The 4 Most Dangerous Words In The English Language

 |  Includes: DIA, SPY
by: Bret Jensen


Even with yesterday's decline, the S&P 500 and the DJIA are right at all-time highs.

However, there are signs of increasing risk in the market that should be watched carefully.

Why skepticism is a needed skillset for investors, and why "It's different this time" are the four most dangerous words in the English language.

I have found over the years that one of the traits that has served me well as an investor is to be remain skeptical, while not turning cynical. One must not view the investment world with rose-colored glasses, but one does not want to miss significant investment opportunities by being overly pessimistic.

I read through dozens of analyst reports a day in search of one or two good ideas a week. I have learned the simple fact is that there are good analysts, there are bad analysts, and the consensus is almost always wrong. Luckily, with new technology, it is easy to look at any analyst or financial blogger's investment history to determine the accuracy of his/her past calls.

One service I use is TipRanks, which tracks and ranks over 6,600 financial analysts and bloggers to gauge the performance of their past recommendations. The best thing about this service is that it is free, where similar services would have cost thousands of dollars annually just a few years ago. I find looking at an analyst's past record helps me put the proper weight on their current recommendation I am currently reading.

I am also skeptical of consensus economic forecasts, as well as to any calls saying "It's different this time" from financial talking heads. At the start of the year, almost every financial and economic pundit was predicting that interest rates would continue to grind up, like they did in the back half of 2013.

What was going to drive this continued rise in interest rates was an improving domestic economy, with the vast majority of pundits predicting 2014 would finally be the year the economy broke out from the ~2% annual GDP growth level it has performed at over the five years of the weakest post-war recovery on record.

As we know through the first half of the year, this has not occurred. The opposite has happened. Ten-year treasury yields have fallen from just over 3% to below 2.6%. I viewed the consensus economic forecast to start the year with skepticism, and kept my portfolio of high-yielding defensive allocation to Real Estate Investment Trusts (REITs) and energy partnerships others were abandoning late in 2013 as interest rates rose. This was a good call, as these sectors have outperformed the overall market so far in 2014. I have lightened my exposure recently as the result of their outperformance.

I never understood how pundits could predict 3% or better growth in 2014, when the economy could only chug along at 2% with the Federal Reserve providing such extraordinary liquidity support. Expecting the economy to add 50% to its growth rate when the Fed was slowly withdrawing from their liquidity support levels seemed illogical. With the revised first-quarter GDP report that came out this morning, the economy would have to grow 3.5% for the rest of the year just to hit 2% GDP growth for the year.

This was predictable. What was going to change to overcome the impacts of the Fed liquidity withdrawal? Was the administration going to drop some of their anti-business/growth policies? Were the two sides in Congress going to work together to put together a comprehensive tax reform package to boost growth or a sensible infrastructure bill that would actually create "shovel-ready" jobs this time around? Was Europe going to break out of its long-term doldrums to actually post good growth figures? Simply put, I saw and see nothing on the horizon that would offset the Fed and produce 3% or better domestic GDP growth. It has been a good call so far.

The current consensus is that equities should slowly continue to rise and be slightly higher by the end of the year. It is a popular view, with the S&P 500 and DJIA within one percent of all-time highs after yesterday's slight pullback.

Naturally, I am skeptical of this consensus. I believe the risk right now in this market is to the downside. There are three key reasons for my skepticism on equities.


Every metric one looks at show investors are incredibly complacent right now in the market. The volatility index is right at seven-year lows. Stock volume has dried up, and the market has gone more days in a row without a one percent move either up or down than it has in two decades. Monday's S&P 500 intraday trading range was one of the tightest on record. It feels like we could be in the "calm before the storm" right here in the market.

Corporate Actions:

Usually, at this point in a post-war recovery, companies would be making investments in new plants, products and expanding their businesses. This would drive job and economic growth, which would increase demand for companies' products in a sort of virtuous cycle. This is not happening, and explains why job and economic growth have been so tepid since the economy officially left the recession in June 2009.

Instead, companies are employing "tax inversion" strategies and deploying capital in other ways that are not driving job or economic growth like they have in the past. One way that is increasingly popular right now is stock repurchases. S&P 500 companies increased the funds allocated to buying back their own stock by almost 60% year-over-year to just under $160 billion in the first quarter of this year. This is up $30B from the previous quarter and the second-highest amount on record. The only higher quarter in level of buyback activity was the third quarter of 2007. Not exactly a great time to make new investments in the market.

M&A and IPO Activity:

Both IPO and M&A activity are at very heightened levels. The market has over a dozen new companies coming public this week, and global IPO activity as of May was 70% higher than in 2013. In addition, at the current M&A pace, deals could reach $3.5 trillion this year. This would be the highest level of M&A deals since 2007, according to data provider Dealogic. These are canaries in the coal mine. Both IPO and M&A activity peaked just before the market tops in 1987, 2000 and 2007.

After the market has rallied over 40% over the past 18 months on a corresponding ~10% rise in earnings, equities seem ripe for a breather. I think we could easily get a five to ten percent correction over the next few months. I know the "experts" would probably dismiss the concerns stated above. Maybe they would say that the central banks have investors' backs or stocks are the only game in town, and it is different this time. As a skeptic, I would say that "It's different this time" are the four most dangerous words in the English language. I have found when pundits agree that it is different this time, that this has about the same chance of being accurate as the phrase "I am from the government and I am here to help you".

So what should an investor do with this skeptical short-term market outlook? I can only illuminate my current actions. Within my own portfolio, I have a higher-than-normal allocation in cash. I have also sold covered calls against most of the growth positions within my portfolio as well. In addition, I am also doing more of short-term event-driven trading recently. I believe this is the best way for me to play this market right now and that better and lower entry points into the market will become available by the end of summer.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.