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posted on 22 October 2017

Examining The Most Hated Bull Market Ever

Written by , Clarity Financial

From last week:

"The seemingly "impervious" advance since the election last November, has had an interesting "stair step" pattern with each advance commencing from a breakout of a several month 3%-ish consolidation range. Furthermore, each advance then pushes to a 3-standard deviation extreme, black circles, of the 50-dma before beginning the next consolidation trading range."


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The last leg higher has been directly responsive to the ramp up in the political "marketing surge" surrounding "tax cuts and tax reform." With the House having already passed their respective budget resolutions, late Thursday, the Senate passed a budget blueprint for the next fiscal year. With both of the "budget resolutions" in place, it was seen as clearing a hurdle to the goal of overhauling the tax code.

This is not new, of course, as the entire rally for the markets since the election has been driven by hopes of lower taxes, despite disaster, floods, fires and Central Bank threats of liquidity extraction.

The bulls are clearly in charge which keeps us allocated to towards equity risk currently.

Do not be mistaken, this "rally" IS all about tax cuts. Despite many who are suggesting this has been a "rational rise" due to strong earnings growth, that is simply not the case as shown below. (I only use "reported earnings" which includes all the "bad stuff." Any analysis using "operating earnings" is misleading.)

Since 2014, the stock market has risen (capital appreciation only) by 35% while reported earnings growth has risen by a whopping 2%. A 2% growth in earnings over the last 3-years hardly justifies a 33% premium over earnings.

Of course, even reported earnings is somewhat misleading due to the heavy use of share repurchases to artificially inflate reported earnings on a per share basis. However, corporate profits after tax give us a better idea of what profits actually were since that is the amount left over after those taxes were paid.

Again we see the same picture of a 32% premium over a 3% cumulative growth in corporate profits after tax. There is little justification to be found to support the idea that earnings growth is the main driver behind asset prices currently.

We can also use the data above to construct a valuation measure of price divided by corporate profits after tax. As with all valuation measures we have discussed as of late, and forward return expectations from such levels, the P/CPATAX ratio just hit the second highest level in history.

The reality, of course, is that investors are simply chasing asset prices higher as exuberance overtakes logic and their actions prove the case. According to data from FactSet, stock-based exchange-traded funds have seen nearly $16 billion in inflows over the past week, which represents an acceleration from recent positioning. Over the past month, about $31.3 billion has gone into stock-based ETFs. The chart below of data from ICI shows much of the same with monthly equity ETF inflows surging since the election.

The same is seen when we also add in equity mutual funds for a look at total equity asset flows.

Not surprisingly, those actions have been backed by their massive elevation in bullish sentiment.

As UMich noted:

"Consumer sentiment surged in early October, reaching its highest level since the start of 2004. The October gain was broadly shared, occurring among all age and income subgroups and across all partisan viewpoints.

There is an unmistakable sense among consumers that economic prospects are now about as 'good as it gets.'"

Most hated bull market ever...hardly.

Historically speaking, you only witness such exuberance in the latter stages of an expansion, not the beginnings of one. The latest survey indicates that consumers do not anticipate an economic downturn anytime in the foreseeable future, which from a contrarian perspective may be a clear warning sign.

Clearly, the expected benefits of tax cuts and reforms is leading investors to overpay for something today they are hoping will become fairly valued tomorrow. In other words, instead of prices catching "down" to market fundamentals, investors are hoping fundamentals will "catch up" to prices.

Unfortunately, there isn't a previous case in history where this has been the case.

Also, when we look at 20-year trailing returns, there is sufficient historical evidence to suggest total, real returns, will decline towards zero over the next 3-years from 7% annualized currently.

(These are trailing 20-year total real returns, not forward)

Re-read that last sentence again and look closely at the chart above. From current valuation levels, the annualized return on stocks by the end of the current 20-year cycle will be close to 0%. A decline in the next 3-years of only 30%, the average drawdown during a recession, will achieve that goal.

For investors, this is crucially important. In the article "Apathy & The Death Of Your Financial Goals," I discussed the reality of the damage caused by market drawdowns. As I stated:

"Crashes matter, a lot."

While investors may "get back to even," eventually, following a crash, the shortfall from their actual financial goal continues to build.

This is why using some method of risk management, such as a simple moving average crossover, can help alleviate some of the financial damage caused by drawdowns.

  • YES! You will miss out on some gains in the market.
  • YES! Sometimes you will be "stopped out" and have to "buy back in."
  • YES! You will be much more successful in obtaining your financial goals long-term.

After all, isn't that why you invest in the first place?

What I can assure you of is that you WILL be wrong from time to time and you WILL lose money. But that is the inherent nature of investing. It is a "RISK" based endeavor.

However, I can absolutely guarantee that trying to "passively index" in the current market environment will absolutely wind up screwing up your long-term goals.

Think about it this way. IF investing was as easy as just buying a bunch of stuff and sitting on it, then why are so many Americans dependent on Social Security for retirement? Via Jared Dillian:

  • 19.7% of retirees get 100% of their income from Social Security.
  • A full third (33.4%) depend on it for 90% of their income.
  • And 61.1% get at least half their income from Social Security.

The federal government's unfunded 75-year liability for Social Security and Medicare combined is $46.7 trillion.

Are you absolutely sure you want to rely on the Government for your retirement?

Think about it the next time someone tells you to just "buy and hold."

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