Seeking Alpha

The Fact That Nobody Is Scared Should Scare The Heck Out Of You

by: Orange Peel Investments
Orange Peel Investments
Long/short equity

North Korean tensions continue to build.

Equity valuations continue to move higher.

Many people recite the adage to "be fearful when others are greedy," but can you actually put it into practice?

By Parke Shall

Things with North Korea don't look like they're going to be getting any better anytime soon. This is just one of several items that baffles us about the way that the market has been trading over the last couple of weeks. As you can see from the chart below, the market has done little but scorch through new all-time highs over the last couple of weeks. All of this comes at a time of heightened political tension between the United States and North Korea, but also North Korea and countries like Japan who have been thrown into the fray.

Chart^SPX data by YCharts

We continue to see the stock market euphoria and ignorance surrounding these geopolitical issues, as well as aggressive stock valuations, as a recurring prompt to be fearful while others are greedy. The Warren Buffett quote about being "fearful when others are greedy and greedy when others are fearful" is tossed around all the time. Generally, it can be tossed around in financial articles and social media with a focus on near term or shorter term events. It is rarely put into application at times of extreme distress, like the 2008 financial crisis, except by those like Warren Buffett who have the time tested minerals to make such a call to go against the grain (and the capital to back it up).

What is even more rare than seeing this phrase in application during crisis is seeing it in practice during euphoria. After all, such is the nature of both capitulation and euphoria. If it were easy to put into application, it wouldn't be "going against the grain." We'd like readers to think about this as we make our case for trying to put yourself in a fearful mindset at a time when the stock market is shaking off anything and everything and volatility continues to move to new lows every day, regardless of what comes out in the news. Seasoned investors who have lived through several longer-term boom and bust cycles would likely tell you that when an article comes out explaining how a once-modest retail store manager is crushing the market by shorting volatility 10 years into a bull market with volatility at all-time lows, that it might be time to reconsider going against the grain. That article was from Business Insider (with our emphasis):

You don't have to be a professional investor to make a killing in the volatility market.

Just ask Seth M. Golden, who previously worked as a logistics manager at a Target store.

The 40-year-old, who lives in a suburb of Ocala, Florida, says he's grown his net worth from $500,000 to $12 million in five years by shorting the CBOE Volatility Index - or VIX - according to a report from Dealbook's Landon Thomas Jr.

It's a trade that's worked extremely well this year: The VIX has fallen 19% as investors have looked unperturbed by middling economic data and escalating geopolitical tension. The so-called stock market fear gauge even went as far as to hit a record low on July 21.

Similarly, when commercials start to appear by online brokerages like E*TRADE that are telling you that "the dumbest guy in high school just got a boat," it may be another reason to consider going against the grain. If you remember, prior to China's bubble almost bursting a couple years back, online brokerage accounts were skyrocketing as any and all money on the sidelines sought to get into the market at any cost, without any consideration for valuations.

On top of the U.S. market being similarly valued in the sense that we believe stocks to simply just be expensive, the market also seems to be shrugging off the fact that this North Korean crisis does not look like it's going to be able to be dealt with with any type of means other than force. In addition, North Korea issued new threats to Japan, dragging yet another name into the midst of what can only be described as a standoff between Kim Jong-Un and U.S. President Donald Trump. UK newspaper Express reported:

Pyongyang's state-controlled news agency KCNA issued a statement yesterday directly threatening Japan, stating the country's preparations for a possible war could be 'destroyed to pieces.'

The statement read: 'Should Japan take the advantages of the US war racket, they can not but be a target of the powerful strike means of the DPRK's revolutionary armed forces.

'Japan can never be safe if a war breaks out on the Korean peninsula. Everything in Japan mobilized for the war can be destroyed to pieces, to say nothing of the U.S. aggression bases there.

'The Japanese authorities are strongly warned that if they go reckless with the backing of the U.S. they can bring irrevocable misfortune to the Japanese archipelago.'

Further adding to the potential volatility is the fact that Donald Trump seems to think that a military force option will be the only effective way to resolve this standoff. He has said as much in his tweets and publicly, even if it goes against the grain of what those in Congress and those in the Republican Party are saying. As if this wasn't enough, it has been reported that Trump may actually plan to visit the demilitarized zone between South Korea and North Korea on his November trip to the Korean Peninsula. Reuters reported on a Yonhap report:

U.S. President Donald Trump may travel to the heavily fortified demilitarized zone (DMZ) separating North and South Korea when he visits South Korea next month, the South's Yonhap news agency said on Tuesday, citing a defense source.

The White House sent an advance team of working-level officials in late September to check candidate sites for Trump's 'special activity' in South Korea, the source was quoted as saying.

Trump was expected to send a significant message to North Korea, either verbally or 'kinetically,' during his first trip to the peninsula as U.S. commander-in-chief, the source said.

If the thought of the president going to the DMZ isn't enough to stir up some volatility, his actual arrival may do just that. In essence, this is actually becoming a good old-fashioned Old West standoff. Unless a wave of diplomacy washes over both leaders prior to November, which we find highly unlikely, we expect the geopolitical landscape to become far more volatile than it is now.

Whether or not this does anything to the stock market or not is another question. The market has basically rode out all of the geopolitical tremors with little or no consequence over the last couple of years. It's this type of ignorance of these events that the market has gotten used to. Life has a way of smacking you down when you become too arrogant or too confident. We believe such a situation could be setting up for the overall market. As we said, in addition to the market being aggressively valued on its own, there doesn't seem to be any type of discount for these geopolitical risks or things like the possibility of tax cuts not happening as planned.

And be reasonable. This doesn't mean that you need to take off all of your long exposure and go net short the market, but it may be a prompting for investors to start to reconsider to rebalance their portfolios. Just the other day we suggested the notion of starting to pare back some of your bigger cap dividend paying long positions that have produced impressive total returns over the last 8 to 10 years, undoubtedly. Other ways of rebalancing your portfolio to hedge for risk could be to increase or introduce the amount of precious metals you're holding or look at commodity prices which similarly can move up in risk off scenarios. Additionally, having exposure to foreign markets and foreign currencies is a nice way to hedge against the dollar and what the residual effects of more quantitative easing could turn out to be, if the market does correct.

Capitulation happens because the market gets a jolt when people least expect it. At a time like this, much of the retail investing world doesn't believe the market is going to do anything but continue to move higher. Every day we see headlines about the market on new highs. It is at this point, when complacency reins, that investors need to be as fearful as they can. After all, that is the whole point to the Buffett quote that is paraded around the financial world by people who have trouble taking its advice. Bull markets happen when you least expect them and bear markets happen when you least expect them. With high valuations and increasing geopolitical risk, we believe the warning signs are out there, it is just up to you to listen to them.

Disclosure: I am/we are short SPY. 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.