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Summary

  • The risk-reward trade-off seems to favor a more cautious approach to the equity markets.
  • We see the potential for 10-15% correction versus perhaps capturing another 3-4% on the upside.
  • Historical precedent should not be ignored by thinking "It's different this time".

Remember the game Musical Chairs? It seems that investors on Wall Street have been playing this game recently, as more and more we are seeing signs that the current bull market may be reaching its final stages. Each new sign that appears represents just one more chair being taken away from the game. The question investors need to ask is "where will I be when the music stops"?

Someone once told me that the key to success in the stock market is to make your money on the way up, but don't give back too much of it on the way down. That seems like a logical approach to building long-term wealth and one that most investors would likely follow, if investing were logical.

However, my experience in the financial markets, over the past 35 years, tells me that people don't invest based on logic. They invest based on emotions. The two most predominant emotions that investors fall prey to are fear and greed.

If you make investment decisions based solely on one of these two emotions you will likely make poor choices in navigating the financial markets. I have always said that the financial markets are nothing more than "emotions in motion"; referring to the psychological aspect of investing. It is important that an investor not only understand their own emotional make-up, but the emotional make-up of the investing crowd, as well.

When I look at the stock market today, I see a preponderance of investors that have thrown caution to the wind, and are willing to ignore the plethora of historical data that suggests that we are closer to the end of a great bull market cycle than we are to the beginning. Oftentimes, Wall Street pundits will use the analogy of a baseball game to illustrate where we might be in a market cycle.

At Altitrade Partners, we believe that we are nearing the end of the game (market cycle), and are probably somewhere in the late innings. If we had to put a number on it, we would probably say that we are somewhere in the 8th or possibly the 9th inning.

I'm going to use another baseball analogy to illustrate how we look at the markets. The best managers in baseball always play percentages. They look very carefully at the history of a particular batter, and how they are likely to fare against certain pitchers (whether that pitcher is a left-hander or right-hander). They also look at the frequency in which certain batters will hit the ball either to the left side or the right side of the field.

Today, baseball managers are utilizing a defensive strategy known as "the shift"; moving the infielders to the side of the field where the batter tends to hit the ball most often. Sometimes, a batter will go the opposite way, but the longer-term percentages will ultimately win out over time. If a batter usually hits to one side of the field 80% of the time, it is likely that he will continue to hit to that side of the field 8 out of 10 times.

The risk, for the manager using the shift approach defensively, is that the batter will go to the opposite field and get a hit. That, however, will occur, at most 20% of the time, using our example above. At Altitrade Partners, we like to be on the side of winning percentages, especially when there is historical precedent to guide our decision-making.

It is said that the four most dangerous words uttered by stock market investors are "It's different this time". We heard it in the run-up to the great technology bubble of 2000 and countless other historical stock market peaks. When this happens, it is a clear indicator to us that investors have traded a logical perspective for an emotional one. It is just one of the red flags that we look for to signal that we may be close to a market top.

We are not market-timers. In fact, we hold fast to the belief that no one can consistently call market tops and bottoms. Most of the famous market prognosticators that have had a major market call have never had another one. Just think about people like Henry Kaufman, Joe Granville, Robert Prechter and Elaine Garzarelli. All of these individuals made highly accurate, historical, market calls, but were never able to repeat the feat.

Instead of attempting to time the markets, we want to put ourselves on the side of playing the percentages. We want to position our trading accounts based on whether we believe the market is likely to head higher, or turn lower, over the next 12-18 months. I wouldn't call it predicting as much as I would call it preparing.

At Altitrade Partners, we are preparing for a decline in the stock market based on the historical indicators that we follow, including technical data, and investor psychology.

A look at our Facebook posts over the past few months will give you an idea of what we have looking at to develop our market strategy moving forward. I won't go through every single chart and graph that we have posted, but will concentrate on a few that we believe are especially important.

First, let's get an historical perspective on the current bull market in terms of duration and return over the past five years, and compare that to other bull markets going back to 1932.

As you can see from the chart below, we are approximately 266 weeks into the current bull market, which started in 2009. The average bull market, since 1932, has lasted about 165 weeks. There has only been one other bull market that lasted longer; a record 406 weeks, beginning in October 1990.

Now let's look at the returns achieved in the current bull market cycle. Again, going back to 1932, the average bull market during the past 82 years has returned 113% to investors. The largest percentage gain was the same bull market referenced in the duration chart above, which returned a whopping 302%, followed by the 1932 bull market which returned 195% over its duration. The current bull market has returned around 175%; making it the third best overall.

(click to enlarge)

To summarize; we are currently 61% above the historical average in duration for bull markets since 1932 and 55 % above the average historical return over the past 82 years.

Another important indicator is investor sentiment (one of our psychological metrics) as measured by a few different data points. First, we look at the VIX, or volatility Index. We are currently in the low 11's. The only other times we had VIX readings this low were in 1994, 1996, 2006 and 2007. Each of these readings was then preceded by a spike in volatility, and lower stock prices.

The VIX seems to be pointing to chronic investor complacency, and a lack of respect for equity investment risk. Just one exogenous event can change all of this in a New York minute. Black swan occurrences historically have appeared when nobody expected them. The types of tail-risk events that could happen in today's environment include a China hard landing, a geo-political crisis in Russia or the Middle East resulting in an oil-shock similar to what we experienced in the 1970's, the Federal Reserve being perceived as behind the recent pick-up in inflation and/or a gaffe in unwinding their bloated balance sheet, or even an unforeseen currency or sovereign banking crisis. While all of these are long-shots, they are being discounted far too heavily by today's investors, even to the point of a zero probability.

This lack of fear, coupled with excessive borrowing on margin to buy stocks, and investor willingness to reach for yield may be setting us up for the perfect storm. Add to this the fact that trading is down some 38% from levels of just four years ago, and the lack of liquidity in some areas of the market, particularly some corporate, government and municipal bonds, and you have a recipe for a potential disaster. What we may be experiencing right now is the proverbial "calm before the storm".

One of the problems, especially during the summer months, when there is very little trading is that panic can spread like a wildfire out of control. All it takes is a few big sales in those thinly-traded securities, and prices can collapse very quickly. That is what happened last summer, when municipal bonds sellers looking to dump their holdings were hard-pressed to find any buyers for their paper. Forced-selling led to panic, and prices cratered. The flash crash of a few years ago also points to how quickly the market can experience a severe vacuum on the downside.

Recently, for a string of 46 days in a row, the Standard and Poor's 500 index failed to see an intraday move of greater than 1 percent up or down; a state of serenity which we haven't seen since 1995.

We have also been experiencing an unusually long time where the S&P 500 Index has not had an intraday move of 2% or more over the past three years. This chart compiled by Credit Suisse illustrates the historical movement in the SPX over each year since 1990. We have had only 22 days over the past 3 years, when the S&P 500 moved in a range exceeding 2% for the day. After a similar lull in 2004, 2005 and 2006, volatility returned to a more normal pattern. We expect to see the same before 2014 comes to an end.

Another indicator that we pay close attention to is the CBOE Equity Put-Call Ratio. The current reading shows extreme optimism and recently has registered a level that is lower than 99% of its historical readings. We believe this is unsustainable for any long period of time.

Yet another interesting chart shows the seasonal tendency of the VIX to rise during the months of August, September and October; especially dangerous times for stocks.

Lastly, the most recent Investors Intelligence numbers show an unusually high number of Bulls vs. Bears; measuring extreme optimism from an historical perspective. We use this as a contrary indicator.

It's not just technical and sentiment indicators that are flashing a warning sign. Some fundamental indicators are also pointing to lower equity returns in the future based on the length and breadth of the current five year bull market. For example, looking at the current Shiller CAPE (Cyclically Adjusted PE Ratio) of 25.88 against its historical mean of 16.53 and median of 15.92, it appears that returns for the S&P 500 during the next five years may be paltry.

(click to enlarge)

While none of these indicators, in and of themselves, provide meaningful insight into where the equity markets may be heading, we believe that taken together they make a strong case for the odds of a stock market correction between now and the end of the year.

Like the baseball manager analogy, we believe that one needs to play the percentages. Based on historical data, we believe that the market will encounter significant headwinds in the not-too-distant future.

It may be time to put on "the shift" and move from an aggressive position to a more market neutral portfolio weighting, or for those investors who can take considerable risks, sell short and/or buy put options.

Remember, the key to building long-term wealth in the stock market is not to give back a significant portion of the gains made during a bull market. Protecting those gains becomes a primary goal when it appears that a regression back to historical norms is likely to result in negative returns for some period of time.

The question is, where will you be when the music stops?

Disclosure: The author is long SPXS, TECS. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

The opinions expressed herein, are exclusively those of Altitrade Partners. We do not provide investment advice, and do not offer buy and sell recommendations on any securities mentioned in our reports. For additional information about Altitrade Partners, including our full disclaimer, we invite you to visit http://www.altitradepartners.com/Altitrade_Partners/Disclaimer.html

Source: Investors Are Playing Musical Chairs. Where Will You Be When The Music Stops?