The market seems to be angling for a break out to new highs; in some cases it has already done so. Just when it had everyone convinced the bull market was over. Investors who were participants in the 90’s, have seen this before. Here’s what you can expect.
Not Done Yet
I was mountain biking with a good friend, Josh, who is a mortgage broker here in Steamboat a few weeks ago. We like to talk on the way up, as it seems to hurt less. He was telling me that June would be his largest month on record for volume of new mortgages, second only to June of 2007. Then he hesitated and said, “and we know how that ended”. The implication was that we must be at another long term peak. For many investors, it’s hard not to give into the expectation that prices must peak now because we’re simply afraid of heights. More to the point, many believe the market peaked 15 months ago and must ultimately yield to a devastating bear market. That feeling is everywhere. In fact, as of the end of May, investor bullish sentiment had reached one of its lowest readings in more than a decade. The American Association of Individual Investors (AAII) showed only 19% bulls at the end of the month, with over 50% choosing to be “neutral”. This is extraordinary. I mentioned this in the last update as a condition that does NOT typically yield a bear market but one that is ready to move higher. Bespoke confirmed with some terrific research about forward returns under these conditions. Take a look at the Red bars, which show the forward returns for the S&P 500 over various time periods when AAII sentiment figures reached these pessimistic levels in the past. Wow!
I told Josh that strangely one of the things I have struggled with the most in client conversations is “talking up” the possibility that this bull market is not over yet. With the intent of setting client expectations, we should all understand clearly what kind of opportunities and risks lay ahead, all things considered.
Strong but Short Move Higher
If the markets really want to break out to new highs in the aggregate using the S&P 500 as a “market” proxy, we would need to see a solid close above 2130 which was the high level set over a year ago. Today, we’re only a few points away. As most investors know, stocks have gone no where in almost two years with several sectors like energy and commodities causing a great deal of pocket pain. Small caps and internationals have also dramatically underperformed as well, down nearly 20% from the highs at their worst. Now the situation is far more constructive with nearly all countries, asset classes, sectors and styles of investing, moving higher in sync. Many have broken long down trends in the last two weeks as well. The rally off the lows in February has been broad based with plenty of supportive technical evidence like breadth and volume. So for now, it seems likely that the lows in February were not the BEGINNING of a bear market but rather the exhaustive END of a long and unproductive market correction that began in the summer of 2014 (no typo). Remember, the end of the 2008 bear market finished much the same way with an exhaustive capitulation type selling cycle in early 2009. In the first three months of 2009, stock prices were down almost -26%! But, once prices finally reversed to the upside, we saw explosive growth for several years. Make no mistake, the situation now is not the beginning of a new bull market however, quite the opposite. The US stock market is already up off the lows by nearly 200%, valuations are still very close to one of the highest levels we have seen in modern history. Investor margin debt is also at an all time high and now liquidity is in question with the Federal Reserve’s new policy of raising rates – slowly.
There are only two things that drive stock prices. One is earnings and the other is liquidity. I would add that investor appetite would have to be a close third as there must be some underlying level of confidence for investors to commit to ownership. Today, earnings are unimpressive having peaked in terms of marginal growth at the same time as stocks in late 2014. Plainly stated, any sustainable surge in stock prices from here will have to go hand in hand with a surge in earnings and some real evidence of new economic growth. It is possible? It’s very possible. I would point to the falling US dollar as a catalyst for higher earnings. I would point to a cycle of labor replacement where companies are laying off older more expensive workers and replacing them with younger new employees who are quite talented and hungry to start their careers even at entry level pay. Labor replacement is a quick way to boost earnings without changing your business very much. I would also point to pending fiscal stimulus, which I’m beginning to see. These are the government, shovel ready, jobs that serve as economic stimulus instead of the more ineffective monetary stimulus. We won’t see this until 2017 with a new administration. Finally, I’m seeing new and resurgent demand from outside the US coming from Asia, Emerging markets and parts of Europe. If China can finish their economic soft landing soon, we could see a dramatic pick up in global economic demand and earnings.
From the liquidity side, we have to remember that even if the Fed raises rates, they are coming off of years of Zero Interest Rates and years of QE. They can raise rates 8-10 times and we would just be back on par with a “normal” central bank interest rate environment. Some are arguing that liquidity is drying up. I would argue that we have liquidity everywhere, like a flood, and it wouldn’t hurt us a bit to do some mopping up.
All told, the opportunity exists for stocks to move higher from here. Our best guess in terms of magnitude is roughly 12-15% higher if earnings can accelerate a bit and we continue to see surging economic indicators with near full employment. But, we shouldn’t expect a lot more than that from a longer term perspective. Ultimately, global stock markets will give in to another painful bear market just as they have done for the last century. This looks like an extension of the current bull market, but not the birth of a new bull market. Set your expectations accordingly.
Jim Stack of Investech had a great piece of advice for all investors, which I’ll share with you in my own words. He said, this is the environment to pursue SAFE profits, but not try to MAXIMIZE profits. The wisdom of ages. We are doing just that in all strategies. While we are nearly fully invested again, a quick look at our holdings will show a nice blend of offensive and defensive positions, leaning on income generators, value styles and oversold sectors instead of chasing areas of the market that are clearly still absurdly overbought.
We’ll enjoy this wave of returns for as long as it lasts keeping our eyes on the big picture.
That’s it for this week, stay cool!
Cheers
Sam Jones
