Why The Bull Story Is Still Bull

During my morning reading, I ran across an interesting article from Jeff Reeves via MarketWatch giving nine (9) reasons why the stock market will “do nothing but go up this summer.”

He states that investors should stop worrying about a downturn in the stock market and stick with U.S. stocks because the economic data is encouraging. While his points are valid, but very debatable, it is critical to remember that the stock market and the economy are two different things. This was a point made by my friends at Alhambra Partners yesterday:

“The bottom line is that GDP growth today doesn’t necessarily mean stock price growth today – GDP growth and stock returns are not highly correlated. In fact, some analysis suggests that they are negatively correlated and perhaps fairly strongly so (-0.40).”

Most-Interesting-Man-LongHowever, it isn’t just Jeff Reeves pushing the bullish commentary, but virtually the entirety of the media press. The siren’s song of “stay long my friends” has risen as of late as the market has struggled to gain ground this year. The reasoning for the continuance of the “bull rally” is footed by the common threads of: 1) interest rates are low, 2) corporate profitability is high, 3) economic recovery is stronger than it looks and; 4) global Central Bank interventions continue to put a floor under stocks.

The problem is that each of those points have been artificially influenced by outside factors. Interest rates are low because of the Federal Reserve’s actions, corporate profitability is high due to accounting rule changes following the financial crisis, and the Fed’s liquidity program artificially inflates stock prices. As far as the economy goes, I think it looks like it looks.

While the promise of a continued bull market is very enticing, it is important to remember, as investors, we have only one job: “Buy Low/Sell High.” It is a simple rule that is more often than not forgotten as “greed” replaces “logic.” However, it is also that simple emotion of greed that tends to lead to devastating losses. Therefore, if your portfolio, and ultimately your retirement, is dependent upon the thesis of a continued bull market, you should at least consider the following charts.


I have often visited the point of valuations and the importance of them. However, valuations are often dismissed in the short-term because there is not an immediate impact on returns. Valuations, by their very nature, are HORRIBLE predictors of 12-month returns should not be used in any strategy that has such a focus. However, in the longer term, valuations are strong predictors of expected returns.

The chart below shows Dr. Robert Shiller’s cyclically adjusted P/E ratio combined with Tobin’s Q-ratio. The problem is that current valuations only appear cheap when compared to the peak in 2000. Outside of that exception, the financial markets are now more expensive than at any other single point in history.


John Hussman recently produced the following chart that shows that valuations at current levels suggest near ZERO 10-year total returns. Not exactly the return that most of the bullish media is suggesting will be the case.

“When you look back on this moment in history, remember that S&P 500 returns had never materially exceeded zero over the decade following similar valuations. The following chart presents a historical scatter plot of MarketCap/GVA versus actual subsequent 10-year returns for the S&P 500. The present level is associated with zero subsequent 10-year returns – with no alternate outcomes. Just a cluster of returns at zero or below, and nothing but blue sky above.”



Another argument for the continuation of the current “bull market” remains the “cash on the sidelines” that will come rushing in just any day now. As Cliff Asness, head of AQR Capital, stated:

“Every time someone says, ‘There is a lot of cash on the sidelines,’ a tiny part of my soul dies. There are no sidelines. Those saying this seem to envision a seller of stocks moving her money to cash and awaiting a chance to return. But they always ignore that this seller sold to somebody, who presumably moved a precisely equal amount of cash off the sidelines.”

Cliff, of course, is right. However, the other argument is that retail investors “missed out on the bull market” and will push stocks higher as they move back into the markets. That is not the case either.

The chart below shows the percentage of stocks, bonds and cash owned by individual investors according to the American Association of Individual Investor’s survey.  With equity ownership at the highest levels since 2007, and near record low levels of cash, the individual investor is “all in.”



Of course, with both retail and institutional investors fully committed to equity ownership, it is not surprising to see margin debt at record levels also.

There are two important points to make about leverage.

First, there have been several reports suggesting the “record margin debt is NOT a problem.” This is true only during the rise. Margin debt is a huge problem when equities begin to fall. As I stated previously:

“It is worth noting that when net credit balances have plunged to very negative levels it has been coincident with major mean reverting events in the market.

While ‘this time could certainly be different,’ the reality is that leverage of this magnitude is “gasoline waiting on a match.” When an event eventually occurs, that creates a rush to sell in the markets, the decline in prices will reach a point that triggers an initial round of margin calls. Since margin debt is a function of the value of the underlying “collateral,” the forced sale of assets will reduce the value of the collateral further triggering further margin calls. Those margin calls will trigger more selling forcing more margin calls, so forth and so on.”

Secondly, margin debt is still rising as the “fear of missing out” on potential upside in the market is trumping logic. However, this has always been the case with investors as they chase returns which eventually leads to “buying tops” and “selling bottoms.” This time will very likely turn out similarly.


Let me restate the obvious, the important thing to remember about margin debt is that by itself, it is inert and poses no real danger to the market. However, when combined with the correct catalyst, it will act as an accelerant to a market correction when forced liquidations fuel additional selling. You have been warned.


I have discussed previously the importance of “price” as an indicator of the market “herd” mentality. One of the major problems with fundamental and macro-economic analysis is that the psychology of the “herd” can defy logical analysis for quite some time. As Keynes once stated:

“The markets can remain irrational longer than you can remain solvent.”

Many an investor have learned that lesson the hard way over time and may be taught again in the not so distant future. As shown in the chart below, the momentum of the market has decidedly changed for the negative. Furthermore, these changes have only occurred near market peaks in the past. Some of these corrections were more minor; some were extremely negative. Given the current technical setup the latter is rising possibility.



The deviation of the S&P 500 and the Wilshire 5000 from their respective 36-month moving average is at levels that have only been seen at four other periods previously. Importantly, that deviation has begun to decline as markets advanced towards their pre-correction peaks. (Noted by red arrows)


Equity Outflows And Portfolio Protection

Lastly, according to latest data from ICI, equity flows have turned negative over the last two months.


Those equity outflows, and bond fund inflows, suggest market participants are becoming more risk averse. This “risk hedging” has also shown up in the number of managers taking on portfolio hedges which has risen to the highest level since 2008 (chart via BofAML.)


It Is What It Is…

I really don’t care much for the “bull/bear” debate that ensues on a daily basis as both camps are eventually wrong. When investing in the markets “it is, what it is” and it is of very little use that some pundit or analyst was “right” during the bull market if they never saw the bear market coming. The opposite is also true.

As a money manager, I am currently long the stock market. I must be, or I potentially suffer career risk. However, my job is not only to make money for my clients, but also to preserve their gains, and investment capital, as much as possible. This is why, although I am often considered a “bear”, I focus on the “risks” that prevail.

Understanding, and analyzing, both sets of arguments is crucially important to navigating the markets successfully over time. The REAL RISK to investors is not “missing out” on a further rise in the markets, but catching the bulk of the reversion that will wipe out most of the gains from the previous advance.

Hopefully, these charts will give you some food for thought.  Remember, every professional poker player knows how to spot a “pigeon at the table.”  Make sure it isn’t you.