In this issue of “Everyone Is In The Pool. More Buyers Needed.”
At the halfway point of January, the market has struggled to hold onto its gains. Such is surprising given the recent passage of a $900 billion stimulus bill and Biden’s proposal for another $1.9 trillion on Thursday. With another $2.8 trillion in stimulus hitting the economy, inducing the Fed to do more QE, markets were seemingly unimpressed.
For the first two weeks of January, the market is up by 0.32% YTD.
As we discussed recently in “There Is No Cash On The Sidelines,” the markets are driven by buyers’ and sellers’ supply and demand.
“In the current bull market advance, few people are willing to sell, so buyers must keep bidding up prices to attract a seller to make a transaction. As long as this remains the case, and exuberance exceeds logic, buyers will continue to pay higher prices to get into the positions they want to own.”
Such is also the definition of the “Greater Fool Theory:”
“The greater fool theory states that it is possible to make money by buying securities, whether or not they are overvalued, by selling them for a profit at a later date. This is because there will always be someone (i.e. a bigger or greater fool) who is willing to pay a higher price.”
The problem comes when buyers are no longer willing to pay a higher price. When sellers realize the change, there will be a rush to sell to a diminishing pool of buyers. Eventually, sellers begin to “panic sell” as buyers evaporate and prices plunge.
As we will discuss in a moment, there is ample evidence that “everyone is currently in the pool.” Such leaves the market vulnerable to three risks we debated over the past week:
The reality is that both a rise in the dollar, with higher yields, is likely to start attracting reserves from countries faced with economic weakness and negative-yielding debt. Such would quickly reverse the tailwinds that have supported the equity rally since March.
The following video covers the current market exuberance and the importance of the dollar.
There is also the problem of monetary policy. As discussed in “Moral Hazard,” investors are chasing risk assets higher because they believe they have an insurance policy against losses, a.k.a. the Fed.
However, this brings us to the one question everyone should be asking:
“If the markets are rising because of expectations of improving economic conditions and earnings, then why are Central Banks pumping liquidity like crazy?”
Despite the best of intentions, Central Bank interventions, while boosting asset prices may seem like a good idea in the short-term, in the long-term has harmed economic growth. As such, it leads to the repetitive cycle of monetary policy.
If you don’t believe me, here is the evidence.
The stock market has returned more than 164% since the 2007 peak, which is more than 3.8x the growth in corporate sales, and 7.5x more than GDP.
But, for the 10% of the population that owns 90% of the stock market, the sentiment is now getting extreme.
While the video discusses some of the extremes currently developing in the market, none better shows this than our investor sentiment gauge. As explained previously, this gauge compiles several measures of investor “positioning” in the markets in terms of actual equity exposure. As shown, we are at levels that have historically had poor outcomes.
Of course, seeing that, you shouldn’t be surprised to see that retail investor confidence (dumb money) is near its highest levels on record.
The interesting thing about the market is that investors are rushing into equities in anticipation of an economic recovery. However, while there will indeed be a recovery, it is likely to fall far short of investor expectations. Such is generally the case. However, with “euphoria” now at mania levels, the only question is just how disappointed they will be?
As noted above, it is quite clear everyone is “now in the pool.” Such raises the question of:
“Who is left to buy?”
While sentiment measures are certainly worth considering, as the old axiom goes, “markets can remain irrational longer than you can remain solvent.” Therefore, from a portfolio management point of view, we want to focus on the technical signs, suggesting that starting to hedge against “risk” is likely prudent.
When markets are exuberantly bullish, along with investors believing there is “no risk” to investing, you see virtually every stock moving higher. We can view this specifically in looking at the number of stocks trading above their 200-dma. As noted by Sentimentrader:
Of course, to no surprise, the put/call ratio is back to a record that usually has preceded short-term corrections.
Such does not mean the market is about to crash, although such would not be unprecedented. The combination of these indicators does suggest that a correction between 5-10% is likely within the next couple of weeks.
What will cause that correction? Who knows. But such is why we have slowly started adding some “risk hedges” back into our portfolios this week. Profit-taking will come next.
By Michael Lebowitz, CFA
We talk a lot about valuations and their importance, but such discussions can be hard to put into context. Therefore, I have produced a series of charts that visualize various valuations of the S&P 500 companies. Not surprisingly, such also corresponds to the current behavior of Wall Street analysts and investors. Instead of cluttering up the commentary space on RIAPro.Net (30-day Risk-Free Trial), we thought you would better appreciate the charts and can share them more easily in an article format.
The charts below are called heat maps. What we like about heat maps is their ability to show two data points in one easy to read format. The following maps show the S&P 500 components market cap and along with a second factor. The larger the company’s market cap is in relation to other companies in the sector, the larger the square. Each graph has a scale on the bottom right relating to the second factor. In the first graph (Price to Earnings), the brighter the red, the more overvalued a company is. Conversely, green is relatively cheaper. Companies are sorted by their sectors and sub-sectors.
The first three graphs are popular measures of valuation. The fourth graph shows that analyst recommendations, despite valuations, are pretty bullish. As shown in the fifth graph, investors are also overly bullish as there is a very low percentage of short positions in general. Lastly, the sixth graph shows this is not just domestic, but high valuations are occurring in many other countries.
You have to look pretty hard to find stocks that are not wildly overvalued.
A ratio between 2-3 is considered somewhat normal, especially for well established mature companies.
P/B is also typically in the lower single digits for mature companies.
You have to look pretty closely to find stocks that do not have buy recommendations.
The continual grind higher has scared away almost all short sellers.
These are not as extreme as the U.S., but P/E ratios around the world are very high. Keep in mind that historical P/E ratios in most countries are lower than in the U.S. for several reasons. But importantly, P/E ratios are relative to the country that domiciles the company. Therefore, just because it may appear cheap relative to the U.S. does not necessarily mean it is a value.
No matter how you look at the markets, either from a technical or fundamental point of view, the long-term risk/reward is not favorable.
What eventually derails the bullish bias is unknown. However, what is certain is that when it occurs, given the more extreme levels of leverage combined with a lack of liquidity, the reversion will be swift.
During a bull market advance, investors always take on substantially more risk than they realize. Unfortunately, it is a painful lesson taught quickly and repeatedly throughout history.
Here are my annual resolutions for the coming year to be a better investor and portfolio manager:
These are the same resolutions I attempt to follow every year. There is no shortcut to being a successful investor. There are only the basic rules, discipline, and focus that is required to succeed long-term.
If you need help or have questions, we are always glad to help. Just email me.
See You Next Week
By Lance Roberts, CIO
This is what our RIAPRO.NET subscribers are reading right now! Risk-Free For 30-Day Trial.
If you need help after reading the alert, do not hesitate to contact me.
Model performance is a two-asset model of stocks and bonds relative to the weighting changes made each week in the newsletter. Such is strictly for informational and educational purposes only, and one should not rely on it for any reason. Past performance is not a guarantee of future results. Use at your own risk and peril.
As an RIA PRO subscriber (You get your first 30-days free), you can access our live 401k plan manager.
Compare your current 401k allocation to our recommendation for your company-specific plan and our 401k model allocation.
You can also track performance, estimate future values based on your savings and expected returns, and dig down into your sector and market allocations.
If you would like to offer our service to your employees at a deeply discounted corporate rate, please contact me.