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Stocks Will Rise and 3 Trades You Can’t Make!

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    July 22, 2014

    I wrote recently that stocks spend 5% of their time hitting new highs while the other 95% of the time has been making up previous losses.  This is shown in the chart below.

    S&P-500-Real-Record-Highs-052214

    I make this point as I saw a flashing banner across the bottom of the TV screen stating the markets have hit 14 new highs this year alone. While this sounds like an amazing feat, it is actually just a function of being in record territory.  For example, assume a dragster sets a record in the 1/4 mile of 7 seconds. The next driver that runs the same strip at 6.999 seconds sets a new record. So forth, and so on. There are two important points to take away from this:

    1. When the markets are at a record level, it only takes infinitesimal advances to set new records.
    2. Records are attained when previous extremes have been breached, which is generally a latter stage event in market cycles.

    However, while logic would suggest that current market levels are getting a bit extreme, the “exuberance” created by current price momentum fuels additional gains. As the ongoing “bullish meme” from mainstream media sources and analysts continue to feed individual’s “confirmation biases” the “fear” of “missing out” blinds individuals of the rising risk.

    Dr. Robert Shiller recently penned an interesting piece at Project Syndicate stating:

     “In recent months, concern has intensified among the world’s financial experts and news media that overheated asset markets – real estate, equities, and long-term bonds – could lead to a major correction and another economic crisis. The general public seems unbothered: Google Trends shows some pickup in the search term “stock market bubble,” but it is not at its peak 2007 levels, and“housing bubble” searches are relatively infrequent.”

    Dr. Shiller is correct. The general public seems “unbothered” by the rising risks in the markets despite a variety of warnings recently:

    Janet Yellen during in the Federal Reserve’s Semiannual Monetary Policy Report to the Congress:

    “The Committee recognizes that low interest rates may provide incentives for some investors to ‘reach for yield,’ and those actions could increase vulnerabilities in the financial system to adverse events…In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk.

    Stanley Druckenmiller and Carl Icahn via the CNBC Delivering Alpha conference:

    “I am fearful that today our obsession with what will happen to markets and the economy in the near term is causing us to misjudge the accumulation of much greater long-term risks to our economy” – Druckenmiller

    “You have to worry about the excessive printing of money.  You have to be worried about the markets.” – Icahn

    Yet, despite these warnings individuals, as shown below are as heavily allocated to the markets currently as they were prior to the financial crisis.

    AAII-Asset-Allocation-071714

    [Note: This goes heavily against the “cash on the sidelines” theory.]

    Furthermore, while individual investors are fully allocated to the equity markets, professional investor sentiment has rocketed in recent weeks to astronomically high levels.

    INVI-BullishSentiment-071714

    While excessive bullish sentiment, low volatility, and a perceived blindness to risk are certainly noteworthy; “irrational exuberance” can drive markets higher would logically be expected.

    The supporting arguments for the “bullish meme” are:

    • There is no possibility of a recession on the horizon,
    • The markets are “fairly valued” based on the current interest rate environment, and
    • There is “no other option but stocks.” 

    While these views certainly bolster the near term perspective of being long the equities, it is important to remember that each of these dynamics can, and do, change much more rapidly than investors can generally react to.

    The chart below shows the annual change in GDP, 10-year interest rates and the S&P 500.  It is important to note that prior to every recession that was an instilled belief that“no recession” was on the horizon, stocks were fairly valued and “stocks were the only place to be.”

    It is also worth remembering that Alan Greenspan and Ben Bernanke both stated that the economy was doing well…just before it wasn’t.

    SP500-GDP-Rates-Recessions-071714

    Why Stocks Could Continue To Rise

    As I wrote previously in “The Coming Market Meltup:”

    It was in 1996 that Alan Greenspan first uttered the words ‘irrational exuberance’but it was four more years before the ‘bull mania’ was completed.  The ‘mania’ of crowds can last far longer than logic would dictate and especially when that mania is supported by artificial supports.

    The statistical data suggests that the next economic recession will likely begin in 2016 with a negative market shock occurring late that year, or in 2017.   This would also correspond with the historical precedent of when recessions tend to begin during the decennial cycle.  As shown in the chart below the 3rd, 7th and 10th years of the cycle have the highest occurrence of recession starts.”

    Recessions-No-DecennialCycle-011414

    “With the Fed’s artificial interventions suppressing interest rates and inflation it is likely that the bullish mania will continue into 2015 as the ‘herd’ mentality is sucked into the bullish vortex.  This is already underway as shown recently in ‘Charts All Market Bulls Should Consider’ which showed individuals are once again piling into stocks and depleting cash reserves in the hopes of ‘getting rich quick.'”

    The 3 Trades You Can’t Make

    As a money manager, my portfolio model remains currently fully investedThe problem is that I am grossly uncomfortable with that allocation given the risks that currently prevail. However, as I have stated many times previously, I must follow the trend of the market or I will suffer “career risk” as clients move money elsewhere to chase market returns.

    This is what I call the “investor duration mismatch.”  While investors are supposed to be investing for long-term returns, buying low and selling high and managing investment risks; the reality is that their emotional biases make them extremely myopic to short-term market movements. In other words, long-term investing comes down to how they performed relative to the market over the last year, quarter or month. (Read more on why fundamentals don’t matter.)

    The problem for investors today is that the “easy money” is no longer available by betting on stocks going up. Which means there is an opportunity brewing in three areas which, unfortunately, investors cannot actually make.

    • Long Volatility (VXX)
    • Long Bonds (Investment Grade Corporates)
    • Short Stocks

    The reason I say that you can’t make these trades is that they are a bet on the eventual market reversion. When the reversion occurs, volatility will significantly rise, interest rates will decline as stock prices drop markedly. The problem is that most investors do not have the patience to let such a “bet” mature. The pressure of betting against a rising market will eventually lead to selling at painful losses.

    The current low-volume market, combined with excessive bullish sentiment, sets up a potential for asset prices to be inflated further. As stated, the risks in the markets have clearly risen, but the next major reversion could be many months away. The problem for most, particularly those touting “investing for the long term,” is when the “dip” turns into a full-fledged “decline” the panic to exit the markets will become overwhelming. Dr. Shiller’s final paragraph summed things up well:

    “Those who warn of grave dangers if speculative price increases are allowed to continue unimpeded are right to do so, even if they cannot prove that there is any cause for concern. The warnings might help prevent the booms that we are now seeing from continuing much longer and becoming more dangerous.”

    Our memories tend to be much shorter than the damage done to portfolios by failing to recognize risk and managing accordingly.

    lance sig

    Lance Roberts

    Lance Roberts is the General Partner and Chief Portfolio Strategist for STA Wealth Management. He is also the host of “The Lance Roberts Show,” Chief editor of the X-Factor Investment Newsletter and the Streettalklive daily blog. Follow Lance on FacebookTwitter and Linked-In

    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.
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