only at materially lower valuations.
Long-term investors should also recognize that on the basis of historically reliable valuation measures, we estimate 10-year nominal total returns for the S&P 500 of only about 1.5% annually from current prices, so given a 2% dividend yield, we actually expect the index to be lower a decade from now than it is today(see Ockham's Razor and the Market Cycle for a review of these measures).
As value investor Howard Marks observed last week:
'Today I feel it's important to pay more attention to loss prevention than to the pursuit of gain. Although I have no idea what could make the day of reckoning come sooner rather than later, I don't think it's too early to take today's carefree market conditions into consideration. What I do know is that those conditions are creating a degree of risk for which there is no commensurate risk premium.'
So while many observers pronounce victory at halftime, in the middle of a market cycle, at record highs and more extreme market valuations than at any point except the 2000 peak, remember the two pillars."
Point Of Consideration
There is little argument that the bulls are currently "in charge" of the market. However, the danger is the complacency that it will always remain so. The chart below is from Friday's "5 Things To Ponder."
"It is a bad sign for the market when all the bears give up. If no-one is left to be converted, it usually means no-one is left to buy." - Pater Tenebrarum
Furthermore, there is a brutal history between the US Dollar, Interest Rates and the financial markets. When the dollar rises in value, the higher value attracts foreign capital into U.S. bonds for the differential in exchange rates. However, the rise in the dollar makes exports much more expensive for international trading partners, who are currently near recession already, and slows their economic growth. With corporate profits currently almost 40% comprised of foreign consumption, this becomes a problem for profit growth domestically.
Secondarily, the rise of interest rates caused by inflows into Treasury bonds increases borrowing costs domestically that slows consumption and economic growth. (For a complete listing of all of the inherent problems with higher rates read: Stock Bulls Should Hope Rates Don't Rise.)
With there being very little economic slack, currently it is unlikely that it will take much of an increase in interest rates to slow housing, consumption and ultimately growth. We saw it last year first hand when the spike in interest rates in June sent the housing market tumbling. It will likely be no different this time.
As Michael Sincere recently stated rather sarcastically:
"If you study history, you know that no one thought the price of tulips, houses, or stocks would ever go down. Even most bulls believe that 'one day' there will be a correction, but that day is far away. After all, the Fed has an unlimited supply of magical tools, and they are determined to keep the market from falling.
Unfortunately for soul-searching bears, the Fed trumps all. As long as new money flows into stocks, interest rates are low, and the market keeps going up, why worry?"
The problem is that the Fed is taking their toys and going home. Should we worry now?
Have a great week.