Too Much Pessimism In The Stock Market
Summary
- It's no secret that I'm bearish on both broader U.S. stock market returns and U.S. bond market returns from today's prices.
- This forecast for historically low nominal and real returns is more applicable to the long term.
- In the short term, almost everyone is bearish too, ironically creating a crowded trade on the short side.
- This idea was discussed in more depth with members of my private investing community, The Contrarian. Get started today »
A 60:40 allocation to passive long-only equities and bonds has been a great proposition for the last 35 years …We are profoundly worried that this could be a risky allocation over the next 10." - Sanford C. Bernstein & Company Analysts (January 2017)
Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria" - Sir John Templeton
Life and investing are long ballgames." - Julian Robertson
Introduction
It's no secret that I'm bearish on real return prospects for U.S. stocks and bonds. After all, I have been putting together a table like this one, which has proved inaccurate thus far, since 2015.
(Source: Author, GMO)
Looking at the table above, which shows prospective real returns on an annual basis for the next seven years, GMO has become more progressively bearish on future bond real returns, and I have too, articulating in a recent article that the bubble in the bond market is nearing the end of its euphoria.
Building on this narrative, as bad as the real return prospects look for U.S. equities, these return prospects have actually improved from a year ago, as the stock market continues to churn, passing time, while the bond market bubble has continued to expand.
The end result is that both the U.S. stock market and U.S. bond market remain historically overvalued, with the equity market keeping rare company with 1929 and 1999 historically overvalued equity valuation templates.
Market participants have noticed these eerie parallels and intuitively understand that higher starting valuations are synonymous with lower future returns.
This fear has collided with the extraordinary market structure imbalances, with seemingly everyone pursuing defensive strategies, defensive growth strategies - think disruptive growth leaders like Amazon (AMZN) or Netflix (NFLX) which excel in a price-cutting world - or defensive dividend growth strategies, creating a market where almost everyone is collectively worried and fearful, yet simultaneously piled into historically crowded investments, and investment strategies.
These historically-crowded trades are ripe for an unwind, something we have seen occurring on a regular basis going all the way back to the volatility unwind early in 2018, and really back to 2016, where historically crowded trades reversed as I articulated, and accurately predicted in one of my favorite titled public SA articles.
This time, the trades are even more crowded and the unwind could be a melt-up higher in the broader stock market, think the S&P 500 Index (SP500), led by the historically out-of-favor economically sensitive assets, which have been left for dead, as almost all investors and traders expect a near-term recession, which as bearish I am on long-term returns for the broader U.S. stock and bond market I do not think is going to happen.
Fear Is Palatable
The American Association of Individual Investors runs a weekly sentiment poll where participants express their view on which direction the U.S. stock market will be headed over the next six months, and the results for the week ending Oct. 9, 2019, illustrate the underlying prevalent fear in the financial markets right now.
(Source: American Association of Individual Investors)
The current bullish-bearish spread, which is a -23.7 reading (this is calculated by subtracting the bearish sentiment reading from the bullish sentiment reading), is actually very close to the low reading registered at the stock market's depth in December of 2018, where the Bull-Bear Spread printed a -28.0% reading for the week ending Dec. 13, 2018.
The Divergence In Sentiment With The S&P 500 Index Is Striking
When the AAII Bull-Bear Spread posted a -28.0% reading for the week ending Dec. 13, 2018, the stock market was in the middle of a plunge that would culminate in a Christmas Eve 2018 closing low of 2351.10, as shown in the chart below.
(Source: Author, StockCharts.com)
This morning, Thursday, Oct., 10, 2019, as I write this piece, the S&P 500 Index is currently at 2937.35, up 0.6% on the day, and 24.9% higher than its closing low on Dec. 24, 2018.
Summarizing, sentiment is currently almost as negative as it was ahead of the December 2018 lows, yet the S&P 500 Index is roughly 25% higher than its December 2018 closing lows.
The Bond Market Is Showing A Different Divergence
Comparing and contrasting the sentiment and price action in the S&P 500 Index, where there is positive divergence between sentiment and price, to what's occurring in the bond market, is striking too, with the iShares 20+ Year Treasury ETF (TLT), currently trading at 142.59, down 1.2% on the day as I write this article, up 19.5% from its December 2018 adjusted closing high of 119.32 (adjusted for dividends), which occurred on Dec. 31, 2018.
(Source: Author, StockCharts.com)
The S&P 500 Index has risen roughly 25% from its December 2018 lows, even though sentiment is at a similarly negative level today, as the broader U.S. stock market has been led by the performance of defensive equities, and interest rate sensitive equities, spurred on by the performance of the bond market, where long-term bonds have risen roughly 20%, as investors of all stripes flock to safety.
Closing Thoughts - The Safety Trade Will Need To Unwind Before The Stock Market Tops
In 25 years of personal investing experience, including over two decades of professional investing experience, combined with the perspective of a market historian, who has combed through more analysis, data, and testimonials than anyone else I know (one of the reasons I thoroughly enjoying participating in this community), I cannot ever recall a significant downturn happening in the stock market, or in the economy, when a majority of market participants were looking for one.
Throughout my study of market history, and through my actual experience, the financial markets have a habit of fooling as many investors as possible, and the curve ball this time, could be an inflationary melt-up, led by economically sensitive equities, and an unwind of the yield propelled safety trade, as sentiment shifts from overly defensive to more optimistic, all happening ahead of the long awaited downturn, which everybody is positioned for now, yet few will be positioned for when a significant downturn actually happens.
If this scenario unfolds, the current market leaders, think the investments that have excelled the past several years and the past decade, including large-cap growth stocks, specifically the vaunted FAANGs, including Facebook (FB), Amazon, Apple (AAPL), Netflix, Alphabet (GOOGL), (GOOG), which are really the longest duration assets in a world starved for growth, dividend growth stocks, including the hyper-valued defensive stalwarts like Procter & Gamble (PG), McDonald's (MCD), Coca-Cola (KO), interest rate sensitive investments, including REITs (VNQ), (IYR), and utilities (XLU), and the heavily embraced bond market, as described earlier, are all poised to underperform dramatically, as a historic capital rotation, which will make 2016's reversal look tame in comparison, is poised to surprise most investors.
In closing, embracing shunned economically-sensitive assets, when almost all market participants are buying quality, front running the passive and ETF flows, and preparing for a downturn, is perhaps the perfect storm of a contrarian opportunity.
The economically sensitive equities that have the potential to rise from the ashes like a Phoenix, include energy equities, which are historically out of favor, and which I have written about extensively over the past several months, with a public article on Exxon Mobil (XOM), an article providing a historical comparison of the natural gas industry in the United States, and another public article on Antero Resources (AR), with all of these articles providing perspective on the historic opportunity from my vantage point.
The Contrarian
There is historic opportunity in the investment markets today. I have spent thousands of hours analyzing the markets, looking for the best opportunities, looking to replicate what I have been able to accomplish in the past. From my perspective, the opportunities in targeted out-of-favor equities today are every bit as big as the best opportunities in early 2016, and late 2008/early 2009. For further perspective on these opportunities, consider a membership to The Contrarian, sign up here to join.
This article was written by
Historically, I have had huge wins and impressive losses based on a concentrated, contrarian strategy. Trying to keep the good while filtering out the bad.
Seeking to run an all weather portfolio with minimal volatility and index overlays to capture my strategic and tactical recommendations along with a concentrated best ideas portfolio, which is my bread and butter, but the volatility only makes it suitable for a small piece of an investor's overall portfolio. The following are a couple of my favorite investment quotes."Life and investing are long ballgames." Julian Robertson
"A diamond is a chunk of coal that is made good under pressure."
Henry Kissinger
"Knowledge is limited. Imagination encircles the world." Albert Einstein
I’ve been on top of the world, and the world has been on top of me. I have learned to enjoy the perspective from each view, and use opportunities to persistently acquire knowledge, and enjoy the company of those around me, especially loved ones, family, and friends.
At heart, I am a market historian with an unrivaled passion for the capital markets. I have had a long history and specialization with concentrated positions and options trading. Made money in 2008 with a net long portfolio, deploying capital in some of the market's darkest hours into long positions including purchases of American Express, Atlas Energy, Crosstex, First Industrial Real Estate, General Growth Properties, Genworth, Macquarie Infrastructure, Ruth Chris Steakhouse, and Vornado near their lows. Shorting, hedging, and option strategies also helped me in 2007 and 2009, and these are skills that I have developed ever since I started trading heavily in 1996.I enjoy reading, accumulating knowledge, and putting this knowledge to work in the active capital markets, learning lessons along the way.To this day, I continue to learn, and some of these learning lessons have been excruciatingly difficult ones, especially over the past several years, as I made mistakes allocating capital, including a sizable portion of my own capital (I always invest alongside my clients), to commodity related stocks. While all commodity related stocks have struggled since April of 2011, coal companies, which attracted me due to their extremely cheap valuations, and out-of-favor status (I am a strong believer in behavioral finance alongside fundamentals and technicals) have been the worst investing mistake of my career. The focus on the commodity arena has been the biggest mistake of my investment career thus far, yet in its aftermath, I see tremendous opportunity, even larger in scope than the fortuitous 2008/2009 environment.The capital that I accumulated and the confidence gained in navigating the treacherous investment waters of 2008 gave me the confidence to launch my own investment firm in the spring of 2009, right before the ultimate lows in the stock market. At the time I was working as a senior analyst at one of the largest RIA's in the country, and I felt strongly that the market environment was the best time since 1974/1975 to start an investment firm.Prior to starting my firm, I was a senior analyst for three different firms over approximately 10 years (Charles Schwab, Redwood, Oxford), moving up in responsibility and scope at each stop along my journey. Since I was a paperboy, I have always had an interest in the investment markets. I love researching and finding opportunities. I was a Chartered Financial Analyst, CFA from 2006-2018. Additionally, I have been a Chartered Alternative Investment Analyst, CAIA. After starting in the teaching program at Ball State University, I switched to a career in finance when I turned a small student loan into a substantial amount of capital. I graduated summa cum laude with a degree in finance from Ball State.
Full disclosure, I am not currently a registered investment advisor, though I did serve in this capacity from 2009-2014, while owning Koldus Contrarian Investments, Ltd. Additionally, I held various securities licenses from 2000-2014 without a single formal complaint filed. At the end of 2014, I voluntarily let my state registration expire, as I transitioned the business to a different structure after going through a brutal business environment, divestiture and difficult divorce and custody battle. Prior to this, I had passed, and held, various securities exams and licenses, including the Series 7, Series 63, and Series 65 exams, in addition to others, alongside the CFA and CAIA designations. Unfortunately, I did not file the proper paperwork to withdraw my state registration, and I did not disclose a personal arrangement, and subsequent civil case, between myself and a former close personal friend and client. This arrangement was initiated informally in 2011, after a substantial period of success, as we aimed to be business partners, and it ultimately resulted in a dispute. I was unaware that I was required to disclose these items, and my securities attorney, at the time, did not advise me to do so. Previously, I had managed a portfolio for this gentleman, and we had taken an investment of approximately $7 million in 2009, and grown it to over $25 million at the beginning of 2012. After a very difficult year of performance, an employee of the firm I owned, and friend, resigned in early 2013, and took the aforementioned client to a competing firm. As a result of not filing the proper paperwork, I agreed to a settlement, with a potential $2500 fine in the future, depending on if I choose to reapply to be a non-exempt advisor. Additionally, while going through the difficult divorce and business dispute and divestiture, I did not file the proper disclosure on two of the annual CFA renewals. As a result, the CFA Institute sought a 3-Year Suspension of my right to use the CFA designation, which I appealed, since the primary investigator in the case sought a 1-year suspension of my right to use the CFA designation for a majority of the investigation. A Hearing Panel heard the case, and went against the recommendation of the CFA's Institute's Professional Conduct Department. Long story short, be careful who you trust, especially when substantial money is involved, and always disclose everything properly, which is hard to do when you are going through difficult situations, as this is the last thing you are probably thinking of at the time. In closing, I have had more experience in the markets, business, and life than most, yet I am grateful & thankful for every day. Additionally, I have learned through success and failures that you have to move forward, and if you can do this, your life will form a rich tapestry of stories.
Disclosure: I am/we are long XOM, AR, AND SHORT TLT PUTS, AMZN PUTS, SHORT PG, AND SHORT SPY IN A LONG/SHORT PORTFOLIO WHERE I EXPECT VALUE STOCKS TO OUTPERFORM. 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: Every investor's situation is different. Positions can change at any time without warning. Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.