The Triumph of Greed Over Fear
It took less than one week for U.S. equity benchmarks to continue their parade of record daily closes after hitting an air pocket on May 17. Last Wednesday’s one day wipe-out on the S&P 500 (-1.8%) and Nasdaq- 100 (-2.5%) felt like a rush to exits was beginning. The news of the appointment of an independent counsel to investigate the Trump administration’s ties to Russia, with some in Congress brandishing the possibility of impeachment, seemed like a legitimate threat to the “Trump rally”. The VIX volatility index spiking +20% reinforced the notion that fear was returning to markets. However this week we saw that greed reaffirmed its dominate position among investor emotions. No one wants to (or perhaps no one can afford to) miss any equity upside gains.
Have U.S. equities become a martingale? That is, a sure bet. Even if most investors still recognize that there is downside risk in equities, buying any form of price dip has become an automatic winning trade. Call us old fashioned, but we are just too skeptical in buying a price dip, whatever the narrative provoking the selling. When we see a sharp daily sell-off, like seen last Wednesday or on March 21 st , which broke below the trading ranges on the S&P 500, our first instinct is not to reach for the falling knife (as we can imagine most investors can relate to). This situation reminds us on a recurring scene from Charles Schulz’s “Peanuts” comic strip. Lucy offers to hold the football for Charlie Brown to kick. Each attempt to kick the football ends up with Charlie Brown flat on his back after Lucy pulls the ball away. Yet each time Charlie believes in Lucy’s coaxing and that “this time is the one”, the long awaited opportunity to finally kick the football. Prudent investors waiting for a normalization of equity market have had to utter “good grief” many times these past years after a sharp sell-off has resulted in a slingshot rally. Consider this first “measure” of complacency versus fear. The S&P 500 has a streak of 232 consecutive trading sessions without a 5% drawdown from the peak – the longest such streak since 1996 and the sixth longest since the inception of the S&P 500 in the 1950s.
While a market correction almost never occurs when a large number of investors are anticipating (or hoping for) a drop in stock prices, it’s hard to imagine that many big money players (fund managers, sovereign wealth funds, even central banks these days) are holding back at this stage. If a fund manager is not 100% in equities by now, for example, we doubt that more expensive equity prices will draw him/her into equity markets. Perhaps a deeper equity market correction will be needed at this stage to pull cash off the sidelines. But this is logical reasoning…emotions play a strong role in investment decisions and even professional investors breakdown and throw everything in when prices seem like they won’t fall. And this is why equity bull markets peak in a buying climax.
We updated two versions of our margin debt charts below. Margin debt, or borrowing money to invest more than the nominal value of a portfolio, is a classic warning sign at the end of bull markets. Margin debt also provides the fuel to accelerate a market decline as leveraged investors and funds are forced to close positions as they slip underwater. Data through the end of April shows that NYSE Margin Debt relative to GDP is once again above the ratio peaks in March 2000 and October 2007. A true long-term investor would only want to engage in buy-and-hold positions when the ratio falls at least below 2%, and preferably below 1.5%.
In the next chart we create a “real” measure of margin debt, normalized for inflation, and compare it to real household income. With this ratio now at record highs, we can surmise that greed is at an extreme.
The ratio of blue chip S&P 100 stock to riskier small cap stocks comprising the Russell 2000 is another decent, market-based metric of greed and fear. We calculated that 89% of the S&P 500 gains since the 2009 low have occurred when the S&P 100 has been in a relative downtrend compared to the Russell 2000, as shown by the red 50-day moving average line in the chart below. The 50-day moving average of the ratio of these indexes has passed an inflexion point in recent weeks. As long as small cap weakness persists, it is unlikely that equities will charge higher.
Finally, we noted in our Commentary, “The S&P 500 or The S&P 495”, that just five stocks have been driving large cap index gains. Another classic sign we tend to see at market tops is narrowing leadership. Our last chart looks at the percent of stocks on the NYSE closing above their 200-day moving average (blue curve). Two points of interest. First, the percent of stocks above their 200-day moving average recently peaked on February 21 st at 72.3% (currently at 57%). In other words, the U.S. equity gains since mid- February have occurred with narrowing participation. Second, comparing the percent above 200 curve to the NYSE Composite index price index (red curve), we see that the two major corrections in this bull market occurred when the percent above 200 has formed a negative divergence with the index price.
In the very near-term, risk-on sentiment remains healthy, but below the extreme readings our Composite Market Risk Indicator showed in the weeks following the U.S. election. We doubt that equities are currently at a sentiment top.
Conclusion
We are dealing with a bull market on steroids, built on central bank asset purchases and inappropriately low interest rates. Some have speculated that about 800 points on the S&P 500 are attributable to central banks. That’s a lot of air under the market. Greed today has been driven, to a large extent, by faith in the ability and willingness of central banks to administer financial markets. Nevertheless, we do not believe that “this time it’s different”. Central banks can neither eliminate economic recessions nor create a permanent plateau of prosperity in equity markets. Indicators such as margin debt shown above and valuations will triumph in the end. In the meantime, financial market distortions continue longer than anyone could have expected. For those buying equities today, heed these trader words of wisdom: “If stock prices fall a little, go ahead and buy. If stock prices fall a lot, then sell”.
