Market Perspective for 11/13/13
Current Conditions
I suppose after the analogy I used in our Quarterly Perspective I should call this Lion Watch. There are few issues I’m especially concerned about:
- Valuation – Value Line’s estimated 3-5 year appreciation potential (35%) is as low as it was at market tops in 1987, 2000, and 2007. This is best interpreted as their best case scenario. For reference, at market lows (2002, 2009) this measure was over 100%.
- Sentiment – As I’ve stated before, margin debt exceeds the peaks of early 2000 and 2007 (though not yet on a percentage of market capitalization basis). See Figure 1.
- Sentiment – IPOs are up more than 50% over last year (which, if you recall Facebook, was a pretty good year itself). IPO activity tends to be greatest in the latter stages of a bull market.
Figure 1
Retrieved 11/13/13 from www.advisorperspectives.com: NYSE Margin Debt Rises to a New Interim High
That said, those concerns just aren’t moving the market at this point. John does a report periodically that takes a “deep dive” into market technicals to see what the market is telling us. And for the most part they continue to tell us the market wants to go higher. We monitor this very closely, and when we see some negative divergences we begin to wonder whether or not it heralds the end of the bull market. But so far, the market has always swiftly recovered. To date we have not seen enough consistent “risk off” behavior to suggest the upward trend has been broken.
Tapering
At some point the Federal Reserve is going to have to taper. When that happens, both bonds and stocks are probably not going to do well. I would use the analogy of having ones cake (plentiful liquidity) and eating it too (rising stock prices). We keep eating and the Fed keeps bringing more cake. We all know that at some point the Fed is going to stop bringing cake and soon after that all the cake will be consumed and investors will have cause for sadness. Bonds are the proverbial canary in the coal mine in terms of how we will know that point is at hand. The big bond sell-off last Friday (11/8/13) on the back of the fairly strong employment report should give stock bulls a little pause. Sure, there will be some asset allocation moves from bonds to stock in the near term, but the higher rates go, the less attractive stocks are. Tapering is a “lion” that we KNOW is lurking out there, but we just don’t know if it will attack anytime soon.
Strategy
It is in my nature to be willing to be early and forego some profits rather than be late and experience sharp losses. The problem is, three months early is probably acceptable to most people, especially if the resulting drop is steep. Twelve months early, on the other hand, is generally not, especially if the market rises 30% during that time. With stocks up close to 25% so far this year, it is reasonable to want to take some profits[1]. Yet securities never go down solely because they get too expensive. Something changes in the narrative such that where once people believed that demand (and prices!) would be higher tomorrow, now they no longer possess that confidence. For example, the bond market believed the Federal Reserve was on hold for the foreseeable future due to global economic weakness until May 22, when the Fed said that it could foresee tapering their bond buying activity. The economic impact of a $10 billion monthly taper (from $85 billion per month to $75 billion) is almost negligible. The changing of the narrative, however, from low rates as far as the eye could see to the beginning of the long slow march back to normalized yields, was devastating to the bond market.
Today I am holding my ground in stocks. Though I see a lot of things that make me uncomfortable from an anecdotal standpoint, I am not ready to get defensive. I want to see the “whites of the eyes” of the next downturn so to speak. I want to know what the narrative is (why people will believe prices are likely to be lower in the near future rather than higher). I want to know if it is driven by profound economic weakness (that greater liquidity cannot overcome) or perhaps a reduction in liquidity due to economic strength, because that will dictate how I will reposition portfolios.
A caveat – the vast majority of Trademark’s investors care about relative returns, so what I have described above is what we believe is the most sensible strategy for those investors. For those whose priorities are more suited to absolute returns (making at least a small amount of money no matter what the markets do), a strategy that relies upon waiting for the stock market to break down technically and fundamentally and for the narrative to change will not work, as getting defensive would occur after the peak had been reached. Those investors would probably benefit from getting more defensive immediately. (You should contact your financial planner if you feel you’re an absolute versus a relative investor and we can discuss changing your current allocation.) There is always the question of where do you redeploy the proceeds of your sales, but market veterans will tell you that if the market is truly over-valued you ultimately won’t regret holding cash.
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