The Halloween holiday is always one of my favorite parts of the year. A time when we all celebrate the things that terrify us the most, cavort in fantastical costumes, and delight in our imaginations like children. The last year’s market behavior appears to be leading investors to conclude that markets only go up, downside risk no longer exists, and that market selloffs are just a fictitious boogeyman. Even if still lurking in the shadows for the time being, future market risk is a growing concern.
A Twitter-Worthy Executive Summary
Based on market behavior/sentiment, market selloffs will never be a problem again. Abnormal investor complacency cannot go on forever.
Almost everything in life has some level of normal, with occasional extreme abnormalities. As an example, take a football team that normally scores about ten points on average per game, then suddenly demolishes an opponent by scoring forty-two points in a single competition. That single game would be considered an abnormal outlier and something none of us, even the most diehard fans of the team, should expect to be repeated the following week. It is far more likely to see that team resume its prior normal scoring pattern than repeat that extreme performance. Investment markets are no different. They have their regular behavior and then occasional extreme outcomes. It may not be readily apparent or reported in most major media outles (especially with all of the current daily political drama) but we are living in extreme times for investors, which has resulted in historic levels of investor complacency. For instance, we are currently at a record number of months without a small -3% correction (i.e. value loss) in markets.
Similarly, it has been almost a record amount of days since a greater -5% correction in markets.
Market corrections are a normal part of market behavior and should be expected, not feared. As stated earlier, their absence is abnormal and it should not be expected to continue. Another abnormality, and sign of complacency, is that average daily change is at one of the lowest levels ever. Since 1928, only 1964 had lower daily change in the markets. Even the average daily volatility is abnormally low, coming in at 0.30%, which is lower than any year since 1928 with the exception of 1968.
The worst peak-to-trough correction is just -2.8% this year with the next closest being -3.3% in 1994. It’s worth noting that years of unusually small drawdowns were not repeated and were followed by increasingly volatile market environments.
On top of this extreme lack of volatility, we also have abnormal levels of positive monthly outcomes. Every single month this year has been positive, and going, “back to 1926 there's never been a calendar year without at least one down month1.” A calendar year pertains to January through December of any given year, but we can find past examples where there have been 12-months of back-to-back gains. There has also never been 13 positive months in a row, which would mean if November ends positively, we would have a new all-time high number of positive months and yet another market abnormality. If December is as well, then two major records will have been broken.
It should not be too surprising that the string of monthly positive outcomes and lack of market volatility is leading to high level of investor optimism (sentiment) in the Ned Davis Research Crowd Sentiment poll. Unfortunately, high levels of crowd sentiment are a historic contra-indicator and have correlated with a forward year (i.e. 12-months from now) average loss of -4.81% in the past.
This complacency is also evident in the Chicago Board Options Exchange VIX Index, commonly referred to as the market’s “fear gauge.” The VIX, which tracks the ratio of put/call options has never been lower than it is today, which represents extreme investor optimism and/or greed. Periods of past low VIX levels have been associated with major market tops, like that of 2007.
All of this complacency would be much less concerning if market valuations weren’t also near historic highs.
Recent months have seen most major news outlets trumpeting seemingly daily reports of new market highs. One of our favorite measures of valuation, the Shiller CAPE Ratio, is at levels not seen since the late 1990s Dot-Com boom. As the chart below shows, the current Shiller CAPE level is higher than any other period of time since the 1880s, including the market peak before the Great Depression.
Another example of valuations being at extreme outlier levels is the total market capitalization to US national GDP (reportedly one of Warren Buffet’s favorite indicators). Like Shiller CAPE, this metric is at high valuations associated with previous market tops.
In addition to the valuation story, the current rally is very old at 102-103 months long. The average bull market (a period of market gains without a -20% sell-off) is just 54 months.
When searching for reasons for why there is so much abnormality in investment markets, we can find no more likely culprit than global central bank activity.
The chart below demonstrates the very strong correlation between the value of the S&P 500 (the red line) and the growth of central bank balance sheets since 2002. The big question for the future is what happens if central banks reverse course on their expansionist policies in tandem, as is currently being suggested by those leading these central banks (with exception) considering this strong correlation with investment markets. What happens when they pull the party’s punchbowl away?
A removal easy money economic support is indeed expected to a significant level in the coming years. Looking into just next year, many market analysts are expected to see a major reduction in central bank support and balance sheets to between $500 billion - $1 trillion.
All of the above topics are not just scary Halloween stories, they represent and suggest very real and rising risks to the marketplace. Even the mighty investment universe must heed the law of reversion to mean. Outliers cannot carry on forever and the greater the abnormality, the more likely the reversion will be fast and violent. Fortunately, our CWM Performance Targeting System (PTS®) is designed to help us control our behaviors during times of either irrational exuberance, fear, or abnormality. Ensuring we are taking proper precautions when warranted and caution is currently called for based on the above and other evidence.
Our CWM PTS® metric currently stands at 1.69 as of 10/24/17. This does not guarantee a market sell-off or crash is near, only that risks are now elevated for markets. At this level we can be highly confident that stocks are more likely to underperform bonds/non-correlated investable assets over the next couple of years, though nothing is ever guaranteed of course. As it stands, the current 1.69 indication suggests we should remain overweight to bonds/non-correlated assets versus stock investments.
Though there is potential for stocks to move higher still, current valuations reflect a high and rising probability of a negative outcome, a risk we are striving to mitigate for our clients. CWM PTS® models continue to be invested conservatively, as they have been for some time. Your CWM team will continue to be disciplined in our efforts to provide the best risk adjusted returns possible.
Please pass this article on to any one you know who may be interested in or might benefit from the information. We are always looking for more great clients just like you and would welcome any opportunity to assist them.
If you have questions or comments about the above subjects or other investment topics, I would love to have a conversation! Feel free to email me at MorganA@CWMnw.com or if you are interested in more regular financial tidbits, follow me on Twitter.
P.S. Sooooo doing this to my kids… Happy Halloween everyone!!!
1Carlson, B. (September 13, 2017). The S&P 500 is up every single month this year. Twitter @wealthofcs
*The PTS Metric is a historical comparative analysis of the S&P 500 and Long Term US Treasuries
This article has been prepared and distributed for informational purposes only and is not a solicitation or an offer to buy any security or investment or to participate in any trading strategy. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice as individual situations will vary. For specific advice about your situation, please consult with a financial professional. Past performance is no guarantee of future results.