Commentary | December 13, 2013 |
Does the cyclical bull market in stocks have further to run, or is a top in progress? The financial press is replete with views on both sides of the question. Is it time for caution in the stock market?
Substantial evidence demonstrates that the Fed’s massive and continuous monetary stimulus – specifically targeted at boosting the stock market among other goals – has been successful, and indeed a major causative of the extended rising cycle in the stock averages that began in March 2009.
Among the reasons we at Sierra remain cautious about the coming year is the unusual duration of this rising phase. From World War II to the end of the Twentieth Century, the stock market declined into a significant bottom in the second year of every Presidential term – with only one exception: The bottom that was “due” in 1986 did not occur, but after the market levitated into the summer of 1987, the sequel was a decline followed by the Crash of 1987. But more typically, the rising phase of the cycles have run about 30-36 months, and the declining phases about 12-18 months.
In our new century, the Presidential Cycle has been disrupted by massive and repeated Fed activism. A cyclical bottom occurred on schedule in 2002, but then Fed largesse led to an extended rise: No decline into 2006, but instead a rising cycle into the summer and fall of 2007 – followed by the largest decline since the 1930’s! (The S&P fell 56% in the following 18 months.)
And now? From the severe sell-off into the lows of March 2009, at this writing the rising phase of the cycle is very long in the tooth – 57 months and counting! Again, various studies have shown how highly correlated this extended rise has been with Fed stimulus, even on a weekly basis.
Can this uptrend continue? Of course. Markets often overshoot both in the rising phase and in cyclical declines. But several metrics demonstrate how extended this bull run has become: Only about 25% of this year’s rise in the S&P is based on actual increase in underlying profit; the other 75% is purely due to increase in the P/E multiple. And based on the current Shiller ten-year P/E of 23.8, the S&P is roughly 25% overvalued.
Valuation, of course, is not a good tool for predicting market tops or bottoms. But coupled with the historical pressure of the Presidential Cycle, and other metrics, our conclusion is that this is a time of unusual risk ahead in stocks.
No one indicator is infallible, so at Sierra we track a number of fundamental, sentiment and “technical” data when we are considering which asset classes we should buy or increase in our portfolios.
In recent months, for example, fewer and fewer stocks are making new highs, the ratio of advancing issues to declining issues is trending weaker, the volume in rising stocks is tending to lag the volume in decliners, and intermediate-term price momentum indicators for most U.S. stock indices have now gone negative. Surveys of advisers, newsletter writers, traders and public investors have been giving extreme readings that typically occur near market tops of at least multi-month significance. Margin debt now exceeds the levels that accompanied the major cycle tops in 2000 and 2007.
In addition, many important indices and stock market sectors have not matched the recent new highs in the S&P 500 and NASDAQ – the kind of divergences that often occur when the stock market as a whole is gradually rolling over.
For example, the Dow Jones Utilities Average made its recent high on November 6, and for the past five weeks has been declining – now down about 6% – and importantly, the Utilities made their high for the cycle (so far) way back in May, and are now 11% lower than then.
The important Oil Services Sector Index peaked on November 15. Thereafter, a number of important indexes peaked near Thanksgiving (November 28): The Philadelphia Bank Sector Index on November 27, the Russell 2000 Index of small-cap stocks on November 29, and both the Dow Jones Transportation Index and the CBOE Oil Index of large, multinational integrated oil companies in late November. Thereafter they have traded lower, even as the S&P and NASDAQ were proceeding to their recent new highs on December 9. (The Dow Industrials has not made a new high since November 27.)
It is also useful to look beyond our borders, since each major risk-on, risk-off cycle tends to become global in scope. The FTSE All-World Ex-US Index peaked back on October 22. EEM, the ETF for emerging markets stocks (priced in dollars), made its most recent peak the same day – but its recovery cycle high was way back in May of 2011. The London Stock Exchange FTSE Average peaked in late October, and Japan’s Nikkei Index on December 3 – and the UK and Japan are the largest stock markets in the world after the U.S. Thus the “headline” U.S. stock indices seem to be the last soldiers standing, unless the coming weeks lead to revivals in some of these other important global groups.
Finally, it is worth noting that the commodity indices (which of course represent baskets of both industrial and reflecting a slowing global economy – a reality that so far the central banks have been successful in leading investors to basically ignore.
Again, none of this conveys any certainty that this major rising cycle is at or near its end, and we do not consider the foregoing as a signal to “sell now”. However, this appears to be a very risky time to put new capital into the stock market, and a good time to tighten up one’s stops.