So far this has been a great year for investors. The US stock market was up 5.6% year-to-date through February and overseas markets are up 4.1%. Bonds, as measured by the Barclay’s Aggregate Bond Index, are only up about three-quarters of a percent so far this year, but annualized that is 4.5%. So we have, in two months, received essentially all from stocks that we should expect in a year if we believe those that have studied valuations levels and subsequent returns, such as GMO and Research Affiliates. As a portfolio manager, I want to believe that there are further gains ahead. Sometimes, however, you get piece of data that makes you feel as though you are kidding yourself. I received this from Goldman Sachs via Heisenberg:
Holy 1929 Batman! This has the potential for a very disappointing outcome. I am aware of how many times I and others have suggested the top must be near because of how expensive stocks have become. Even reaching the 100% percentile, as the median stock has done, is no guarantee that the market rolls over starting tomorrow. But this peak seems different. Stocks did very well in 2013, and they surged again in the third quarter of 2014, the first half of 2015, and again in 2016 after Brexit brought interest rates to fresh lows – but not after any of those events did you have the sense that the bears had thrown in the towel. Investors were still nervous. Today, the narrative of tax cuts and de-regulation as a rationale for further gains is so strong that investors find it difficult to NOT be in the market. Reflecting this, the technical measure of investor sentiment (RSI) has been above 70 for three weeks, which is extremely unusual. This confirms the capitulation to the bullish side. So does a VIX of 11 and near record narrow corporate bond spreads. Apparently, nothing bad can possibly happen right now.
Having established that valuation is scary, investor sentiment (usually a contrary indicator) is off the charts, and market technicals are so good they are alarming, the question is what do the fundamentals say? The fact that earnings are rising and interest rates are low is bullish without question. The sustainability of rising earnings also looks good, at least in the short term. The sustainability of low interest rates is less certain. The Fed meets in mid-March and it appears likely that they will hike rates a quarter point. It also seems more likely that the three hikes scenario – proposed last December but priced out of stocks by mid-February as some economic measures remained sluggish – is back on the table.
It is my belief that the “Trumpflation” narrative is so powerful right now that nothing else matters. Every advisor should be asking themselves what their core strategy is. If it is some variation of “buy low, sell high”, you have to start doing some selling now (they don’t make a percentile above the 100th). If it is “buy relative strength, sell relative weakness” that is fine, but you are setting yourself up for a future where you and the crowd are all trying to get out at the same time. From a client management standpoint this is hard, but shouldn’t it be? Think about it. If you tell your client you believe we should be lightening up on stocks and they say fine, we are probably not at the top. If on the other hand they push back and you feel like they are probably right, then I suggest the top is very close. Outperforming the crowd always involves doing something that they were unwilling or unable to do.
All of that said, there is one thing that troubles me from a “this is the market peak” standpoint: low volatility sectors are not underperforming. The fact that utilities are up 6% or so and the low volatility factor fund (USMV) is up around 6.5% versus the S&P 500’s 7% tells me that a correction may be coming but the ultimate peak is a ways off. At the very, very top of a bull market, you are not only squeezed out of bonds and cash but also the “wrong” stocks.
 Source: YCharts.com as measured by the S&P 500 and MSCI EAFE.
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