The phones were ringing off the hook. Desperate clients wanted to know what was happening, minute by minute.
Clients were being margin-called left, right and centre. Heck, I was even in a margin call in my personal account. I barely had time to scratch myself, let alone figure out what to do about my own margin call. The natural contrarian in me said “Buy more! Things can’t get much worse”. So I did.
It was 16th September 2008 and things were about to get much worse.
Lehman Bros had filed for Chapter 11 the previous evening. My bosses wanted regular updates on the the firm’s derivatives exposure and my colleagues and I were working 16-hour days.
Panic was in the air. People aren’t depressed when there’s panic. There’s too much energy in the emotion of panic for depression to set-up shop.
Clients were panicking about losing more money.
The firm was panicking about exposure levels.
We were all panicked by the prospect of losing our jobs!
Every week, a couple of people in the dealing room would receive a call from human resources. You could always tell when someone had received a call from HR. They would either burst into tears or they would develop a very somber, ashen appearance. They would discreetly leave the dealing room, never to be seen again. A few hours later – after security had escorted them from the building – their personal belongings were packed into a cardboard box by one of the desk assistants and said box would be couriered to the individual in question.
Over the next few months, panic levels would continue to rise and many clients would sell their positions in disgust – at or near the lows of the market – and swear off stocks for many years to come.
A meltdown is a relentless march lower in stock prices and this is what the last one felt like.
In case you are unfamiliar with the term, A “melt-up” is a relentless march higher in stock prices. Basically the opposite of a meltdown. This is what the market has been experiencing in 2017.
During meltdowns, people get bearish. This is a function of both panic and herding behaviour.
And during this melt-up, people have been getting…bearish. The psychology behind this is fascinating.
Rather than taking market strength, solid earnings, low volatility, synchronized global economic growth and strong technicals as positive underpinnings of this bull market, many market commentators choose to look for signs of extreme caution.
As I wrote last week, many commentators are what I describe as ideological bears. Many others assume that, because this bull market has been going for 8½ years it must be due to die of old age. Add to these two, a third category of bear. Those who remain so scarred by what happened in 2008/09 that it’s just a bridge too far for them to think of stocks in positive terms at all.
The stock market is definitely one of the biggest mind games out there. And this enormous mind game affects everyone involved, regardless of education and experience. A formal education in traditional finance can even hinder one’s ability to be a successful trader in markets if its taken too literally.
Traditional finance theory teaches that market players are rational profit maximizers, when in reality nothing could be further from the truth. As harsh as this may sound, as traders what we are trying to do a lot of the time is profit from the mistakes of others. Human behavior plays a much, much bigger role in stock market movements and trends than we like to believe.
There has been a lot of talk recently about the “flattening” in the yield curve.
The yield curve is a line that plots yields of differing maturity, from overnight to 30 years.
Short-term interest rates are heavily influenced by monetary policy, while long-term bond yields are a function of GDP growth expectations combined with inflation expectations. If the market expects growth and/or inflation to be high, people will usually sell bonds and their yields will rise. If the market expects growth and/or inflation to remain low, people will buy bonds and drive down their yields.
A “normal” yield curve is one where longer-dated yields are higher than shorter dated yields, to reflect the increased risk associated with time.
The yield curve flattens when short-term interest rates rise relative to long-term interest rates.
An “inverse” yield curve is when short-term rates are higher than long-term rates. An inverse yield curve has proven to be an accurate predictor of recessions over the years. This is why the shape of the yield curve and the recent flattening that we have seen is of interest.
Research from Ned Davis Research points out that it takes 7 months on average from yield curve flattening to inversion and a further 14 months on average to the start of recession. The median S&P gain is +7% before inversion.
According to Jeremy Grantham of GMO, investors have an extreme preference for comfort. And the two factors that make investors most comfortable of all are high profit margins and low and stable inflation. Stability of GDP (as opposed to actual growth) ranks a distant third.
This helps to explain why investors are prepared to pay higher than average valuations for stocks in the present environment. It may also mean that a flat yield curve should not cause stock investors to run for the hills, so long as profit margins hold up. Gratham argues that a jump in inflation expectations – or a collapse in profit margins, or both – would be required to cause investors to flee the stock market. Neither of these seem likely in the near term.
The flattening we have seen in the yield curve is a function of short-term rates rising more quickly than longer-term bond yields. Fed policy is the cause, rather than a collapse in inflation or growth expectations.
How long will this bull market last?
We’re in a bull market. I hope this is a given.
The Dow, the S&P and the NASDAQ are all making record highs.
The Advance/Decline line has also made a new high, confirming that this bull market is not over yet. The A/D line is a measure of market breadth. A rising A/D line tells us that more stocks in the S&P 500 are rising than falling. When the S&P 500 is making new highs, we want to see the A/D line also making new highs to confirm the health of the trend.
In a “melt-up”, a narrowing in breadth is a cause for concern. According to Ned Davis Research, in 90% of stock market tops, the A/D line peaked on average 99 days ahead of the market top. The A/D line is still increasing so no warning bells here.
Low corporate bond yield spreads and a VIX below 15 both indicate bull market conditions.
Real GDP continues to grow at a modest 2% pa. This trend looks likely to continue for the foreseeable future.
Monetary conditions remain easy with M1 money supply growth continuing at 7% pa. With the latest Fed minutes showing concern over inflation readings continuing to surprise to the downside, we can expect the path to monetary tightening will remain slow and cautious.
For Q3 2017 earnings, 74% of companies have reported positive earnings surprises and 66% have reported positive revenue surprises. This is what has given the market extra fuel over the past two months.
Weekly AAII sentiment revealed there were more bulls last week, with bullish percentage rising to 35% from lows of 29%. No sign here of any euphoria towards stock ownership.
These are all good reasons to give the current bull trend the benefit of the doubt. I expect the prevailing conditions will mean we’ll see further – possibly significant – gains over the next 12-18 months.
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