Greed And Fear Are Constants
Since greed and fear have remained constant throughout human history, asset bubbles are not a recent phenomenon. The Dutch tulip bulb bubble that occurred in the 1600s shared many of the same attributes of the dot-com and housing bubbles. From Investopedia:
The Tulipmania that gripped Holland in the 1630s is one of the earliest recorded instances of an irrational asset bubble. By one account, tulip prices soared 20-fold between November 1636 and February 1637, before plunging 99% by May 1637, according to former UCLA economics professor Earl A. Thompson. As bubbles typically do, Tulipmania consumed a wide cross-section of the Dutch population, and at its peak, some tulip bulbs commanded prices greater than the prices of luxury homes.
Common Traits Of Bubbles
In all three cases (tulip, dot-com, and housing):
How Does The Present Day Compare?
It has been 16.8 years since the end of the dot-com bubble. Have stocks experienced gains similar to the period that ended with the speculative dot-com blow-off peak in 2000? If we compare stock returns in the last 16.8 years to the returns in the last 16.8 years of the tech boom, the gains are significantly different (see bar chart below).
An 18-Fold Difference In Returns
Over the last 16.8 years (2000-2017), the S&P 500 gained 46%, which really doesn’t look anything like the eye-popping 842% gain that occurred in the prior 16.8 year period (1983-2000). The 842% gain represents an 18-fold increase over the 46% gain.
New All Time Highs vs. Consolidation
Bubbles see participants push asset prices to never seen before heights, which is exactly what occurred on almost a daily basis between 1995 and 2000. Consolidation periods are marked by a very low number of new all-time highs (ATM), which is exactly what occurred between 2007 and early 2014. Both graphs below span the exact same number of calendar days (2,286).
Bubble vs. Consolidation
On October 31, 2016, the NYSE Composite Stock Index was trading at the same levels seen nine years earlier. Contrast the “zero progress” look of the nine-year period on the bottom portion of the image below (2007-2016) with the 1,026% gain that occurred during the last nine years of the tech boom era (top portion). The top portion looks like a bubble; the bottom portion looks like consolidation.
Consolidation Can Be Very Relevant
The expression, “the longer a market goes sideways, the bigger the move that follows” applies to the S&P 500 chart below, which dates back to 1925. The orange boxes highlight periods of consolidation marked by a low number of all-time highs. The periods between the orange boxes represent secular trends marked by a large number of new all-time highs. More detailed information on the concepts shown in the chart below can be found in this December analysis. The chart below was created using data from Stockcharts.com.
Do We Have Widespread Participation Today?
It was not unusual to go to a cocktail party in 2006 where 50% of the attendees worked as realtors, appraisers, developers, flippers, etc. It was not unusual to discuss tech stocks with your cab driver in 1999. It was also common to hear “you can’t lose money on tech stocks” or “real estate is a sure bet.”
The percentage of adults that own stocks has been declining since peaking in 2007. Therefore, participation has been on a downswing rather than a bubble-like upswing in recent years. The recent decline in stock market participation may also provide a source for new funds in the coming years, as outlined on January 6.
Are Valuations A Showstopper?
Based on numerous valuations metrics, it is difficult to make a case that stocks are cheap in 2017. However, a recent analysis of P/E ratios at major peaks, major bottoms, and within the context of secular trends says present day valuations, taken in isolation, are not a showstopper for stocks.
Historical Bubbles vs. 2017
The July 2016 description below of the current bull market hardly paints a picture of euphoric market participants with a “it’s different this time” state of mind. From The Wall Street Journal:
The seven-year bull market in stocks still doesn’t get much love. That is precisely why more milestones could be in the offing. The S&P 500 closed at a record on Monday—its first since May 2015 and the 109th of this bull market. Yet the higher stocks climb, the more skeptical investors seem to get, at least judging by where they put their money. That lack of exuberance and the market’s increasing resilience could be exactly what propel stocks in the months ahead. Consider the reaction to Brexit. Investors pulled nearly $8 billion from U.S. equity funds in the week following the June 23 U.K. vote to leave the European Union, the fourth biggest weekly withdrawal of the year, according to the Investment Company Institute.
Ultimately, personal opinions mean very little in the financial markets. Therefore, it is appropriate to leave the 2017 column in the table below blank. Only time will tell.
Is The Watercooler On The Mark For 2017?
As the markets kick off 2017, there are some common themes making their way from watercooler to watercooler. Two of the most common are: (1) stocks are expensive from a historical perspective and thus risky, and (2) if earnings do not improve substantially over the next few years, the bulls are in big trouble. These themes were captured in the January 3rd edition of The Wall Street Journal:
Valuations have risen above their long-term average, prompting many analysts to warn that stock gains could be vulnerable without an upswing in corporate profits. “It’s earnings growth that drives stocks over the long term,” said Tom Cassidy, chief investment officer at Univest Corp. of Pennsylvania’s Wealth Management Division. While “we won’t know if any of these policies will actually be implemented” until later in the year, a rise in earnings typically results in additional stock gains, Mr. Cassidy said.
Are Earnings Really The Primary Driver Of Stock Prices?
It sounds logical and comforting that “earnings drive stock prices”, but is it an accurate and factual expression? If the answer is yes, we would expect the S&P 500 to have a high correlation with earnings. It may be helpful to review what we can learn from correlations. From stockcharts.com:
The Correlation Coefficient is a statistical measure that reflects the correlation between two variables. In other words, this statistic tells us how closely one variable is related to the other. The Correlation Coefficient is positive when both variable move in the same direction, up or down. The Correlation Coefficient is negative when the two variables move in opposite directions. The Correlation Coefficient oscillates between -1 and +1. In general, anything above .50 shows a strong positive correlation.
This Is What A Helpful Correlation Looks Like
Using a rudimentary example to illustrate what a strong correlation looks like, the graph below shows the correlation between the S&P 500 (SPY) and the Dow Jones Industrial Average (DIA). We would expect the two major stock indexes to zig and zig together for the most part, which is exactly what the typically-high correlation shows. All things being equal, if we own the S&P 500, we prefer to see a healthy Dow.
This Look Can Be Harmful Rather Than Helpful
Stockcharts.com tells us a high correlation typically produces figures above .50. What can we learn from the correlation between stocks and earnings? As shown below, the correlation between stocks and earnings is all over the place and does not appear to be particularly helpful in any meaningful way. In fact, you can make an argument that tracking something that often results in a negative correlation can be more harmful than helpful.
!GAAPSPX is trailing 12-month earnings from the period starting 18 months ago and ending 6 months ago (it is actual reported earnings rather than a highly uncertain forecast of possible future earnings). According to Robert Prechter:
“Earnings don’t drive stock prices. We’ve said it a thousand times and showed the history that proves the point time and again.”
Can Valuations Be Helpful Or Harmful As A Market Timing Tool?
This week’s video takes a 100%-fact-based look at P/E ratios looking back 30 years, examining valuations at major market tops, major bottoms, and within the context of established trends.
You may be surprised what we can learn about the various roles played by valuations, earnings, and investor psychology, and more importantly, how those roles may impact 2017. Do the results back up the watercooler theories that stocks are currently overvalued and highly dependent on strong earnings growth in the coming years? You can decide.
The tweet below is a sample of the kind viewer feedback regarding the video above.
Cash Hoarding Era May Be Coming To An End
We can gain some insight into the economic confidence of business leaders by monitoring shifts in investments in plant, property, and equipment. With business leaders anticipating tax cuts, investments in infrastructure, and a more-friendly regulatory environment under the Trump administration, conditions are more favorable for capital expenditures. From The Wall Street Journal:
Despite years of near-zero interest rates that made borrowing cheap, many big U.S. corporations have been hoarding cash or plowing money into safer pursuits in the wake of the recession. Some, like General Motors Co. and railroad CSX Corp., borrowed to prop up pension plans. Others, including Home Depot Inc. and Yum Brands Inc., used cheap debt to repurchase shares. Meanwhile, overall spending on building new factories or upgrading aging equipment languished. That is likely to change soon. “We could be in store for a significant [capital-expenditure] boom,” said Charles Mulford, an accounting professor at Georgia Institute of Technology in Atlanta.
Rare Annual Signal Last Seen Before Secular Turn In 1982
The return of “animal spirits” to both the corner office and financial markets aligns with this week’s stock market video, which covers a very rare annual signal that was nailed down on December 30, 2016. From Yahoo Finance:
“Outside years, as Citi’s chart outlines, are big-time bullish for stocks into the next year. In the last 81 years, there have been only two “outside years” before 2016 (which will meet the standard if the S&P 500 closes above 2,135; it’s currently trading near 2,250): 1935 and 1982. Both of these years were followed by the S&P enjoying double-digit gains — +28% in 1936, and +17% in 1983 — which potentially sets the table for a monster rally into 2017.”
The video covers the importance of what an outside year tells us about market psychology and makes numerous comparisons between 2016-17 and the 1982-84 period. A kind viewer noted on Twitter the time investment to review the evidence covered in the video is “time very well spent for long-term investors”.
Trump Could ‘Ignite Animal Spirits’
How is it within the realm of possibility the U.S. stock market is entering a new secular bull market after consolidating for over 16 years? One theory was covered recently by Bloomberg:
Economic changes under the Donald Trump administration may be more significant than shifts from “the socialists to the capitalists” in the U.K., U.S. and Germany from 1979 to 1982, according to Bridgewater Associates founder Ray Dalio. Comparing Trump to Margaret Thatcher, Ronald Reagan and Helmut Kohl, Dalio said the incoming administration may have a much bigger impact on the U.S. economy than can be measured by tax changes and fiscal spending. The Trump era could “ignite animal spirits” and attract productive capital, the billionaire fund manager wrote in a LinkedIn post on Monday.
Another Piece Of Long-Term Evidence
In recent months, several pieces of longer-term bullish evidence have surfaced, including a signal that has only occurred ten other times in the last 35 years, a clear and factual message about stocks, a reliable contrarian indicator, weekly charts (1982-2016) painting a bullish picture, and a rare reading from a trend-strength indicator.
Signals Assist With Probabilities
No indicator, signal, or piece of evidence can predict a highly uncertain future; they simply provide some insight into the probability of good things happening relative to the probability of bad things happening, which implies bad things are always on the list of possible market outcomes.
Rare Secular Stock Market Signal
This week’s stock market video focuses on a very rare secular signal that has only occurred one other time since 1928.
Small Sample Size
It should be noted the video above covers events with a very small sample size, meaning relying on this evidence in isolation is probably not wise. Therefore, our focus, as always, is on the weight of the evidence.
Our purpose is not to forecast, but rather to understand the facts we have in hand. If the facts change in a bearish manner, which may very well be the case, flexibility will prove to be valuable. It should be noted the first link in this article goes to evidence that was presented on August 20; since then, despite many dire forecasts on Wall Street, the S&P 500 has gained over 4%.
Today’s post, which covers the chart below, can be found on See It Market
Another Bullish Voice
Given many of the charts we have presented over the past four months paint a favorable picture relative to the long-term outlook for stocks, it may be helpful to hear another voice.
In a note to Bank of America/Merrill Lynch (BOAML) clients on December 15, technical research analyst Stephen Suttmeier covered the longer-term bullish case for stocks. From Yahoo Finance:
“Given the post-Brexit capitulation on ‘rates lower for longer’ and the seismic shift to ‘a rising rate environment,’ the current secular bulltrend best fits the 1950-1966 secular bull market,” Suttmeier writes.
“The 1950s was a period of higher stock prices and higher US interest rates. The US 10-year yield bottomed near 1.5% in late 1945 and the S&P 500 remained firmly within its secular bull market until yields moved to 5-6% in the mid 1960s. The S&P 500 rallied 460% over this period.”
The concept of consolidation, one we have covered many times, is also highlighted by BOAML via the chart below.
Is There A Strong Case For A 1987-Style Crash In 2016?
When stocks are making new all-time highs, many are wondering if the markets are setting themselves up for a repeat of Black Monday. On Monday, October 19, 1987, the Dow Jones Industrials plunged 22.61%.
This week’s stock market video addresses the following questions:
- How does December 2016 compare to the period leading up to the 1987 stock market (VOO) crash?
- Is the present day similar to the latter stages of the dot-com bubble (1998-2000)?
- Does the present day look more like the high-risk periods noted above or more like outstanding buying opportunity periods, such as 1982 and 1994?
Investment Implications – The Weight Of The Evidence
While shorter-term momentum has been waning in the stock market, the longer-term outlook, given what we know today, remains favorable. As long as that is the case, we will continue to hold our growth-oriented positions through the inevitable volatility that occurs even within the strongest trends. For example, during the 2013-2015 period marked by a strong bullish trend (see green box below), on 45% of the 600 trading days the S&P 500 posted negative returns. Markets are never easy.