Expect The Unexpected
This past week saw U.S. equity indexes post six consecutive record high closes, adding yet another layer to the post election rally that was already exaggerated by mid-December. This market is now confounding the Bulls in addition to the Bears, as few expected indexes to climb to current levels as rapidly as we have seen. We believe that equity indexes make absolutely no sense today. This past week the CPI and PPI inflation measures came in hotter than expected, showing that inflation is indeed ticking up. Fed chair Yellen, during the Humphrey Hawkins testimony before Congress, said straight out “if we do not raise rates we run the risk of causing a recession”. This is as hawkish as a Fed chairman has been since 2007. That equity markets don’t care now that rates will be rising faster would seem to be indicative of exuberance among traders. The probability of a less-accommodative Fed is not yet enough to derail the rally that Wall Street is billing based on stronger-than-forecasted company (manipulated) earnings and the idea that Trump will “reinvent” the entire U.S. economy. The foundation of this rally is so shaky it’s a marvel that we have seen equity indexes tack on another +15% post-election in an aging bull market that seemed ready to roll over prior to the U.S. election.
One thing that investors have to now deal in this “new normal” is to expect the unexpected. Consider the following:
- In the first half of 2016, financial market experts, economists, and the media were talking endlessly of the catastrophic consequences of Brexit for financial markets. The U.K. voted to leave the EU and all risk assets used the Brexit as a slingshot to move higher.
- Prior to the U.S. election, Trump was portrayed as the worst possible thing for the U.S. economy. The large majority of investors expected markets to tank should Trump win. Markets tanked alright, for a couple of hours.
- The constitutional referendum in Italy at the beginning of December was expected to be a decisive moment for the euro zone. A rejection of constitutional reform by Italian voters was to bring political turbulence to Europe’s third largest economy. Voters indeed rejected reforms, the prime minister resigned, and …markets tanked? No, markets did not care, and the Italian 10-year yield actually fell (why did that happen, Mario Draghi?)
- After a mind-boggling 12% run-up in the Dow Jones Industrial Average from the U.S. election into year-end 2016, investors overwhelmingly began expecting either profit-taking in the new year or a Trump blunder to send markets back down. After over 6-weeks of sideways trading, markets “unexpectedly” broke out to the upside, catching most market observers leaning the wrong way once again.
If investors can retain one lesson from recent market behaviour, it is not to let Wall Street talking heads and the media influence your investment decisions. First, they flat out don’t have anything more to offer than a “best guess” (and the best guess of the consensus is always wrong). Second, do not doubt for a minute that Wall Street banks are talking up their positions (or talking down positions that they would like to buy cheaper). “Pump and dump” is becoming an all-too-frequent practice in equity markets.
Currently, the word on the Street is blue skies for as far out as we can see. The economy will be even stronger under Trump in the future. Earnings will accelerate in the future. The hand-off of the stimulus baton from the Yellen and the Fed to Trump and fiscal spending will continue to support markets in the future. Friends, in the equity markets, the future is now. Equity valuations fully reflect in our opinion this rosy (and still quite uncertain) future. Markets no longer discounts today’s real world economic reality and investors participants have become nothing more than stimulus junkies.
Valuations have always been our guide in the past, but in the new central bank controlled investment environment, company valuations are leading us astray – in the short term. Valuations are being disregarded due to the low interest rate environment. This will prove to a very costly mistake for those buying equities today and turning a blind eye to the price paid for a dollar of company earnings. No one who understands risk can be comfortable in this market. Each day you remain long equities, you are playing hot potato with the inevitable bursting of this extraordinary bubble in U.S. equity indexes. To say that we are dealing with a gambler’s market is an understatement. We suppose that once a significant dip on the S&P 500/Nasdaq does not get bought up, as investors have become all too assured in expecting, that the door will be too narrow with the rush to the exits. What will cause this dip that doesn’t come back up? At this point, we are guessing that a black swan event will be needed to begin inverting the uptrend in equity markets. Warning signs are appearing, such as the combination of rising gold and bond yields. We have seen numerous cases in the past (1973, 1979-81, 1986-87) when these two assets simultaneously signaled inflation and therefore higher central bank policy rates. No need to remind invests how equities reacted during these time frames.
While fundamentally equities have more than priced in all the “good news” that Wall Street is dishing out, technically, we are on the look-out for signs of a reversal. We noted this week in a Daily Update that the Dow Jones Industrial Average just attained its double bottom objective. We measured the height of the double bottom formed by the late 2015 and earning 216 lows and projected this distance higher, as shown on the chart below. Perhaps the latest run-up in February was just a technical move to attain this objective.
On the S&P 500, we took the height of the 2014-2016 horizontal trading range and projected this higher from the point of break-out after Brexit. This gives an objective of 2450, another +4% higher from current levels. If technicians are “expecting” the S&P 500 to climb to this level, we’d remind investors to be prepared for the unexpected and a sharp downturn before 2450. The S&P 500 14-day RSI is at 77 – a historically high over-bought reading. Another 4% would seem overly optimistic.
Conclusion
Market pundits relying on fundamentals, as well as technicians, are unanimously expecting equity markets to move higher. They were also in agreement several times in 2016 that markets should have fallen. We encourage investors not to fall into the trap of listening to Wall Street banks and the media and to make their own, objective investment decisions.
