Submitted by Lance Roberts of STA Wealth Management,
At the beginning of January, I wrote an article entitled "Market Bulls Should Consider These Charts" which detailed some of the more excessive measures of market exuberance. Of course, it was only a few days later that the emerging markets/carry trade unwind began in earnest. However, that rout was short lived as the Federal Reserve acted quickly to reassure the markets that they would not reduce their ongoing accommodative policy any time soon.
Following that sell off, the markets remained trapped in a fairly tight trading range as concerns over weak economic and fundamental data rose. During this time, I regularly tracked this consolidation process in my weekly missive "The X-Factor Report." I repeatedly stated that while the markets were consolidating there was no technical reason to reduce equity allocations in portfolios. To wit:
"Over the last couple of months, I have been running a consistent analysis of the market consolidation that began in early February. During the last two weeks in particular, I began discussing two possibilities which included a market breakout or another market failure. This week, the market did the former by breaking out of the consolidation and continuing its current bull market cycle.
We chose to remain allocated in our models due to the fact that despite the “sell signal” being in place the markets had technically done anything wrong."
As stated, the "good news" is that the breakout of the market to new highs, following the consolidation process of the previous months, does reaffirm the current bullish trend of the market. The "bad news" is that the consolidation process did little to reduce the overbought, over extended and excessively bullish readings in the market.
The chart below shows that while the current bull market trend remains in place, the recent "consolidation" failed to reduce the overbought, overly bullish, conditions in the market.
While the promise of a continued bull market is very enticing it is important to remember, as investors, that we have only one job: "Buy Low/Sell High." It is a simple rule that is more often than not forgotten as "greed" replaces "logic." However, it is also that simple emotion of greed that tends to lead to devastating losses. Therefore, if your portfolio, and ultimately your retirement, is dependent upon the thesis of a "never ending bull market" you should at least consider the following charts.
Bob Farrell's rule #9 states that when everyone agrees; something else is bound to happen. The next three charts show the level of "bullishness" of both individual investors (AAII Survey) and professional money managers (INVI Survey).
A look at just "professional" investors shows an extreme level of bullishness only seen at major market peaks.
It is interesting to note that the 8-week moving average of bullish sentiment for individuals has declined prior to the eventual peak in the market.
In the original January report, I discussed the deviation in price of the S&P 500 and Wilshire 5000 indices from their long term (36 month) moving average. Moving averages are the "gravity" to prices. The longer the moving average, the greater the "gravitational force" that is exerted on prices. Each chart below is the percentage deviation above the current 36-month moving average. Using a 3-year moving average is an extremely long time frame. Moving averages act as "gravity" against rising prices. The longer the time frame of the moving average, the greater the gravitational pull.
Therefore, when prices get too far above, or below, the long term average the greater the potential for a "reversion to the mean" to occur. REVERSIONS are one of the three critical components in portfolio management with the other two being FUNDAMENTALS and TREND. While "fundamentals" are the key to investment returns over the "long term," portfolio risk management primarily revolves around shorter term price "trends," being either positively or negatively sloped, and "reversions" to the long term moving averages.
With that understanding, the following charts show the deviation in price from the long term underlying moving averages (36 months).
I could go on. The simple fact is that virtually ever single market and sector is grossly extended as exuberance over the current bullish trend has taken root. This exuberance is most clearly seen by the near record low levels of "fear" in the market as shown below.
Stocks have not "reached a permanently high plateau" nor will "this time be different." As with all late cycle bull markets, irrationality by investors in the financial markets is not new nor will it end any differently than it has in the past. However, it is also important to realize that these late cycle stages of bull markets can last longer, and become even more irrational, than logic would dictate.
When I write such articles, I am immediately presumed to be a "perma-bear," and that I am therefore not invested in the market. This is most assuredly not the case. As a money manager, I am currently long the stock market. I must be, or I potentially suffer career risk. However, my job as an advisor is not only to make money for my clients, but also to preserve their gains, and investment capital, as much as possible. That is why I point out the "risks" contained in the markets.
Understanding the bullish arguments is surely important, however, the risk to investors is not a continued rise in price, but the eventual reversion that will occur. Unfortunately, since most individuals are only told to consider the "bull case," they never see the "train coming."
Hopefully, these charts will give you some food for thought. Remember, every professional poker player knows how to spot a "pigeon at the table." Make sure it isn't you.