Market/Economy - A Few Observations
Over the last couple of days we have been engaged in an overhaul of our website in order to bring an array of new features and options over the next few months. As a consequence I have not been able to write as much as I would have liked, however, it gave me an opportunity to step back and listen/read what the rest of the media and analysts were talking about. As we discussed in last week's missive - the level of exuberance is quite astonishing. More importantly is the assumption that the current economic "green shoots" are of an organic nature rather than the artificial effect of massive global liquidity injections combined with an abnormally warm winter season which is skewing the seasonal adjustment factors in economic reports. In this regard I have a few observations from the last couple of days.
Observation 1: The Myth Of Bullish vs. Bearish
The market has finally, after 5 arduous years, reclaimed the 1500 level. That's awesome. It's fantastic. It's wonderful. After five years, not adjusting for inflation, investors are finally back to even. Yet, this is consistently trumpeted by the media as a bullish case for investors to go plunging into the markets as it will assuredly go higher. Bullish optimism, as seen by many measures, is reaching extreme levels. If you disagree with the bullish view - then you're bearish and, obviously, wrong.
The argument of someone being bullish or bearish is complete nonsense. It is like two kids in a school yard pointing fingers at each other and calling names. The assumption by media, and most individuals, is that if someone presents a non-bullish cash then that person is all in cash. The majority of the time this isn't the case.
When markets are rising everybody is an investment genius. A recent article showed that a group of 100 monkey's stock picks outperformed the majority of mutual funds and hedge funds. Rising markets are not my concern. My job is to analyze the data as it develops and identify the risks that could lead to catastrophic drawdowns to investment portfolios. Getting back to "even" is not an effective retirement planning strategy.
Analyzing data for why it is supportive of the current advance is useless. I already know the markets are advancing so bleating the same bullish commentary as everyone else is ineffective at managing portfolio risk. Therefore, digging into the data to discern why it is "not supportive" of the current market trend is much more useful in identifying the risks that will eventually lead to a reversion in the markets. It is the reversions that set back investors years from their investment goals.
Therefore, while my analysis is often considered bearish by the media, it isn't. I am quite bullish on the markets short term. However, giving you 10 reasons as to why the market might go higher from here, encouraging you to take on further speculative risk in your portfolio, isn't really helpful. What is more to your advantage is the analysis of why it may not. Risk management in portfolios is the key to long term investment success.
Observation 2: Markets Extremely Overbought
In this past weekend's newsletter I went to some length discussing the much overbought conditions of the financial markets. I discussed some very long term charts that are clearly giving early warning signals that the current cyclical bull market is closer to its end rather than its beginning.
The chart below is another measure of the market in the same vane. Like the variety of charts discussed previously this weekly chart of the S&P 500 (SPY) clearly shows that the current advanced has pushed the overbought/oversold indicator into an extreme overbought condition. The market has historically began a topping process when these conditions have been present in the past.
The warning signs are clear. However, the catalyst that sends investors sprinting for cover is unknown. While it could certainly be some issue that we are currently familiar with, such as the debt ceiling or something from the Eurozone, investors have already been desensitized to these concerns. Most likely it will be an event that is currently not even being discussed such as:
- An ousting of Angela Merkel in the upcoming elections in Germany
- A successful launch of a long range missile from N. Korea that demonstrates the ability to reach the U.S.
- A sharp reversion in China's economy
- An escalation of China/Japan tensions
- A recession in the U.S. due to the continued drag in Europe.
- Or a natural event of mass proportions that disrupts the economy.
I don't have any idea what will eventually cause the market to crack. What I am absolutely, 100%, sure of is that it will happen. The only question is whether, or not, you will be paying attention to your portfolio when it does.
Observation 3: Economic Data Not Supporting Bullish Sentiment
The economic data that is currently being released, as mentioned above, is currently being boosted by a variety of short term artificial supports. For example:
- Incomes were boosted in the last two months of 2012 by corporations paying out bonuses and special dividends before the changes to the tax laws.
- The unseasonably warm winter is allowing people to work when they are normally shut in by inclement weather. Higher levels of employment are being boosted by seasonal adjustments and skewing employment and economic data higher than normal.
- Manufacturing reports showed a burst of activity due to the impact of Hurricane Sandy.
- Markets are being pushed higher as $85 billion a month is injected by the Federal Reserve
The point here is that much of the economic recovery that we are seeing currently is the direct result of artificial interventions and one time effects that are not organic or sustainable.
The chart below shows the Economic Output Composite Index. This index is comprised of the Chicago Fed National Activity Index, the ISM composite index, NFIB Small Business survey, several of the major regional Fed Reserve manufacturing surveys, and the Chicago PMI. This is a very broad composite survey of economic activity across the country.
There is little evidence currently from this data that there is any substantial pickup in economic activity from the manufacturing side of the equation. However, with more than 70% of GDP driven by consumption, a look at the consumer may give us some further clues as well.
Despite the sharp rise in the market since December consumer confidence has waned. More importantly, the impact of higher taxes on already tightly constrained household finances, see recent post on consumer deleveraging, has cut confidence in their future outlook. This is important because the recent plunge in future expectations historically leads the current confidence levels.
Consumption has also been reflected in the recent weekly retail sales numbers which show an exceedingly sharp decline, the largest going back to 2006, in the past month.
While the media, economists and analysts are currently pinning the majority of their investment outlooks on the back of a strengthening economy, currently, the evidence is not supportive of such hopes. In the very near future the economic data will begin to improve to confirm the recent surge in the stock market or prices will revert to reality. This is why we must continually monitor, analyze and adjust our investment strategies accordingly.
Observation 4: Dow 14000 / S&P 500 Means Nothing
The surge in the markets since December has gotten the media all excited. CNBC has recently put up a point-counter with the number of points left before the markets reclaim the 2007 highs. However, while the excitement of getting back to where we were 5-years ago is certainly more fun than a 20% plunge - the reality is that it should not be viewed as a sign of victory but rather a sign of caution.
First, even if the markets are able to obtain their 2007 peaks the average investor will still be nearly 10% behind on an inflation adjusted basis and nearly 20% below the peak in 2000. This is the effect of inflation on your retirement savings over time. It will take quite a while longer for investors to recoup the damage to get back to where they started but they have lost over a decade of time in preparing for the retirement.
Secondly, the average cyclical bull market last about 3.8 years which is about where we are now. Valuation wise this certainly doesn't look like 1982 or even 2009. The supportive backdrop of falling interest rates and inflation has come to an end and are more likely to rise in the future which puts the "markets are cheap" argument at risk. There is a sub-par growth rate in the economy which puts pressure on profit margins and the effectiveness of cost cutting and accounting gimmickry to boost margins and earnings over the past four years is wearing thin. Furthermore, earnings, like everything else in life, are very cyclical. With earnings pushing up to previous peaks it is only a question of time before the next "earnings recession" begins to appear.
The liquidity fueled cyclical bull rally that started in 2009 is very long in the tooth. I am not saying that the next major market crash is imminent but what I am suggesting is that the euphoria that is building in the markets is very reminiscent of previous major peaks in the markets. While markets can certainly remain irrational for much longer than most have ever thought - the current underpinnings of this rally remain very weak outside of the massive liquidity injections by the Federal Reserve.
Opportunities to participate in market rallies come along more often than taxi cabs in NYC. In the last 30 years I have never seen the "boat leave dock" and never come back. The trick to long term investing success is the understanding that there is no "bullish" or "bearish" - there is simply the analysis of the risks that permanently impair your ability to retire. Wall Street, very much like a casino is Las Vegas, is designed to separate you from your money. If you blindly bet long enough against the house you will lose. Successful investors, very much like a professional gambler, understand the risks and place their bets accordingly. They also know when it is time to fold and go home.