Bullish Bias Continues Into December
The first week of December continued its bullish advance as “bad news” became “good news.”
The announcement by Pfizer (PFE) of supply chain problems was seen as “good news” as it means more demand for Government stimulus.
On Friday, the dismal employment report, with no bright spots, was also “good” as it meant more demand for stimulus.
The problem is that the stimulus does not create organic, sustainable economic activity. Stimulus only pulls forward future activity into the present, leaving a future void to fill. The size and scope of the stimulus discussed will not directly benefit consumers nearly to the degree seen previously. Such would leave the market very susceptible to disappointment.
Nonetheless, as shown below, the markets did break out of its recent consolidation and have pushed to new highs. Such is not surprising, given we are in the midst of the seasonally strong time of year. (The following chart is a modified version from my colleague David Larew @ThinkTankCharts)
The bottom panel of the chart shows a “buying panic” is currently in process. Such does not come without risk. Furthermore, the analysis from Doug Kass is an excellent summation between the media chatter and fundamental realities.
“There is a tendency for commentators, strategists, and others to believe ‘price is truth,’ and to respond accordingly in trading and investing. If one is consumed by the price, it is imperative to recognize the potential pitfalls to that approach and the artificial influences of that price action.
But to me, this is a failing, more so today than ever, and certainly when the market’s are less friendly as passive products and strategies are the tail that wags the market’s dog. One should always question the legitimacy of short term price action, stay independent in view, and avoid becoming overly self-confident and the “Group Stink.”
Currently, the market is extremely “one-sided” as investors chase markets. As I noted yesterday, the number of stocks above their 200-dma is at the highest level seen in several years. Such is not healthy, and previous peaks have consistently preceded “unexpected declines.”
“Fear and greed ebb and flow. Fear, prevalent in March, has been replaced with greed in November.” – Doug Kass
Give Me A Sign
While we certainly want to be opportunistic and take advantage of the markets can give us, we also must remember that “crowds are wrong at peaks and troughs.” Importantly, whatever good news exists, it has already been well “priced-into the market.”
As Doug notes, the underlying fundamentals are likely not supportive of current expectations, which leave the markets vulnerable to disappointment next year.
“As we look out beyond this year and into 2021-22, profit and economic expectations seem too optimistic as a number of small and large businesses have been gutted by Covid-19. The amount of private and public debt that has accumulated over the last year (and 10 years!) will serve as a governor to growth at a time in which the Federal Reserve has little ammunition left and is “pushing on a string.” Indeed, 2021 may mark a reversal of aggressive monetary easing which has been the straw that has stirred the market’s drink.” – Doug Kass
If only there were a sign?
Sign, Sign, Everywhere A Sign.
“Sign, sign, everywhere a sign
Blockin’ out the scenery, breakin’ my mind
Do this, don’t do that, can’t you read the sign?” – Five Man Electric Band
Over the last couple of weeks, we have discussed the more extreme bullish positioning in markets. In this past week’s 3-Minutes video, we went through quite a few charts showing the same.
Yes, there are certainly a lot of signs.
On Thursday, SentimenTrader posted a great chart bringing all of this together.
“For the 1st time in 15 years, 60% of the indicators we track are showing an excessive amount of optimism. An excess of excesses.” – SentimenTrader
In the short-term, the takeaway is that bullish sentiment can, and often does, carry markets further than logic would predict. However, without exception, when “everyone is on the same side of the boat,” a reversion will occur. But that is how markets function over time.
As I discussed previously, the level of speculation in the market is quite rampant as investors have no fear of a market crash. Currently, the speculative call option buying is at a record level, while put buying (a hedge against downside risk) is non-existent. That deviation has pushed the Put-Call Option ratio to a new low.
Again, this doesn’t mean that a market correction is imminent; however, history shows that such extremes have led to short-term corrections or worse. All that is needed is a “catalyst” to start the selling.
For now, it seems as if there is “no risk.” But it is at these periods, where your “emotional bias” is tugging you away from “logic,” that investors tend to get themselves into trouble.
However, there is one thing we are watching closely.
The Volatility Signal
In a market that reaches a point of more extreme complacency, it is not surprising to see volatility drop to lower levels. However, it is when volatility becomes more depressed that the contrarian signal becomes more critical.
As shown in the chart below, the volatility index ($VIX) has troughed where previous mark peaks formed. However, just because a certain level gets reached, it doesn’t mean a correction is immediate. Often, lower levels remain for some time. But, when a “buy signal” is triggered (vertical dashed lines) and volatility turns upward, it has typically been a rapid event.
Also, the volatility signal is more critical when the market becomes simultaneously stretched to more extreme levels. With the market currently pushing a 3-standard deviation extreme from the 50-dma, the “stage is set” for a short-term correction.
Notably, that deviation, combined with a negatively diverging RSI (top panel), and more than 90% of stocks above their 200-dma, is a warning. As the vertical lines show, the combination of these measures has previously aligned with market peaks.
Pulling It Forward
Over the past week, headlines of more stimulus have bolstered the bulls. The current proposal, which will likely get whittled down in negotiations, is $900 billion. Such a bill is far short of the original $2.2 trillion package markets had “bid up” for previously.
There are a couple of problems with a bill of this size and structure. Given the rather sharp economic recovery seen in the third quarter, the stimulus input will have a more muted impact on future activity. Also, given this bill does not have “direct checks to households,” the boost to consumption will be far less.
The idea of “stimulus” also leads to a second premise of “pent up demand.” Since consumers have been “locked down” due to the pandemic, there is a vast amount of “pent up” demand in the system. As soon as consumers are “unleashed,” they will rush into the economy and spend with reckless abandon.
In a normal economic recession, such would likely be the case. However, in this cycle, the excess unemployment payments and direct checks to households led to a spending spree in houses, automobiles, and various services.
In other words, there is likely not as much “pent up” demand as market participants currently expect. If holiday retail sales are any indicator (retail makes up ~40% of PCE, which is ~70% of GDP), then consumers may be more “spent up” rather than “pent up.”
“Black Friday in-store sales down 54.5% YOY, but all Bubblevision wants to talk about is how online was up 21.5%. Total consumer spend last holiday season was $730.7B. Online was only a little over $100B. The 21.5% increase in online is insignificant.” – TheMarketEar
The Instability Of Stability
I previously wrote an article on why the Federal Reserve is so dependent on stability in the financial markets.
“The ‘stability/instability paradox’ assumes that all players are rational and such rationality implies avoidance of complete destruction. In other words, all players will act rationally, and no one will push ‘the big red button.’
The Fed is highly dependent on this assumption as it provides the ‘room’ needed, after more than 11-years of the most unprecedented monetary policy program in U.S. history, to try and navigate the risks that have built up in the system.
Simply, the Fed is dependent on ‘everyone acting rationally.’”
Unfortunately, the record shows that such has never been the case.
Doug Kass made a great point on this issue last week.
“While it is clear to most how far beyond the past norms zero and negative interest rates have taken us, I think that exposition needs to go one step further to be complete. The missing element is the absence of the concept of instability of the current equilibrium created and supported by zero/negative interest rates.
It is important to emphasize that, as well, how enormous the ‘distance’ financially to the next equilibrium point will be once this bizarre instability is finally disrupted – as it must be someday.
The point to be hammered home is how ‘far,’ in financial terms, it is to the more stable and natural equilibrium supported by interest rates that reflect real growth rates.
Here the operative descriptive phrase is a long way down!”
Portfolio Positioning Update
We agree with Doug’s point on instability. When reviewing the market’s more extreme positioning on so many different levels, such is why we have continued to position more defensively over the past couple of weeks.
Therefore, it is at these points in the market, where investing seems like a “can’t lose” opportunity, that “risk” tends to present itself in the most unruly of fashions. It is also at these points where investors get lured away from their investment disciplines to “take on a little more risk.” However, it is there that investors find out they have taken on much more risk than they realize.
Such is why, over the last couple of weeks, we have provided you with investing rules and guidelines. These are the same rules and discipline that we use in our practice.
Do they always work? Absolutely not. However, more often than not, those rules keep you from losing large amounts of capital.
For now, we are carrying higher levels of cash than usual after reducing our bond duration and size and took profits in some of our more egregiously overbought equity positions. Therefore, with better positioning and lower beta, we can wait for the next opportunity to add to our equity risk.
Lastly, we are watching the U.S. Dollar very closely. It is now extremely oversold with a large net-short position. Such is a prime setup for a rather sharp reversal, which would lead to lower prices in commodities, stocks, emerging markets, international6 markets, and bitcoin.
But that is a story for later.