Over the last couple of days I have been focusing on the longer-term risks of currently overvalued markets. The primary problem with valuation measures and fundamentals is that markets can remain detached from reality for much longer than logic would dictate. As Sam Ro pointed out, valuations are a very poor measure of short-term performance. He is right, but as I stated:
"...while valuations do not matter at that moment, they will and when they do they will matter a lot."
But it is not just valuation levels that markets are currently ignoring, but also an ongoing deterioration in economic underpinnings. As I noted on Monday, corporate profitability is currently running at a much weaker pace than originally estimated as the economy failed to gain traction.
Despite hopes of economic liftoff, the reality has been quite the opposite as the "restocking cycle" following a very weak Q4 of 2013 and Q1 of 2014 quickly faded. The economic composite index shown below shows this most clearly.
(The economic composite index is comprised of several Federal Reserve manufacturing regions, Chicago PMI and National Activity Index, NFIB Small Business Survey and the Conference Boards Leading Economic Indicators. It is a very broad measure of the economy and tracks very closely to the ebb and flow of GDP.)
The dashed black line shows the level that has signaled the onset of a recession. It is also worth noting that since the mid-90's, as financial engineering and technology began to change the economic landscape, the growth of economic output has deteriorated. This is the basis of the "structural shift" argument that currently plagues employment and wages.
However, for today's discussion, it is important to note that declining levels of the economic composite index has been mostly a coincident indicator of weaker stock market performance or outright contractions.
Since the beginning of this year, as the economic composite has declined, the financial markets have struggled to stay afloat. This struggle can also be seen in the deterioration of price momentum and internal strength measures.
As I discussed in detail recently:
"The effect of momentum is arguably one of the most pervasive forces in the financial markets. Throughout history, there are episodes where markets rise, or fall, further and faster than logic would dictate. However, this is the effect of the psychological, or behavioral, forces at work as 'greed' and 'fear' overtake logical analysis.
There have been many studies published that have shown that relative strength momentum strategies, in which as assets' performance relative to its peers predicts its future relative performance, work well on both an absolute or time series basis. Historically, past returns (over the previous 12 months) have been a good predictor of future results. This is the basic application of Newton's Law Of Inertia, that states 'an object in motion tends to remain in motion unless acted upon by an unbalanced force.'
In other words, when markets begin strongly trending in one direction, that direction will continue until an 'unbalanced' force stops it."
As shown in the chart above, the price of the market currently remains in a positive trend but the underlying momentum and strength measures are showing signs of a negative divergence. This suggests that while market prices are trending higher, the risks of a correction are currently rising as the "supports" weaken.
Chris Ciovacco recently penned another piece of relevant analysis:
"It is typical for markets to become a bit fussy when the Fed is on the verge of shifting policy. The stock market has been following the indecisive script. As shown in the chart below, the broad NYSE Composite Stock Index has been quite volatile and moving sideways for nine months."
"As the Fed postures, market participants have been jumping back and forth relative to their preference for more-conservative fixed income instruments (ARCA:TLT) and growth-oriented stocks (ARCA:SPY). If I invested in TLT in July 2013 and you invested in SPY, there would be no winner as of March 2015 (see below)."
"The wild swings between risk-on and risk-off are part of the interest rate cycle equation. Our approach is to implement a “less is more” strategy until the market calms down a bit. Less is more refers to making fewer adjustments to our allocations during binary periods of risk-on and risk-off. For now, we continue to hold an equity-heavy allocation with some offsetting exposure to bonds and currencies...the big picture does not align with 'a bear market is imminent' scenario, which allows for some patience with growth-oriented positions."
Chris is correct in his assessment that the technical bullish trend remains intact for now, and I agree that portfolios need to remain tilted towards equity risk for the time being. However, with valuations and fundamentals not currently supportive of asset prices at current levels, it is clear that investor overconfidence has risen markedly. Since investors repeatedly fall prey to the psychological factors of anchoring, herding and the disposition effect, it will be more important to pay attention to the price dynamics of the market for early warning signs of a change in the currently bullish trend. As I will discuss momentarily, it is the disposition effect that is most critical.
Despite much commentary recently about the needs of individuals to just index their portfolios and focus on the long-term, the reality is that never happens. The "herd effect" is quite apparent as investors cling to the hopes that the markets can turn in a seventh positive return year in a row despite the statistical odds against it. However, as long as markets rise, the "fear of missing out" overrides the logic of the risk management in portfolios.
When the market eventually cracks, the "disposition" effect will trump all the good intentions of "buying and holding" for the long-term. The eventual "panic to sell" will lead to a significant destruction in investment capital and a reversion in investor psychology to extreme negativity. While the basic premise of investing is to "buy low" and "sell high," repeated studies show that there are precious few who do.
Of course, this is the psychological cycle of the market. This time is not different, and the result will be same. It will only the be the timing and the catalyst that are different.
The negative divergence of the markets from economic strength and momentum are simply warning signs and do not currently suggest becoming grossly underweight equity exposure. However, warning signs exist for a reason, and much like Wyle E. Coyote chasing the Roadrunner, not paying attention to the signs has tended to have rather severe consequences.
