July 7th, 2015
by Lance Roberts, StreetTalk Live
The seemingly never ending "Greek Crisis" has certainly garnered the world's attention over the last couple of weeks. And while market volatility has certainly increased as of late, it is important that we step back and look at the markets objectively.
As I stated very early last week, as Greece defaulted on their debt payment to the IMF:
"if we step back from the media's messaging and take a look at the market, a significantly different picture begins to emerge. The chart below is a monthly chart of the S&P 500 index."
"When put into some perspective the recent "decline" is much less dramatic. Importantly, the markets continue to maintain the longer-term "bullish trend" which has been the hallmark of the market's accelerated advance since the onset of "QE3" in December of 2012.
Importantly, for investors, the TREND of the market remains positively biased for now. Regardless of your personal bias (bullish or bearish,) as it relates to the economy or markets, the positively sloping market trend requires portfolios to remain tilted toward equity (risk) based exposure.
However, and importantly, where investors inherently go wrong is the extrapolation of the current condition indefinitely into the future. As shown in the chart below, there are internal dynamics that suggest that current "environment" for carrying excess "risk" is deteriorating."
"The market, on multiple levels, has reached points that have existed only at previous major market peaks. Furthermore, the internal dynamics are issuing very similar warnings, in terms of momentum, deviation, and relative strength, as to what was seen just prior to major turning points previously. While this does NOT mean that the market is on the verge of immediate mean-reverting correction, it does suggest that future market returns are likely to be far less robust than what has been seen previously."
China Likely The Real Threat
China is likely more of a threat to the financial markets than Greece because what is happening in China, and as being witnessed by the Shanghai index, is NOT being covered by the media. As I have stated previously, what trips up the market is generally not an event that the market is well aware of, but one that catches it by surprise. The events in Greece, have been, and continues to be, widely publicized which has allowed the markets to factor in potential outcomes. However, that is not the case with an event emerges without warning. That "surprise" factor is what has historically been the "match" that ignited a more significant market correction.
Furthermore, while it is often stated that major market reversions never occur outside of a recession, the reality is such correlations are only seen in hindsight as recessions are recognized well after the event. The chart below shows the NBER's (National Bureau of Economic Research) recession announcements as compared to the S&P 500 index.
The reality is that the markets lead recessions, and likely are a major contributor to recessions as the plunge in asset prices impacts consumer confidence. It is worth remembering that at the peak of every stock market cycle has been the clarion call of "economic prosperity" and "peak employment," Record levels of anything should be a warning.
No Time For Complacency
For investors, it is not time to become complacent or dismissive of market action. While recent price declines have not violated or changed the current bullish trajectory of the market, it does not mean that such will not eventually become the case. The markets, much like a ball thrown in the air, have been lofted higher due to an enormous amount of "force" that was created though liquidity interventions, suppressed corporate profitability, pent-up investor demand, and a variety of other factors following the financial crisis.
However, when that "force" is exhausted the ball will eventually return to earth. The markets, like anything, adheres to the laws of physics. The gravitational pull of the longer-term moving average will eventually drag prices into a mean reverting event. At that point, the issue of valuations, price extensions, and a variety of other factors will become vividly apparent. Unfortunately, for most it will be far to late to be proactive which will lead to a replication of the "buy high / sell low" process that has destroyed investor capital repeatedly in the past.
Speaking of valuations. Nan Lu and I did some work recently on valuations and forward total (dividend reinvested) real (inflation adjusted) returns over long periods of time.
I have discussed the importance of valuations and forward return expectations in the past (see here) but John's commentary is very important because it highlights a huge disconnect between what individual individuals THINK and how they ACT. Specifically, individuals believe they are truly "long term" investors and that they will make investments for very long periods of times (10 years or more.)
However, as shown by repeated studies, that belief is confounded by the fact that individuals react to short-term market volatility and other inputs which leads to emotional decision making. Of course, the media/press/blog community is primarily to blame for these actions by focusing a spotlight on each data point within the financial markets rather than helping investors focus on the "long game."
One of the more useless discussions as of late has been on the irrelevance of high valuations as it relates to market returns of the next 12 months. To wit:
""The so-called CAPE, popularized by Professor Shiller of Yale is extended but unfortunately has no ability to predict stock price outcomes a year later," Citi's Tobias Levkovich said on Friday. 'Yet, that does not seem to confound the bears, which we find both intriguing and revealing about motive rather than study.'"
The problem is what I have addressed in the past as a "duration mismatch". Shiller's CAPE ratio is not about what happens in the next year but rather what returns investors should expect over the next 10 or 20 years. After all, we are saving and investing for our retirement, right?
The following two charts show the TOTAL (dividend reinvested) REAL (inflation adjusted) forward returns from every level of CAPE since 1900. I have noted with the red box the current range of CAPE.
The good news is that forward returns over the next decade or two have IMPROVED from the low levels witnessed at the turn of the century. The bad news is that forward returns are likely to be PRIMARILY a function of inflation and dividends more than capital appreciation. Unfortunately, most investors will do far worse.
It is time to pay close attention to market dynamics and adjust portfolio risk exposure accordingly. While I don't know WHEN the next major market reversion will occur, I do know that it eventually WILL. This is why managing portfolio risk and paying attention to the overall trend of the market will allow for a more logical decision-making process rather than reacting to headlines.
It is always better to be more conservative during periods of market uncertainty as it is much easier to increase portfolio "risk" when the overall enviroment gains clarity. However, spending long periods of time making up losses is much more problematic in achieving long-term investment goals.
As Issac Newton once said: "Gravity's a bitch."
Have a great week.
Disclaimer: All content in this newsletter, and on Streettalklive.com, is solely the view and opinion of Lance Roberts. Mr. Roberts is a member of STA Wealth Management; however, STA Wealth Management does not directly subscribe to, endorse or utilize the analysis provided in this newsletter or on Streettalklive.com in developing investment objectives or portfolios for its clients. Please read the full disclaimer.