Stocks and bonds are both expensive in the long term, while no one expects inflation…
As the month of March posted its final closing print for the S&P (at over 1,880), the equity market participants celebrated five year bull market anniversary (from March ’09 to March ’14). Ironically, majority of them most likely missed the first few years and have been pilling into the trend as of late. How typical. Conversely, I feel that the opposite course of action might be prudent and here are just a few simple reasons why.
Chart 1: This is the second longest bull market in the 80 year history!
According to historical data, the current US equity bull market is the second longest in the last 80 years and third longest in a 100 year history (as the roaring 20s hold close similarities to the roaring 90s). As we can see in Chart 1, over the last several weeks, the current bull market has edged out the infamous 1982-87 and 2002-07 bull markets in terms of length.
A keen student of historical market trends should be able to observe that each and every prolonged bull market (which builds financial and economic excesses) does not usually end with mild correction, but rather serious market re-pricings. In other words, just as majority of the retail investors are becoming confident with stock investing once more (slowly forgetting the lessons of 2008), history shows us that risk increases substantially as the trend ages. Consider the following:
- 1920s bull market lasted 8 years and crashed by almost 90%
- 1980s bull market lasted 5 years and crashed by 40%
- 1990s bull market lasted almost 8 years and eventually crashed by 50%
- 2000s bull market lasted 5 years and crashed by 50%
I am not necessarily predicting another monster crash, but what I am trying to put forward is the notion that the longer the bull market goes on for, the higher the excesses become and the more painful the clean out could be on the other side.
Chart 2: Annualised return over 5 years has been 3rd best in half century
As we focus away from the bull market length, and towards the gains achieved, we can see that the current bull market gains also hold very close similarities to previous long bull markets discussed in Chart 1 (to see the zoomed in version of the chart, click here). The chart above shows the 5 year rolling performance for the S&P 500, where gains have now spiked above 170% for only the third time since the 1960s. The first two were into 1987 and 2000 market peaks.
The market has gifted investors one of the best 5 year return periods in half a century and history shows us that such periods do not last forever. In the recent article, Bloomberg has described the current bull gains through “annual compounded returns” over 5 years. The article states that S&P 500 has:
…generated total returns for U.S. investors of 25 percent a year since the bull market began on March 9, 2009. The rally compares with 27 percent annually during the last five years of the technology bubble, a period when the S&P 500 gained 233 percent and $9.3 trillion of equity value was created, data compiled by Bloomberg show.
The S&P 500 Equal Weight Index, which strips out biases related to market value, has added more than 29 percent a year in the current run. That’s almost twice as much as in the last half of the Internet bubble, data compiled by Bloomberg show.
I find it ironic that in 2014, majority of Wall Street investment bank research notes state that the current bull market might replicate the gains seen during the late 90s tech bubble… all we have to do is keep buying stocks into the next few years. I guess anything is possible (yes, one day even pigs might fly), but the truth is that the market has already replicated the tech boom by gifting investors 25% annualised returns (including dividends) over the last 5 years.
Chart 3: This fifth strongest 5 year performance in over 140 year history
Instead of just looking at the market from 1960s to present, I took the 5 year rolling performance concept in Chart 2 and applied it to the last 140 years with Robert Shiller’s S&P data. The chart shows that gains in excess of 100% during the period of 5 years are 1.5 standard deviations above the historical mean.
Interestingly, including the current bull market, there have only been eight events in 140 year history where markets have gifted investors returns in excess of 100% over 5 years. These include gains into the peak of 1882, 1901, 1929, 1937, 1956, 1987, 2000 and 2014 (all marked on the chart above). Out of these eight, seven have led to serious corrections or outright crashes, while one (in 1956) lead to only a mild pull back. In all respect, the bull market in 50s was coming out of a Great Depression and extremely depressed stock valuations (refer to Chart 4).
Furthermore, we can see from the chart above, that it makes complete sense to buy equities when the rolling 5 year performance trends below 1 standard deviation away from the mean. Therefore, from the opposite perspective, it would also be outmost prudent to be cautious or even bearish during periods when the equity market trends 1.5 standard deviations above the 140 year historical mean.
After all, according to my own analysis, the market has only ever traded at these overextended levels 8.6% of the time or 143 months in the last 140 years. Mind you, outright majority of that was during the late 1990s tech bubble.
Finally, since I have already discussed various valuations before, I will not go into it again. However, it is worth stating that Chart 4 shows that this articles conclusion confirms overextended CAPE 10 and other valuation metrics. I believe the US equity market is in a dangerous spot right now.
Chart 4: Market is at 3rd most expensive level, beaten by 1929 & 2000!
Chart 1: Gold has outperformed other asset classes over the quarter
Gold has outperformed all other major asset classes over the last quarter. The chart above shows that up until recently, the yellow metal has returned over 13% for the rolling 3 month period. Not a bad performance when compared to US equities, GEM equities or US Treasury Long Bond which returned 0%, -7% and 6% over the same time period respectively. Moreover, this was definitely a surprise to majority considering just about everyone came into 2014 super bearish on the precious metals sector.
Chart 2: Hedge funds have piled into Gold over the last three months…
However, the situation has changed quite quickly after such a superb rally. With a strong performance, comes the momentum chasers (think dumb money hedge funds). This is quite a repetitive scenario, where Johnny Come Lately’s pile into a hottest performing asset class of the quarter, as they extrapolate previous quarters return into the future. They “hope” the momentum continues for longer so they can also make a positive return.
Now, in all respect, bullish sentiment is not always a sign to worry, especially during uptrends where its quite normal to see bulls dominate bears (as long as it doesn’t become too extreme). However, Gold has not yet proven that it has started a new uptrend. Its price action is rather negative, despite such a strong quarter. As we can see in Chart 2, a technical pattern of lower lows and lower highs still remains in place.
Chart 3: Precious metals have dramatically underperformed other assets
So where to from here for the yellow metal? Personally, I have maintained that the price of Gold has a date with the $1,000 per ounce physiological and technical level. In any event, whether I am right or wrong, and whether Gold continues its sideways consolidation or breaks down lower, investors should be reminded that the overall Precious Metals sector has dramatically under-performed all other asset classes over the last 3 years. Therefore, this sector of the market is one of the only areas offering value, unlike overvalued and aged US stock bull market or the extremely overextended 32 year secular bull market in US Bonds.
Chart 1: Merrill Lynch states that sentiment is as low as March 09 levels
This is pretty funny to me. Its the funniest thing I’ve read all week actually. Or maybe this isn’t “the funniest thing”, but it sure is the stupidest thing I’ve read all week. I just hope no one out there believes that sentiment is “near March 2009 levels” after one of the longest and strongest bull markets in history.
Chart 1: Bearish divergence between S&P 500 and its 200 MA still in play
We have looked at various divergences with the US equity market over the last few months. One of many that is still in play is the S&P 500 index vs its own 200 day moving average. Historically, this type of bearish divergence indicates a loss of momentum and has almost always led some kind of a correction (mild or serious).
Chart 1: Gold priced in G4 currencies show further weakness is possible
On this blog, we usually follow the price of Gold in US Dollar terms. Since USD is a reserve currency (for now at least), majority of the global trade as well as raw material exchange is done in this currency. However from a investor point of view, Gold priced in other global currencies sometimes offers clues to the direction of the metal itself, well before it happens in its USD price.
Interestingly, the price of Gold is Euros and Pounds has recent made a lower low, unlike the USD price. Furthermore, due to the BoJ weakening currency policy, Gold priced in Yen has held up relatively well, unlike the other developed nation currencies. The pattern of lower lows and lower highs in the Euro and Pound priced Gold markets could be a signal that further weakness will also occur in USD Gold price too.
Chart 2: Strongest Gold demand comes from Global Emerging Markets
However, it is just as important to track the price of Gold in currencies where demand is strong, historical link is alive and tradition towards Gold is respected. Several that I have chosen above include top consumers including India, China, Russia and Turkey.
Other than the Chinese Yuan, other GEM currencies have suffered in recent years. Whether its the Indian Rupee, Russian Ruble or the New Turkish Lira, all of these currencies have experienced substantial pressure against the US Dollar. Therefore, it should be no wonder as to why Gold prices held up better against these currencies. Finally, from a consumer point of view, higher Gold prices in local countries also hurts demand.
- Recent AAII survey readings came in at 35% bulls and 27% bears. Since the last report in March, AAII bullish readings have fallen ever so slightly, while bearish readings have remained pretty much unchanged. However, turning our attention to the less volatile AAII monthly allocation survey, we can see the investors continue to add exposure towards equities, while reducing their cash levels, a major warning signal of complacency.
Chart 1: Extremely low level of bearish advisors usually signals a top!
- Recent Investor Intelligence survey levels came in at 51% bulls and 19% bears. Over the last four weeks, bullish readings have pulled back slightly while bearish readings have slowly started to rise. Nevertheless, the chart above shows that for 24 weeks in the row, percentage of bearish advisors has remained below 20%. This type of a sentiment condition is very rare and warns of major complacency amongst investment participants.
- Recent NAAIM survey levels came in at 91% net long exposure, while this weeks intensity was recorded at 150%. Over the last month, fund managers have been rising their exposure towards equities on weekly basis, while the intensity of exposure (difference between the most bullish and most bearish exposure) has stayed extremely elevated at 170% net long when averaged over the last 6 weeks.
- Recent ICI fund flows reports showed that “equity funds had estimated inflows of $1.23 billion for the week, compared to estimated outflows of $962 million in the previous week. Domestic equity funds had estimated outflows of $267 million, while estimated inflows to world equity funds were $1.50 billion.” Money continues to flow into the stock market, as seen in this chart here showing 15 consecutive monthly inflows. This streak is bound to be broken eventually, as a more meaningful correction starts (more likely sooner rather than later).
- Moreover, the next sell off might not be a correction, but rather a bear market. Chart 2 shows that money market funds have diverged quite a lot from the overall broad equity market value, signalling high complacency levels similar to 1981, 1987, 1998, 2000 and 2007. All of those dates were peaks prior to at least a 20% drop in equity prices and some full blown crashes.
Chart 3: Rydex traders are not only optimistic, they are outright greedy!
- Recent Rydex fund flows are rising to higher and higher levels by the day. Rydex traders, usually considered as dumb money, are pilling into US equities at such a fast rate, you might as well call the long trade a “free lunch”. They are so greedy right now, that they are sure the market will rise to higher and higher levels… in their view most likely “a sure bet”. While previous optimistic levels lead to sharp sell offs as seen in Chart 3, the current level of greed just might lead to something even more worrisome.
- Recent commitment of traders reports (also known as dumb money) showed that speculators have slowly, but surely been closing their net long bets on technology stocks. Hedge funds and other speculators currently hold over just over 74,000 net long contracts, which is a substantial decrease from 113,200 at the start of March. Nevertheless, speculators aren’t anywhere near outright bearish levels yet. Previous months chart can be seen by clicking here.
- Long term volatility conditions can be seen by looking at the chart here. As the trader in the recent Bloomberg interview states, since the 2008 the VIX has settled five times below 14 and now twice below 13. With many traders now purchasing puts on the VIX, it seems that the market consensus is that the low volatility is here to stay. Consensus is rarely right from my own experience, so I would be cautious with this view. Generally speaking, other volatility indicators are also signalling ongoing complacency. These include Junk Bond Credit Spreads, Corporate Bond Credit Default Swaps and 2 Year Dollar & Euro Swap Rates (thanks to Scott Grannis’ blog for charts).
- According to NYSE, Margin Debt (measure of investor leverage) climbed to yet another record high in February 2014. These days, there isn’t a month that passes by where we don’t learn that leverage is increasing at an almost exponential pace. Official nominal margin debt readings now stands at $465.72 billion, $14.5 billion higher than last month. Inflation adjusted margin debt in todays dollars is seen in Chart 5, while investor net credit levels, currently at record lows, can be seen by clicking here. Thanks to Doug Short for both charts.
- Side note: I originally warned about the developing weakness in Consumer Discretionary equities all the way back in middle of January. This situation is now developing further, where the Discretionary sectors continues to under-perform both the overall market as well as Consumer Staples sector. The chart above shows S&P 500 vs Discretionary / Staples Ratio, which represents the cyclicals vs defensives performance. Usually, cyclical sectors will turn down first before the market peak, as seen in early 2007 and early 2011. The same is true for the bottoming process too, where cyclical sectors sense the recovery before the market itself, as seen during late 2008 and late 2011. Interestingly, we are once again getting a warning from the ratio above, which could potentially mean that the market is now starting a topping process. Watch carefully!
- The situation has not changed much in the Bond sentiment surveys compared to the March report. As Treasury prices have mainly moved sideways, so has the sentiment. Both Market Vane Bullish Percentage and Consensus Inc survey remain at or close to neutral level. Neither of these surveys is giving us any contrarian signals worthy of a trade nor an investment right now. However, the fund flows towards corporate debt and especially the junk bond market (easily seen with narrowing spreads), is very frothy right now.
- Recent ICI fund flows reports showed that “bond funds had estimated inflows of $1.28 billion, compared to estimated inflows of $2.48 billion during the previous week. Taxable bond funds saw estimated inflows of $1.23 billion, while municipal bond funds had estimated inflows of $49 million.” Retail investor panic is usually a signal to buy an asset, and this was once again proven by corporate bond price sell off in 2013 (seen in the chart above). Large fund outflows by the public usually occur near market troughs and this time was no different. The price has managed to bottom and rally somewhat, gifting those contrarians who went against the herd a decent total return (including the yield) for a few quarters now. Interestingly, as the rally continues, the fund flows are back again…
Recent commitment of traders report (also known as dumb money) shows that small speculators have just above closed all of their net short bets against the Treasury Bonds. Recent COT report showed that small speculators now hold only -5,000 net short contracts. Personally, I believe that specs could actually turn net long on the Treasury Bond market if and when the equity market experiences a more significant correction. A warning signal for the equity market could be the inverse correlation with bonds and a possible breakout from the current basing pattern. Watch that neckline closing on the Long Bond!
Chart 8: Commodity index reaches resistance as specs build positions!
- The recent commitment of traders reports (also known as dumb money) showed that hedge funds and other speculators continue to remain very bullish towards the overall commodity complex, with exposure reaching over 930,000 net long contracts (custom COT). This is now the highest net long exposure since September 2012, just before the price peaked. Majority of the net long contract building has come from Agricultural and Precious Metal sectors, which have rallied decently over the last quarter. The chart above shows that the equal weighted commodity index has now reached a technical resistance area and its time for consolidation.
Chart 9: Brent Crude Oil is acting very weak despite the commodity rally
As already discussed in a few posts as well as last months sentiment report, several industrial commodities that are economically sensitive are acting rather weak. One of these is Brent Crude, the global barometer for energy prices. As we can see in the chart above, prices peaked out during the Lybian Crisis into May 2011. For the last three years, prices have gone essentially nowhere. Technically, Brent Crude is now at crossroads, with a major price decision looming in coming days or weeks. Pay a close attention to this one, as it could be an important signal for the overall global economy.
Chart 10: Dollar positioning is neutral as price holds important support
Recent commitment of traders reports (also known as dumb money) have shown a gradual decrease in bullish positioning towards the US Dollar. During the last report in early March, cumulative G10 positioning by hedge funds and other speculators stood at $10.3 billion net longs. The sell off that occurred into the Fed press conference shook those net long speculators out completely, with current positioning pretty much at neutral levels (neither long nor short). Comments by Fed Chair(wo)man Yellen have changed the dynamics of the currency markets a bit, with the Dollar bouncing of its support. At the same time the Euro, Pound, Franc and Yen have been rather weak as of late.
Chart 11: Canadian Dollar is one of the more hated currencies right now!
- Sentiment survey readings on various currencies has been skewed towards European continent strength and Emerging Market weakness, which has sort of created a US Dollar neutrality, so to speak. Having said that, commodity currencies like the Aussie and in particular the Loonie continue to under-perform. As we can see in the chart above, thanks to SentimenTrader, survey readings have now fallen to negative extremes last seen during the GFC and late 2008 panic sell off. Let us not forget that the Canadian Dollar peaked all the way back in middle of 2011 and has been in a bear market for three years now. The currency is down 7.3% over the last 12 months and almost 13% over the last three years (the worst 3 year performance since 1998).
Chart 12: Hedge funds are once again cutting their net long bets on PMs
Recent commitment of traders reports (also known as dumb money) showed hedge funds and other speculators burnt by jumping onto the precious metals too late. Last months report warned that Gold, as well as Gold Miners, were becoming very overbought in the short term and a correction was looming. Interestingly, just before the correction started, specs increased net longs in Gold and Silver substantially. Now… with a price drop, we see those positions closed again. Current Gold hedge fund positioning stands just over 100,000 net longs; while current Silver hedge fund positioning stands at just over 14,500 net longs. Respectively, that is 31.4% net longs as a percentage of open interest in Gold and 18.9% in Silver… not yet close to single digits associated with intermediate bottoms and buying opportunities.
Chart 1: Feds goal to improve employment by printing money has failed!
The chart speaks for itself. Federal Reserve has failed to improve economic conditions by printing money, but it has not failed to create yet another artificial economic situation. Once the QE is withdrawn, the financial markets could be in for a rude awakening worse then 2008.