Submitted by Mike O'Rourke of Jones Trading,
The better than expected trade balance for June was its best monthly reading since 2009. The report will help fuel an upside revision to Q2 GDP. Yesterday’s trading action was indicative of a market starting to acknowledge the growing likelihood of tapering next month. The action appeared to carry over to the currency markets as the Yen strengthened versus the Dollar (chart below).
We always discuss our market view in terms of “risk vs. opportunity.” This 4 year Bull market has been registering new all-time highs on a nearly daily basis. Days like today’s 57 basis point drop in the S&P 500 are being mocked as a correction or large sell off for the current environment. It appears that after so many years of the “Great Rotation” being hyped, the public has (to an extent) been trained to take their Bond fund proceeds and roll them into equity ETFs. While it is unlikely that baby boomer money will come back to equities and sustain the rotation, there is money flowing in. While we are no fans of the bond market, we are still stunned that there are people selling “safe” assets and rolling the proceeds into “risky” assets at all-time highs.
While this rotation is driven by the relative value argument, it is likely that even if equities do not continue to rise each passing week, their relative inexpensiveness to bonds will be whittled away. It is interesting that people overlook that in 2007 as the market peaked, stocks were at their most attractive level compared to bonds (the Fed Model) since 1980. Nonetheless, the wall of money going into ETFs is disconcerting since this is “Blind Buying.” This is not investors seeing value in a stock or a fund manager, but rather just that lunge for exposure to participate in the new highs.
We believe in the saying that something is “well bought if it’s half sold.” This means purchasing an asset at such an attractive price that it could relatively quickly be sold at a profit, in which case you probably will not want to sell it for some time. One very public example of this are the purchases Warren Buffett has made historically. As the quintessential “buy and hold” investor, throughout his career Buffett swooped in and made his largest, most aggressive purchases during ugly environments then moved to the sidelines. In so many repeated cases, the purchases where done so well there was no need to worry about the sale, and in many cases he never has sold. It is an example of why paying the right price is so important. Likewise, paying the wrong price can be devastating.
There are three cornerstones to our current view that risk far outweighs opportunity.
As 4 ½ years of $1 Trillion of fiscal stimulus and $1 Trillion of monetary stimulus per year wind down, there are likely to be negative repercussions.
Since 2000, the rate of economic growth has been approximately half that of the previous 70 years. As such, we don’t believe that warrants paying above the historic multiple for the market.
Finally, while earnings have recovered and registered new highs, overall the growth is low quality and as such unlikely to be sustainable without the economy picking up.
One can go further and talk about risks like a different Fed next year, Debt Limit and Budget battles, and relatively slow global growth.
While we wish we could predict when the turn will come, obviously we can’t. In the context of the previously mentioned importance of paying the right price for assets, we though it worth exploring what has been the risk of paying the wrong prices.
The table above lists the all-time high peak prior to every 20% down move in the S&P 500 since 1954 (when the market finally overtook its 1929 highs). There are several 20% breaks not included like the summer of 2011 and the almost 20% move of 1976-1978 because they did not come from new highs. What we sought to capture was how quickly the initial damage of the market break was done. In most cases, the market lost 10%-15% in the span of a few short months. On average within 4 ½ months, the S&P 500 erased just over a year’s worth of gains. With the exception of the 2000 peak, since 1985, market reversals averaged a 19% drop in less than 2 months. Although the 2000 peak gave S&P 500 investors 8 months to reduce risk, the real action was in the Nasdaq, which dropped 37% in a month.
Although a top cannot be predicted, it is worth being aware that if one happens, it will likely erase a year’s worth of gains in fairly short order.