Perception Trumps Reality
I awoke on Tuesday this week to Bloomberg’s “Daybreak” app proclaiming that Dow futures were poised to open above 26,000 for the first time. They expanded on that by stating that this was the fastest 1000 point rise in history! Immediately, I flashed back to 1999, when I was a young, green buck on the trading floor, and CNBC had made a similar claim that the Dow Industrials Index had just completed its fastest 1000 point rise from 10,000 to 11,000. CNBC then went on to tell the audience that the slowest rise occurred on the move to the 1000 level. Yeah, they really did that. So, in incidents separated by 20 years, two of the most watched financial news outlets have reflected a lack of understanding of basic math (i.e. how percentages work). Or, maybe they are just catering to the average investor, which they assume lacks such knowledge. Either way, it is somewhat depressing for investment professionals attempting to perform any robust analysis. In the short-term, it is often meaningless, as many market participants react to noise.
For institutional investors, it is not news that many in the financial media, along with most average investors, are financially (and mathematically) illiterate. Much of the time, it is of no real consequence. Occasionally though, when markets become particularly ebullient, investors’ credulity becomes paramount. John Maynard Keynes famously remarked on the persistence of irrationality in the markets. But I must disagree with his assessment. It’s not that investors are necessarily irrational, it’s just that they don’t know any better. On a recent trip to my home state of South Carolina, I conversed with an octogenarian uncle about the markets. As I attempted to explain that much of the recent upswing in the global economy, and the markets, has been driven by massive new injections of quantitative easing by Europe, Japan and China, with the GOP tax cut as kicker, I was met with this simple logic: “But my investment account is going higher, and I see that as a good thing.” Well, who can argue with that! Honestly, I cannot call it irrational. It is inherently rational. Investors’ “reptilian brains” guide them toward such lines of thinking. And for now, it is working. Unfortunately, history tells us that when the retail investor is in this frame of mind, it’s time to get cautious.
While novice investors simply sense an immediate betterment in economic conditions, and feel compelled to buy in, those of us tasked with providing professional analysis seek to parse the data understand the reasons why. Don’t get me wrong, as a trader, I often simply bought into momentum without spending an excessive amount of time “thinking”. Certainly, I would have never survived Wall Street in the late ’90’s otherwise. But for me, determining the why was always a primary motivation. If you don’t understand the reasons markets are moving, anticipating the next chain of events is impossible.
Prior to coming to New York in 1998, I was listening to a recruiter for a job as an investment advisor at a major investment firm. The speaker described a fellow advisor in the following terms: “Her clients love her! She probably pulls down $1 million a year. And honestly, I don’t think she even knows what a mutual fund is.” I wonder if her clients still loved her in 2002? Or 2008? The point being, it’s easy to promote passive investing, which is in vogue now, when markets are marching higher. Professionals concerned about the drive toward passive investing should keep this in mind. Worries about passive investing are likely a contrarian signal (albeit early).
Just Follow the Money
Countless market prognosticators have been made to look foolish over the last year for being overly bearish. Underinvested fund managers are feeling heat as well. Initially, market valuations have been touted as the primary reason for caution. More recently, excessive exuberance indicated by relentlessly bullish price action has been the primary call for worry. Central banks have pulled skeptical investors kicking and screaming into the market over the last several years. Our recent experience could be described as a “Perverted Goldilocks” situation where economic weakness leads to more QE, which drives markets higher. Economic strength then leads to central banks curtailing liquidity, which causes economic and market weakness, but not too much, because overall liquidity still remains fairly abundent. Yet, the weakness is enough to once again bring the central banks back to injecting liquidity. Round and round we go.
Markets definitely seem to think this time is different from periods of strength experienced in recent years. It could be that a global synchronization of growth is adding to optimism by providing a stronger sense of fundamental solidity. Regardless, I continue to believe that the primary impetus to the past year’s strength has been unabating global monetary stimulus (see Manna From Heaven ). Additionally, the GOP tax plan, which U.S. investors clung to for hope through weaker economic data early last year, came through with a bang right before Christmas. I have already addressed the dubious nature of the economic impact from the tax plan (see Candy and Liquor for X-mas ), but much of that is a long-term story. In the short-run, a massive tax cut for corporations incrementally increases profits (+10% has been the general consensus). Given high equity valuations, it is reasonable to believe that the market has “priced in” the tax cuts already. But I believe that sort of fundamental view is irrelevant under present circumstances.
A short-term jolt to the economy through deficit spending, as well as, a sharp increase in inflow to corporate coffers is having the immediate effect of juicing market momentum. The man on the street is seeing his 401K appreciating, and will get $1000 (on average) extra in his paycheck over the next year. To quote my uncle, “I see that as a good thing”. Never mind whether we have the fundamental backdrop for sustainable strong growth. Who cares if equities are expensive relative to history. Does it matter for now if increases in bonuses by large corporations are a one-off, done only for PR purposes? “Average Joe” is feeling good, and looking to dance. Right now, that’s all that matters.
Blow Off Time
Wall Street is replete with trading indicators. On a standalone basis, many are typically useless. However, my experience has been that technical indicators, properly constructed, can be quite powerful if employed in conjunction with an understanding of the fundamentals. By properly constructed, I mean an indicator should not be a product of statistical overfitting (i.e. the indicator only works on the specific data used to create it). A classic example of such an indicator is the “Hindenburg Omen” ( Hindenburg Omen ), which sought to predict crashes. My guess is that almost any indicator designed to predict crashes will eventually fail for this reason, because crashes are quite rare. Furthermore, in our age of extraordinary monetary intervention, bearish indicator signals are much more likely to fail.
With the above caveat in mind, Chart 1 shows the spread between “AAII Bulls” and “AAII Bears”, which is constructed using a survey from The American Association of Individual Investors ( AAII ). While this indicator can at times do a pretty good job of calling short-term equity market turns, it is shown here mostly for illustrative purposes. As the chart illustrates, individual investors recently became the most bullish they have been since late 2010. That is a pretty shocking detail. Also, it’s likely not a coincidence that the 2010 reading came 2 months after the Fed implemented QE2.
While such a spike in the Bull/Bear spread usually presages at least a minor market correction (worse than -5%) within the next couple of months, it is probaly unwise to be too negative given other factors. For instance, Chart 2 adds nuance by showing “AAII Neutral Investors”, along with a 52 week moving average (red line). Notice that for the past several years, the 52 week moving average has remained above the highs of the previous cycle, showing extraordinary uncertainty. However, recently there has been a sharp drop in Neutrals to around 24%, which has been a floor for the past few years, as uncertainty has remained stubbornly high. A further move down in neutral investors, along with an increase of the Bull/Bear spread would provide a pretty good contrarian signal, as it would show investors were moving “all in”. But we’re not there yet.
Ultimately, the purpose of looking at sentiment surveys is to attempt to discern what I believe is the most important part of predicting market turns: positioning. Economic and corporate fundamentals provide the baseline levels for what equity market returns are likely to be, but it’s the fundamentals relative to positioning that determines market direction, and the rapidity of moves. Sadly, it is virtually impossible to get a full picture of overall investor positioning. Ideally, what we would like is a comprehensive view of the allocation among all asset classes for all investors. Instead, we must rely on various surveys to provide us with a rather murky view. At best, it’s like trying to discern the picture from a jigsaw puzzle with half or more of the pieces missing.
The AAII survey provides a decent picture for individual investors, but it’s a pretty crude device. For measuring sentiment among institutional investors, one of the best resources is the Bank of America Merrill Lynch Fund Manager Survey ( BAML FMS ). It provides a pretty comprehensive view of major asset classes, with much more detail than can be found in any survey for individual investors. The most recent survey shows that the professional herd has shifted sharply from rather cautious views in recent years. Cash levels sit at 5 year lows of 4.4%. A majority of fund managers (55%) are now overweight equities. Hedge funds now have their highest net long position (49%) since 2006. And most fund managers now see the bull market extending into 2019.
Approaching Cyclical Conclusion
Some market commentators have been saying for the past few years that we could not see an end to the bull market, because bear markets never begin without a wave of substantial, and broad-based, bullish sentiment. Generally speaking this is true, but I think it conflates a couple of things; typically, with rare exceptions (1987 for instance), bear markets come about in concert with recessions. That is, the market cycle is primarily driven by the business cycle. Despite two global mid-cycle slowdowns (2012 and 2015-16), we have avoided recession, as central banks world-wide have repeatedly flooded the world with liquidity. To a great extent, the persistent economic weakness throughout this cycle has prolonged the expansion by preventing the economy from getting to the “blow off” stage. Without a tight labor market, and pressure on resource prices driving inflation, central banks have been free to provide virtually endless liquidity. We are likely now entering a period when these conditions no longer hold.
As the U.S. economy begins to exhibit late-stage dynamics, with tightening labor markets and rising inflation expectations, market sentiment is approaching worrying levels. I must stress that we are not in the danger zone yet, assuming no deterioration in growth! Professional investors still have excess cash they can deploy. Individual investors do not look to be “all in” quite yet. Although, positioning seems to be moving rapidly in that direction. The relentless bullish action, with virtually no meaningful pullbacks, increases the risk of a sharp downturn when the cycle shifts.
In the meantime, investors should keep a keen eye on inflation and interest rates. As has been the case for several years, the one thing that could upset the market apple cart quicker than anything would be a quick rise in interest rates. Such a move is not likely to happen unless central banks pivot to a much more hawkish outlook, or at least, inflation surprises on the upside, leading investors to extrapolate more hawkish policy. If that happens in the wake of another leg higher in the market, as both individuals and professionals move the last of their chips into the pot, things will get ugly.