Hope Springs Eternal (Optimism in the Markets)

I have been bearish on equities since late 2015 and remain so at the start of 2017. I’ve seen comments saying that I am issuing the same types of arguments that have kept people out of equities since the start of the bull market. My response is I was not bearish until late 2015 when most of the gains had already occurred. Secondly, just because I have been wrong for a year doesn’t mean I must change my mind. I must reevaluate the scenario and see why I have been wrong, but doesn’t mean I have to turn bullish. Stocks are objectively expensive and the economy is weak. It had a spurt of growth at the end of 2016, but spurts of growth in this recovery have been met with despair. Economic cycles still exist which means a recession will come soon given that this recovery has lasted almost 8 years. When stocks are expensive, they can always get more expensive. This recent rally has exemplified that.

The chart below is just another example of the excessive optimism in the market. It goes up to 12/28, but I expect the updated metrics to be very similar given the S&P 500 is slightly higher as of today’s close. The chart shows that the S&P 500 has a negative price performance when the NDR trading sentiment composite is above 62.5. It has been above 80 at the end of the year which would signal a high likelihood for a correction if this indicator holds true.


The chart below shows an interesting bifurcation among the ‘haves’ and the ‘have nots’ in the market. Those companies not in the top five per sector have a return on equity near the bottom of the 2008 recession. Part of this is because of low interest rates. Big companies like Microsoft and Apple can issue massive bond offerings at low yields to acquire capital to do buybacks and make acquisitions which enhance their competitive advantages. The same smaller companies which have a low return on equity are the ones which have rallied so vociferously in the past few weeks since Trump has been elected. The earnings don’t back up their rallies unless Trump’s deregulation comes in as expected. Usually at the end of the cycle, breadth shrinks. This means only a few companies rally. In our current market, we have great breadth, but the breadth of the earnings has been weak which can be an alternate signal that we are nearing the end of the cycle.


As you can see from the chart below, on a PE ratio basis the market has only been much more expensive in the early 2000s. On an EV/EBITDA basis, it looks worse as we are currently even closer to the peak valuations of the early 2000s. These are just two ways to look at valuations. There are many others which show similar results. The takeaway is not that valuations don’t matter even though stocks keep going higher. These charts give you the perspective of an experienced investor who has traded every market. That investor knows how the narrative can shift from greed to fear quickly as human emotion is a tough thing to gauge. While some argue that the market is efficient, I use the current market to explain how wild inefficiencies can happen as excitement and the fear of missing out rule the day.


The chart below shows the Goldman Sachs financial conditions index paired with the Russell 1000 index. It shows the recent divergence as hope is springing eternal in the market. The credit market tends to be a more accurate depiction of the conditions than equities because it’s larger. The conditions are still stronger than they were early in 2016, which I expect to change. There may have to be a larger decline in credit to move the needle and send stocks lower.


I have seen one noted bear who has thrown in the towel because some data has improved. He claims if the jobs data improves, the bears will have nothing to hang their hats on. I disagree because much of the data which has improved since Trump’s election has been surveys and when they get overheated, it can be a sell signal. There are many other data points besides employment which are rolling over. I’d also argue that employment will not start another upcycle again, considering it barely moved off its peak. The chart below shows real business fixed investment declining for the first time since the last recession. It tends to lead employment data which supports my point that employment will not rebound on a year over year basis. Skipping the entire recessionary part of an economic cycle is possible, but it is not the norm. I need to see overwhelming evidence of positive data points to come to that conclusion because it is rare. Instead we’ve seen a small uptick similar to other parts of this recovery.


The final point I have is according to the Eurasia Group, the political landscape is worse than it has been in many decades; they call it a political recession. One example given is that China is scheduled for a leadership change. This may cause President Xi Jinping to respond with force to any American foreign policy changes. This can escalate tensions given Trump has had harsh words for the country. Any tensions would boost the value of the dollar in a flight to safety trade. This is bad for American exports and multinational firms’ profits.


            There are many ways to show the market is overly optimistic. If I provide facts to back up my opinions, I do not see myself as hurting anyone. I acknowledge that I can be wrong and I think the readers know this as well. Indicators which have been reliable can be wrong in the future. If there was ever an indicator with a perfect record, everyone would use it until it became useless. Since we don’t have that indicator, I try my best to give an objective viewpoint of where I see the market going in the next 6-12 months.

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