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Are Investors Properly Heading the Warning Signs or Waiting out a Category 5 Hurricane?

Posted by Metals Corporate on

Are Investors Properly Heading the Warning Signs or Waiting out a Category 5 Hurricane?

By John McDonald

If you’re familiar with what happens during Hurricane season, you’ll remember that whenever a category 2 storm is headed to shore, local and state authorities will provide warnings to residents. The warnings usually center around locking things down around the house and staying inside. If the category advances to a 4 or a 5, the warnings turn into outright evacuation. 

Although most head those warnings, there are many who don’t want to leave and decide they are capable of riding out the storm. At a certain point, if an evacuation isn’t completed by the time the storm hits, it’s too late to run. Decisions to stay while in the path of a treacherous hurricane can be life-threatening and trying to run when it’s too late can prove to be fatal.

Dealing with a pending hurricane can be somewhat similar to dealing with market bubbles. 

By the time the bubble has burst, too many investors attempt to run by liquidating their holdings, often taking massive loses. The ensuing panic during a market crash is not a pretty sight. In the midst of it, investors don’t care if they look foolish by selling off everything.

But the real consideration is whether they should have chosen to “look foolish” before the bubble burst. That’s the questions investors must ask themselves and, in doing so, they need to be able to identify and head the warning signs for evacuation.

Acting before it’s too late

No matter how many overvaluation and crash cycles investors remember (i.e. 1929, 2000, 2008, etc.), there is that speculative mindset that keeps them holding on until the very last minute – and beyond, hoping to squeeze as much out of the overvaluation as possible.

Ideally, investors should always be mindful of two things.

First, they should understand when favorable market conditions and a speculative mindset gives way to a more conservative, risk-averse mindset. Second, investors should know when an overvalued and overbullish market reaches its unsustainable limit.

In cases like this, the idea that “things that are too good to be true usually are” should be top of mind and should help investors see the cliff well before they are taking the precipitous step over it.

Market internals or the group of indicators traders use when attempting to calculate the market direction are usually a good gauge of speculation, as they’ properly help identify the transition from speculative to risk-averse.

This current market cycle appears to be a bit different, as market internals indicated that extreme speculation had reached its peak by January 2018. New records continue to be set by the S&P 500 and the Dow this year with a few mini-corrections between early 2018 and now.

The battle, it seems, continues between those speculative investors who see no end to a bull market (and potential Federal Reserve easing) and investors concerned about a pending recession and massive market losses. In short, there has been great market volatility since early 2018 but very little durable market gains.

If one considers the cumulative total return of the S&P 500 since the year 1998, along with the collective total return of the S&P 500 – but only for periods of favorable market internals, there is no real assurance that the market internals will be able to distinguish periods of speculation and risk-aversion the same way in the future.

Can we see the limits of bullishness?

Historically, we’ve been able to identify the limits to overvalued bullish behavior, but the Federal Reserve’s commitment to extended quantitative easing has made this virtually impossible to do.

That does not mean that there isn’t a cliff lurking somewhere.

 In fact, there are variants that are indicative prior to the most horrific crashes (i.e. 1929) and while we have seen very similar variants in late 2016 and early 2017, there has not been the resulting crash.

This variant, or bubble, has been observed again in mid-2019, with negative market internals in addition to a generally flat yield curve (i.e. a 10-year Treasury bond yield less than 1% above the 3-month Treasury bond yield). The only time this was observed was during the market high in the year 2000 as well as the market high of late 2007.

The reason for mentioning this is not to say that we have reached the peak potion of this particular cycle, but to simply indicate where we are. In this scenario, similar to the pending Category 4 or 5 hurricane, an evacuation should certainly be on the table for now rather than wait until the storm hist and evacuate at that time.

Investors should examine their tolerance for losses that normally follow the kinds of peaks that we are witnessing now. The reason being that the long-term notion of maintaining a passive investment position will often exceed Treasury bill yields, even during peak periods such as now.

Such an investment position is now closer to high risk and low reward than at any other time other than the immediate weeks surrounding the 1929 market peak.

Although it may appear that the markets have recovered since the late 2018 mini-correction, it’s worth noting that the index currently sits less than 3% above the high from late last year, just prior to the dip. The same warnings exist, perhaps with more dire indications in other areas, particularly on the economic front. 

From a psychological standpoint, investors have difficulty exiting a bull market once stocks start to take a dip (even at -7%).

If you look at past bull market peaks, most are followed by sharp declines that keep investors paralyzed, hoping that they could recover through the following bear market. In looking at the peak in March 2000, the S&P declined 11.2% over the next dozen-plus trading sessions.

 It nearly recovered by September but then declined again by more than 12% over the next two dozen-plus sessions. This has occurred during other market losses as well and is what typically locks investors into not making any move at all. 

Weathering the hurricane

With the Federal Reserve looking to return to its easing mode at the end of July 2019, this idea may be what’s driving the market highs. With very few exceptions, every initial Federal Reserve easing (i.e. cut of 0.5% or more, followed by a period of tightening of at least 0.5%) has been related to an economic recession.

In addition, with the reported payroll growth, along with the surveyed payroll shortfalls during the coming months, investors should be prepared for a significant reversal in terms of job growth.

It’s worth keeping in mind that Non-Farm Payrolls (what the establishment reports) and Civilian Employment (a result of the household survey used to determine the unemployment rate) shows a divergence during the first 6 months of 2019 (Civilian Employment grew by only 60,000 jobs in the first 6 months of 2019).

When we’ve seen this before, what followed were periods of recession.

In short, while investors are excited about the Federal Reserve returning to easing, but those actions are typically associated with U.S. recessions. It seems investors are very intent on riding out the worst category 5 hurricane from the comfort of their homes – even after dire warning upon dire warning has encouraged them to evacuate.  

A mention of valuations

It’s also worth noting that in October of 2002, when the multiple of nonfinancial market capitalization to nonfinancial corporate gross value-added was 1.11, it was the highest level ever identified at the end of any market cycle in history. The current multiple is 2.27, suggesting that we are in uncharted territory in terms of the heights of a bull run and a potential collapse that might follow.

Other indicators show similar activity and relying on the Federal Reserve may only make matters worse.

There is usually very little correlation between Federal Reserve policy changes and cyclical economic fluctuations. U.S. economic expansion typically follows a simple, mean-reverting course, where the output gap (actual GDP vs. potential GDP) at the low point of the recession has narrowed at a rate of about 8% each quarter.

That has never been impacted by the most extraordinary monetary policies. 

Unless there are definitive market internals that are clearly favorable, the Federal Reserve’s easing – regularly associated with recessions – should not be relied upon to improve durable support for financial assets.

At the completion of the current cycle, we could see a market loss of 50%, optimistically, or a worse case market loss of up to 65%. With that in mind, it seems most investors are not really heading the evacuation signs.

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