October is here….we will be watching for market dynamics closely

Given the month ahead of us,  the near-record level valuations of the markets, cycle theories calling for a peak, world tensions in many areas, and massive debt growth that has not abated, it would be reckless to ignore the risks this month.  To be clearer, it is not just this month but the next number of months that should be closely watched.  The world saw the pendulum swing as far as we have seen it since 1929 in 2009, but we have seen that pendulum swing back, probably way too far the other way. A review of how zero interest rates and massive money printing saved us in 2009, but in the end may kill us today….

In a perfect world, we would see the markets have one final blow off top with divergences in place. This simply means that one or two markets hit all-time highs, while others fail to hit those levels. This tends to be common at market tops, and we are watching for them.

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As the pendulum swings. It is critical to understand what drives markets more than anything….market sentiment or belief or lack of in stocks.

In 2009, we were at record low levels of optimism, with pessimism taking hold in all areas of societies.  The prevalent belief was that the world was falling apart, and no one wanted to own stocks.  Hindsight is wonderful, but if investors simply used sentiment indicators, they would have been piling in stocks at that time.

The market continued up from that point, but it took about four years before retail investors started to be comfortable with equities once again. Many took longer, and some have never returned, as they were burned in the early 2000`s and again in the 2007-09 crash.  It is clear why sentiment hit a major low, as the pain was massive financially and economically. Also, the media at that point was creating fear within individuals, as things did look very scary.

So as Central Banks moved trillions and trillions of dollars into world economies and stock markets, the economic and fiscal world responded…not great, but they did not fall into the abyss, which is what could have happened without massive Central Bank and government intervention.

So, we have seen the markets rally consistently since 2009, with little volatility. Gains were achieved partially by earnings improvement, but primarily by huge corporate buybacks of their shares, which has been the theme for years. That pushes the number of shares down, which means the price of the stock can go up without the Price Earnings (PE) ratio rising.  Also, the PE ratio has expanded from its low in 2009 of 14 to over 25 today. That is an increase of about 80%. Median level is 14.66 since 1870, so the current level is also 72% above the median. No wonder stocks have soared.  Companies have fewer outstanding shares due to all the buybacks, and the PE expansion has been dramatic.  Yes, earnings have improved, but they have not been the driving force of stock market moves.

If you look at the Shiller PE 10 year average which eliminates short-term fluctuations in price-earnings levels, the nosebleed valuations are even more dramatic. Today we are at the second highest level in history (higher than the 1929 peak before the greatest stock market crash in history). The only time it was higher was in the technology boom of the late 1990`s into 2000. That was a totally different period, as there was a real belief that the world had found a new paradigm via the technology revolution; demographics were in favour as the baby boomers were in their peak spending years, and total debt was high but not out of control.

Fast forward to today, and you have a period of technology movement but not near to the extent as to the initial phase of the 1990`s, as many of the current inventions have occurred but improved. There will be unbelievable breakthroughs in future decades but look for a lull first.

Demographics are now an obstacle towards growth, as baby boomers are past their primary period of spending and instead are saving for retirement or just past a period in life of major spending. On top of this, the millennials have not been dealt a fair deal, as high-paying jobs and careers have not been there for them, but instead, society has made sure they were burdened with incredible student debts. Most importantly debt at all levels (government, household, corporate and financial firms) is at extreme levels, where a rise in interest rates will fiscally destroy many holders of debt.  The period of leverage from debt is over, so this long period of debt expansion is coming to an end.

Here is a chart of market psychology, which we have shown you before;

As you can see, the only people buying at the beginning of this move in mid-2009 was `smart money` – investors who are said to have a comprehensive understanding of financial markets – they can identify or foresee trends before others.  Institutional investors follow including mutual funds, hedge funds and pensions followed finally by retail investors, about halfway through the cycle.

Today, we believe we are close to the Euphoric stage, or in other words, market peak.  A final blow off market top would be perfect but not needed.  This month we will be watching closely.

For those of you who say it has to do with Trumps disastrous moves, or North Koreas-Trump threats, or succession vote from Spain by Catalan, or horrific shootings such as Las Vegas, or disastrous weather events like the hurricanes and earthquakes, forget it.  Just think of how the market moved up when Trump was elected, although most thought the markets would crash, Brexit, travesties in Syria, massive movement of immigrants in Europe, etc. These may have a short-term impact, but as long as investor confidence and mood is rising, stocks will rise.

Once they get to these euphoric levels is when to be very careful.  Signs are there given many confidence indicators we follow. Most investors and money managers believe that any small market correction should be bought into, as stocks do nothing but go up. Interesting thinking…..brings back memories of 2000 or 2007 when sentiment was very similar. Today, we are even at higher levels in a number of indicators.

Here is a chart of Elliott Waves, which we have studied at a deep level, and believe that it has significant credibility. It may not always be correct, but it has called major turns very well. They see the current period as a huge turn coming:

The right side is the S&P500, and the left side is a defined Elliott Wave up cycle.  The beginning would be in March 2009 and the area that is labelled 5 is today. We could still see a blow-off top, meaning the market could shoot beyond the channel short term, but generally blow off tops end major runs, and do not start or continue them.

We will watch closely, as should you. Our customers will be first to hear if our market timing indicators scream `sell.’

Matt Sammut
Founder & Chief Investment Strategies