After The Fire

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by: Eric Parnell, CFA

Summary

Stocks have entered into a euphoric phase.

Many investors want to participate in the stock market gains, but wish to avoid the subsequent bear market pain.

After the fire, the fire still burns.

"After the fire the fire still burns
The heart grows older but never ever learns
The memories smolder and the soul always yearns
After the fire the fire still burns"

- After The Fire, Roger Daltry, 1985

Stocks keep drumming higher. But the pace of the advance in recent months is starting to take on that familiar look of euphoria we have seen a couple of times before over the past two decades. And with still fresh memories of what has come in the aftermath of such episodes, many investors understandably are feeling a degree of caution about how to proceed with the currently blazing hot stock market. Thus, it is reasonable to consider what we might reasonably expect in the aftermath of today's historically exceptional bull market once it reaches its final peak.

The Fire Still Burns

The U.S. stock market is unquestionably raging. After what was a two-year period of muddling returns from late 2014 through Election Day in November 2016, stocks have since exploded higher. And lately, they have seen nothing short of unstoppable with the classic elbow kink to the upside that is often seen during the final stages of a bull market.

Of course, this is not the first time we have seen such a kink to the upside, as the same thing happened in late 2012 in advance of the beginning of the Fed's extraordinary QE3 stimulus program, and here we are more than four years later with the bull market still going strong.

The Memories Smolder

Of course, we have seen such extraordinary market behavior in the past. Consider the following.

The first was the bull market from March 11, 2003, to July 19, 2007. Despite the various risk signals at the time, including signs that housing market stresses were bubbling their way to the surface, there was little indication if any in the stock market during the summer of 2007 of the troubles that lie ahead.

In fact, not only had stocks on the S&P 500 Index (NYSEARCA:SPY) just exceeded their previous March 2000 highs, as reported corporate earnings had recently just surged to $84.92 per share for the most recently completed quarter ended 2007 Q2, which was markedly higher than the $50.95 per share total during the previous market peak. Moreover, stock valuations were still quite reasonable at the time at 17.7 times trailing 12-month as-reported earnings (and far more attractive on a forward earnings basis, which of course turned out quite different than projections at the time). Overall, it looked like nothing but clear sailing ahead for stocks (NYSEARCA:DIA) at the time.

The next was the bull market that ended for the S&P 500 Index on March 24, 2000 (it ended for the Nasdaq (NASDAQ:QQQ) earlier that month on March 10). Once again, it appeared that there was no end in sight for the stratospheric rise of the U.S. stock market that day. Even the still frothy Nasdaq was surging its way back higher after a sharp correction earlier in the month.

And just like at the 2007 market peak, corporate earnings were still surging higher in 2000 Q1 following a period of stagnation from 1995 Q3 to 1999 Q1. In fact, corporate earnings kept running higher on an annual basis for two more quarters through 2000 Q3 before finally topping out. Unlike the 2007 episode and much more like today, valuations had reached a rich 29.4 times trailing 12-month as-reported earnings. But despite the premium valuations "we all knew that the revolution in technology would drive earnings higher in the years ahead" as I heard one analyst put it at the time, which would help close this valuation gap. In short, it seemed like the raging bull market at the time would never end.

Of course, in both cases they did end. And they ended badly.

The Heart Grows Older, But Never Ever Learns

When listening to the cacophony of voices opining on investment markets, I am often hearing the same justifications that I remember hearing back in 2000 and 2007. And indeed, they may very well be proven right for the next several years. Nobody knows when today's bull market will finally end. But the higher it climbs and the more disconnected from underlying fundamentals it becomes, the more dramatic the subsequent downside is likely to be once the fire burns out.

So in the interest of learning from these past episodes, what can we reasonably expect once the market finally peaks? Will the lights go out all at once with stocks tumbling to the downside? After all, stocks lost more than -50% of their value during the past two bear markets. Or will there be time for investors to take action to protect themselves before the real selling begins?

It is a question I often receive from investors. How can you be fully allocated to your targeted stock weighting in your investment strategy while also maintaining a bearish view that all of this ends badly for the U.S. stock market? Are you simply just closing your eyes and hoping for divine intervention once the market finally peaks?

The answer to the first question is that one should not forgo participating in a stock market rally if it is determined to persist. The answer to the second question is simply no.

A point that I repeatedly emphasize in my articles on Seeking Alpha is to remain allocated to stocks, to continue to participate, but to avoid becoming complacent. This last point, complacency, is the key for what often gets investors unwittingly trapped in the jaws of a bear market. They drink the Kool-Aid, become complacent, ignore historical precedent, and buy into the notion that the laws that have defined the U.S. stock market going back to the buttonwood tree will somehow be repealed this time. And it ends up badly every single time.

One of the best ways to avoid becoming complacent is to stick to your investment philosophy and closely observe the lessons from history. For history has an uncanny way of rhyming over and over again through the decades.

And one of the ways that history can be used to stay invested while avoiding complacency and still protecting oneself against the downside is to observe what has happened in the immediate aftermath of past major market tops.

After The Fire, The Fire Still Burns

"The fire still burns, raging through the pain
Blackening the promises the tears and the rain
The fire will burn
'Til the wind begins to turn
And it all begins again"

- After The Fire, Roger Daltry, 1985

Consider the following once again.

First, consider the months after the stock market peak in July 2007. The stock market subsequently corrected by -12% through August. But then it bottomed and began rallying back to the upside. By early October, it had crawled across the goal line to set new all-time highs before getting turned back once again with another -11% decline through November. Once again, it found its footing - at a higher intraday low no less - and rallied once again through mid-December before rolling over once again, this time for good.

Next, consider the months after the stock market peak in March 2000. The stock market dropped precipitously by -14% into mid-April before bottoming - at a higher low - and quickly bouncing back. It proceeded to thrash back and forth through the summer, with rallies falling short of the previous highs, but lows that were higher than the previous lows. And by the start of September 2000, stocks were on the brink of breaking out to new all-time highs.

No matter how euphoric the stock market may be, stocks do not fall in a straight line once the bull market finally expires. Put simply, the stock market gives you more than ample time to make your way to the exits in a generally orderly way. The key is not becoming complacent when these episodes break out.

What exactly defines these market topping episodes? A new all-time high, followed by a sharp correction, followed by a subsequent bounce that fails to definitively break out to new all-time highs before falling back to the downside.

The Soul Always Yearns

So why should we expect that the stock market will still bounce solidly higher even after the bull market peak in the future? Put simply, thanks to the understandable behavioral instincts of investors. Sure, the stock market is priced beyond all rationale. And someday we'll look back on the current episode the same way we did the tech bubble in the late 1990s and the housing bubble in the mid-2000s with a sense of regret and wonder as to how we didn't see the eventual downfall that followed well in advance. But that does not mean that investors will wake up to this realization immediately after what we will eventually come to know as the bull market peak.

Instead, many investors will eagerly buy into stocks following the first few meaningful corrections after the bull market is over. Why? Because so many investors have been deprived of the opportunity to get on board the current bull market for so long. As a result, the first few major post-bull market peak corrections will be seen by many as the buying opportunity that they have long been waiting for. It is this understandable investor demand that helps propel stocks back higher for months after the bull market has expired and the new bear market is starting to make its way. And it is during these transitional periods where investors who are keeping a close watch can be positioning for what lies ahead.

The Bottom Line

After the fire of the bull market peak, the fire still burns for months as the market fights its way back to break out to new highs. And it is during these episodes that stretch out over several months where investors can be taking action on the margins in their portfolios to prepare for the stock market potentially turning to the downside. Why the emphasis on "on the margins?" Because a properly designed asset allocation strategy should already be built to withstand a good degree of the downside that comes with a sharp stock market correction. It's not about shifting dramatically in and out of stocks with an entire portfolio. Instead, it is about incrementally trimming certain allocations and incrementally adding to others as events unfold and as dictated by market forces at any given point in time. As a result, an investor is not attempting the improbable by trying to market time, but instead is actively managing their portfolio consistent with their overall investment philosophy.

This also answers the inevitable next question. What if the bull market does not die? This after all is precisely what we saw during the period from late 2014 up through last summer, where many of the makings of a market peak has turned into a bull that continued to ride higher. Just as we saw in 1998 to a certain extent, by carefully managing risk and adjusting on the margins within the framework of a diversified asset allocation strategy, one can continue to move to the upside with the market even if the bull ends up defying gravity and living for another day.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

Additional disclosure: I am long selected individual stocks as part of a broadly defined asset allocation strategy.