Observations and Outlook January 2018

Investors have not been as fully invested in the stock market since 2000.  Does this mean anything?

Maybe.  It is a reflection of investor expectations though.  One can infer this by assuming investors own what they think will go up in price and therefore is investors are very long, then they expect prices to rise.  The American Association of Individual Investors (AAII) recorded the highest level of optimism in 7 years, since December 2010.  The historical average is 38.5%.   In an article from AAII, dated January 4, 2018 they review how markets performed after unusually high bullish and usually low bearish sentiment readings.

From AAII:    “There have only been 46 weeks with a similar or higher bullish sentiment reading recorded during the more than 30-year history of our survey. The S&P 500 index has a median six-month return of 0.5% following those previous readings, up slightly more times than it has been down.   Historically, the S&P 500 has realized below-average and below-median returns over the six- and 12-month periods following unusually high bullish sentiment readings and unusually low bearish sentiment readings. The magnitude of underperformance has been greater when optimism is unusually high than when pessimism has been unusually low.”

This does not necessarily mean that our current market will decline rapidly.  Actually, AAII finds that while returns are below-median, they are positive.  Positive as in ‘above zero’.   Sentiment drives markets and when sentiment gets too extreme, either in bullish for stocks or bearishness for bonds or any other financial asset, returns going forward are likely to disappoint.  If everyone has bought (or sold) who is left to drive prices up (or down)?   What we need to recognize is that investors become optimistic after  large advances in the stock market, and pessimistic after declines.  UM-Probability-of-Stock-Mkt-Rise-Oct-2017-1024x705_thumb1

Again, this chart above does not mean we are about to enter a bear market.  It only shows the markets progress at points of extreme optimism.  We can see in 2013 into 2015 rising expectations and a rising market as well as from 2003 to 2007.   Now that we can visualize the mood of the market, lets review some other metrics from 2017 and what is in store for 2018.

2017 was interesting in several areas.  It was the first time in history the S&P500 had a ‘perfect year’ where every month showed gains in stock prices.  We are also in record territory for the longest length of time without a 5% pullback, almost 2 years.   Historically, 5% drawdowns have occurred on average 3-4 times each year.  In addition to price records, there are several valuation metrics at or near all-time records.    The ‘Buffet Indicator’ (market capitalization to GDP) just hit 1.4, a level not seen since Q4 1999.  “Highest ever” records are exceeded well into mature bull markets, not the early stages.  Stock markets generally spend most of the time trying to recover to previous highs and far less of the time exceeding them.    Momentum and priced-to-perfection expectations regarding tax policy are driving investors to be all-in this market, as reflected by Investors Intelligence Advisors’ (IIA) and American Assoc. of Individual Investors (AAII) stock allocation and sentiment surveys each at 18 and 40-year extremes.  Combined with the Rydex Assets Bull/Bear Ratio, at its all-time extreme bullish reading, it’s difficult to argue who else there is to come into the market and buy at these levels.

However, bullish extremes and extreme valuations can persist.  Their current levels do likely indicate that we are well into a mature bull market.   The bull was mature in 1998 too and went on to get even more extreme.  This is the case many perma-bulls trot out, that since were not as extreme as 1999, there is plenty of room to run, and ‘dont worry’.

The US Dollar and Quantitative Tightening

The current ‘conundrum’ is why is the US dollar so weak?  We have a Fed that is raising interest rates growth likely to exceed 3% in the fourth quarter.  Usually a rising currency would accompany these conditions.    The dollar declined throughout 2017.  This was a tailwind for assets outside the U.S. whose value in dollar terms increases as the dollar declines vs foreign currencies.   If the dollar begins to move back up this will be a headwind for ex-US assets and for sales/profits to large companies in the S&P 500 who do almost half their business outside the U.S.

In addition, central banks have given notice that, while the Fed ended QE in late 2015, other central banks are beginning to end their programs with the European Central Bank reducing its bond purchases from 60 billion euros per month to the current 30 billion, and down to 0 in September 2018.   The Bank of Japan (and the Japanese Pension Fund) have declared they are reducing their purchase of stocks, bonds, and ETFs.  Only China hasn’t formally announced and end to market interventions.   Most pundits are pointing to the bond market as the area that will be most affected.  Possibly, but to claim that bonds will get hurt and stocks will be fine is ignoring how global equities have performed hand-in-glove with banks’ liquidity injections over the past 10 years.  Both stocks and bonds will likely be affected.

Yield Curve Inversion (or not)


The chart above shows in red the persistent decline in 30-year treasury rates.  This week Bill Gross called the bottom (in rates, the top in prices).  This may be premature as one can see dips and climbs over the past few years, all of which have been accompanied by calls of the end of the 35 year bond bull market.

What is more interesting is that in the past 3 recessions, the yield curve as seen through the 10-2 Year Treasury Yield Spread declines, through the zero level (aka inversion, 10yr bonds paying less than 2 year notes) before a recession.   Our current level of .5% is not far from zero.   Most people are waiting to see it invert before saying a recession in on the way, often adding it will be a year beyond that point.    If one looks very closely at the chart we can see said spread actually increase after bottoming out, just prior to a recession starting (which wont be officially recognized until 6-8 months along).   While there are different factors influencing the 2yr and the 10yr rates, a spread widening might be a more important development than continued compression.

Finally, what does all this mean for an investor.   In short, we must all recognize that a 24 month span without a 5% decline is extremely unusual, as there are often 3-4 in a given year.   Also that when investors are most optimistic, returns often lag with the more extreme readings leading to more significant changes.  Mature bull markets eventually end and investors with a longer term horizon need to have a strategy not only for growing their investments, but also protecting the gains one already has.

We all know how to deal with a bull market, but few people have a strategy on how to deal with a bear market.

Adam Waszkowski, CFA