“There is Nothing More Deceptive than an Obvious Fact”[i]
The Dow and S&P 500 both closed last week at record levels. Obviously, one would conclude, stocks are having another good year. Even an experienced market observer would naturally feel it’s a redux of 2013’s 30% advance given that seemingly each day’s headlines include “a new stock market record”. The obvious is that the indexes are at record levels. The current deception is that the underlying signals are suggesting caution.
This most recent rally began in mid-May. Prior to that the markets spent six weeks trading sideways to lower and was marked by a divergence between the blue chips and the rest of the market. Specifically the Dow and S&P 500 moved sideways while the Nasdaq and Russell were soggy. (The Nasdaq was down 3% and the Russell fell over 6% from the start of April to the middle of May.)
But just as the “sell in May and go away” crowd was feeling emboldened, equities stopped retreating and buyers returned. And while the Dow and S&P grabbed headlines, the lagging Nasdaq and Russell has also participated and have recovered their year-to-date losses within a few weeks. Here are the major averages for 2014.
Dow Jones Industrial Average +2.1%
S&P 500 +5.5%
Nasdaq Composite +3.5%
Russell 2000 +0.1%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
Naturally record stock market levels often coincide with increased investor enthusiasm. While emotion is somewhat difficult to accurately measure, there are clear signs of complacency. Last week Investors Intelligence showed that over 60% of responding advisors were bullish which is the highest level since October 2007. Importantly, Investors Intelligence defines any number above 40% as “excessive optimism”[iii] Also, there were only 17% bearish advisors which is lower than in October 2007.
There are a couple other attention grabbing nuggets to pass along. The CNN Fear and Greed Index reached 86 on Friday which is the highest in a year and also in extreme territory.[i] This survey’s scale ranges from 0 to 100 with higher numbers reflecting greed. Lastly, the CBOE Equity Put/Call ratio hit a low of .43 last week which was the lowest one-day reading since January 2011. This index is based on the buying of put options (bearish) vs. call options (bullish). Readings below .50 and above 1.00 are viewed as abnormal.
For those unfamiliar with these statistics, they are used as contrary indicators. In other words, widespread optimism and few worriers is usually a headwind to higher prices as bullish investors have already put their money to work which could mean a peak in buying power. In the past it has been prudent to step away from the crowd when sentiment gets this ebullient.
Combining the market’s current emotional state with some fundamentals results in even more alarming signs. John Hussman points out that when sentiment is optimistic (II survey above 60% bullish) at the same time as market records and an S&P 500 P/E above 18 (measured by trailing earnings), it has been a sign of a top. Dr. Hussman states that only times that these three stars have aligned were October 2007, January and May 1999, August 1987, and January 1973.[ii] Attention, please.
Dr. Hussman points out that these may have not been the top ticks but, importantly, all preceded material market corrections. While short term timing is difficult, there are some other trends that support near term caution. During the past 10 years, June has averaged a 1.33% decline making it the worst month by a wide margin (the next worst is August with a .45% average decline). Also as a point of reference, over the past 50 years September is the weakest month.
The above data probably suggests a correction (they can be very unpleasant for those who’ve forgotten) but we wouldn’t expect a bear market. Aside from investor’s emotional state, the economy is doing ok. Corporate earnings continue to grow. According to Factset, 497 of the S&P 500 companies have reported 1st quarter earnings with 74% exceeding the mean estimate. 53% have reported revenues above the mean estimate. The estimated growth for 2nd quarter earnings is 5.4%[iii] Further corporate balance sheets remain strong and mergers and acquisitions have been very active.
“Abby someone? Abby who? Abby Normal.”[iv]
Turning to the fixed income market, the U.S. 10-year treasury has had a roller coaster ride recently. From a 2.70% yield at the end of April, the yield dropped to 2.4% at the end of May. The yield then rebounded back to 2.65% during the past 1 ½ weeks. For those not familiar with the bond market, this may not appear
to be that significant, but it is not normal behavior. It is incredible volatility on both an absolute and relative basis. There has been a lot of ink spilled over the cause but there has not been a definitive reason identified. We’ll be keeping an eye at this and will continue to search for causes.
Today’s capital market conditions are challenging. But this is nothing new. We wonder if the record stock prices is the ‘obvious fact’ or the ‘deception’. After all, it seems illogical that this is happening in the face of terrible fiscal and monetary policy. Which leads to the following quote which has been making its way around investment blogs and other social media platforms recently. We think it accurately describes 2014’s markets but it was actually written 25 years ago by the sagacious Merrill Lynch strategist Bob Farrell.
“Money managers are unhappy because 70% of them are lagging the S&P 500 and see the end of another quarter approaching. Economists are unhappy because they do not know what to believe: this month’s forecast of a strong economy or last month’s forecast of a weak economy. Technicians are unhappy because the market refuses to correct and gets more and more extended. Foreigners are unhappy because due to their underinvested status in the U.S., they have missed the biggest double-play (a big currency move plus a big stock market move) in decades. The public is unhappy because they just plain missed out on the party after being scared into cash after the crash. It almost seems ungrateful for so many to be unhappy about a market that has done so well. . . . Unhappy people would prefer the market to correct to allow them to buy and feel happy, which is just the reason for a further rise. Frustrating the majority is the market’s primary goal. . . .” [i]
[i] Robert Farrell, September 5, 1989
[ii] www.hussmanfunds.com, “Weekly Market Comment”, June 9, 2014
[iii] Factset, “Earnings Insight” June 6, 2014
[iv] Young Frankenstein, 1974
[i] Arthur Conan Doyle
[ii] The Wall Street Journal, June 7, 2014