3 Things Worth Thinking About

Courtesy of Lance Roberts of STA Wealth Management

No Bubble Here

Yesterday, I reviewed some the longer term macro trends of the markets noting some deterioration that should give rise to some concern. However, the bullish trends currently remain intact which suggests that portfolios remain more heavily tilted towards equity exposure for the time being.

Shortly after posting my analysis, I received an email of the following chart with a title that simply stated: “I do not know why anyone is talking about bubbles…”

Nasdaq-Biotech-NoBubble-092514

There are a couple of important points to consider:

First, a quick scan of the entire biotech sector gives me 262 companies with a total outstanding share float of 15.8 billion shares. The average daily trading volume of all of these companies combined is just a bit more than 190 million shares a day. Consequently, if a major correction begins and sellers emerge, more than 50% of all shares are owned by institutions, it will take approximately 83 days to clear all of the outstanding shares.

In other words, the “meltdown” in the biotech sector could be extremely large given the current “parabolic” extremes that exist.

Secondly, is the ongoing bullish spin that the current market is in no way similar to (insert previous crash year here.) This is something that I have addressed in the past stating:

“This ‘time IS different’ only from the standpoint that the variables are not exactly the same as they have been previously. Of course, they never are, and the result will be ‘…the same as it ever was.’”

It is true that valuations for the broad markets are not as high as they were in 2000 or 2007, but they are pushing overvalued territory.

What is clear is that the stage is set for a major market reversion that will most likely coincide with the next economic recession. The question that we must answer is “when will it occur and what will be the trigger?” Unfortunately, we will only know those answers in hindsight.

For the majority of investors who have a fairly short time horizon to retirement, it is naïve to think that a “buy and hold” passive approach to portfolio management will serve you well. The risks are clearly rising and simply ignoring those risks will not make the result any less painful.

Everyone Is A Genius In A Fed-Induced Stock Rally

That last point brings me to Michael Sincere’s always brilliant work wherein he states:

“At market tops, it is common to see what I call the “high-five effect” — that is, investors giving high-fives to each other because they are making so much paper money. It is happening now. I am also suspicious when amateurs come out of the woodwork to insult other investors."

Michael’s point is very apropos. When markets go into a relentless rise investors begin to feel “bullet proof” as investment success breeds confidence.

The reality is that strongly rising asset prices, particularly when driven by artificial stimulus, will “hide” investment mistakes in the short term. Poor, or deteriorating, fundamentals, excessive valuations and/or rising credit risk is often ignored as prices rise. Unfortunately, it is only after the damage is done that the realization of those “risks” occurs.

As Michael states:

“Most investors believe the Fed will protect their investments from any and all harm, but that cannot go on forever. When the Fed attempts to extricate itself from the market one day, that is when the music stops, and the blame game begins.”

In the end, it is crucially important to understand that markets run in full cycles (up and down). While the bullish “up” cycle last twice as long as the bearish “down” cycle, the damage to investors is not a result of lagging markets as they rise, but in capturing the inevitable reversion. This is something I discussed in “Bulls And Bears Are Both Broken Clocks:”

“In the end, it does not matter IF you are ‘bullish’ or ‘bearish.’  The reality is that both ‘bulls’ and ‘bears’ are owned by the ‘broken clock’ syndrome during the full-market cycle. However, what is grossly important in achieving long-term investment success is not necessarily being ‘right’ during the first half of the cycle, but by not being ‘wrong’ during the second half.”

The markets are indeed in a liquidity-driven up cycle currently. With margin debt near peaks, stock prices in a near vertical rise and “junk bond yields” near record lows, the bullish media continues to suggest there is no reason for concern.  

 SP500-MarginDebt-Yields-092514

However, as the support of liquidity is being extracted by the Federal Reserve, they are simultaneously getting closer to tightening monetary policy by raising interest rates. Those combined actions have NEVER been good for asset prices over the long term.

Housing Sales Closely Tied To Mortgage Rates

There was quite a bit of “hoopla” yesterday over the rise in new home sales as a sign that “economic recovery” was still intact. However, it is important to remember that people buy “payments” rather than “houses” and as a consequence the direction of interest rates has much to with the demand to buy new or existing homes.

First, let me provide just a brief bit of context about yesterday’s data point on “new home” sales. The headline release of 504,000 new one-family homes sold is a bit misleading as it is an annualized number. In actuality, it was just 41,000 which isn’t nearly as exciting of a number. More importantly, let’s put this number into some context to history.

Homes-New-092514

The number of new homes sold is currently at levels that have historical been near recessionary lows, not six years into the economic recovery. This is particularly disappointing when you consider the billions of dollars thrown at housing through HAMP, HARP and other bailout initiatives.

With that context in place let’s take a look at the recent surge in new home sales with respect to the level of mortgage rates.

Housing-Activity-MortgageRates-092514

As you can see when interest rates have moved up, the demand for “buying” has quickly evaporated for a couple of reasons.

  1. Psychology – buyers have been trained that abnormally low-interest rates are now the norm so if mortgage rates rise much above 4% they pull back on purchases to await a lower interest rate.
  1. Ability – as stated above buyers are very sensitive to the level of payment. If rates rise, so do their monthly obligations which impair the ability to “afford” the payment. This is why subprime auto loans are now back to 2006 levels as buyers can only afford cars that are stretched out to more than 70 months.

The recent decline in mortgage rates “sucked” buyers off of the sidelines to purchase a home. However, as I discussed at length in “Bulls Should Hope Rates do not Rise” the impact of the Federal Reserve hiking interest rates could have an exceptionally quick negative impact on economic growth.

The is little argument that the current trends could last longer than reasonably believed, which is why we currently remain invested in the markets. However, it is inevitable that things will change. The problem for most is that by they time they recognize that the underlying dynamics have changed it will be too late to be proactive, only reactive. This is where the real damage occurs as emotional behaviors dominate logical processes.

Did you like this? Share it:
About Ilene

Speak Your Mind

%d bloggers like this: