Beware The Complacency Of The Crowd

Includes: IWM, QID, QQQ, SPY, TZA
by: Kevin Flynn, CFA

Looking back, I think the only thing that has really changed since last week is an increase in the level of complacency. I am not the only one to have noticed: Zero Hedge did a page that included the very high sentiment readings at the American Association of Individual Investors (AAII) and Investor's Intelligence, along with record high levels of margin debt on the exchange. That was also picked up by economist John Mauldin, by way of the Motley Fool. The danger in elevated margin debt levels is that they exacerbate downturns when they come. Doug Kass passed on many of the same readings.

The market seems complacent as well, rallying sharply in the pre-market on news of an improvement in German factory orders, coming ironically the day after the EU cut its growth outlook for the year. The rally went beyond that of course, going by the traders that appear on the tube these days. It's the usual bull clamor - buy the dips, a fourth-quarter rally is in the bag, another five percent rise in December. Stocks can't lose, because the Fed won't taper unless the economy improves, so either way it's up (historically, wrong on both counts).

The S&P 500 did move up a small amount over the last week, though the change may have vanished by the time you read this column. It could well depend on Thursday's initial estimate of third-quarter GDP, likely to be a market-moving event. I gave some thought to delaying this week's column so that I could report some analysis therein, but elected not to do so because the initial estimate doesn't really merit much in the way of conclusions. GDP revisions can be quite large, and I am still dubious about the second-quarter figure of 2.5% real annualized growth, for it depends on a very low annual inflation rate (+0.6%) that has apparently been found nowhere else but the GDP report. I'll be looking at the nominal figures for both quarters.

If you listen carefully, you can hear many reasons why stocks should continue to rise - the VIX isn't low enough yet, the Fed can't taper until March because the economy isn't good enough (still an odd reason to buy stocks, though no longer surprising), performance-chasing, the lack of retail participation, the increase in retail participation, the desire to mark a new high, the number of shopping days until Christmas. I haven't heard anyone mention earnings except insofar as they are beating estimates, and we all know what a manufactured surprise that is. The fourth-quarter earnings growth that was projected to be about 17% back in January, then 10% at the end of the third quarter, is coming in at about at about 4.5% versus estimates of just under 2%. Weak earnings growth is not a sound foundation for 25% annual stock market gains, not 56 months into a bull market.

There are some technical reasons besides complacency to fear current levels. Next week will make a year that the S&P has not been oversold once on an intermediate basis, not even mildly so. This is unusual behavior - 13 months has been about the limit since the 1990s. The Nasdaq is even more overbought on an intermediate basis, the highest it's been since February 2011, with the Russell also remaining overbought (though to a lesser extent) despite its relative underperformance in recent days (another warning sign). Long-term the Russell is practically off the charts for being overbought, with the Nasdaq the most stretched since the tech bubble and the S&P 500 doing late nineties-style levels as well.

But those are intermediate and long-term conditions, which can last for months, even years. Only the S&P is clearly overbought on a short-term basis (though not severely), with the Russell having fallen back to nearly neutral short-term and the Nasdaq somewhat but not egregiously overbought. I took some limited profits on the inverse small cap ETF TZA I recommended two weeks ago, but am looking to reload if stocks move higher over the next two days. The QQQ short (or long the inverse ETF, QID) I encouraged last week is about unchanged, but I will add to that as well this week if the markets give me the chance. Intermediate conditions change more slowly, but the levels we are seeing are usually followed by 20%-plus drops before the markets regain their footing.

The question is when a pullback of that magnitude might occur, and I don't yet see one as imminent this year. I still say a pre-Thanksgiving fade is more likely than not, especially with AAII readings so high, but it will need some external event to push prices down much past a four or five percent decline. In the meantime, an EU rate cut or Goldilocks-style jobs report could push us higher first. The former isn't very likely, but the latter has a good shot at happening.

The jobs report also has a chance of producing an outlier. The latest report (October) will include preliminary benchmarking revisions, meaning the last seven or eight months are going to be provisionally retallied. Given that jobs are a lagging indicator, there seems a fair chance that the revisions will be positive. Going by the weekly claims reports and the feeling in my bones, a figure under 100,000 seems possible on Friday (consensus is for 120K), while going by the methodology of previous reports, a figure of 150,000 is plausible. An oddity I noticed on Tuesday in the latest ISM non-manufacturing report was that most of the data seemed unchanged except for the ratio of growing to contracting industries, which was nearly a dead heat at 10-8. That's behind part of the feeling in my bones.

Any jobs number between 100K and 140K will be in the Goldilocks zone, and should produce at least a one-day rally in all but the most extended markets. It's not clear to me how the markets will receive a number below 100K or above 150K; the market's presumption seems to be that low is good (because of more Fed easing), but the shelf life on that particular view seems to be getting old.

For now, I've been selling a few winners and buying some S&P puts as a short-term trade. If we finish higher over the next two days, I'll add to all of my hedge positions - TZA, QID, and the puts.

Longer term you don't want to know the size of the hole we're digging for ourselves, but I do think that notwithstanding the usual geopolitical caveats, a new high is quite possible before the end of the year. The chances for that will depend on how much of a fade we get over the next few weeks. The market is half of the way up a blow-off top, and should that come to pass some serious big ugly is going to soon follow. But why worry about it now? First comes the blow-off - maybe - and as for the rest, well, that's next year's problem.

Disclosure: I am long TZA, QID. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.