Eye Opening Charts and Commentary are a Wake-up Call
By the Curmudgeon
Article excerpts and charts this week as selected by the Curmudgeon. Hopefully, they’ll be a wake-up call or at least a sanity check for bullish investors and speculators.
Victor’s thought-provoking comments are here.
Please email the Curmudgeon (email@example.com) to express your interests, opinions, suggestions, comments, or concerns. Have a great week!
The prices of stocks, bonds, and real estate, the three major asset classes in the United States, are all extremely high. In fact, the three have never been this overpriced simultaneously in modern history.
Clearly, this is a time for investors to be cautious. Beyond that, it is largely beyond our powers to predict. Consider this trifecta of high prices:
· Stocks. Prices in the American market have been elevated for years, yet despite periodic interruptions, they have kept rising. A valuation measure that I helped create — the cyclically adjusted price earnings (CAPE) ratio — today is 37.1, the second highest it has been since my data begin in 1881. The average CAPE since 1881 is only 17.2. The ratio (defined as the real share price divided by the 10-year average of real earnings per share) peaked at 44.2 in December 1999, just before the collapse of the millennium stock market boom.
· Bonds. The 10-year Treasury yield has been on a downtrend for 40 years, hitting a low of 0.52 percent in August 2020. Because bond prices and yields move in opposite directions, that implies a record high for bond prices as well. The yield is still low, and prices, on a historical basis, remain quite high.
· Real estate. The S&P/CoreLogic/Case-Shiller National Home Price Index, which I helped develop, rose 17.7 percent, after correcting for inflation, in the year that ended in July. That’s the highest 12-month increase since these data begin in 1975. By this measure, real home prices nationally have gone up 71 percent since February 2012. Prices this high provide a strong incentive to build more houses — which could be expected eventually to bring prices down. The price-to-construction cost ratio (using the Engineering News Record Building Cost Index) is only slightly below the high reached at the peak of the housing bubble, just before the Great Recession of 2007-9.
There are many popular explanations for these prices, but none is adequate.
Curmudgeon Suggestion: consider the illustration below (from the NY Times) as a comprehensive explanation. The three heads shown could be those of the last three Fed Chairs – Powell, Yellen, and Bernanke.
Timing is important, yet it’s impossible to time the markets reliably. It would be prudent, under these circumstances, for investors to make sure their holdings are thoroughly diversified and to focus on less highly valued sectors within broad asset classes that are already highly priced.
Professional investors have long tracked the options market for clues on the stock market’s next turn. Now, favored by individual investors for its small upfront investments and potentially quick payoffs, options trading is hitting levels never seen before.
At times, options trading has dwarfed activity in stocks, creating leverage that traders and analysts say stands to accentuate both up and down moves in the market.
Nine of 10 of the most-active call-options trading days in history have taken place in 2021, Cboe Global Markets data show. Almost 39 million option contracts have changed hands on an average day this year, up 31% from 2020 and the highest level since the market’s inception in 1973, according to figures from the Options Clearing Corp. By one measure, options trading by individual investors has risen roughly fourfold over the past five years, according to Cboe data.
“I’m hooked on the options,” said Britt Keeler, a 40-year-old individual investor based in Winter Park, FL. “You could lose it all really quick but you could hustle and kinda hit the jackpot. Everyone is using leverage. And they’re using it because you can make a ton more money,” he said.
By one measure, options activity is on track to surpass activity in the stock market for the first time ever. In 2021, the daily average notional value of traded single-stock options has exceeded $432 billion, compared with $404 billion of stocks, according to calculations by Cboe’s Henry Schwartz. This would be the first year on record that the value of options changing hands surpassed that of stocks, according to Cboe data going back to 2008.
Some analysts say the zeal for options trading is translating to bigger swings in individual stocks, and fueling the momentum behind many rallies. When individual investors buy call options, the Wall Street firms that sell options often hedge their positions by buying the shares, further contributing to rising markets.
“It creates a circular kind of melt up. It’s a reinforcing loop,” said Mr. Karsan, of options activity in individual stocks. (Curmudgeon: Until the music stops!)
The activity can also exacerbate downturns, traders say, though for much of the past year the stock market has recorded a steady climb higher. The heavy trading has made quarterly dates when options expire a focus point for many investors, who say hedging activity around the contracts can fuel greater instability in the stock market.
Short-term trading using derivatives including options can increase the prospect of a violent shakeout if individual stocks or major indexes take an abrupt turn, traders and analysts say.
Bespoke: Charts of the Week
September proved to be a weak month for the broader market just as it was last year. The drawdown in the S&P 500 snapped a six-quarter streak of finishes above the 50-day moving average. While six straight quarters of finishing above the 50-DMA is impressive, as shown in the chart below, it wasn't close to a record streak.
Richmond Fed Manufacturing Composite turned in its first negative since the early days of the pandemic. As this reading shows, companies are struggling to produce the goods needed to meet consumer demand.
The Dallas Fed reported that its Manufacturing Business Activity index fell to a level of 4.6. While still positive and indicative of growth, this month's reading came in below consensus forecasts.
Policy makers and central bankers are stuck in a mindset from the last crisis and need to alter their thinking.
Cognitive traps (rear-view framing, confirmation bias, blind spots, etc.) can slow the shift of policy makers’ focus to supply disruptions, which have become the main cause of the economic malaise of today and tomorrow. Instead, they reinforce some approaches, particularly in monetary policy, that inadvertently amplify the stagflation winds that are starting to blow across a growing number of countries.
Cognitive biases are particularly problematic at a time of big changes in the operating environment. This was clear in the aftermath of the 2008 financial crisis with the overly cyclical economic mindset that delayed policy responses to what constituted a structural and secular shock several years in the making. We are seeing it today with one that is evolving too slowly from demand to supply.
The economy and financial markets could use a break from the Federal Reserve’s “full-throttle” monetary policies. Stress is building with the economic and asset price wheels spinning so fast there is a sense that at any moment something could break. The Federal Reserve, in our opinion, has “QE’d” so hard and for so long that their policies have become counterproductive.
Meanwhile, Fed members attempt to justify current policies by claiming there is too much slack in the labor market and inflation is transitory. The Fed’s views conflict with some of the most pressing challenges workers and business owners are experiencing.
Assuming current trends continue, we expect the transitory inflation narrative will eventually succumb to reality (persistant inflation) and threaten the Federal Reserve’s ability to monetize debt and maintain negative real interest rates. Without the Fed’s intrusive interference in the free markets, interest rates would once again move freely, allowing asset prices to properly reflect their underlying fundamentals. Ironically, instead of the Federal Reserve saving us from inflation, we believe it will be inflation that saves us from the Federal Reserve.
Unless inflation expectations rise along with nominals, real rates could become less negative for a while. This chart shows that the 5-year real TIPS yield is about where it was in the spring of 2013, when we had the original taper tantrum.
Given the relationship between Treasury Inflation Protected Securities (TIPS) break-evens and nominals, it’s possible that the 10-year yield could climb to a 2-handle if the Fed exits the scene. If so, that could cause some more multiple-compression for equities.
IPOs and secondary offerings are surging, but share buybacks are strong also. Over the years, the demand side of companies buying back their shares from the public has outpaced the supply of companies selling their shares to the public.
The chart below shows cumulative share buybacks by sector. Since 2004, US companies have spent $11 trillion on repurchases, or about a fourth of the market cap of publicly traded US equities. Wow.
The chart below shows the cumulative stock supply and demand since 1982. I view the early 1980s as the start of the modern financial era, so that seems like a good place to start.
Price is at the intersection of supply & demand. The chart below shows IPOs and secondary issuance. With the surge of companies monetizing their value, it’s tempting to draw parallels to 2000 and conclude that pretty soon the stock market will be drowning in a sea of supply.
The data shows that nearly 40% of the time, two months of positive performance gets followed by at least one month of negative performance. Since 1871, there have only been 12-occurrences of 6-month or greater stretches of positive returns before a negative month appeared.
For September, the S&P turned in a negative 4.89% return. While the decline was average for a market correction period, the financial media made it sound like the market just “crashed.”
If you didn’t like the recent decline, you have too much risk in your portfolio. We suggest using any rally to the 50-dma next week to reduce risk and rebalance your portfolio accordingly.
For the past 16 months, buyers came in the very next day after investor behavior went to risk-off mode……. Until now. This just ended the longest streak of risk-on behavior in 22 years.
Sentiment Trader: S&P 500 Ends Streak
With a loss to end the month, the S&P 500 finally ended its streak of 227 days of being within 5% of a 52-week high. That was the 8th-longest streak of being within 5% of a high since 1928.
The S&P also ended its long streak of positive months. It was the first lower monthly close in 7 months. That's not its longest streak but is one of the longer ones when trading at an all-time high.
In September, Bank of America's "Sell Side Indicator," the firm's "contrarian measure of Wall Street's bullishness on stocks, declined to 58.5%." That dip in bullishness "resonates with our cautious market view, especially heading into the [third quarter] earnings season, where multiple companies have already issued disappointing guidance amid a worsening inflation environment," she wrote in a Friday note to clients.
LPL's Jeff Buchbinder argues "earnings is the big near term risk" given how many companies have warned of supply chain issues, he told Fortune. Meanwhile, although he notes there's a "low probability" of this happening, Bunchbinder suggests that "if it looks like the Democrats aren't going to get anything done" in October regarding passing an infrastructure package, "we can see that as a risk to markets because investors have priced in some of that spending," he suggests—even if failing to pass it could mean some relief in terms of tax increases in the near term.
"The stock market is filled with individuals who know the price of everything, but the value of nothing." — Phillip Fisher
Stay healthy, enjoy life, success, good luck and till next time….
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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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