econintersect.com
       
  

FREE NEWSLETTER: Econintersect sends a nightly newsletter highlighting news events of the day, and providing a summary of new articles posted on the website. Econintersect will not sell or pass your email address to others per our privacy policy. You can cancel this subscription at any time by selecting the unsubscribing link in the footer of each email.



posted on 15 January 2017

Danger Lurks As Extremes Become The Norm

by Lance Roberts, Clarity Financial

Extremes Become The Norm

There have been a litany of articles written recently discussing how the stock market is set for a continued bull rally. While Trump was initially expected to be extremely bad for the market, post-election he somehow became extremely good for it.

extremes.become.norms.380x200

The are some primary points in common among each of these articles which are:

  1. interest rates are low,

  2. corporate profitability is improving,

  3. oil prices are rising, and

  4. Trump’s fiscal policies will supplant the Fed’s monetary policies.

While the promise of a continued bull market is very enticing it is important to remember, as investors, that we have only one job: “Buy Low/Sell High." It is a simple rule that is, more often than not, forgotten as “greed" replaces “logic." It is also the simple emotion of greed which fosters exuberance and extremes which ultimately reverts into devastating losses.

Therefore, if your portfolio, and ultimately your retirement, is dependent upon the thesis of a continued bull market you should at least consider the following charts which are a collection of current “extremes" in the market.


Extreme Valuations

It is often stated that valuations are still cheap. The chart below shows Dr. Robert Shiller’s cyclically adjusted P/E ratio. The shaded area is the current deviation of P/E’s above or below their long-term median P/E.

Click on any chart for larger image.

Currently, valuations are pushing levels only witnessed in 1928-1929 and 2000. However, it is often suggested the current valuations are nowhere near the “dot.com" level so obviously stocks are just mildly overpriced. The problem is current valuations only appear cheap when compared to the peak in 2000. In order to put valuations into perspective, I have capped P/E’s at 25x trailing earnings as this has been the level where secular bull markets have previously ended. I have noted the peak valuations in periods that have exceeded that level.

With valuations at levels that have historically been coincident with the end, rather than the beginning, of bull markets, the expectation of future returns should be adjusted lower. This expectation is supported in the chart below which compares valuations to forward 10-year market returns.

The function of math is pretty simple - the more you pay, the less you get.

Extreme Prices

I have often compared market prices to the equivalent of “stretching a rubber band." Prices can only deviate so far from the long-term trend line before a mean reverting event eventually takes place. Much like a “rubber band," prices can only be stretched so far before having to be relaxed to provide the ability to be stretched again.

The chart below shows the long-term trend in prices has compared to its underlying growth trend. The vertical dashed lines show the points where extreme overbought, extended conditions combined with extreme deviations in prices led to a mean-reverting event.

This is shown a bit clearer below which compares the deviation of the S&P 500 from the long-term growth trend. Currently, while only slightly below the peak of the 2000 “dot.com" bubble, the deviation is at levels that have ALWAYS coincided with a negative mean reverting event or very poor, and highly volatile, forward returns.

Extreme Allocations

Another argument I hear made consistently is that retail investors are only just now beginning to jump into the market. The chart below shows the percentage of stocks, bonds and cash owned by individual investors according to the American Association of Individual Investor’s survey. As you can see, equity ownership and near record low levels of cash suggest that the individual investor is already likely “all in."

Extreme Leverage

Of course, with investors fully committed to stocks it is not surprising to see margin debt at record levels as well as investors leverage up to chase returns.

When we look at the levels of Margin Debt/GDP ratio as compared to the S&P 500, we find a high correlation between peak levels of debt and subsequent market returns. Not surprisingly, extreme levels have been more indicative of “ends" rather than “beginnings."

Extreme Sentiment

Bob Farrell’s rule #9 states that when everyone agrees; something else is bound to happen. The next two charts show the level of “bullishness" of both individual investors (AAII Survey) and professional money managers (MarketVane, NAAIM & INVI Surveys). Surprisingly, investors are currently more exuberant than just about at any other time on record.

If we smooth the index with a 4-week average we get a better view of the current level of exuberance. Importantly, such levels of exuberance have been historically, once again, associated with short to intermediate-term, or worse, corrections.

When extremes become the norm, and are readily accepted as such, it has historically been associated with market bubbles.

  • 1929 - Stock reach a permanently high plateau

  • 2000 - This time is different

  • 2007 - It’s a Goldilocks Economy

While I am not suggesting the markets are about to crash tomorrow, I am suggesting that future returns are likely to be much lower than currently estimated by the majority of the financial media.

“But Lance, since you are all ‘bearish and $#(%,’ you are all in cash and missed out on the markets advance."

That would be incorrect.

As a money manager, I am currently long the stock market. I must be, or I potentially suffer career risk. However, my job as a portfolio manager is not only to make money for my clients, but also to preserve their gains, and investment capital, as much as possible. Understanding the bullish arguments is surely important, but the risk to investors is not a continued rise but rather the eventual reversion that will occur.

Unfortunately, since most individuals only consider the “bull case," as it creates confirmation bias for their “greed" emotion, they never see the “train coming."

Currently, with everyone on the “same side of the trade," any exogenous event which triggers a movement in the opposite direction tends to result in a stampede. Hopefully, these charts will give you some food for thought.

Remember, every professional poker player knows how to spot a “pigeon at the table."

Make sure it isn’t you.

>>>>> Scroll down to view and make comments <<<<<<

Click here for Historical Investing Post Listing










Make a Comment

Econintersect wants your comments, data and opinion on the articles posted. You can also comment using Facebook directly using he comment block below.




Econintersect Investing


search_box

Print this page or create a PDF file of this page
Print Friendly and PDF


The growing use of ad blocking software is creating a shortfall in covering our fixed expenses. Please consider a donation to Econintersect to allow continuing output of quality and balanced financial and economic news and analysis.


Take a look at what is going on inside of Econintersect.com
Main Home
Analysis Blog
The Job Guarantee, Wage-Price Inflation And Alternative Solutions: Part 1
The Job Guarantee, Wage-Price Inflation And Alternative Solutions: Part 2
News Blog
17 March 2017: ECRI's WLI Growth Index Shows Continued Moderate Slowing Of Rate of Growth
Durable Goods New Orders Improved in February 2017
Why NASA Won't Send Humans To Venus
Rail Week Ending 18 March 2017: Short Term Rate of Growth Slowing
How Taxes And Transfers Affect The Work Incentives Of People With Low And Moderate Income
How Tourism Affects China's Current Account Surplus
Infographic Of The Day: The Habits Of Highly Successful Entrepreneurs
To Where The Maple Syrup Flows
The U.S. Has The Most Expensive Healthcare System In The World
Five Maps That Will Change How You See The World
What We Read Today 16 March 2017 - Special Public Edition
Hate Groups In The U.S. Are Flourishing
What We Read Today 23 March 2017
Investing Blog
Early Headlines: Asia Stocks Mixed, Dollar, Oil Up, Gold Down, Health Care Vote Today, Calif. Solar, Russia And Poison, Mumbai Bridge, Sanctions Cause Suffering In N. Korea, And More
Tesla Is Playing The Long Game
Opinion Blog
Time To Stop Rewarding Economists For Bad Behaviour
The American Dream: An Endangered Ethos
Precious Metals Blog
These Gold Stocks Will Produce Much Bigger Gains Than Gold Itself
Live Markets
24Mar2017 Pre-Market Commentary: Looks Like Markets Will Flatline
Amazon Books & More






.... and keep up with economic news using our dynamic economic newspapers with the largest international coverage on the internet
Asia / Pacific
Europe
Middle East / Africa
Americas
USA Government































 navigate econintersect.com

Blogs

Analysis Blog
News Blog
Investing Blog
Opinion Blog
Precious Metals Blog
Markets Blog
Video of the Day
Weather

Newspapers

Asia / Pacific
Europe
Middle East / Africa
Americas
USA Government
     

RSS Feeds / Social Media

Combined Econintersect Feed
Google+
Facebook
Twitter
Digg

Free Newsletter

Marketplace - Books & More

Economic Forecast

Content Contribution

Contact

About

  Top Economics Site

Investing.com Contributor TalkMarkets Contributor Finance Blogs Free PageRank Checker Active Search Results Google+

This Web Page by Steven Hansen ---- Copyright 2010 - 2017 Econintersect LLC - all rights reserved