5 Things To Ponder: Words Of Caution

Tyler Durden's picture

Submitted by Lance Roberts of STA Wealth Management,

The financial markets have not done much since the beginning of the year but that is not necessarily bad news.  Despite Russia's annexation of Crimea which sparked threats of military conflict, the Federal Reserve tapering asset purchases, massive "polar vortexes" and less than impressive economic data - the markets have remained mostly resilient. I discussed yesterday that there are signs of deterioration in the market internals which are typical of market tops. 

Howard Marks once wrote that being a "contrarian" is a lonely profession. However, as investors, it is the downside that is far more damaging to our financial health than potentially missing out on a short term opportunity.  Opportunities come and go, but replacing lost capital is a difficult and time consuming proposition.  So, the question that we will "ponder" this weekend is whether the current consolidation is another in a long series of "buy the dip" opportunities, or does "something wicked this way come?"  Here are some "words of caution" worth considering in trying to answer that question.

1) Born Bulls by Seth Klarman via Zero Hedge

In the world of investing there are only a handful of portfolio managers that are really worth listening to.  Ray Dalio, Howard Marks and Seth Klarman rank at the top of my "read every word" they say list.  In this regard, I suggest that you take some time this weekend to read Seth's year-end 2013 investor letter which details the many dangers that lay ahead.  The problem is that most investors are blind to those dangers as they continue to follow the madness of crowds.  

"In the face of mixed economic data and at a critical inflection point in Federal Reserve policy, the stock market, heading into 2014, resembles a Rorschach test. What investors see in the inkblots says considerably more about them than it does about the market.

 

If you were born bullish, if you’ve never met a market you didn’t like, if you have a consistently short memory, then stocks probably look attractive, even compelling. Price-earnings ratios, while elevated, are not in the stratosphere. Deficits are shrinking at the federal and state levels. The consumer balance sheet is on the mend. U.S. housing is recovering, and in some markets, prices have surpassed the prior peak. The nation is on the road to energy independence. With bonds yielding so little, equities appear to be the only game in town.

But if you have the worry gene, if you’re more focused on downside than upside, if you’re more interested in return of capital than return on capital, if you have any sense of market history, then there’s more than enough to be concerned about.

 

A skeptic would have to be blind not to see bubbles inflating in junk bond issuance, credit quality, and yields, not to mention the nosebleed stock market valuations of fashionable companies like Netflix and Tesla. The overall picture is one of growing risk and inadequate potential return almost everywhere one looks.

There is a growing gap between the financial markets and the real economy."

2) What A Mean Reversion Would Mean To The Market by Shawn Tully, CNNMoney

I have often written about the consequences of mean reversions, read "30% Up Years", to the average investor.  However, during ripping bull markets, as Seth states above, there are few individuals that have the "worry gene."  I do.  Therefore, I agree with Shawn analysis of the markets and the framework for an eventual reversion.

"Seldom have so many of the metrics that influence stock prices strayed so far from the long-term trends we've come to consider 'normal.' Corporate earnings are far above what's normal historically, interest rates are way below normal because of Fed intervention, and bond prices that wax when rates wane are hovering at seemingly unnatural heights. The typical investor might echo something Yogi Berra could have said: 'I'm confused by the 'new normal' because it's so unusual.'

 

The total expected return is that 4% plus inflation of around 2%, or a total of 6%. That return comes in two parts. The first is the dividend yield of around 1.6% a year (large companies today pay out about 40% of their profits), and the second is earnings-per-share growth of 4.4% annually. Keep in mind that earnings per share increase at a far slower rate than overall corporate earnings that over long periods track GDP, because companies typically issue large numbers of shares each year, in excess of buybacks, to fund their plans for expansion.

 

That's hardly a wonderful outlook, and it's a long way from bountiful future Wall Street expects. But the second scenario is far more daunting. It demonstrates the dastardly meanness in mean reversion.

 

The abnormally low real rates are the work of the Fed. They cannot last. Once demand for capital supplants money supply creation as the principal force driving rates, as it must, real rates are bound to rise sharply, restoring the trend that began in mid-2013. That's why the mean-reversion scenario is the most likely, if not inevitable, outcome. One scenario is fair, the other is poor, and the poor one will probably reign. The Wall Street pundits can't stop thanking the Fed. They should reconsider."

3) Stocks On The Precipice Of A Huge Move by Todd Harrison via Minyanville.com

"Neil Young famously sang, "I caught you knocking at my cellar door; I love you baby, can I have some more; ooh, ooh, the damage done."
 
The bears have repeatedly knocked on both sides of the cellar door that is S&P 1850 seventeen times as they tried to break out to the upside and another seven times as they tried to knock it back down.

"The first is the percentage of Russell 2000 stocks above their 200-week moving averages, which is at 40% (MKM Partners).  Historically, when that percentage reaches 40%, it was at or near an intermediate-term top in the index.  The second is the average return for the 1-, 3-, 6-month and 1-year periods following those events. Take a good look."

Minyanville-Russell2000-032814

"History doesn't always repeat but it often rhymes, and after the insane run in the small caps and biotech stocks some perspective is an important context when mapping forward risk. As we often say, to fully understand where we are, we must understand how we got here."

4) Is This A Correction Or A Coming Crash? by Michael Gayed via MarketWatch

"Has the correction finally started? There are enough things happening behaviorally within the market to consider this. The deflation pulse, which has been a big theme of mine over the past year, remains alive and well. We must all ask ourselves why in the world Treasurys are so well bid when the Fed is stepping away from stimulus.

 

"Judge a man by his questions rather than his answers."

—Voltaire

 

We must also ask ourselves why defensive sectors such as consumer staples, health care and utilities are leading. When low-beta areas of the market outperform, that tends to be a warning sign of coming volatility and a potential correction ahead for equities."

5) Keep Buying Or Get Out?by Martin Pelletier via Financial Post

Retail investors have a very bad habit of "buying high and selling low."  This is due to the combined effect of an always bullish media bias combined with the emotional flaw of greed.  However, retail investors generally lack the tools, information and discipline to identify major turning points in the market.  Martin makes some valid points about what "smart money " is doing and focuses on the single most important point.

"But it isn't the smart money doing the buying. Recent Bank of America research shows institutional clients have been large net sellers of stocks since mid-February despite receiving large inflows from investors.

 

Corporate insiders have also been hitting the sell button. As cited by Mark Hulbert, editor of Hulbert Financial Digest, officers and directors in recent weeks have on average been selling six shares of their company stock for every one that they bought. This is more than double the long-term adjusted ratio since 1990 and is the most pessimistic insiders have been in more than 25 years. The closest we've come to this level was in early 2007 and early 2011.

With the smart money exiting, who's behind the bids?

ICI-EquityFlows-032814

"Not surprisingly, average retail investors have been huge net buyers of stocks and stock funds since early June of last year. This trend has gained so much momentum that these investors now hold eight times as much money in bull funds compared to bear funds, setting a new all-time high.

 

If you are considering going all-in or, worse, leveraging up, we recommend taking a step back to examine what your long-term investment goals really are and measure them in the context of the current market environment. Moving away from the herd can help you avoid buying market tops and selling market bottoms.

 

Finally, remember that no one truly knows what is going to happen when pundits call for new highs or the next major correction. Your time is better spent focusing on what you can control and that is managing risk, because if history teaches us anything it’s that irrational behaviour works both ways."


Bonus Video:  WSJ Interviews Yale economist Dr. Robert Shiller on his thoughts about what actually drives markets.