Bullish Optimism is Beginning to Reach Extremes

By Lance Roberts, StreetTalk Advisors

Since the end of last year the bullish optimism for 2013 has risen to an almost fevered pitch.  Concerns of any further disruption from the Eurozone have faded into the mist.  With the“fiscal cliff” issue resolved, and little concern that the “debt ceiling” will not be raised, the worries of a domestic drag have been all but alleviated.  Furthermore, despite slowing earnings and revenue growth, the outlook for 2013 earnings growth is remarkably ebullient.  According to the vast majority of the media, analysts and portfolio managers there is absolutely nothing to be worried about, particularly given the fact that every major central bank is now engaged in some sort of financial easing campaign, and the markets should surge to record highs by year end.

However, maybe it is in this very optimistic outlook that we should find at least the smallest grain of concern.  Bob Farrell once stated: “When all experts and forecasts agree – something else is going to happen.”   As a portfolio manager I am not paid to garner portfolio returns but rather manage the risk of loss.  It is in the risk management, as we discussed previously, that long term returns are achieved.  It isn’t as fun, or as sexy, as driving a Ferrari at top speed but the crashes won’t kill you either.

There are many ways to measure investor optimism.  The chart below is the composite index of bullish sentiment of both individual and institutional investors.  As you can see the index is now at levels normally associated with the beginnings of market peaks.

The next chart is of the Volatility Index.   The volatility index, which is used as a gauge of investor fear, is currently at levels normally associated with extreme complacency.  What is important to note is that the level of complacency is not the concern but rather how quickly such complacency can turn to fear.

The last chart is my composite indicator which combines bullish versus bearish sentiment, highs versus lows, volatility, and the index’s rate of change into a single measure of risk.   When looking at a variety of different measures combined into one indicator we can clearly see that optimism has begun to reach extreme levels.  I have identified the previous times that the market has pushed up into these more extreme reading which have all equated to more intermediate tops.

This all very much aligns with our recent discussion on the current state of this rally:

“The question of how far the rally will likely go is shear speculation.  Using past history as a guide I currently think that the market could reach our intra-year target of 1560 as shown in the first chart above within the next three to four months.  After that, however, I suspect that a resurgence of economic weakness caused by increased taxes, potential spending cuts and a continued drag from emerging markets and the Eurozone will begin to negatively impact the markets.  The chart below shows the likely trajectory in the months ahead.”

As with all forecasts and projections it is simply just my best guess.  However, what is clear is that the markets are once again very overbought and extremely optimistic.  This doesn’t mean that the market will not rally further but, historically speaking, it has not been wise to assume that the advance will continue indefinitely.  The reality is that we are very long in the tooth in this current rally and we are now seeing a multiple expansion based on rising prices and deteriorating earnings.  Such an event has never ended well – although it can last far longer than is generally imagined.

Ben Bernanke’s fingerprint is clearly present in the current rally.  The trend is currently positive and internal dynamics are relatively stable as money rotates from safety into risk.  However, as stated above, the markets are overbought, overly bullish in terms of sentiment and complacency, and fundamentals are showing signs of weakness.   While 2012 made a very strong advance in the face of rather substantial headwinds it is unlikely that 2013 will repeat such a showing.

One of my favorite quotes is by Howard Marks who said:

“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that “being too far ahead of your time is indistinguishable from being wrong.”)

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.” 

The problem with being a contrarian investor is that it is grossly unpopular.  People would rather hear all the reasons why a market will advance rather than the reasons that something might go wrong.  Being a contrarian gets you quickly labeled as a “bear” and you are definitely no fun to invite to parties.  However, it is the understanding of the inherent risks, when investing your savings, which separate success from failure.

What matters most to me is not a label of “bullish” or “bearish” but the understanding of the risks that can destroy large amounts of capital in a relatively short period of time.  The economic data is far from strong and most of the bullish expectations are built around a premise that the world has achieved a financial equilibrium.  That is not a bet that I am willing to take – are you?

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Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.
Lance Roberts

Lance Roberts

Lance Roberts is the CEO of STA Wealth Managment. The mission of STA Wealth Managment is simple - lead our clients to financial success by actively managing their assets while limiting risk to capture returns. Through the utilization of economic and technical analysis, historical research, and risk controls, we build portfolios which will create long-term investment results.

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  • Rik

    Markets look to be driven by QE. And partly the fact that QE money is clearly not ending up as SME debt.
    However the economic fundamentals looks till poor.
    So my guess is the following.
    We go to are close to a new equilibrium with QE-effect on top of the normal one.
    When there is no more QE to be expected, but just the presnt QE as it is, risks will be higher downside than upside.
    While at the same time less liquid assets like RE which react much slower have not yet the full QE effect priced in.
    So I expect at a certain point a move to those assets from the liquid ones.

    Next to normal market stuff (1) and if the QE stops (2) or is even reversed (3) effects. 2 and 3 being both negative. The main reason why downside risk at new equilibrium looks higher and substantially than the upside.

    Which ones will sell off first, will probably depend on the economy when we are there. Risk off equity-like stuff first, risk on bonds first.

  • Andrew P

    I don’t know. With all this QE worldwide, things are likely to just drift along laa-dee-daa until there is an unforeseen external shock. When (and If) such a shock takes place, the Fed is largely out of bullets without a big increase in government spending. They can’t cut interest rates much more, QE is already buying nearly all government debt, and it wouldn’t do much good if they cut long term rates to zero. And would the government be able to boost spending if the shock spikes oil prices?

  • Boston Larry

    Lance is a party pooper. We are all having so much fun as our stocks go up. This rally should be good for another week or 2 or 3…. In the meantime, why spoil the party atmosphere?

  • Anonymous

    The risks are far to great for an equity market correction and or a simple down year. The market has to be supported and held up. There simply are no alternatives in the Bernanke controlled economy. That is and has been the investment thesis. So, what is going to be the managed return this year?

  • Boston Larry

    “In the last two weeks, investors sank $11.3 billion into global stock mutual funds, excluding exchange-traded funds, according to data firm Lipper. That includes $3.8 billion in the week ended Wednesday, marking the biggest two-week inflow since April 2000, Lipper says.

    Some $1.4 billion flowed into U.S. stock mutual funds. “It looks as if the shift to those products may have some legs.”

    Are we about to witness a melt-up in risk assets as the little guy exchanges out of bond funds into equities? Source: http://blogs.wsj.com/marketbeat/2013/01/18/morning-marketbeat-simon-says-rotate/?mod=WSJBlog

  • Andrea Malagoli

    I am also in the camp that thinks equities are being driven by two things:
    a) QE
    b) A re-inflation of the credit bubble [thanks to (a)]

    So, it is reasonable to assume that equities will keep having good support as long as the Fed keeps performing its massive operations.
    At the same time, this is uncharted territory, so nobody knows if this can collapse catastrophically at some point. This is true worldwide (why on earth are European equities rallying?).

    So, lots of risks, but no time to short yet. It is a sort of catch-22 situation: fundamentally bearish but tactically long …

  • http://pragcap Michael Schofield

    That frames it pretty well, Andrea. For now, I think we have a good year long, after a pullback. Later, who knows. Maybe I short everything and post margin with credit cards.

  • perpetual neophyte

    I really like a lot of what Lance posts, but what is the actionable item from this analysis? Reduce equities? By how much (“a little,” “a lot,” X% from neutral allocation)? Which equities – all, certain geographies, certain sectors within those geographies? Reduce all risk assets, including high yield corporate debt?

    And, if you do any of that, what is the measure by which you determine when to go back to a neutral weighting in those items? Where do you put the cash raised from those changes in the meantime?

  • Anonymous

    Stay long and keep adding to your positions. If we get a correction it will be contained by the Federal Reserve and its crony banks. An external shock will first appear in the capital flows. When the capital flows reverse, pull the trigger. Until then, buy the dips, avoid paying fees and work on your golf game.

    Feel confident that the Federal Reserve has mastered the not only the business cycle, but how to manage the whole US economy and capital markets.

  • Denny

    Could be. Dumb money is always the last guy standing. But it would be a hoot if the little guy stayed out and the markets went into a dive taking down all the hedgies who tried to front run this market.

    The stock market has generated $10.5 trillion in paper wealth since the bear market ended and your going to need real money coming in so your can take out and monetize your profit. I mean, isn’t that how the game is played?

  • S.E.

    Find the beta of your portfolio, then using the beta of a short fund (PSSAX) find the mix that delivers the amount of Beta you are willing to accept going forward. I doesn’t hurt if you have modeling software that also shows drawdowns for comparison.

  • S.E.

    Oh, ya, convert the hedge near the bottom of the correction

  • hangemhi

    His charts contradict his statements. Bullishness only just reached his “extreme” line with past levels FAR higher and/or lasting far longer. And the VIX is back to where it was in 2004 where it lingered for 3 years. Meanwhile all of the comments above, and everywhere else I read, everyone is preaching caution. To me this all adds up to us being no where near the top in price or duration. As for inflows – well duh, they’re just catching up. There is so much money on the sidelines its insane. We’re going to need months, if not a year or two, of record inflows (I have no evidence for this opinion, so would be happy to see a chart or be corrected) to get back to business as usual. Lastly, debt levels are WAY down per this chart http://research.stlouisfed.org/fred2/graph/?s1id=FODSP

    And the housing market is taking off, which will lead to jobs, which will lead to banks loosening their standards all over again. Trust me, I am still cautious, but I’m starting to feel like we’re just getting back on the irrational exuberance bus with anywhere from a 6 month to 3 year drive ahead of us. The market can only truly correct in a huge way when people stop questioning this rally and start believing in it. Tell me – who believes in it??????

  • C.L.

    Mr. Roberts – you gave reasons why the market could correct – not why it has peaked. IF this is a true bull market the corrections will be relatively shallow; why anticipate it if put protection is so cheap?

  • Old Dog

    Japan has been doing QE for a generation with predictable results. The US is early in that game.

    And when QE completely quits working here the US will seriously devalue the dollar as Japan is doing now.

    And it is clear to anyone with a pulse that devaluation drives huge amounts of money into equities very quickly.

    Or maybe you prefer guns and gold.

  • Adrian

    From what I see a minor correction in the markets are welcomed because of overbought levels but, and I say but, data in economic conditions of US and the rest of bigger economies show we have a lot to go until we reach some top levels.
    So my guess is we’ll have a few days – maybe weeks of mild corrections and markets will start to grow again.
    Don’t forget we didn’t had a decent economy grow in the last 5 years anywhere but in China.

  • http://diaryofarepublicanhater.blogspot.com/ Mike Sax

    It seems to me the fact of the business cycle means that being a contrarion will make you right about half of the time-acutally maybe a little less as booms are longer than busts.

    For awhile back in 2008 I was a “contrarion” or at least a “bear” in that while most wanted to belive the market had bottomed back in July-before Bernanke proised more facilities and the SEC hinted at action against short sellers-I still thought the market would tank again.

    I was just a-very small personal investor-but I was employing a strategy where I bought up say 10 or 20 or so of option puts in mostly bank stocks and held them until a big price move where I could make a very big quick profit-of 300 or 400% and get out. It worked for awhile but of course I got to greedy and ended up broke.

    I get what you’re saying about the market being oversold, but for me the big story has been how hard it is for the kind of trading I played then working anymore. While everyone was speaking of the end of “buy and hold” back in 2008, if you did have the money and patience to hold on since March 2009 you’d be in pretty decent shape.

    I get your point about being overbought but it seems to me that the market may continue to go through steady, slow upward movement for awhile. If you consider the economy, we’re in a very different place than we were in 2007 when the last bear market started.

  • http://diaryofarepublicanhater.blogspot.com/ Mike Sax

    My point about “buy and hold” is that what for me has really stood out as a characterization of the marekt-post April 2009 after the initial big jump in bank stocks following the March 9 rally-is a lack of volalitity. This has made it very hard to try aggressive trading strategies-to the extent that what you need for this is the big sudden move in a particular stock’s price.