Strategy I: Melt-Up Musings.
I visited our accounts deep in the heart of Texas last week, specifically in Austin, Dallas, Fort Worth, and Houston. They all wanted to talk about the potential for a stock market melt-up. They also asked me what could go wrong for the market. I said that I am most concerned about a melt-up followed by a meltdown. I’ve been raising the odds of a melt-up this year. And I am doing it again today.
Consider the following:
(1) 60/30/10. On January 24, 2013, I first suggested that if we all just keep calm and carry on, “then maybe the cyclical bull market will morph into a secular bull market.” The S&P 500 rose to a new record high on March 28, 2013 for the first time since October 9, 2007. Also in early 2013, I detected “anxiety fatigue” among many of our accounts. After the widely dreaded “fiscal cliff” scare turned out to be a non-event at the start of 2013, they were tired of being anxious that the bull would get tripped by a bear.
On May 9, 2013, I first assigned subjective probabilities of 60/30/10% to Nirvana, Melt-Up, and Meltdown scenarios. On May 16, I observed, “In other words, we have nothing to fear other than an absence of fear. … Perhaps now that investors are no longer fearful that the end is near, all the liquidity pumped into the financial markets by the major central banks over the past four years to avert the Endgame scenario is about to cause the Mother of All Melt-Ups (MAMU).”
(2) 40/40/20. This year, on March 6, I lowered the odds of the Nirvana scenario (from 60% to 40%), and raised the odds of the Melt-Up one (from 30% to 40%) because stocks were doing just that, melting up. Increased Melt-Up odds implied that I should raise the odds of a Meltdown (from 10% to 20%), since the former scenario tend to lead to the latter one the way that booms lead to busts.
(3) 30/50/20. Then, on August 2, I wrote: “Today, we are raising the odds of the Melt-Up scenario from 40% to 50%. The Meltdown scenario remains at 20%, while the Nirvana scenario gets cut from 40% to 30%. By the way, a melt-up followed by a meltdown won’t necessarily cause a recession. It might be more like 1987, creating a great buying opportunity, assuming that we raise some cash at the top of the melt-up’s ascent. Our animal instincts will have to overcome our animal spirits.”
(4) 20/55/25. Today, I’m raising the odds of the Melt-Up scenario to 55% mostly because melting up seems to be what stocks continue to do. I’m also raising the Meltdown odds to 25%. As a result, Nirvana is down to 20%.
The extraordinary rally to multiple record highs this year has been driven by several solid fundamental factors. Earnings have continued to rebound from the energy-led earnings recession during 2015 and the first half of 2016. The pace of global economic growth started to quicken late last year. President Donald Trump’s administration is moving rapidly on deregulation, and more slowly on enforcing current regulations. He has yet to deliver on cutting taxes and bringing back overseas earnings, but both remain possible. Inflation and interest rates remain low, which justifies historically high valuation multiples.
However, this Nirvana scenario seems to be rapidly morphing into the Melt-Up scenario. As one of our NY accounts observed last week in an email exchange with me: It’s “a case of FOMO, as the youngsters call it these days—Fear Of Missing Out.”
Strategy II: The Fourth Phase. In 1725, Antonio Vivaldi composed The Four Seasons, a set of four violin concertos. The sounds of each concerto resemble its respective season. So for example, “Winter” is punctuated with pizzicato notes from the high strings, suggesting icy rain. “Summer” sounds like a thunderstorm in its final movement, which is often called “Storm.”
One of the great virtuosos of the investment business was Sir John Templeton. He observed that bull markets experience four phases: pessimism, skepticism, optimism, and euphoria. Similarly, my friend Laszlo Birinyi has also identified four phases: reluctance, digestion, acceptance, and exuberance. Where are we now in the current bull market? See if you agree with the following phase demarcations as I see them for the current bull market:
(1) First and second. The first phase started on March 9, 2009 and ended after the second and worst correction of the bull market, on October 3, 2011 (Fig. 1).The second phase included three minor corrections, with the last one ending on November 15, 2012.
(2) Third and fourth. On July 8, 2014, I wrote that the S&P 500 was moving from the third to the fourth phase. Now I’m thinking that the third phase was extended by the energy-led earnings recession. Instead, the third phase might have ended on February 11, 2016, when the S&P 500 fell to the lowest reading since April 11, 2014, taking out some of the optimism that had been building during the third phase. During the fourth phase since then, there have been no significant corrections, which certainly must be contributing to the mounting euphoria/exuberance about stocks.
(3) P/E phase profile. The S&P 500’s forward P/E also can be used to identify these four phases (Fig. 2). It mostly fell during the first phase, when earnings caught up with the initial bull market euphoria. During the second phase, it rose slightly but remained relatively low as investors continued to fret about another financial crisis and a renewed recession. During the third phase, the forward P/E trended higher, rising to a cyclical peak of 17.2 on February 24, 2015. It was back down to 14.7 on January 20, 2016. It has been above 17.0 ever since January 24, 2017, and was at 18.0 at the end of last week.
This is all still Nirvana territory but bordering on Melt-Up terrain, in my opinion. If the P/E rises over 20.0, that would suggest to me that the exuberance phase of the bull market is well underway.
Strategy III: Front-Cover Curse. The melt-up is making headlines. Randy Forsyth’s column in Barron’s this week is titled “The Meltup Before the Storm?” He notes: “‘The bull market in everything’ is how the current issue of the Economist sums up the state of affairs. The magazine’s subhead does ask, ‘Are asset prices too high?’ which implies that the inevitable correction is at hand. The cover illustration also features a bull, a redoubtable contrarian indicator of trouble ahead.”
Randy also observes: “On the CNN Fear & Greed Index, fear was nowhere in evidence on Thursday. The index closed at 95 on a scale of zero to 100, a score deemed to be ‘extreme greed.’”
Apparently, the so-called “most hated” bull market in stocks is now loved. Let’s review some more loving indicators:
(1) Corrections are MIA. The S&P 500 hasn’t had a significant panic attack or correction since early 2016 (Fig. 3). The index’s level has been above its rising 200-day moving average since May 26, 2016 (Fig. 4).
(2) Sentiment is bullish. The Bull/Bear Ratio (BBR) compiled by Investors Intelligence rose back above 3.00 over the past two weeks as the percentage of bears fell below 18.0% (Fig. 5).
(3) VIX is comatose. The S&P 500 VIX remains in record-low territory, falling to a record low of 9.2 on Thursday and edging up to 9.7 on Friday (Fig. 6). It is highly correlated with the bearish component of the BBR. It tends to spike in response to panic attacks. The previous spike peaked at 16.0 as a result of a short-lived North Korean crisis (Fig. 7).
(4) Dow Theory is smoking. Both the DJIA and DJTA rose to record highs last week (Fig. 8). The latter seems to be breaking out of a trading range that started last year.
(5) P/E multiples are elevated. On Friday, the S&P 500/400/600 forward P/Es rose to 18.0, 18.2, and 20.2 (Fig. 9). Daily data since 1999 show that the S&P 500 multiple remains well below its 1999/2000 bubble peaks around 24.0. However, both the S&P 400 and S&P 600 are back to levels that previously marked their cyclical tops.
The Russell 2000 P/E is especially rich at 27.0 at the end of September (Fig. 10). Even richer is the 34.8 multiple for Russell 2000 Growth (Fig. 11). Then again, if Trump delivers on deregulation and on tax cuts, smaller corporations might benefit more than larger ones.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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