Understanding that “Jack” is a street term for money, you might appreciate the pun. I believe we have entered a market environment where there is still upside opportunity, perhaps even significant upside, but that ultimately we are angling toward another bubbly equity market condition that doesn’t end well for the unaware investor. Several new measures of stock market valuation and sentiment extremes have come to my attention recently giving me some greater doubt about the longevity of this bull market. At the same time, I’m seeing the market speak of an economic slowdown ahead through sector and asset relative strength. All things considered, my big bold statement regarding our investment stance from here on out is as follows:
Big Bold Statement
Most, if not all, gains from this point forward in the global stock markets are likely be erased in the next subsequent global bear market decline.
I’ll tell you why in a minute
Please re-read the big bold statement again and then take a deep breathe and remember this. Investing is never easy, certainly nothing like 2013,which was clearly one of the easiest years in my 20 year career. The markets will have bull and bear cycles until the end of time and that is why we have developed mature tools to guide our clients’ money in both up and down market conditions. None of our investment strategies are of the buy and hold type where we assume that markets are perfectly efficient. Markets are only as efficient as investor psychology will tolerate and we know that humans are emotional creatures. Extremes will be hit both on the up and down side presenting a very inefficient market condition in other words. One of our basic investing creeds is based on the assumption that few investors have the necessary tolerance to ride through any of the real bear markets of the past (40-50% declines) without selling in panic at some point – usually at the worst possible time. Our methods and discipline will voluntarily reduce our exposure to risk, hopefully at an opportune time near the top, in order to make the investing experience tolerable as market losses become more severe for others. There is growing evidence that we are going to be reducing our risk exposure voluntarily as we see growing evidence that the market is approaching some extremes. Remember, we’re not there yet but simply recognizing the situation as it develops.
Valuation Extremes
I don’t want to go into too much detail on this but market valuation analysis always yields variable results depending on what you might use as your measuring stick. The Fed (Janet Yellen) has commented several times on their view that the market is NOT overvalued based on analysts’ expectation of future revenues. That metric is probably one of my least favorite as expectations can and often do, change over night and tend to be highly biased toward the recent past. If that evaluation metric were used at either of the last two major market peaks in 2000 and again in 2007, they would have been useless in predicting any of the subsequent carnage in stocks or the economy. Better methods of valuation that have had some solid predictive or coincident value, have been market capitalization for all common stock as a percent of nominal GDP (GMO, Hussman) as well as aggregate price/ 10- year inflation adjusted earning (Shiller). In a nutshell, the vast majority of the valuation metrics that have proved to be historically accurate since the late 1940’s are suggesting that the US stock market is now between 65 and 75% overvalued (see below)
(CHART HERE)
Now before you drop your toast, consider that overvalued markets at extremes have moved as high as 150% overvalued in the year 2000 and were almost 100% overvalued in the year 2007. So you see, there is room for the market to run higher but I am now coming to understand that we are nearing the very high end of the range for all credible metrics. GMO (Jeremy Grantham), curmudgeon that he is, even suggests we’ll see the S&P 500 hit 2250 in the next 24 months before our market hits a 2-sigma extreme from which heavy bear markets unfold. 2250 is a clean 20% higher than where we are today and worth a considerable allocation to stocks if it’s really available.
Other Extremes
Other extremes are coming from the less statistical side of things, more sentiment, and moral hazard type stuff. For instance in the last year, we have seen a near frenzy in IPO offering especially among fad companies with zero revenue. Bitcoin and several other things that I would never invest in, ran up 5,500% in 2013 only to crash and fail dramatically in a tornado of fraud. Cyber currency IPO with a 5,500% gain! Come and get it! What? Internet stocks did another parabolic rise in 2013 gaining 50, 100, 200% in a single year. We played some of these in our New Power model but cut and ran early in the year. It’s not wrong to be a momentum, investor as long as you’re ready to cut and run when you need to. I believe most momentum drive internet and biotech stocks are roughly ½ way down to their ultimate bottoms this year. These types of instant riches are definitely one of the calling cards of market tops. Real estate is again approaching that crazy cycle of bidding wars for junk on spec by people using other people’s money. Still, despite the fact the Fed is pulling back on their QE measures methodically, there seems to be a well entrenched assumption that if things go south, we can always rely on the Bailout Nation to make our pain go away. Moral hazard is with us. While we at All Season Financial had a reasonably good year, I think I will also expect to hear the growing din of demand for ever great returns based on the perception that the gettins’ are good! Balancing these demands and our business risk with the growing list of extremes that I see in the market will be my cross to bear for the next year or so.
Sector and Asset Strength
I often speak to this subject as it helps us identify where we are in the business cycle. Take a look at this first chart of the business and sector cycle below courtesy of the cool relative strength tool on www.stockcharts.com .
(CHART HERE)
You’ll notice that when Energy, Consumer staples and Healthcare lead the market, we are often looking at a “market top” of some sort. The economy, shown in the green curve, doesn’t actually top out until later when it reaches “full recovery”. By then stocks of all types are on their way down (aka a bear market). Now look at the sector strength since the beginning of 2014
(CHART HERE)
Can you see the curve in the market’s preference for energy, consumer staples and healthcare? Utilities are up big this year and we’re not sure why but they represent such a small part of the US stock market, that no one really cares J Sector preference is pretty clearly pointing to a pending market top. Of course this can change and we’ll be watchful for strength in cyclicals, tech and industrials as a group to indicate another potential surge higher – perhaps up to GMO’s 2250 mark?
Asset class rotation is painting the same picture of a pending market top as long term Treasury bonds are just crushing everything this year, up nearly 11% while stocks and most commodities are still flat. I don’t get it but it is what it is. Bonds are forecasting recession, sectors are forecasting recession and yet the economic reports are almost universally gaining strength each month. It would make sense that the market is beginning to forecast events in the economy that are not yet apparent with the very typical lead time of 6-9 months. We’ll see.
In summary, it seems that no matter what happens in the next year we have now entered the land of the overvalued market. While not yet at historical extremes, we need to move into a shorter-term frame of action where we might give the market and our holdings a shorter leash. Losers and weak positions should be sold quickly without much puzzling, while any buys should be slow with a heavy burden of proof to qualify. Raising cash is not wrong but let’s not be in a hurry either. Finally, let’s keep our “Jack” nimble and assume that profit taking is in our future. When the real decline comes and hits hard, we’ll hope to have our physical and emotional capital intact for what could be one last great buys of this decade.
Cheers to that
Have a great week
Sam Jones
