Blue Skies

Blue skies smilin’ at me
Nothin’ but blue skies do I see
Bluebirds singin’ a song
Nothin’ but bluebirds all day long

- Blue Skies, Irving Berlin

The late Sir John Templeton once said, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” A week ago, bullish sentiment among investment advisors soared to the highest level in 30 years (Investor’s Intelligence), joined last week by a 16-year high in consumer confidence. When one recognizes that the prior peak in bullish sentiment corresponds to the 1987 market extreme, and the prior peak in consumer confidence corresponds to the 2000 bubble, Sir Templeton’s words take on both relevance and urgency. As I detailed last week, the most historically reliable valuation metrics have advanced within a few percent of their 2000 peaks, while the median valuation of S&P 500 components is now easily at the highest level on record (for charts and other analysis, see The Most Broadly Overvalued Moment in History).

Extremes in consumer confidence, coupled with extremes in investor sentiment, valuation, and price extension, have regularly marked important market peaks and troughs. In most market cycles across history, those extremes have usually been joined or closely followed by early deterioration (at peaks) or improvement (at troughs) in the internal uniformity of market action. When various components of market internals begin to diverge from the “obvious” trend, it indicates that investor risk-preferences are shifting from risk-seeking to risk-averse, or vice versa. The most negative market outcomes generally emerge when overextended valuations are joined by early deterioration in market action. The most favorable market outcomes generally emerge when material retreats in valuations are joined by early improvement in market action.

I’m fully aware of how eagerly many investors dismiss our current concerns, as well as our record prior to 2009, because of the inadvertent challenges that followed my 2009 insistence, after a market collapse we fully anticipated, on stress-testing our methods against Depression-era data. The central lesson of the recent advancing half cycle is this. Unlike other market cycles across history, even the most extreme overvalued, overbought, overbullish syndromes were not enough to discourage speculation in the presence of zero interest rates. Instead, zero interest rate policy required one to wait for market internals to deteriorate explicitly before adopting a hard-negative outlook, a restriction that we imposed on our methods in mid-2014 (see Portfolio Strategy and the Iron Laws for a more detailed narrative). As I noted last week, absent that challenging period, I doubt that anyone would find my present market outlook, in the face of historically obscene valuations, as either controversial or inconsistent with the identical concerns I expressed in 2000 and 2007.

Presently, we observe the broadest market valuation extreme in history, with the steepest median valuations on record, and the most reliable capitalization-weighted measures within a few percent of their 2000 peaks. In addition to extreme valuations, bullish sentiment, and consumer confidence, market action has deteriorated in interest-sensitive sectors, and internal dispersion has been widening more broadly. As of Friday, more than one-third of stocks are already below their 200-day moving averages. Indeed, even with the major indices near record highs, more NYSE-traded issues set new 52-week lows last week than new highs, while credit spreads abruptly widened.

All of these considerations have been remarkably useful in helping to identify points of risk and opportunity in prior market cycles, and despite the stumble that followed my stress-testing decision in 2009, I’m convinced that these considerations are relevant here. Those of you who have followed my work over the years will recall that a material market retreat, bearish sentiment, dismal consumer confidence and positive divergences after the 1990 market low were among the combined factors that encouraged me to advocate a fully leveraged investment stance. Similar considerations prompted our constructive shift in early 2003, after the 2000-2002 bear market collapse. Though confidence remained weak for months after that market low, I emphasized “suffice it to repeat that consumer sentiment is actually a lagging indicator that can be predicted from past movements in indicators such as capacity utilization, inflation, and unemployment.” Put simply, elevated levels of consumer confidence are less a signal of forthcoming consumer spending as they are a signal of forthcoming investor losses.

Conversely, in the context of extreme valuations, sentiment, overextended market action, and deteriorating uniformity (particularly across interest-sensitive securities), investors should take the recent high in consumer confidence as a warning of euphoric sentiment. In August 2007 (see Strong Economic Optimism), I offered a similar warning shortly before the global financial crisis began:

“Despite credit concerns, Wall Street remains exuberant about economic prospects. Last week brought a 6-year high in consumer confidence, evidently supporting the idea that the consumer remains strong and the economic expansion remains intact. Unfortunately, if you examine the data, you'll quickly discover that consumer confidence is a lagging indicator, well explained by past movements in GDP, employment, and capacity utilization. Worse, for the stock market, it's a contrary indicator (especially when it is well above the ‘future expectations’ component of the same survey). This is a fact that I've noted at both extremes, not only in early 2000 when new highs in consumer confidence supported a defensive position, but conversely in the early 1990's, when new lows in consumer confidence supported a leveraged position in stocks (prompting that “lonely raging bull” comment in the L.A. Times).

“High levels of economic optimism are regularly observed at the peaks of both U.S. and foreign economic expansions. This includes the general consensus of individuals, businesses, politicians, central bank officials and notoriously - economists. That shouldn't be surprising. It's the very nature of a peak that it can't be produced except by unusual optimism. Here's a phrase you don't hear a lot - ‘global recession.’ It's interesting how immediately and reflexively Wall Street rules it out. A great deal of the world's present stock market capitalization relies on ruling it out for years and years to come.”