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posted on 09 April 2017

Questioning The Bullish Trend

Written by , Clarity Financial

While there is NO QUESTION the bullish trend currently remains intact, the release of the FOMC minutes revealed that even the Federal Reserve has begun to question the efficacy of the bull market.


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Just to remind you, the entire catalyst behind the post-election rally has been the “hope" that tax cuts will boost earnings enough to support current market valuations. However, interestingly, while the markets continue to hope for “fiscal policy" reforms, according to the release of the FOMC minutes there is little consideration being given to Trump’s agenda. From the minutes:

“Participants continued to underscore the considerable uncertainty about the timing and nature of potential changes to fiscal policies as well as the size of the effects of such changes on economic activity. However, several participants now anticipated that meaningful fiscal stimulus would likely not begin until 2018. In view of the substantial uncertainty, about half of the participants did not incorporate explicit assumptions about fiscal policy in their projections."

Furthermore, the FOMC also raised concerns over the level of valuations in the markets.

“Broad US equity price indexes increased over the inter-meeting period, and some measures of valuations, such as price-to-earnings ratios, rose further above historical norms. A standard measure of the equity risk premium edged lower, declining into the lower quartile of its historical distribution of the previous three decades. Stock prices rose across most industries, and equity prices for financial firms outperformed broader indexes.

Just for the record, here are both measures. The first chart below is the Cyclically Adjusted P/E ratio and its inverse Earnings Yield (see this for an explanation.)

Currently, the implied Risk Premium for U.S. equities is in the bottom third of its long history. While there are many suggesting we have entered into a new “secular bull market," the related risk premium of investing in equities over “risk-free" assets suggests differently.

“No matter how you value the market, it is simply expensive."

Combine rich valuations with over confidence and the markets have tended to have poor outcomes.

Lastly, the Fed minutes also touched on the detachment between the “hard" and “soft" economic data. While there have been numerous articles recently suggesting the economy will catch up with the current levels of optimism, the recent employment and economic data suggests some caution.

With Q1-GDP currently tracking near 0.6%, as noted by the Atlanta Fed GDPNowCast on Friday, the “Trump Confidence" boost has yet to materialize in actual activity.

Bullish For Now, Bearish Later

I wrote previously a piece on the problem with “Buy and Hold" investing. The crux of the article is that spending a bulk of your time making up lost gains is hardly a way to build wealth longer-term. More importantly, is the consideration of “time" in that equation. Unless you discovered the secret of immortality, “long-term" is simply the amount of time between today and the day you will need your funds for retirement.

Of course, such articles always derive a good bit of push back suggesting that individuals cannot effectively manage their own money, therefore, indexing is their only choice.

I simply disagree.

Yes, managing risk in a portfolio will create underperformance over short-term periods BUT much less than being overly exposed to equities during a period of decline.

As I have stated previously, participating in the bull market over the last eight years is only one-half of the job. The other half is keeping those gains during the second half of the full market cycle.

In other words, while the bull market is intact, remain “bullish". Just don’t forget you also need to be “bearish" later.

If the market breaks support, the subsequent decline will quickly wipe out the gains of the year. The probability of such happening in the months ahead is roughly 71% as discussed last week.

The purpose of risk management is to protect investment capital from being destroyed which has two very negative consequences.

  1. When investment capital is destroyed, there is less capital to reinvest for future gains.

  2. The destruction of compounded returns. Small losses in principal can quickly erode years of gains in wealth.

Raising cash and protecting the gains you have accrued in recent years really should not be a tough decision. Not doing so should make you question your own discipline and whether “greed" is overriding your investment logic.

While the financial press is full of hope, optimism and advice that staying fully invested is the only way to win the long-term investing game; the reality is that most won’t live long enough to see that play out.

You can do better.

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