Last summer, I paused to reflect on the long, strange journey of today’s market environment, invoking the words of the Grateful Dead in their bluesy anthem, Truckin’. This month, I veer from counterculture rock lyrics to the soulful incantations of Otis Redding, who poignantly captures what feels like the prevailing market sentiment: “I’ve been loving you too long to stop now.”
True, in the last three weeks we’ve experienced the first real volatility since early 2016, which has been a much-needed reminder that extended tranquility is not the norm for financial markets. But my fear is that with the indexes already having regained over half their losses, too many investors are still unwilling to end their love affair with the nine-year-old U.S. bull market.
To understand the acute cases of equity addiction gripping investors today, it’s helpful to first view the world through the eyes of the afflicted. The S&P 500 hasn’t experienced a down month in 15 months — an unprecedented winning streak — although at -3% as of this writing, it seems probable that February will break that streak. The S&P is still up over 18% in the last year and has averaged almost 15% over the last five years. The magnetic vortex of the Vanguard Group, with its nearly $5 trillion in assets under management, testifies to the massive popularity of passive funds, and with those kind of recent returns, it’s not hard to understand the appeal.
Even though the past few weeks have shaken people out of the mental complacency bred by seemingly easy, low-risk returns, it remains to be seen whether they will vote with their dollars or settle back into the status quo. Either way, the market is no less expensive than it was a month ago, and I see correlations between today’s dangerously high metrics and future volatility.
People’s feelings toward the economy are still overwhelmingly positive, as demonstrated by recent 17-year highs in the ongoing consumer sentiment surveys conducted by the Conference Board and the University of Michigan, and a 31-year high in the AAII Investor Sentiment survey (bulls now outnumber bears nearly 5 to 1). Historically, extreme levels of confidence from investors and consumers have been a contrarian indicator.
Additionally, we see a widening gap between rising consumer sentiment and a declining personal savings rate, a divergence that in the past has served as a precursor to the end of the economic cycle. As we near economic and cyclical peaks, people become more confident about the direction of the economy, leading them to consume more and save less. At the December reading, Americans were only saving 2.4% of their disposable income, the lowest level on record except for a brief period in 2005. Saving, or holding cash, often feels counterintuitive to investors when housing prices and portfolio values are rising, but it’s precisely the defensive position I would argue such expensive market conditions demand.
The ratio of stock market capitalization to GDP is also north of 140%, its highest level ever outside the tech bubble peak. The measure, colloquially known as the “Buffett Indicator” after the Sage of Omaha’s affinity for it, is a long-term valuation indicator that gauges how large a share of the economy the stock market represents on paper. Whether you subscribe to the view that it should revert to its long-term average or its upward-trending shorter-term average, the current level is clearly unsustainable.
And let’s not forget, there is compelling evidence that the earnings boost from the new tax law has already been priced into U.S. stocks. The market is forward-looking, and Wall Street analyst estimates already imply that most companies will see a permanent, dollar-for-dollar increase to their bottom line from the corporate rate cut. That’s a high bar for companies to clear, and it ignores the possibility (a strong one, in my view) that much of the short-term profit windfall will be competed away over time.
Investors need to think more broadly and less conventionally when it comes to data points for spotting mispricing. Just as a flashy car wouldn’t provide accurate insight into the long-term potential of a new romantic partner, short-term returns and earnings multiples don’t tell the whole story of a company (or a market).
When I began drafting this missive in late January, I had planned to write, “There’s no way of knowing when volatility will return; we just know it will, and that investors need to prepare.” Little did I know how timely those words would be. Maybe the past few weeks mark a secular shift in investors’ mindsets toward risk, or maybe it’s just a bump in the night that will soon be forgotten. The bottom line is that investing, like love, is not meant to be easy; it requires steadfast independent thinking and hard work to capture upside when markets rise while also protecting capital when they fall.
Going against the whims of an irrational market is neither easy nor comfortable, and it comes at the risk of looking like a fool while everyone else seems to be making money hand over fist. Some investors can’t resist the siren song of easy money — an unfortunate reality that buyers of short volatility strategies learned the hard way last week. But I suspect we haven’t seen the worst yet, and for those who can’t keep their emotions in check and adhere to a disciplined process, I’m afraid Otis won’t be the only one left lamenting a love that outlasted its welcome.