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TFTB: Putting Markets Rise Into Perspective

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    July 8, 2014

    Today’s “Thoughts From The Beach (TFTB)” is a brief look at the markets. Last week, I was flooded with emails asking basically the same question:

    “With the economic data disappointing expectations, why did the markets rally to all-time highs?”

    It is a good question.

    From my perspective, there are three primary factors at work in the markets currently. First, there is an inherent “fear” of missing an advance in the market. While investors are supposed to “buy low and sell high,” the problem is that in an exuberant market no one wants to “miss out.” It is this emotional bias that sucks the last of the “investor holdouts”into the market.

    Secondly, there is a “bad news is good news” mentality that currently prevails. The markets clearly understand the positive effects of the Federal Reserve’s ongoing liquidity interventions and one of the primary concerns for the markets is the current reduction in that program. The “tapering” of the liquidity that is flowing into the financial system puts the current market advance in jeopardy. The “hope” is that if the economic news remains weak enough, then the Fed may slow its “tapering” process and will not lift the overnight lending rate as soon as currently expected.

    Lastly, there is an extreme amount of complacency in the market currently. The sheer“lack of fear,” as stated above, is the trap that sucks unwitting investors into the market. The mentality is:

    “I cannot get any return at the bank in my savings account (in case you’ve forgotten, savings accounts are where you do not lose money so that your ‘savings’ are ‘safe’) so I will stick my money into the stock market because it seems like a ‘can’t lose’ market.”

    There have only been a few times in history where that type of mentality has prevailed. Each one was just before a major market correction that destroyed individual’s savings and their financial goals.

    I recently wrote about a potential “melt up” in the stock market. The rapidly increasing levels in complacency and bullish sentiment are making me much more concerned about investment risks in the market. The following charts detail my concerns and are the focus of today’s missive.

    Complacency Trigger

    While there has been much dialog about the current extremely low level of the volatility index, levels by themselves are fairly irrelevant unless they are put into context. The chart below shows the Volatility Index versus the S&P 500. What is important to note is that a falling “VIX” is normal as markets rise. However, it is when the VIX becomes extremely oversold, in this case I am using weekly data, concurrently with a very LOW level on the index that it has signaled previous market tops. I have highlighted these previous occurrences in yellow.


    Deviations Rise

    The next chart shows something that I have discussed previously. Moving averages only exist because at some point in time prices have traded both above and below that “average” level. Therefore, the longer the time frame of the underlying moving average, the greater the “gravitational” pull on prices. The chart below shows the S&P 500 versus its 3-year (36-month) moving average.


    What is important to note is that currently the S&P 500 is elevated more than 20% above its 3-year moving average. This is a level that has only been seen four other times in history and the subsequent reversions were quite painful for investors.

    Message Of Interest

    The next chart shows the correlation between interest rates and the financial markets since the turn of the century. Not surprisingly when stocks were rising, money rotated out of bonds and into stocks to chase returns. Conversely, when stocks were falling money rotated into bonds to seek safety.


    What this analysis shows is that the current rally in the financial markets is not drafting money out of bonds to chase stock prices higher. In other words, “stocks ain’t buying the rally.”

    The problem, however, is that over the last 14 years there has not been another period where yields and prices have deviated so significantly from each other. Nevertheless, for investors, it should not be overlooked that the current rally in the markets is not being“bought” by a rotation from bonds into stocks. This makes the rally somewhat suspect.

    The Most Important Lesson

    Of course, the problem is that this analysis will primarily be viewed as “bearish,” or more simply “wrong,” as long as the financial markets are rising. However, it does not take a tremendous amount of analysis, or personal experience, to logically conclude that the current market trend will not last forever. Market prices are ultimately affected by the laws of physics, and what goes up will eventually come down.

    It is from that logical analysis that the first law of investing was written: “Buy Low – Sell High.” It has often been written, it is often spoken, unfortunately, it is rarely heeded. The chart below, simple in its construction, most clearly demonstrates this basic law.


    What is important to derive from that chart is that it is NOT IMPORTANT to sell at the precise market peaks or buy at the exact bottom. The majority of gains in the markets are made by capturing 80% of the move up and only 20% of the move down. Unfortunately, for most investors, they achieve exactly the opposite by allowing the emotions of “fear” and “greed” to drive their investment decisions.

    While the markets could certainly move higher from current levels in the short term, it is extremely likely that at some point we will look back and wonder why we did not see what so clearly obvious. Of course, when that time arrives most will be far too busy pointing fingers and blaming others for leading them astray. In the end, however, it is our personal savings that we are putting at risk so whose fault is it if you are not paying attention to the risks you are taking?

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    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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