As a private investment management firm we’re not restrained from reducing risk when we see fit. Perhaps its an old Irish Catholic bromide that “No good will come of this” attitude rears its head every time I see and excessive or parabolic moves in markets, asset classes or stocks. Parabolic Markets = The End is Near.
We’ve seen these kind of parabolic moves before: Treasury Bonds in 2012, Gold in 2011, the NASDAQ in 2000-2001. In 2013 we took profits in parabolic stocks such as FU, SGOC, FONR. All three gave back their gains and in the case of FU – the company has been delisted with balance sheet issues.
Do you remember 1987? Big hair and even bigger shoulder pads. Celtics and Lakers along with team oriented basketball. Duran Duran and endless amounts of Phil Collins and a parabolic stock market that never pulled back until the music ended on October 19th where the Dow Jones Industrial Average dropped 22.6% in a single day.
Some but not all of the main culprits of the crash are evident now and while market cycles never entirely repeat themselves, they can echo the movements of the past. I believe there is a good chance that we’ll see a short and sharp market sell off sometime soon to alleviate the extreme investor bullish psychology.
What the markets have going for themselves for the time being is a nil chance for a recession anytime soon. Most major Bear Markets occurs as the economy is heading into recession and that is not the case. So, what I’m expecting is a brief but potentially painful market correction of short duration that could commence at any time.
Most market pullbacks can largely be ignored as we can’t compensate for all of them. My focus is to identify the environments where major pullbacks are likely. Pullbacks of the size that they cannot be ignored, in the range of 20% to 30% or more.
The biggest hurdle for the markets going forward is the issue of extreme investor bullish sentiment. For those unaware, “sentiment” is an inverse indicator. This means when investors (both pro’s and amateurs) are extremely bullish its a negative and high risk for the markets. When those investors are extremely negative its a positive and low risk environment for stocks.
I recently came across a very good paper discussing the relationship between sentiment and stock returns: “Investor Sentiment and The Cross Section of Stock Returns” by Malcolm Baker and Jeffrey Wurgler. Published by National Bureau of Economic Research.
Page 5: “When sentiment is low (investors are bearish) subsequent returns are higher on young stocks than older stocks, high return volatility than low-return volatility stocks, unprofitable stocks than profitable ones, and non payers rather than dividend payers. When sentiment is high (as it is now), these patterns completely reverse. In other words, several characteristics that were not known to have and do not have any unconditional predictive power actually reveal sign-flip patterns, in the predicted directions when one conditions on sentiment.”
In plain English, this means that the stocks that were so profitable for us when investors were fearful and negative can turn quickly and decline sharply in price when investors are too giddy and positive.
The chart below will give you an idea of how extreme sentiment is at present and where it ranks in years past, and a look to what happened going forward. Remembering the “echo” Investors Intelligence Bulls minus Bear is the highest since February 1987.
But what contributed to this extreme positive sentiment? Here are some culprits:
2013 was the first time since 1995 where the S&P 500 Index never declined to touch its 200-day moving average.
So as of the end of the year the S&P 500 would have to decline at minimum 10% to even touch the present 200-day moving average. This also means that select portfolios with less than 500 stocks would likely fall greater than 10%, 20% would not be surprising.
In December the Federal Reserve announced they will be “tapering” Quantitative Easing. The chart below shows the previous attempts to wean the economy off of QE and subsequent market reaction. Note: Once difference to this round of tapering is that the economy is not quite as weak as before which may account for no immediate market sell off.
Lastly, we have the Presidential Cycle. The Presidential Cycle is a way of looking at the equity markets through the lens of 4 year Presidential term. The Presidential Cycle is closely related to the business cycle which is largely controlled by the Federal Reserve. The second year of the Presidential term is uncharacteristically weak relative to the other three years. Don’t let the mean rate of return fool you, there have been many second years where at some point the major market indices were down in excess of 10%.
Not since 1995 has the S&P 500 not had at least a 10% pullback. Normally, you can count on a 10% pullback within an ongoing bull market to a great time to add funds or bring new accounts online. But 2013 is the year of the relentless rally where 2% pullbacks are new 5% pullback. Extreme bullish investor sentiment which is normally a good barometer of when to ease up on portfolio exposure has been pointless, as previous blog posts have demonstrated.
So, whats going on you ask? Why is this year different from the others and what does it mean going forward?
Markets are clearly being driven higher by the Federal Reserve current policy of Quantitative Easement and its by product of 0% short term interest rates.
Its no coincidence that when the Fed ended QE1 and QE2 markets fell apart with declines of -16% and -19% respectively in 2010 and 2011.
Its fashionable right now to analyze each economic tick (especially the recent positive employment data) to determine when the Fed will end QE3. But the truth is we really don’t have an accurate guess for when that will happen.
Three things we know for sure at the moment:
1. We are in the midst of the strong season for equities and that will last until March 2014.
2. The economy as measured by employment is improving. Contrary to politically biased media outlets job growth is not coming from part time employment. GDP growth in the 3rd quarter was stronger than expected. This is market friendly.
3. Bob Dieli’s Aggregate Spread and RecessionAlert.com are both at benign/miniscule odds of recession. Market friendly again.
My best guess of what will happen? Eventually the Fed must end QE3 and the markets may anticipate this ahead of time by churning nowhere or showing internal deterioration in strength. My thinking is that the Fed will do nothing till at least after congressional budget talks in January but by the time March comes around and temps here begin to melt some snow we should be decreasing our equity exposure in a meaningful way.
We are taking the profit in shares of SGOC after the stock erupted for another 35%+ gain this morning. Stocks that go parabolic usually become very unstable when profit taking eventually takes over and we’d like to be out of the stock before that begins to happen. As you can see by the chart it has made similar leaps before but it usually gives up about half the gain in short order.
No positions
Brad Pappas
For the past few weeks we’ve become increasingly more cautious as investor enthusiasm has reached euphoric levels. The irony of this is that Jason at Sentimentrader.com has published a study that euphoric investor enthusiasm doesn’t always lead to weakness, it frequently can create a short term top followed by churning market action before resumption of the rally. Churning action is not bad at all and in the past week we’ve seen two of our holdings make extraordinary leaps: FONR catapulted from $11 to $19 and today SGOCO Group rose 47% in a single day.
Combined with this is the fact that we are in the strongest season of the year for stocks. This evening I ran a study dating from 1999 to 2013 where I measured the rate of return for our models from November 19 to March 31 of the following year.
There were 12 time periods measured and I excluded 2008 and 2009 from consideration due to recession. Note there was a recession in 2001-2002 period as well but small cap value defied the recession and posted strong gains. The results are a combination of both real time and hypothetical data.
Average gain November 19 thru March 31 was 18.91% including all fees and expenses.
Low return was 5%. The high return was 30%. Median 17%.
There were no negative returns.
The markets reluctance to sell-off despite high sentiment readings but with strong seasonal strength gives me the sense that holding inverse exchange traded funds may not work this time and they were sold for a small loss.
Brad Pappas
Long FONR and SGOC
A quick update on our current status:
The major market indices are at or near major market highs which will likely be a difficult hurdle to surpass in the near term.
In addition, investor sentiment is extremely positive which has negative implications going forward in stock prices.
To our way of thinking the combination of negative investor sentiment with markets at historical highs implies either a sawtooth churning market with little or no gain or a moderate decline in prices in the near term. We don’t believe at this time that a major market top is playing itself out, we believe based on Ned Davis’s market cycle analysis that a major top is due in the Spring of 2014.
All recession indicators remain in positive territory.
So, we are essentially playing defense for our clients by selling off stocks falling in our ranking systems and raising cash rather than reinvesting on the long side. We have added a significant amount of inverse exchange traded funds that should aid in buffering downside volatility in client portfolios.
Should a decline emerge to the degree that overwhelming positive sentiment is reversed we will reverse our course and liquidate the inverse ETF’s and add new long stock positions for a potential new leg up in the indices that could last to March/April 2014.
Brad Pappas
“Who is left to buy” is a rhetorical question of course. But for those not understanding the implications of rampant bullish sentiment, its a quick and easy explanation.
Investor Sentiment is an inverse indicator. The greater the positive sentiment the higher the risk and odds of a market pullback. Peaks in sentiment don’t have to mean the rally will come to an end but it usually implies there will be at least a pause. And, more frequently a sell-off great enough to instill fear back into the market place. As the saying goes: “If this was easy, everyone could do it.”
Adding to the list of extreme sentiment indicators is the National Association of Active Investment Managers. According to Sentimentrader.com the average manager is now 94.6% exposed to stocks along with a very low standard deviation which means there’s a whole lotta group think goin on.
There there is the Investors Intelligence (add joke here) Bearish Percentage: 15% That is a level only achieved three times since since 2008 and in each case there was a moderate pullback.
Brad Pappas
No positions
