Thursday, February 23, 2017

Another bubble? Bring it on!

Anytime the Dow makes a new high you can be reasonably assured of hearing the B-word bounced around in the media.  Memories of the last bubble are still vivid and painful enough to trigger flashbacks of the bubble’s collapse.  It’s only natural then that investors fear a return of irrational exuberance.  Despite these fears, the evidence of a newly formed bubble is surprisingly lacking, as we’ll uncover here.

Asset manager Jeremy Grantham famously defined a bubble as any asset whose price has moved at least two standard deviations above its longer-term statistical mean, or norm.  This definition is too rigid, however, and can sometimes be misapplied to see bubbles where none actually exist.  Markets can sometimes exceed the 2 standard deviation rule in non-bubble environments, as when the utilities sector last year experienced a 3 standard deviation event. 

This definition also is overly reliant on statistics and is lacking in the psychology department.  Investor psychology, after all, is a primary driving force of the pricing mechanism in all free markets.  What Grantham’s 2 standard deviation event rule fails to consider is that if a market experiences a record-breaking and sustained run-up, it can sometimes occur without widespread participation by small traders and investors.  And without large scale participation among retail traders the psychology of a bubble is lacking, i.e. there is no bubble.

The latest rally in the major stock market averages has once again fueled talk of a mania for equities in the popular press.  As discussed in previous commentaries, though, there is as yet no evidence of widespread direct participation in the equity market by small investors.  Much of the movement behind the rally to new highs is courtesy of institutional activity, with the public participating only indirectly via retirement savings funds.  Nowhere to be seen is the incessant preoccupation with day trading, swing trading and stock picking which were symptoms of the last two bubbles. 

One explanation for this startling lack of bubble psychology despite the all-time highs in stock prices is the K-wave.  Readers of this commentary should be familiar with this most basic of all long-term economic cycles, which answers roughly to the 60-year equity market cycle.  The K-wave deflationary descent bottomed in 2014 based on the Kress cycle count.  K-waves are often divided into four sections or “seasons” with each section being assigned a season of the year (e.g. winter, spring, summer, fall).  The following graph was devised many years ago by P.Q. Wall and does an admirable job of describing the K-wave seasons.

If we assume that K-wave winter season ended in 2014, we’re now in the early phase of K-wave spring.  Early spring can easily be confused with winter due to the occasional freeze or snow storm that sometimes happens during the transition period between the two seasons.  But as the season progresses the signs of new life and warmth that always accompany spring gradually become more evident.  In that same vein, the last couple of years might easily have been confused with winter due to periodic outbursts of deflation in the global economy.  Yet we’re starting to see unmistakable signs that K-wave spring has truly sprung, even in the weakest performing foreign markets. 

To take one example, China’s stock market is starting to show renewed signs of life after being in a bear market the last two years.  China has also recently begun trying to increase its economic growth by providnig plenty of credit.  As Dr. Ed Yardeni has observed, “During January, total ‘social financing’ rose by a record $542.3 billion.  That’s not on a y/y basis, but rather on a m/m basis!  On a y/y basis, social financing totaled $2.7 trillion over the past 12 months through January.  Bank loans, which are included in social financing, rose $335.7 billion during January m/m and $1.8 trillion over the past 12 months.”

The emerging markets have experienced a similar rebound along with several euro zone markets.  As the U.S. leads the rest of the world out of global recession, there can be no denying that the K-wave is beginning to work its spring-time magic.

The aggressive policy stance by China’s central bank has led to worries that China’s real estate and stock markets may soon experience another bubble.  This in turn has added to fears that the U.S. will soon experience another bubble event in the stock market.  This need not concern us, however, since painful memories of the credit crisis are still strong enough among central bankers to prevent a bubble from forming, let alone get out of control.  Even China’s last taste of an equity market bubble ended prematurely when frightened policy makers quickly tightened money and credit in fear of the consequences. 

Now let’s assume for a minute, though, that a bubble was allowed to form in the U.S. equity market this year.  Would this be such a bad thing?  Considering that the biggest advances in technological progress and development, to say nothing of widespread prosperity, have occurred during bubbles it’s easy to answer that question in the negative.  While the naysayers focus on the negative aspects of a bubble’s implosion they neglect to mention that even after the inevitable popping, society is still immeasurably better off than before the bubble began.  Indeed, a bubble might be just what is needed to put the U.S. economy back on the right track for vigorous growth.   

It should be added that when it comes to economic policy, it’s always best to err on the side of too much growth than on too much austerity.  The events in Europe of recent years serve as a stark reminder of this fact.  Thus whenever fears of a bubble are discussed, it would do policy makers well to consider that the benefits of a loose monetary policy always outweigh that of a tight one. 

Probably the biggest argument used by the bubblemongers right now is the chart of the NASDAQ 100 Index (NDX).  This chart can easily be used to justify the fear of an incipient bubble, yet the investor psychology and mass participation factors are curiously missing right now. 

Before we arrive at the bubble stage, we should see increased interest bordering on obsession among small investors as the stock market becomes a primary focus among the masses.  As this hasn’t yet happened, the inescapable conclusion is that the long-term bull market hasn’t reached bubble proportions yet and therefore has a ways to go before expiring.    

Tuesday, February 14, 2017

The bull market no one believes in

The stock market continues to make new highs, yet none of the signs which accompany a market bubble are evident.  Investors are asking, “When will the Dow finally correct?”  By “correct” they mean “decline.”  However, a market correction doesn’t always entail a decline for the major averages and can sometimes take the form of a lateral consolidation or trading range.  That appears to be the case for the 2-month period from December through early February when the Dow and S&P made little headway.

In fact, in January the Dow Jones Industrial Average (DJI) recorded its tightest trading range of only 1.1% in over 100 years.  This continues a prolonged sideways pattern in the Dow and other averages since mid-December when the post-election rally reached a plateau.  The question everyone was asking was whether this plateau was merely a temporary “pause that refreshes” in an ongoing rally or the end of the rally and the prelude to another market setback.  The Dow provided the answer to that with the last week’s breakout above the top of the trading range ceiling.  It has rallied each day since, putatively on the hopes generated by President Trump’s forthcoming tax-related announcement.

While the bull market in equities continues, a surprising number of investors are either mistrustful of the rally or outright bearish.  According to a recent article in BBC News, there are a growing number of wealthy and politically liberal U.S. citizens who are doing things in the wake of Donald Trump’s election that were commonly seen by politically conservative citizens during the Obama years.  That is, they are buying guns, becoming survivalists, and preparing for an impending catastrophe related to the Trump presidency, the article reported. 

It was also reported that a number of wealthy Americans are preparing for what they believe is the apocalypse.  According to Business Insider, some have purchased underground bunkers while other wealthy individuals are planning to emigrate to New Zealand.  “Saying you’re ‘buying a house in New Zealand’ is kind of a wink, wink, say no more,” said Steve Huffman, CEO of the Reddit web site.  “Once you’ve done the Masonic handshake, they’ll be, like, ‘Oh, you know, I have a broker who sells old ICBM silos, and they’re nuclear hardened, and they kind of look like they would be interesting to live in.” 

The common denominator in these accounts is fear among the upper class.  The dread of an uncertain future which was pervasive among America’s middle class for much of the last eight years has now been transferred to the upper class.  While it might be premature to ascribe this to the recent rush back into gold, bond funds and other safe-haven investments, it would seem that there is just enough uncertainty among the upper crust to account for the lack of movement in the major stock market indices since December. 

Tight, narrow trading ranges in the major indices are launching pads for major moves in either direction.  In the context of a bull market, they typically represent rest and consolidation before the next move higher.  The odds technically favored this outcome, yet a substantial number of investors still don’t believe in the strength of the bull market.  This is reflected in the manifestations of fear among the upper class mentioned above, as well as in the path the market rally is taking. 

There is talk among some observers that the market is undergoing a “melt-up”.  This is an erroneous application of that term.  A classic melt-up is characterized by a runaway, almost straight-up and sustained market rally on high volume with widespread participation.  The trajectory of the major indices since November can hardly be described as “melting up.”  Rather, the market’s path has been measured and well-ordered, as the daily chart of the NYSE Composite Index (NYA) attests. 

The real melt-up phase of this bull market hasn’t even started yet.  We’ll know it has arrived when we see runaway stock prices coupled with increased participation among the legion of retail investors still on the sidelines.  Even institutional investors are surprisingly tempered in their usual optimism, as expressed in their collective 2017 forecasts.  Melt-ups have a way of surprisingly even the bulls in how high they carry the market averages before peaking.  For now, though, a combination of fear and cautious optimism holds sway among investors and this alone is enough to argue that the bull market still has legs.

Monday, February 6, 2017

The danger of being bearish in a bull market

One of the biggest contributors to losses for traders in the financial market is the temptation to sell short.  Borrowing shares of a company that are not owned by the seller in the hopes of making a massive profit has shipwrecked more traders than probably any other factor.  With stories abounding of the quick and easy profits to be made in selling stocks which are supposedly on the verge of plummeting, it’s no wonder that the allure of “shorting” is so irresistible to so many. 

Selling short is a simple enough proposition: place a short sale order with your broker for a company whose shares you believe are overvalued or technically “overbought”.  Then just sit back and wait for the profits to start rolling in.  If only it were that easy!  The trouble with selling short is that in most cases the odds are against the short seller.  This is due to a number of factors, some of which we’ll examine here. 

Perhaps the biggest risk for short sellers is the crowded short trade.  A high-profile example of what happens when too many traders pile into a single stock on the short side occurred recently – a cautionary tale if ever there was one.  It involved the loss of one man’s entire fortune due to a misguided attempt at selling short one of the most widely traded U.S.-listed stocks.  It’s a textbook case of what can go wrong when attempting one of the most dangerous of all trading maneuvers. 

According to MarketWatch, Canadian investor F.S. Comeau bet his last $249,000 against Apple Inc. (AAPL) in an attempt to reclaim $2.5 million lost in poor investments.  At the time of the trade, shares were valued around $122, and MarketWatch reported that an increase of just $6 would deplete Comeau’s savings. 

Apple shares screamed higher last week when the tech giant released an impressive Q1 earnings report and Comeau lost substantially.  As of this writing, AAPL shares had risen to a 52-week high of $130.50.

Before Apple released its earnings report, Comeau, who live blogged his reactions while wearing a wolf mask, acknowledged the capacity of investors aware of his short position to fade his trade.  “With 14,000 people watching, you guys could really mess with me,” he said.  When the company released its report his reaction was terse but poignant: “Oh, no.”

YahooFinance described Comeau’s reaction to Apple earnings as follows: [Comeau] kept howling.  And crying.  And throwing his pre-popped, celebratory champagne bottle.  There was a timeless stretch of blank camera stares, and then the sound of dry heaving. With mask still on, he pulled out a trashcan, and vomited more than his life savings.”

This misguided trader can perhaps be excused for his desperation born of inexperience.  What’s inexcusable, though, are the far more experienced trading advisors who gave assurances to their followers that Apple was a prime short-sale candidate despite all the technical and fundamental evidence to the contrary.  This misleading advice undoubtedly led to many hundreds of traders making the same mistake as Comeau. 

More than anything, the Apple experience provides a wonderful cautionary tale for all would-be short sellers.  The lesson here is that in an established bull market it’s best to avoid selling short altogether.  Trading against the prevailing trend is especially dangerous when one considers that short interest can quickly reach critical levels, thus the slightest bit of contrary news can catalyze a massive rally.  Short-covering rallies tend to involve wealth-destroying upside gaps, as the latest Apple stock experience proved.  These gaps are products of the urgency among short sellers to exit the trade.  They frequently represent losses on an unimagined scale.

Since naked short selling involves borrowing, the debt component of this trade ensures that the volatility factor will be greatly magnified vis-à-vis buying outright.  While this can sometimes work to a trader’s advantage in a bear market, it can prove catastrophic in a bull market.  The best policy is to avoid shorting unless a major bear market is underway and downside momentum has been thoroughly established.  Even then, your timing must sometimes be perfect. 

In a bull market the trend is truly your friend, and trading against the grain is usually a fool’s errand.  Best leave that to the men wearing wolf masks.  

Thursday, February 2, 2017

Financial Sense News Hour

I was recently interviewed by Cris Sheridan of the Financial Sense Network (  The interview can be downloaded at the following link:

In it we discuss the possibility that 2017 will witness an extreme "blow-off" in the stock market followed by a major sell-off later in the year.  Special thanks to Cris and everyone at FSN.

Why stock market analysts will be wrong about 2017

We’re already a month into New Year and there has been an ample amount of sentiment data to suggest that investors, both retail and institutional, aren’t terribly enthusiastic on the stock market outlook for 2017.  Granted that institutional analysts are still bullish, as per usual, but in the round table type opinion polls I’ve seen they’ve apparently lowered their expectations.  Everyone seems to be preparing for a somewhat disappointing year based largely on the assumption that after eight years of a bull market, surely another major rally is out of the question.

The decennial rhythm we discussed in an earlier commentary argues against these diminished expectations.  Indeed, seventh year of the decade tends to be one of unusual volatility for stock prices.  While it’s true crashes, corrections and panics are quite common in the seventh year (e.g. September 1987, October 1997, February/August 2007), the seventh year also sees a pronounced tendency for sustained rallies in the first seven months of the year.  Accordingly, 2017 could be a year filled with tremendous opportunity for making money in the stock market – in both directions. 

For 2017, the 10-year rhythm equates to 2007.  As you recall, 2007 was a momentous year characterized at once by great volatility alternating between great fear and euphoria.  It was the year that saw the last major stock market top and also the onset of the credit tsunami which overwhelmed the market the following year.  If the decennial pattern holds true, 2017 should witness both a meaningful rally to new all-time highs as well as a decline of potentially major proportions.  In short, it could turn out to be a big year for the bulls as well as the bears.

As for the idea that the bull market is getting “long in the tooth” and has therefore exhausted its upside potential, consider that the previous two years could well be characterized as a stealth bear market.  The major large cap indices essentially went nowhere in 2015-2016 while the Russell Small Cap Index (RUT) experienced a 25% decline.  That’s a bear market by anyone’s definition. 

Retail investors have also been quite pessimistic since 2015 in the overall scheme of things.  From the start of 2015 up until the election, more than $200 billion was pulled out of U.S. equity funds and ETFs, while a bit more than that was funneled into bond funds and ETFs.   That two-year stretch of risk aversion, however, is apparently ending as investors have gradually embraced more risk tolerance since the election.  Since the election nearly $46 billion has flowed into U.S. equity funds, while nearly $3 billion has left bond funds, according to money flow statistics.

The evidence strongly suggests that the past two years served the purpose of clearing out the excesses generated by the long-term bull market which began in 2009.  In other words, the market is rested and ready to resume its potential as we head further into 2017.

Another concern among investors is that the rise in interest rates since last year could stifle the stock market’s upside potential.  While it’s true that sustained periods or rising Treasury yields have often proved a hindrance to higher stock prices, there is an exception to that rule.  According to LPL Research, there have been 11 periods of rising interest rates (at least a 1% rise in the 10-year Treasury note) since 1996, each lasting an average of six months.  During those times, the S&P 500 rose an average of 5.44%, thus proving that in the early stages of rising interest rates stocks and yields often rise simultaneously.

We’re at a point in the long-wave credit cycle where interest rates are ready to rise after being depressed for years.  According to K-Wave theory, after the 60-year economic cycle bottomed in 2014 we should see a gradual increase in rates as the economy recovers its former vigor.  Of course this process will take a long time to complete – possibly decades – but we’re likely at a point in the newly formed 60-year cycle where even a temporarily sharp run-up in rates won’t damage the economy or even necessarily hinder the stock market.  In fact, rising rates at this point indicates increasing demand for credit and a corresponding improvement in the economy. 

Following is a 10-year chart of the 10-year Treasury Yield Index (TNX).  The double-bottom in the interest rate is clearly visible between the years 2012 and 2016.  I believe this marks the long-term low in interest rates for the previous long-term cycle.

As long as rates don’t rise too high, too fast it’s very possible that stock prices will rise along with Treasury yields without much interference along the way.  An added bonus to the rally in T-bond yields is that bond prices are now in a downward trend.  This should serve to discourage investors who piled heavily into the bond market in the last few years.  It should also cause them to look more closely at stocks as a long-term investment once again, especially as painful memories from the 2008 crash gradually wear off.  The underperformance of corporate debt vis-à-vis equities should also encourage investors to take a second look at the stock market.  Below is the 1-year graph of the Dow Jones Corporate Bond Index.

The bottom line is that 2017 should see an increase in business activity across the board as the U.S. returns to a normal business cycle after being artificially suppressed by the actions of central banks for years.  Moreover, the decennial rhythm suggests that except for a period of potential weakness in the August-October time frame, year 2017 will likely prove to be a memorable one especially from the standpoint of the upside potential in both the equity market and the U.S. economy.