The Great Revolt
April 28, 2016
- S&P 500: 2095.15 (4/27/16 close)
- 200dma: 2014.93
- 50dma: 2026.38
- Price/200dma: 104%
- 200dgr: -2.09%
While on paper I am close to the self-imposed ‘stop-loss’ level on my bearish market bet, I am growing increasingly stubborn with each and every tick higher.
The more information I uncover in my search for proof that we are in the midst of a new cyclical bull market, the greater my conviction grows that we are smack in the middle of bear market territory.
My latest findings come courtesy of a friend who recommended I take a look at Lowry’s – a venerable market research shop with a deeply analytical, objective process rooted in almost 90 years of market history. Their approach is extraordinarily simple, focusing on three core pillars: supply & demand, buying/selling pressure, and market breadth.
In summary, Lowry’s is bearish. Like, hugely so.
Critically, I believe their conclusions are firmly underpinned by fundamentals. Everything comes back to valuation. While favorable economic and monetary macro conditions can trump ‘yuge’ overvaluation for an uncomfortably long period of time, when the ‘technical’ health of the market deteriorates to current levels, valuation becomes a likewise uncomfortable fact of life for market bulls citing a favorable macro backdrop and long-term chart ‘breakouts’ as reasons to remain fully invested.
In summary, I believe we are currently witness to a large-scale valuation revolt against global central banks. Let’s call it, The Great Revolt.
Two simple charts, courtesy of the April 2016 BAML Global Fund Manager Survey.
Equity & Bond Overvaluation
Admittedly, the BAML survey data only goes back to 2003. But I would argue that there has been a reasonable amount of global financial market ‘action’ since then, allowing us to glean some actionable takeaways.
(1) Chart #1 refutes the bullish notion that above average cash balances (also found in the BAML survey, but not included here) are positive for near- to medium-term equity market returns. Global bond markets are so outrageously mispriced that investors would, rightfully so, rather hold 0% to -% yielding cash.
Think about it. Global central banks are stuffing global financial markets into assets one, two, maybe three risk levels above historic norms…yet at the margin, investors would rather hold cash than bonds. Why would those same investors instead put money to work in even riskier equity securities?
When the global ZIRP/NIRP train left the station in 2008, starting with government securities investors gradually moved up the risk chain, concurrently driving expected asset class returns from slightly overvalued/fairly valued (2009-2011) to now outright extreme overvaluation.
During the Revolt, this process should work somewhat in reverse. Due to direct central bank intervention in global bond markets, perhaps bonds will remain ‘bid’ while equities decline; but who knows…maybe everything declines at once, as global participants realize they hold one giant valuation hot potato.
(2) Chart #2 demonstrates that while fund managers behave pro cyclically with regard to positioning, as a group they are remarkably accurate in their valuation assessment. This accuracy spans various asset classes too – for example, well in advance of the USD rolling over in 2016, managers surveyed identified the ‘long USD’ trade as crowded, and the USD itself as overvalued (going by memory on the latter, but pretty sure).
Note the accuracy in the survey’s assessment of 2009, 2010, 2011 and 2012 valuation conditions. If you invested thru those periods, you know how attractive the opportunity set was from a bottom-up individual security standpoint. In my opinion, the bottom-up opportunity set informs survey answers more significantly than a simple broad market valuation opinion.
So per chart #2, you want to do as managers say, not as they do…until now.
(3) The current gap between positioning and the % saying equities are overvalued – the first since 2008 – is the ‘Revolt’. At this point, valuations are at such an overvalued extreme that it largely does not matter what global central banks do. Of course anything can happen in financial markets – we could get a ‘Tulip Bubble’ situation in global equities – but at present investors refuse to buy in to current valuations; a fact that is coming thru not only in this survey, but in fund flow data and buying/selling pressure indices (Lowry analysis below).
So – like 2008, now is not the time to fight the seemingly bullish positioning demonstrated by this survey.
(4) In 2007, valuation experts GMO declared the global financial market to be in one giant valuation bubble, which they define as 2-standard deviations above fair value.
GMO currently believes there are pockets of opportunity and that US equities have a fair bit of work to do to reach the 2-stdev bubble definition (Grantham thinks we get to SPX 2300-2500 before another 50% crash). But per the BAML survey, global investors vehemently disagree.
While down from the 2014/2015 highs, the current assessment is that global equities are materially more mispriced than they were in 2007. As John Mauldin would say, some things just ‘make you go hmmm’.
GMO 7-Year Expected Returns
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To be clear, I am far from a central bank conspiracy theorist. Janet Yellen, and Ben Bernanke before her, is/was not staring at Bloomberg waiting for a dip in the equity market to jump out and ‘ruin’ the natural cycles markets move in…as some market bears would lead you to believe. That thinking, and its ilk, is nonsense.
Central banks are largely forced to respond such as they have due to the enormous weight of debt hanging over the global economy. Yes, they focus on financial market conditions, which involves keeping an eye on equity markets…
But can anyone say with a straight face that central bankers have deleted the corrective/cyclical nature of financial markets? Did we not have two 50% large-scale bear markets in the span of 10 years…and are staring down the third in 20 years?
If you are a fan of markets and market psychology, it does not get much better than this environment.
(1) Their Average Power Rating Index (APR) is based on measuring the strength of buyers in 1,000 key NYSE-traded stocks. At major market bottoms this index breaks 20, signifying large-scale oversold conditions. At the 2/11/16 low, the APR was 36.
(2) In healthy uptrends, buying pressure leads the market. As of 4/22, Lowry’s Buying Power Index had dropped 21 points since 3/18 alongside the broad market rally. Not a sign of a healthy market.
(3) One of the tell-tale signs of an impending bear market is a market advance led by a narrow group of stocks. So, when the NYSE advance/decline line recently broke to new highs, bullish participants quickly jumped to this as a sign of a renewed market uptrend.
As Lowry’s points out, over 50% of NYSE issues are non-operating company issues – bonds, preferreds, converts, etc. As such, Lowry’s created a custom ‘Operating-Companies-Only’ index in order to track true underlying equity strength.
When the S&P 500 came within 1.3% of its ATH in mid-April, Lowry’s OCO A/D fell materially short of its May/July 2015 highs – a worrisome negative divergence for the bullish camp.
To measure underlying market breadth, Lowry’s utilizes a ‘% of stocks 20% below their 52-week high’ indicator. Very simple. And it removes the guesswork embedded within the various back-tested market models. Across time, it is relatively straight forward to analyze, IMO.
According to Lowry’s analysis of bear market history, bear markets move thru the small caps –> mid caps –> large caps pattern, with large cap strength a classic hallmark of the early stages of a bear market. This current market is no different. Small/mid/large % 20% below their 52wh:
- July 2015: 22%, 6%, 3%
- November 2015: 52%, 27%, 18%
- February 11, 2016: 82%, 60%, 48%
- April 20, 2016: 56%, 32%, 16%
At washout bear market bottoms, the total % of OCO issues 20% below their 52wh averages 90-95%. At the February 11, 2016 low this figure stood at only 71%. This figure since 2014:
- July 2014: 14%
- May 2015: 25%
- July 2015: 34%
- February 11, 2016: 71%
- April 20, 2016: 39%
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So while Lowry’s admits the strength of the rally out of the 2/11 bottom has surprised them, this rally is well within the norm of bear market rallies dating back to the 1920’s, particularly when taking into account the very weak breadth and declining buying power.
At bare minimum, this market is a ‘show me’ story with a lot to prove. But with central banks quite literally ‘all in’, and global investors ‘revolting’ against global asset valuations, the risks are skewed heavily to the downside at this point in time.