Fear Of Missing Out

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by: Terence Reilly

Courtesy of Cashin's Comments this week comes an interesting insight about the bond market from a stock market maven who has had a hot hand. Jim Paulsen sent our friend Arthur Cashin an email in which he explains history's treatment of stocks when bond yields move quickly.

Since 1980, when the 10-year bond yield was more than one standard deviation below its trend, the S&P 500 average annualized gain in the ensuing year was a robust 14.25%! When the 10-year yield was within either one standard deviation above or below trend, the stock market's average annualized gain in the subsequent year was still a healthy almost 10%. However, when the bond yield was more than one standard deviation above its trend, the stock market in the following year only provided a paltry 2.71% average annualized gains.

Moreover, whenever yields were higher than one standard deviation above trend, the stock market declined in the ensuing year 43% of the time compared to only about 19% the rest of the time! Within the last month, the 10-year Treasury bond yield has risen beyond one standard deviation above trend (as of Jim's writing the 10-year was at 2.44%. It ended the week at 2.66%!). Consequently, despite ongoing strength in equity prices, the recent rise in yields may already be starting to pressure the stock market.

Let's combine that thought about the bond market with current equity valuations. Courtesy of FPA Capital is their note that when the levels in the CAPE Ratio rise above 26, returns from equities decrease. Returns in the past 100 years from current CAPE Ratio levels average NEGATIVE 7% over the next 3-year period.

  • When S&P 500 CAPE was below 10x, 3-yr returns of 39%; between 10x and 14x, returns of 34%; between 14x and 18x, returns of 13%; between 18x and 22x, returns of 20%; between 22x and 26x, returns of 22%; between 26-30x, returns of negative 1%; greater than 30x, returns of negative 7% (31x today!)

From a technical perspective, we are awestruck by the current level of Relative Strength in the S&P 500. The RSI is at its highest level ever. Ever! The word Unsustainable comes to mind.

Investors seem to be in panic buy mode in a Fear Of Missing Out (FOMO). Money has flowed into mutual fund and stock ETFs at the highest pace ever over the last four weeks. $58 billion in fresh money hit markets in the last month. Last week was the 7th highest week ever, according to Bank of America (NYSE:BAC). That money came into the market after the market was off to one of its fastest yearly starts on record. We are setting a lot of records lately. That has red flags rising left and right. It's not to say that the market roar won't continue but at this pace the market will be up 166% for the 2018 if things continue. What cannot continue - won't. Trees don't grow to the sky.

We would remind you that in our blog last week we noted Bond King Jeffrey Gundlach's line in the sand for equities. In his latest conference call Gundlach stated that the 2.63% level on the 10-year is going to be a very important level and at which stocks may begin to suffer. The 10-year closed the week at 2.663%.

The combination of higher rates, the end of QE and tax reform may push the market and economy into overheating. Late stages of bull markets can have very sharp and quick moves to the upside. It is starting to feel more like 1998-99. That's the key. Are we in 1998 or 1999? It makes a big difference for our returns. Watch for price acceleration.