Eighteen months and 283.97 points ago, I wrote an article entitled “The Coming Market Meltup & 2016 Recession” in which I discussed several reasons for the market to enter into blowoff stage of the bull market advance. I gave several reasons at that time for such an outcome including the statistical probabilities surrounding the Decennial and Presidential election cycles. However, one of the primary drivers at that time was the ongoing Central Bank interventions.
While the Federal Reserve has stepped away from inducing liquidity into the financial system, the ECB and Japan have taken over the foray which has driven capital into the U.S. markets seeking higher yields and returns. These actions remain supportive for equities in the near term and continue to drive asset prices higher even in the light of rather substantial risks.
I was reminded of that writing this morning as I reviewed the ongoing drama of Greece and their rather tiring charade of “debt chicken.” In case you have existed on another dimmensional plane, here are the latest headlines that bring into focus what is currently transpiring.
- Greece’s Ruling Party Goes To War With Its Own Central Bank
- Greece Requests New ELA After Massive Outflows
- Greek Default Is Political Suicide
- Greece Considers Last Ditch Proposals To Avoid Collision
- Greece Spells Out Terms For ‘Debt Crisis’ Breakthough
- Eurozone Welcomes New Greek Debt Proposals
- Debt Relief To Be Discussed After Program Implemented
- Syriza Members Warn Tsipras Against Betrayal
- Whatever Happens – Greece Will Be Reliant On EU And IMF For Years
You get the idea….Greece has become the poster child for the Navy acronym “S.N.A.F.U.”
And yet, even with the threat of a potential systemic debt event on the horizon, stocks have continued to make advances as the “bullish bias” remains firmly intact.
As I discussed in this past weekend’s missive:
“While the rally this week was nice, it failed to break back above resistance which it needs to do to reestablish the bullish trend. Currently, the markets have held the long-term bullish trend line that has remained intact since December of 2012 with two successful tests over the past month. That is bullish for now and indicates buyers are still in the market. However, there is a BATTLE being waged between the bulls and the bears as prices have continued to deteriorate from early-year highs. That battle should be resolved soon, and for now the bears have the advantage.”
“Importantly, notice that the previous OVERSOLD condition in the lower panel is now back to OVERBOUGHT. This suggests that the current rally is likely near completion. This does not mean that the markets can’t rally to new highs, they certainly could. However, the risk, for the moment is to the downside. However, as stated above, the BULLISH TREND remains intact which keeps portfolios allocated towards equities.”
However, while the large capitalization stocks that comprise the S&P 500 have so far failed to breakout to “new highs,” this has not been the case for the more speculative small and mid-capitalization companies. In the past week, both of those indices broke out to new highs with small caps leading the charge.
Of course, there is nowhere more relevant to witness speculative risk taking than in the biotech sector. Since 2009, this one sector is up almost 600% and it was early 2014 when Janet Yellen suggested that this space was “expensive.” With biotechnology marking new highs, it is clear that investors have clearly disregarded that warning.
With investors now fully allocated to stocks, it is not surprising to see “speculative risk appetites” showing up in surges in portfolio leverage.
This is all very coincident with what is witnessed during the third stage of a bull market advance.
3 Stages Of A Bull Market
Cyclical bull markets tend to follow three very distinct stages during its advance:
- Denial – the end of the previous bear market is not believed, and the early advance is heavily discounted as just a “bounce” that will soon fail.
- Acceptance – the realization that the previous bear market has ended but doubts remain about the veracity of the current bull market.
- Exuberance – the belief that the previous bear market was an anomaly and that stocks can, and will only, rise from current levels.
The chart below shows these three phases of the bull market over the past three market cycles.
It is necessary to remember what was being said during the third phase of the previous two bull market cycles.
- Low inflation supports higher valuations
- Valuation based on forward estimates shows stocks are cheap.
- Low interest rates suggest that stocks can go higher.
- Nothing can stop this market from going higher.
- There is no risk of a recession on the horizon.
- Markets always climb a wall of worry.
- “This time is different than last time.”
- This market is not anything like (name your previous correction year.)
Well, you get the idea. However, if none of this sounds familiar, it likely means you weren’t investing during the previous two bull markets. As any good lawyer will tell you – “ignorance of the law is no excuse.”
The markets are currently conforming to historical precedents that suggest investors are becoming desensitized to “risk” as markets seem invulnerable. High levels of complacency have been hallmarks of similar late-stage market advances.
It is quite likely that the markets could very well suffer some minor corrective action this summer. However, I suspect that the current advance will then continue though the end of the year as the “bullish bias” is confirmed. Such confirmation will provide the catalyst for the final advance of a “market melt up” leading to a blow-off peak as the last of investors are drawn into the frenzy.
However, that frenzy, likely in 2016, will collide with reality as the economic and fundamental weakness will converge to spark a much more serious market decline. Such an outcome was also noted by Jeremy Grantham noted in early 2014:
“My personal guess is that the U.S. market, especially the non-blue chips, will work its way higher, perhaps by 20% to 30% in the next year or, more likely, two years, with the rest of the world including emerging market equities covering even more ground in at least a partial catch-up. And then we will have the third in the series of serious market busts since 1999 and presumably Greenspan, Bernanke, Yellen, et al. will rest happy, for surely they must expect something like this outcome given their experience. And we the people, of course, will get what we deserve.”
Lastly, it is necessary to note that “reversions” do not occur without a catalyst. What will that catalyst be? I have no idea and nor does anyone else. It certainly appears that the threat of a global liquidity crunch from a Greek bankruptcy is of little concern and is already factored into the market.
It is the unknown, unexpected and unanticipated event that strikes the crucial blow and begins the market rout. Unfortunately, due to the increased impact of high frequency and program trading, reversions are likely to occur faster than most can adequately respond to. This is the danger that exists today.
Are we in the third phase of a bull market? I don’t know for certain. Most who read this article will say “no” as it fails to support the “bullish thesis.” But such denial was also the hallmark of every previous bull market cycle. Only in hindsight we will know for certain, but for many that could be far too late. I only suggest, as an investor myself, that we should consider the possibility, evaluate the risk and manage accordingly.