At the end of February I wrote an article entitled “Get Ready For A Run To All-Time Highs”wherein I stated:
“At this time we are still confident in our price target of 1560 on the S&P 500 this year. However, it is possible that the markets could rise to the rising trend line, as shown in the first chart below, of 1600. However, let me be clear – while our target is 1560 I am not saying that is where the year will end. At the current trajectory that target could be reached as early as this summer. However, as David Rosenberg correctly stated in his recent missive:”
“One thing to keep in mind that could well limit the severity of any near-term correction is the Fed. Recall that in 2010, and again in 2011, the Fed was scheduled to terminate its Quantitative Easing programs and this aggravated the selloff. So after crying ‘uncle’ twice to stem the market’s decline and extending QE, the Fed late last year, introduced perpetual QE — and Bernanke yesterday gave no sign at all that he is about to back away from the program. He doesn’t see bubbles forming: and if he did, he made it quite clear that the dual mandate of full employment (not there with a U6 rate over 14%) and price stability (in the current case, preventing deflation) would still take precedence. I have long cited the 85% correlation between the Fed’s balance sheet and the market’s direction over the past four years — the extent to which the laws of diminishing returns begin to set in will be interesting to see, me-thinks, over the next several weeks and months.”
Yesterday, the S&P 500 reached that initial target sending mainstream media into a tizzy as the smell of an all-time high is within grasp. The issue, however, as I disucssed yesterday onFox Business News, is that the risk of owning stocks is getting pressed to extremes. In the previous article I published the following chart (updated through the most recent close) and stated:
“The weekly chart of the S&P 500 index below shows the markets still in extreme overbought territory and at levels that have normally been associated with intermediate term tops. This overbought condition combined with excessive investor optimism supplies the ingredients necessary for another correction of 10% to 20% as seen over the past three years. However, as Rosenberg stated, with a never ending QE program in place the catalyst for such a correction will likely be something far more serious than the current budget debates in Washington.”
The overbought/oversold indicator runs from 0 (which is the maximum overbought condition) to -100 (the maximum oversold condition). As a reminder this is a weekly indicator – using weekly data, rather than daily, reduces volatility and errors due to short term impacts. Currently, the indicator is at 0.45 – less than 1/2 point below the maximum overbought condition.
However, it is not just this one indicator that is pegging extremes. Another, that I monitor very closely, is the percentage deviation from the 50-week moving average which is very slow to develop but has historically had a great track record of indicating tops, or bottoms, in the making. When deviations get 5% above/below the 50 week moving average the markets have experienced short term corrections. However, once deviations exceed 10% the corrections have been far more dramatic. Currently, the devaition from the 50-week moving average is above 10% as shown below.
The record is pretty clear. The markets are extremely stretched to the upside on many measures. However, what is most concerning, are these technical extremes combined with the rise in margin debt/leverage and record low yields on junk bonds. Those last two issues are the gasoline for fire – as I stated in “There Is No Asset Bubble?”:
“The only missing ingredient for such a correction currently is simply a catalyst to put ‘fear’ into an overly complacent marketplace. There is currently no shortage of catalysts to pick from whether it is further fiscal policy missteps stemming from the upcoming ‘Debt Ceiling’ debate, a resurgence of the Eurozone crisis, or an unexpected shock from an area yet to be on our radar.
In the long term it will ultimately be the fundamentals that drive the markets. Currently, the deterioration in the growth rate of earnings, and economic strength, are not supportive of the speculative rise in asset prices or leverage. The idea of whether, or not, the Federal Reserve, along with virtually every other central bank in the world, are inflating the next asset bubble is of significant importance to investors who can ill afford to once again lose a large chunk of their net worth.
It is all reminiscent of the market peak of 1929 when Dr. Irving Fisher uttered his now famous words: ‘Stocks have now reached a permanently high plateau.’ The clamoring of voices that the bull market is just beginning is telling much the same story. History is repleat with market crashes that occurred just as the mainstream belief made heretics out of anyone who dared to contradict the bullish bias.”
The problem is that with the markets extremely overbought and extended - a correction in price that is large enough to trigger margin calls becomes the nightmare that investors have lived through in 2000 and 2008. The unwinding of leverage is brutal, extreme and very fast. Investors have little opportunity to get out of the way of such an unwinding and when it occurs it will begin without any real warning.
The market could certainly climb higher to 1600, as I stated previously, which is roughly a 2.5% gain from current levels. However, a correction to support, that does not break the current uptrend, is currently 7.5% lower. On a risk/reward basis those are not odds that I would bet on in a casino. However, this is the point that eludes mainstream analysts and pundits – the investing game is not about chasing some random benchmark index to new highs. It is about capitalizing on opportunities to make money in the market and preserving those gains, and primarily the invested capital, along the way.
Barry Ritholtz recently posted a great peice in this regard (click here to read entire post):
“I prefer to employ Risk Analysis rather than engage in pure Market Timing.
Rather than making a low probability attempt to market time, there are quite a few things other things investors should at least be aware of, rather than attempt to jump in and out:
• What is the overall trend in the market — is it rising or falling or going sideways?
• Are Earnings rising or falling?
• Is my asset allocation percentages appropriate for the current secular cycle?
• How are stocks valuations? Measured by both a simple forward P/E and a longer term 10 year (i.e., Shiller CAPE), are stocks cheap or pricey?
• Am I taking advantage of mean reversion to rebalance my holdings based on asset class?
• Are interest rates rising or falling?
• What do the regular 5%, 10% even 20% pullbacks mean to your portfolio?
• Do I understand that my comfort level about market volatility and risk is typically inverse to present opportunities?
Most people are much better off if they simply do two things: Rebalancing their holdings on a regular basis and changing the tilt of their allocations on rare occasions (i.e., 70/30 to 60/40).
Focus on maintaining an intelligent balance of assets, and leave the martket timing to the newsletter writers. When they get it wrong, they lose subscribers. When you get it wrong, it crushes your retirement plans . . .”
The problem for investors that are chasing the markets now, and heaven forbid those just jumping into it, is that they are setting themselves up for failure once again. The mantra of“buy low and sell high” is continually lost on investors who do just the opposite by falling prey to emotional biases that are spurred by mainstream analysts and pundits who are generally“talking their book.”
As Barry states above it is time to consider rebalancing portfolios, raising some cash and reducing risk. While he is absolutely correct that no one can effectively, and consistently, time the markets (being all in or out) what we can do is treat our portfolios like a rheostat. When risks rise – we reduce our allocation to the areas that could effectively hurt us the most. When risks fall – we increase our allocation to risk. For example, the recent rally in stocks has vastly increased the risks of a correction at some point in the future, however, bond prices have declined as bonds have been sold to chase stocks. When the markets eventually correct this flow of money will reverse and the increase in bond exposure will hedge the stock prices fall and bond prices rise. Looking at undervalued, or out-of-favor areas of the financial markets, has always tended to be adventageous when money rotates out of stocks either temporarily or longer term.
The risk/reward ratio of investing in stocks is currently skewed well out of the individual’s favor. This doesn’t mean that you should run completely into cash as the markets are about to crash. Howver, it does mean that the markets could well experience a 10-20% correction at some point as it has every year since 2008. With the real risks buried well below the headlines, being margin debt and historically low yields on junk bonds, the current combination of these variables within the markets have not ended well for investors in the past. Could this time be different? Sure, it could – but how much of your personal retirement savings are you willing to bet on it?
Images: Flickr (licence attribution)
About The Author
Lance Roberts – Host of Streettalk Live
After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.
Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.
Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.