Stocks Will Rise And The 3 Trades You Can’t Make

My Comments: Once again, the question of a market crash raises its ugly head. And once again, no one has a clue when it will happen.

And once again, as I tell my clients and prospective clients, it really doesn’t matter if you have your money where it can grow regardless of when and how severe the coming crash.

The author includes among his 3 Trades… something you CAN participate in if you have access to the tactical approach to investing that I recommend for all my clients. Some of you know what I’m talking about. The rest of you will have to call or send me an email.

By Lance Roberts   Jul. 18, 2014

I wrote recently that stocks spend 5% of their time hitting new highs while the other 95% of the time investors spend in the market has been making up losses. This is shown in the chart below.
I make this point as I saw a flashing banner across the bottom of the TV screen stating the markets have hit 14 new highs this year alone. While this sounds like an amazing feat, it is actually just a function of being in record territory. For example, assume a dragster sets a record in the 1/4 mile of 7 seconds. The next driver that runs the same strip at 6.999 seconds sets a new record. So forth, and so on. There are two important points to take away from this:
1. When the markets are at a record level, it only takes infinitesimal advances to set new records.
2. Records are attained when previous extremes have been breached which is generally a later stage event.

However, while logic would suggest that current market levels are getting extreme, the “exuberance” created by current price momentum fuels additional gains. As the ongoing “bullish meme” from mainstream media sources and analysts continue to feed individual’s “confirmation biases” the “fear” of “missing out” blinds individuals of the rising risk.

Dr. Robert Shiller recently penned an interesting piece at Project Syndicate stating:
“In recent months, concern has intensified among the world’s financial experts and news media that overheated asset markets – real estate, equities, and long-term bonds – could lead to a major correction and another economic crisis. The general public seems unbothered: Google Trends shows some pickup in the search term “stock market bubble,” but it is not at its peak 2007 levels, and “housing bubble” searches are relatively infrequent.”

Dr. Shiller is correct. The general public seems “unbothered” by the rising risks in the markets despite a variety of warnings recently:

Janet Yellen during in the Federal Reserve’s Semiannual Monetary Policy Report to the Congress: “The Committee recognizes that low interest rates may provide incentives for some investors to ‘reach for yield,’ and those actions could increase vulnerabilities in the financial system to adverse events…In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk.”

Stanley Druckenmiller and Carl Icahn via the CNBC Delivering Alpha conference:
“I am fearful that today our obsession with what will happen to markets and the economy in the near term is causing us to misjudge the accumulation of much greater long-term risks to our economy” – Druckenmiller

“You have to worry about the excessive printing of money. You have to be worried about the markets.” – Icahn

Yet, despite these warnings individuals, as shown below, are as heavily allocated to the markets currently as they were prior to the financial crisis. (Note: there are more charts in the original article which I am not adding here. If you need to see them, here is a link to the original text: http://seekingalpha.com/article/2322275-stocks-will-rise-and-the-3-trades-you-cant-make )

Furthermore, while individual investors are fully allocated to the equity markets, professional investor sentiment has rocketed in recent weeks to astronomically high levels.

While excessive bullish sentiment, low volatility, and a perceived blindness to risk are certainly noteworthy; “irrational exuberance” can drive markets higher in the short term for much longer than most expect.

There is currently a belief that there is no recession on the horizon, that markets are “fairly valued” based on the current interest rate environment, and there is “no other option but stocks.” While these views certainly bolster the near term perspective of being long the equities, which will continue to drive asset prices higher, it is important to remember that each of these dynamics can, and do, change much more rapidly than investors can generally react to.

The chart below shows the annual change in GDP, 10-year interest rates and the S&P 500. It is important to note that prior to every recession that was an instilled belief that “no recession” was on the horizon. It is worth remembering that Alan Greenspan and Ben Bernanke both stated that the economy was doing well…just before it wasn’t.

It was in 1996 that Alan Greenspan first uttered the words ‘irrational exuberance’ but it was four more years before the ‘bull mania’ was completed. The ‘mania’ of crowds can last far longer than logic would dictate and especially when that mania is supported by artificial supports.

The statistical data suggests that the next economic recession will likely begin in 2016 with a negative market shock occurring late that year, or in 2017. This would also correspond with the historical precedent of when recessions tend to begin during the decennial cycle. As shown in the chart below the 3rd, 7th and 10th years of the cycle have the highest occurrence of recession starts.

With the Fed’s artificial interventions suppressing interest rates and inflation it is likely that the bullish mania will continue into 2015 as the ‘herd’ mentality is sucked into the bullish vortex. This is already underway as shown recently in ‘Charts All Market Bulls Should Consider’ which showed individuals are once again piling into stocks and depleting cash reserves in the hopes of ‘getting rich quick.

The 3 Trades You Can’t Make
As a money manager, my portfolio model remains currently fully invested. The problem is that I am grossly uncomfortable with that allocation given the risks that currently prevail. However, as I have stated many times previously, I must follow the trend of the market or I will suffer “career risk” as clients move money elsewhere to chase market returns. This is what I call the “investor duration mismatch.” While investors are supposed to be investing for long-term returns, buying low and selling high, the reality is that their emotional biases make them extremely myopic to short-term market movements. The problem with short-term market movements is that they have NOTHING to do with underlying fundamentals. (Read more on why fundamentals don’t matter.)

The problem for investors today is that the “easy money” is no longer available by betting on stocks going up. Which means there is an opportunity brewing in three areas which, unfortunately, investors cannot actually make.

• Long Volatility (NYSEARCA:VXX)
• Long Bonds (Investment Grade Corporates)
• Short Stocks

The reason I say that you can’t make these trades is that they are a bet on the eventual market reversion. When the reversion occurs volatility will significantly rise, interest rates will decline stock prices drop markedly. The problem is that most investors do not have the patience to let such a “bet” mature. The pressure of betting against a rising market will eventually lead to selling at painful losses.

The current low-volume market, combined with excessive bullish sentiment, sets up a potential for asset prices to be inflated further. As stated, the risks in the markets have clearly risen, but the next major reversion could be many months away. The problem for most, particularly those touting “investing for the long term,” is when the “dip” turns into a full-fledged “decline” the panic to exit the markets will become overwhelming.

Dr. Shiller’s final paragraph summed things up well:
“Those who warn of grave dangers if speculative price increases are allowed to continue unimpeded are right to do so, even if they cannot prove that there is any cause for concern. The warnings might help prevent the booms that we are now seeing from continuing much longer and becoming more dangerous.”

Our memories tend to be much shorter than the damage done to portfolios by failing to recognize risk and managing accordingly.

(My final note: Risk is not something to be avoided; it is something to be understood and managed. If you want to know how this is done, call me or send me an email. – TK )

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