Equity markets, or markets in anything for that matter, have a manner of moving in such a direction as to maximize the number of fools and the level of frustration among the population of investors. The “pain trade” is real and it’s been in full effect since last fall. Markets are melting up again this morning on a reasonably decent employment number in the US, pushing the S&P 500 further into new high territory and eliciting cries of, “Why!” or “What’s so good about these numbers?? The economy stinks!” or “But, but, the market is massively overvalued!” or “This earnings season have been terrible!” The reactions are valid to a certain extent. A 165K non-farm payrolls handle combined with 7.5% unemployment would have generated unimaginable amounts of hand-wringing during an economic boom period like the 1990s if there were some way to transport Twitter and blogs and today’s mass media back to that era. Nominal GDP in the US is running at a 3.5% to 4.0% clip, very weak by historical standards. Real GDP in America is barely above stall speed. Europe remains in recessionary limbo. China’s GDP is slowing and leaders there are spending time how to navigate a very tricky transition from a capital intensive manufacturing economy to one more services oriented. Long-term P/E ratios, as we’ve discussed in our chartbook and other blog posts, are significantly stretched in the US and near to slightly above historical median levels in overseas markets. Based on Bloomberg’s data, this revenue is flat to down year over year for the S&P 500 companies that have reported; earnings growth is barely above zero. Reading the financial press can be a heartburn inducing exercise.
But, and this is an important “but”, fundamentals are only one part of a story over the short and intermediate term. Over the long-term or very long-term, fundamentals usually win. John Maynard Keynes, however, famously pointed out two truths: “In the long run, we are all dead,“ and “The market can stay irrational longer than you can stay solvent.” Other factors figure prominently in market action. Liquidity, sentiment, psychology, central bank action, geopolitics, perception, and many more factors are a part of the brew. We are witnessing this now. On the sentiment and psychological front, we pointed out two weeks ago that individual investor equity market sentiment figures in the US remained near levels seen at bear market bottoms even though the S&P 500 was probing new highs. It’s improved slightly since then, but remains in negative territory. We observed that this was probably an indication that individual and institutional investors are significantly underexposed to equities relative to historical precedent. Anecdotal evidence backs us up on this. While flows have improved this year, many billions of dollars have exited equity funds over the past several years, flowing into fixed income and money market products. Granted, equity ETFs captured a bunch of the flow as well; nonetheless, according to Leuthold Weeden, from 2007 to approximately the end of Q3:2012, ETF inflow combined with equity mutual fund outflow netted to negative $150 billion. Pension funds and other institutional investment vehicles have exposures to equities now that fall far below levels seen over the past two or three decades. The pessimism continues, too. As the Financial Times reported a few weeks ago, “UK Pension Funds reject ‘cult of equity.’” According to the article, 41% of UK pensions expect to reduce their exposure to UK equities in the next 12 months while 28% plan on reducing their exposure to global equities. Using data from Pensions & Investments, corporate pension funds equity exposure in the US is at the lowest levels witnessed over the past three decades. From 1984 to 1994, exposure averaged about 52%. This increased to near 64% from 1995 to 2000. The initial stages of the secular bear dented this somewhat, but not much; equity exposures in the period leading up to the 2008 crisis were just south of 60%. Currently, equity exposures are in the mid-40s range. Fixed income has swallowed up a good portion of the asset allocation flows. In a world of 2% yields and underfunded pensions, this has to be a nailbiting period for many institutional managers.
It’s times like these with markets grinding higher and individuals and institutions underinvested that irrational, performance-chasing behavior can really catch a spark. We’re not making a prediction that markets are going to go on a parabolic upward rampage here, nor are we saying that we’re about to embark on a 1990s like run with near 20% annualized returns. On the contrary, we’re still a bit cautious about annualized returns over the next 10 or 15 years relative to the historical record. Momentum is important, though, and tends to push counter intuitively against the herd, at least in the early to middle stages of a cyclical or secular bull market. Cracks appear in the damn. Eventually, institutional managers and individual investors say, “Darn it, I can’t take it anymore, I’m all in!” Unfortunately, these timing decisions prove regrettable. Again, as shown above, exposures to equities and sentiment reached their highest levels just before the 2000 and 2007 peaks. The opposite was true in 2002 and 2009. Interestingly, disbelief remains rampant today, even after a few years of decent returns, especially in the US. To reiterate, this could be the kindling that keeps markets grinding higher, contradicting the news flow, and confounding many.
There are a few quick lessons to draw from the global equity rally over recent quarters:
- Market performance and news flow are almost always disconnected. Just because headlines scream, “Out! Out! Out!” doesn’t mean markets are ready for the fall. The opposite is true. Positive news flow on the new economy, for instance, reached a peak in 1999 and early 2000, just before markets began a secular bear journey. Memories dim—with 20/20 hindsight, many say they definitely saw the late 2008 collapse coming--but news flow remained sanguine in early to mid-2008 with talk that subprime was “contained” and that the economy was still on track. The September/October 2008 swoon caught almost all investors completely off guard. Even the Fed remained optimistic through summer 2008 based on a reading of the Open Market Committee minutes. Thus, “What Wall St. knows ain’t worth knowing.” Many experiencing market upside pain now have spent more time worried about backward-looking headlines, and less time understanding Mr. Market.
- It’s helpful to combined technical trading rules with a fundamentals-based investment style. In a world like the present, with fundamental valuation indicators showing overvaluation, but markets moving higher, a technical sensibility could keep you participating in a trending up market. Past episodes have shown that poor fundamental environments (such as 2000) combined with a technical breakdown lead to very poor outcomes. Trading rules can help pull exposures down before the real mess begins. Similarly, in a situation with a decent valuation environment but a declining market, sensible technical trading rules can keep one out of the market until the clouds lift. It doesn’t always help. Some of the whipsaws surrounding the European debt crisis have been painful. However, the point is to recognize and capture (or avoid) the really big moves. Bottom line, during larger secular/cyclical moves, injecting a technical sensibility can keep investors out of the pain trade trap.
