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%.
