Notably, there is a necessary clarification that must get made. Warnings have different degrees of outcomes.
For example, a warning label that says “only wash in cold water” has an outcome that results in a shirt that will now only fit a toddler. Conversely, the warning label on a hairdryer explicitly states, “do not use while taking a shower.” The consequence of ignoring such a warning is costly.
The same applies to warnings in the stock market for investors. A “warning” when stocks are not extremely overvalued, excessively bullish, or extended is not as critical as when they are. Therefore, the first thing we need to understand is how important are the warnings we are seeing?
The advance in the market over the last 12-years is the result of years of monetary accommodation and near-zero interest rates. As such, it is no surprise the deviation of the market from its long-term moving averages is extreme.
The critical thing to remember is that “mean reversions” are a constant throughout history. Therefore, the greater the deviation in one direction, the greater the reversion will be.
Besides getting extremely extended, the market is also excessively overvalued. There are two critical takeaways from the chart below.
Lastly, investors are convinced there is “no risk” in the market because the Fed provided an “insurance policy” against loss.
Such is the very definition of “moral hazard.”
Investor exuberance is evident from the massive increase of household equity ownership as a percentage of their disposable personal income. The current deviation from the long-term exponential growth trend rivals every previous bubble in history.
Yes, this time could be different. But, unfortunately, it just usually isn’t.
“Behind The Curtain” warnings are not widely discussed in the mainstream media and are generally relegated to more opaque analysis.
One such indicator is the CBOE SKEW index. The index measures the perceived tail risk of the distribution of S&P 500 investment returns over a 30-day horizon. It is similar to the VIX index, but instead of measuring implied volatility based on a normal distribution, it measures the implied risk of future returns realizing outlier behavior.
A SKEW value of 100 indicates the options market perceives a low risk of outlier returns. Conversely, values above 100 reflect an increased perception of risk for future outlier events.
On Friday, the reading was 170. The chart below smooths the SKEW with a 50-DMA which is now the highest level on record.
Another measure, as noted this past weekend, is the Bespoke “irrational exuberance” indicator that subtracts “Valuation Confidence” from the “One Year Confidence” survey data. That reading exploded higher recently for both institutional and individual investors.
The key takeaway is that “investors simultaneously think the market is overvalued but likely to keep climbing.”
In simplistic terms, investors are as bullish as they can get.
During a market-mania, Wall Street rushes to bring new companies to market to fill the “demand” from seemingly insatiable investors. That demand for “product” eventually leads Wall Street to start pushing money-losing companies into the public markets. As noted by Sentiment Trader last week:
Not surprisingly, the explosion in IPOs is the result of the demand from investors. Bloomberg noted that 254 profitable companies issued secondary or add-on shares over the past 12 months. But 748 unprofitable companies did the same.
Notably, the amount of equity issuance is minuscule relative to the total market capitalization, but it is the “investor appetite” that makes it possible. Historically, that “exuberance” is a classic hallmark of a market peak.
An old Wall Street adage says, “no one rings a bell at the top of the market.”
Near peaks of market cycles, investors get swept up by the underlying exuberance. That exuberance breeds the “rationalization” that “this time is different.”
How do you know the market is exuberant currently? Sentiment Trader had a great graphic on this last week.
“This type of market activity is an indication that markets have returned their ‘enthusiasm’ stage. Such is characterized by:
Currently, we are seeing every box checked. Irrational exuberance from investors, easy credit with investors taking out personal loans to buy stocks, and risky stocks outperforming. The level of exuberance currently matches previous major market peaks, the only missing ingredient is a catalyst to start the reversal.
The biggest problem is that investors are crowded into a theatre with a single exit. When the selling starts, the exit will become very narrow, very fast.
As noted by Jason Zweig, this is a “stock ‘gamblers’ market.”
Yes! This time is indeed different. But so was every previous overly exuberant bull market in history.
These all certainly sound like logical assumptions, and, at the time, were seemingly accurate. That is, until they weren’t. As noted, market reversions are brutal events that reset investor thinking.
While this time is undoubtedly different due to unprecedented interventions, it is likely these “behind the curtain” warnings should not get ignored.