Exactly How Many Warnings Do You Need?

Authored by Lance Roberts via RealInvestmentAdvice.com,

When I was growing up my father, probably much like yours, had pearls of wisdom that he would drop along the way. It wasn’t until much later in life that I learned that such knowledge did not come from books, but through experience. One of my favorite pieces of “wisdom” was:

“Exactly how many warnings do need before you figure out that something bad is about to happen?”

Of course, back then, he was mostly referring to warnings he issued for me “not” to do something I was determined to do. Generally, it involved something like jumping off the roof with a queen-sized bedsheet convinced it was a parachute.

After I had broken my wrist, I understood what he meant.

With that in mind, there are currently plenty of warning signs individuals might want to consider before taking that leap. Here are four to consider.

Warning 1: Investor Confidence

There are several different surveys of retail investors which all currently show the same thing. Individuals have never been as hopeful as they are currently that the stock market will continue to grind higher. Last week, I discussed the Gallup poll which showed investor optimism at the highest levels since 1999.

The latest survey comes from the University of Michigan survey courtesy of Business Insider.

The preliminary survey of consumer sentiment for September showed a record 65% expected probability that stocks would rise in the next year. The data goes back to 2002.

As BI noted:

“The report in February noted that people who were most bullish for the year ahead, and could invest more in stocks, were in the top third of income distribution and in the top tier of stock ownership. In other words, the respondents to this survey have reaped strong gains on a riskier asset class in a short period of time and are hoping this continues.”

As I have discussed many times previously, the stock market rise has NOT lifted all boats equally. More importantly, the surge in confidence is a coincident indicator and more suggestive, historically, of market peaks as opposed to further advances.

As David Rosenberg, the chief economist at Gluskin Sheff noted:

‘For an investment community that typically lives in the moment and extrapolates the most recent experience into the future, it would only fall on deaf ears to suggest that peak confidence like this and peak market pricing tend to coincide with each other.”

He is absolutely correct. As shown below in the consumer composite confidence index (an average of the Census Bureau and University Of Michigan surveys), previous peaks in confidence have been generally associated with peaks in the market.

Warning 2 – All Hat, No Cattle

For those of you unfamiliar with Texas sayings, “all hat, no cattle” means that someone is acting the part without having the “stuff” to back it up. Just wearing a “cowboy hat,” doesn’t make you a “cowboy.”

I agree with the premise that leverage alone is not a problem for stocks in the short-term. In fact, it is the increase in leverage which pushes stock prices higher. As shown in the chart below, there is a direct correlation between stock price and margin debt growth.

But, margin debt is NOT a benign contributor. As I discussed previously in “The Passive Indexing Trap:”

“At some point, that reversion process will take hold. It is then investor ‘psychology’ will collide with ‘margin debt’ and ETF liquidity. It will be the equivalent of striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.”

Not surprisingly, the expansion of leverage to record levels coincides with the drop in investor cash levels to record lows. As noted by Pater Tenebrarum via Acting-Man blog: (The following also reinforces Warning #1)

 “Sentiment has become even more lopsided lately, with the general public joining the party. It may not ‘feel’ like the mania of the late 1990s to early 2000, but in terms of actually measurable data, the overall bullish consensus seems to be even greater than it was back then.


Along similar lines, here is a recent chart that aggregates the relative cash reserves of several groups of market participants (including individual investors, mutual fund managers, fund timers, pension fund managers, institutional portfolio managers, retail mom-and-pop type investors). It shows that there is simply no fear of a downturn:”

So much for the “cash on the sidelines” theory.

When investors believe the market can’t possibly go down, it is generally time to start worrying. As Pater concludes:

“As a rule, such extremes in complacency precede crashes and major bear markets, but they cannot tell us when precisely the denouement will begin.”

Warning 3 – Valuations

In an extensive, must-read report at Zerohedge, Deutsche Bank’s Jim Reid, the credit strategist unveiled an extensive analysis of the Next Financial Crisis”and specifically what may cause it, when it may happen, and how the world could respond assuming it still has means to counteract the next economic and financial crash. The bottom line is simple:

“With the global levels of over-valuation of stocks and bonds, combined with excessive optimism and leverage as noted above, has set the stage for exceedingly low returns over the next decade or longer.”

As noted in the report:

“With that baseline in mind, what happens next should be obvious: unless one assumes that the laws of economics and finance are irreparably broken, a deep recession and a market crash are inevitable, especially after the third biggest and second longest central bank-sponsored bull market in history.”

Valuations, as discussed most recently here, are a very poor market timing device for short-term investors. However, from a long-term investment perspective, valuations mean a great deal as it relates to expected returns.

As I addressed in “Shiller’s CAPE – Is There A Better Measure:”

“The need to smooth earnings volatility is necessary to get a better understanding of what the underlying trend of valuations actually is. For investor’s, periods of ‘valuation expansion’ are where the bulk of the gains in the financial markets have been made over the last 114 years. History shows, that during periods of ‘valuation compression’ returns are much more muted and volatile.


Therefore, in order to compensate for the potential ‘duration mismatch’ of a faster moving market environment, I recalculated the CAPE ratio using a 5-year average as shown in the chart below.”

“There is a high correlation between the movements of the CAPE-5 and the S&P 500 index. However, you will notice that prior to 1950 the movements of valuations were more coincident with the overall index as price movement was a primary driver of the valuation metric. As earnings growth began to advance much more quickly post-1950, price movement became less of a dominating factor. Therefore, you can see that the CAPE-5 ratio began to lead overall price changes.


As I stated in yesterday’s missive, a key ‘warning’ for investors, since 1950, has been a decline in the CAPE-5 ratio which has tended to lead price declines in the overall market.”

Notice the downturn in the CAPE-5 ratio preceded the 2016 market swoon. However, thanks to rapid Central Bank interventions, that valuation slide was rapidly reversed is now approaching previous highs. With earnings estimates being revised lower, economic growth remaining weak, and monetary policy being reigned in, the danger to investors longer-term is mounting.

Warning 4 – Share Buy Backs

The use of “share buybacks” to win the “beat the estimate” game should not be readily dismissed by investors.

“One of the primary tools used by businesses to increase profitability has been through the heavy use of stock buybacks. The chart below shows outstanding shares as compared to the difference between operating earnings on a per/share basis before and after buybacks.”

The problem with this, of course, is that stock buybacks create an illusion of profitability. If a company earns $0.90 per share and has one million shares outstanding – reducing those shares to 900,000 will increase earnings per share to $1.00. No additional revenue was created, no more product was sold, it is simply accounting magic. Such activities do not spur economic growth or generate real wealth for shareholders.

As noted by Business Insider that strategy deployed to boost share prices since the financial crisis is on the decline.

“Spending on buybacks, however, has slipped over the past six months. Investment-grade-rated corporations repurchased $64 billion worth of stock in the second quarter, down from $84 billion in the fourth quarter of 2016, according to data compiled by Bank of America Merrill Lynch.


The decline puts added pressure on the stock market, which has become accustomed to buybacks pushing shares higher during lean times when real fundamental catalysts aren’t present.”

Like margin debt, exuberance and valuations, investors have little need to worry about the decline in share buybacks in the short-term.

As BI concludes:

“The real test will come at the first sign of downward turbulence.”

If They Don’t “Buy & Hold” – Why Should You?

Of course, these are just “warning signs.” None them suggest that the markets, or the economy, are immediately plunging into the next recession-driven market reversion.

But they are warning signs nonetheless. Past experience suggests that future returns are likely to be far less than historical averages suggest. Furthermore, there is a dramatic difference between investing for 30 years, and whatever time you personally have left to your financial goals.

While much of the mainstream media suggests that you “invest for the long-term” and “buy and hold” regardless of what the market brings, that is not what professional investors are doing.

The point here is simple. No professional, or successful investor, every bought and held for the long-term without regard, or respect, for the risks that are undertaken. If the professionals are looking at “risk,” and planning on how to protect their capital from losses when things go wrong, then why aren’t you?

Exactly how many warnings do you need?


fx Shocker Thu, 09/21/2017 - 11:08 Permalink

The article lists good indicators and warning signs. however, it's just that: a warning sign. Not more.A low volume rally, frequently interrupted by sideways market , followed by another low-volume rally may linger on for another 2-3 years, and here is why: WHO is going to sell in massive amounts? private households have already been net-sellers over the past years. CBs, sovereign wealth funds and corporations have been the big net buyers. Unless you show me why anyone of those shall turn meaningful sellers, I just don't see what will bring the market down at this point. People shiftig from stocks into Bonds? seriously? Markets may double from here, despite all the warning signs getting ever more warning

In reply to by Shocker

chubbar ejmoosa Thu, 09/21/2017 - 08:54 Permalink

The whole issue of where the market goes is alluded to in this quote. "Notice the downturn in the CAPE-5 ratio preceded the 2016 market swoon. However, thanks to rapid Central Bank interventions, that valuation slide was rapidly reversed is now approaching previous highs".The question is twofold. 1). Do the central banks and/or the ESF have the ability to thwart large numbers of investors all selling at once? I think the answer has been demonstrated to be yes, and the preceeding quote gives an indication that they have done so in the past.2). Do the central banks intend to thwart the selling off of the markets WHEN even the most stalwart investors decide to leave the arena? That question goes to motive and goals of the bankers, something I don't think is cut and dried in my conspiratorial mind.Admittedly, the leverage employed by the investors using margin debt gives me pause after seeing that chart. It certainly shows me that investors versus central banks are the cause of the relentless upswing in the markets. That alone negates some of my thoughts on what is underpinning this market. That being said, if the market crashes, it's over for the US economy for a LONG time. So, given that eventually even the dimmest investor bulb is going to come on saying the over valuations can't last, the economy isn't improving and it's time to sell, what do the CB's do when that happens?

In reply to by ejmoosa

cluelessminion Thu, 09/21/2017 - 08:24 Permalink

Been warning friends and acquaintances for *decades* about the lack of true fundamentals supporting stock price gains.  The market "crashed" or went through periods of big declines about 4 times during that period.  The rest of the time it was pretty much "up, up and away".  What little money I did have in the market simply withered away because I kept pulling it out thinking there was going to be this big drop.  Had I just left it there like everyone was saying I'd have at least twice as much money in my accounts as I had now. I really don't know what else to say.  Being a sheep in the market paid for a lot of little people, and a smart gal like me really missed out. Still, I'm getting ready to take my small amount of stocks and leave the market completely.  Too old for the risk.

Common_Cents22 cluelessminion Thu, 09/21/2017 - 08:43 Permalink

yes, the trick to making money is run just ahead of the herd on the way up.....but get out of the way when the herd is about to stampede off the cliff.you can't think too smart, or you'll be too early to get out...and too late to get back in.  but the real "smart" money on wall street doesn't make money on timing, they make money by cheating the system, arbitrage, making money on transactions, fees, commissions, HFT frontrunning cheating.most of wall street is just cheating, not market direction betting.  

In reply to by cluelessminion

Grandad Grumps Thu, 09/21/2017 - 08:29 Permalink

The problem is that we have been inundated with chicken littles and boys who cry wolf for so long we are now numb. The people who were going to, did their preps 5 years ago and have been waiting while Johnny come lately presumed genius after presumed genius tell us daily that the end is (now) nigh.

Well Bullshit ... and yet likely.

The entire financial system is a fraud run by evil satanic criminals. There is no free market. Price is completely computer controlled. Using these assumptions, what do the charts really tell us?

adr Thu, 09/21/2017 - 08:32 Permalink

Real World: Businesses are folding left and right. Health insurance costs more per month than your house, and other living costs have doubled or tripled. More than half of people under 30 are living with their parents or in college like shared living quarters. People in high paying tech jobs don't actually have lives since they spend 24/7 at their corporate headquarters. Nothing is working like it should. Wall St World: Never better and real world data doesn't matter. Even thousands of fake currencies can be worth billions just because. Going out of business doesn't mean anything because even a bankrupt company can sell more debt as long as they have shares to trade. If you don't have shares, too bad. It's a depression folks. Has been for almost 20 years. 

NYC_Rocks adr Thu, 09/21/2017 - 08:45 Permalink

There is some truth to what you're saying.  In the 30s they didn't have a food stamp program.  It doesn't "look" like a recession or depression today because the welfare state goes into debt and keeps most off the street.  Millions on food stamps.  If we didn't have this program and others, we would see how bad it really is.  It's a temporary band-aid as it's not sustainable.

In reply to by adr

The Ram adr Thu, 09/21/2017 - 09:17 Permalink

Interesting that you mention the IT jobs.  yes, here in South FLorida, many of the IT jobs are contract positions, and one has to work continuously to keep things going knowing that there can be a gap between contracts.  The salaries here in South FL are pitifully low for senior IT folks, although in general, the IT salaries are well above the average salary here (which is not saying much).  It's just a slow burn to the bottom as H1B visaa are brought in or work is outsourced.  IT is not what it use to be.  There are a few niche positions left, but most IT has gone 'commodity job.'  

In reply to by adr

ThanksIwillHav… Thu, 09/21/2017 - 08:34 Permalink

Roads are built like crap, constant repair.  Decorative concrete cracking, water stains and mold.   Newer home and building under constant repair due to faulty construction.  On and on.   

mjcarr51 Thu, 09/21/2017 - 08:35 Permalink

"Exactly How Many Warnings Do You Need" You got to be shitting me. Aren't many people / funds who'd still be solvent having heeded ZH's 1st, 10th, 100th, 1000th, fuck probably 5000th warning, This market is the same thing only different as the dot com ridiculousness One time, when it starts to come down, it'll keep moving lower. Until then, it's like pissin' in the wind, .......... if you're lucky. I know.   

Common_Cents22 Thu, 09/21/2017 - 08:36 Permalink

i have 100 employees i pay 10-15/hr, no benefits.  they get some overtime and some get laid off in slow season.   That is all i can afford.   I feel bad for them, not sure how they get by.   I barely take a paycheck keeping the biz going, very tough to pass on price increases.   Being forced to do something for Fraudbamacare will be real bad.  Welcome to the "new" economy.

venturen Thu, 09/21/2017 - 08:40 Permalink

 The market can remain irrational longer than you can remain solvent. But when this one goes it is going to be a doozy....as so many trillions were printed to push it up and given to so few.

RSDallas Thu, 09/21/2017 - 09:17 Permalink

"unless one assumes that the laws of economics and finance are irreparably broken" This sums it up.  The market has been broken since the beginning of this calamity!  There will be no correction until a specific market of credit blows up and I'm not sure what that will be mortgages (doesn't look like it), corporate debt (mayyyybeeee but doubtful), Sovereign debt implosion (more likely for some, think Venzuala) but they won't bring down the market.  China??????