The blow-off top vs. the final top.
Characteristics of the last two blow-off tops.
Positioning your portfolio - and your patience.
Many investors have been wondering and possibly strategizing around the eventuality of a blow-off top in the stock market. The two most important things you should know is that one, we are in it now; and two, don't expect it to look like Nasdaq 1999, because it won't. One of the most common justifications I see for defending today's valuations is that some symptom isn't as excessive as 1999. If your standard for excess is the dot.com bubble, then you are going to get caught by all the others for the next fifty years or so.
Many long-term indicators are at nosebleed levels, and you probably are familiar with some of them - Shiller P/E, market cap to GDP ratio, Tobin's Q, S&P price-to-sales, to name four of the better known ones. They are at or near all-time highs. But they are also long-term indicators, not short-term buy and sell signals. Long-term indicators can remain in extreme ranges for some time, commonly six to eighteen months.
The third important thing you should know about blow-off tops is that in the case of the S&P 500, the blow-off top has historically not been the final top of a bull market, and is usually (though not always - there are no guarantees in this business) succeeded by new highs. The Nasdaq's near vertical up-and-down blow-off top in early 2000 is comparatively rare - but that final surge was one of a kind.
The two linchpins of today's valuations are Fed policy and price momentum. In theory there is a third factor, namely the earnings growth that has been dwelling away off in next year's results somewhere for the last four years now. The growth is going to come as a by-product of the upward shift in economic growth that we have also been awaiting these past years.
The growth lift-off (as opposed to the Fed's policy lift-off) isn't going to happen this year, not after the weak first quarter. Even if we average real growth of 3.5% the rest of the way this year, including the second quarter, we would still finish under 2%.
That won't necessarily bother a rising stock market that is always ready to wash away any bad quarters as transitory while a good data point for a mere week can serve as conclusive proof that the turning point has arrived. What's important, we are told, is the ramp-up we are about to have to better growth. A case in point is the latest IMF report, which cuts this year's estimate for real GDP in the US to 1.7% (it had been estimated at 3% last year). The IMF, like other organizations, is again telling us "wait 'til next year," with a 3.0% projection for 2015 that apparently everyone on Wall Street is buying into (just as they did last year).
The IMF projection crucially depends on the contribution from personal consumption to expand by a third from the 2014 estimate, or from 1.5% contribution to 2.0%. This is founded on the basis of "better balance sheets, rising consumer confidence, and the ready availability of consumer credit." It also mentions the strengthening of the labor market as underpinning growth.
The problem is that all of these conditions have been present for about two years, with no noticeable impact on real income growth, real GDP, or spending. An argument can be made that a tightening labor market will in time boost wages, but I don't see the IMF's projected 5.9% unemployment rate for 2015 - only a couple of ticks better than now - as really causing much pressure on wages, especially with so much of the gain coming from part-time work. The report is also counting on "a healthier housing market" to support "a steady pick-up in residential investment," but the latest data on starts and new home sales show 2014 levels of activity have declined from 2013.
While I don't expect the stock market to suddenly start caring more about GDP data or personal consumption, the failure of the economy to grow as fast as asset prices will in time drag them down after the Fed exits QE. Some of you may be familiar with Dan Hussman's exposition of what is called the Sornette wave. The wave is a log-periodic function, but don't worry, I'm not going to make anyone break out their slide rules or graphing calculators. The gist of the wave is that they characterize the final stages of price bubbles, and are also the steepest part of the rise.
The last two big bull markets (for my purposes, those periods must exclude pesky things like recessions) were 1995-2000 and 2003-2007 (I realize there is an argument that 1994 was part of a longer secular bull, but it isn't relevant for our purposes). In each case, markets rallied at a fairly steady clip before reaching the blow-off stage, in which the slope of the price trendline would steepen dramatically. In the first bull market, this stage began in the wake of the Long Term Capital (LTC) crisis (after the Fed cut rates) and lasted until the end of the third quarter of 1999 (I am talking only of the S&P). The final top didn't come until about six months later.
With the 2003-2007 bull market, the ascent broke away from its long-term trendline in the summer of 2006 - even as the Fed was tightening - with the blow-off portion of the move ending the following summer. and the final top coming a few months later in the fourth quarter of 2007, when the bank began to loosen again.
In the blow-off top of the 1990s, the S&P gained roughly 40% from its LTC trough in late 1998 to the end of the blow-off stage a little more than one year later. The market later peaked in the first quarter of 2000; the funds rate peaked at the end of 2000, then declined dramatically for a year. It was not enough to stave off a recession and stock market crash.
In the current market, we broke out from the long-term trend with the announcement of the third round of quantitative easing, the so-called QE-infinity, in September 2012. That move is closing in on a 40% gain (roughly) over what is now a 22-month period.
The critical part of this is what it means to you the investor. The most important (and reliable) conclusion is that based on today's valuations, the expectations for long-term returns from the stock market are now between zero and negative for nearly any period of more than one year and less than ten years. It also increases market vulnerability to a pickup in volatility, but that works in both directions. Though the ride should soon start to get a little choppier than the recent extreme lows in volatility, there are convincing arguments that the S&P will rise another 10 or 15% from current levels before the final top has been made, with a 10%-plus correction quite possibly mixed in with the trip (there is usually at least one such wobble before the bull finally lays down his head).
There are other blow-off signs blooming, such as this call for multiple expansion that is very reminiscent of 2007 and flies in the face of the fact that about 80% of the gains since the beginning of 2013 are due to multiple expansion (so says UBS). Merger mania is in full swing now, another late-stage symptom, but one that usually lasts at least a good year or so. It's another indication the final top is probably not a matter of weeks (though I'll say it one more time - expect more volatility in the meantime).
One thing to consider with your investment approach is to do what much of the institutional market is doing, shifting towards more defensive sectors (utilities, telecom, and the like) as the markets move higher, a way to build in some safety while not being under-invested. Understand, however, that institutions are playing a relative game. If the next market downturn is a peak-to-trough loss of 40% and a fund has succeeded in losing only 30% with defensive positioning, that would count as a huge victory for the fund. Individuals may not see it that way, especially if they are retired or nearly so.
My own rule of thumb advice for non-clients is to start cutting equity exposure by reducing it 10% with each additional quarter of positive S&P returns. Some advocate all cash, but very few people are capable of watching the market go up for another year or so (it might be three months, it might be fifteen) while they gut it out on the sidelines - that leads to capitulation at the worst time. For aggressive portfolios, you could trim some winners, or simply add some downside protection in the form of puts, covered calls or a very limited amount of short-selling (careful on that last one- I don't expect that the market top is in yet. However, volatility should provide some trading windows).
Many accuse me of being a perma-bear because I keep pointing out the disconnect between the growth in asset prices and the growth in earnings, though I continue to maintain that the market is set to reach higher levels before the party is over. Consider me more of a perma-skeptic who has been around the Street far too long to believe its gushy self-promotion - it is, after all, a production machine at the end of the day - and is genuinely worried what the third crash will do to the mindset of the investing public. Make good use of this blow-off top move, and above all do not fall in love with it. Stocks don't know that you own them.
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.