The masses are fooled by the plethora of information that is thrown at them.  Many decide that it is too overwhelming, so they decide to let the investment management system, via an advisor or bank, take things over for them.  This is a major mistake, which is not to say that bank and advisors are bad, but the system is slanted towards them, not you. So you have to reverse things. But first, you must get passed all the information that is there to confuse you.  Instead be aware of the following…

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There is so much data and information that investors can look at assessing.  Some refer to it as ‘noise’, most of which is useless to an investor. It may be very applicable to a trader as markets can move short term based on news or fundamentals, but the overall direction of markets are quite set in stone. That may sound strange to you, as all of us here the media say markets are running to highs or they are crashing, and it feels like this is on a constant basis.  But markets trade based on momentum and generally in one direction for a period.  Have a look at this chart:

I realize it is a busy chart but the key things to note are:

  1. The periods that are noted as Secular Bull and Secular Bear markets
  2. The up and down movements in a Secular Bear market versus the steady uptrend in a Secular Bull market
  3. That each period of up and down movement in a secular bear is called a cyclical period, and they generally take at least a year to play out and can be as long as 8 years
  4. The secular bull periods tend to be a pretty much straight line up with minor corrections – this is where investors should be fully invested and not spooked out of the market

Critical point #1:  you have to know if you are in a secular bear or secular bull market.  Our strong belief is that the secular bear that began in 2000 has not ended.  The way to know it has ended is when market multiples crash to extremely low levels – between 5 and 8 is the norm.  Have a look at the next chart to see the PE levels where bull markets and bear markets end:

As you can see with the red circles, in secular bear markets, price-earnings ratios have made it down to levels of 4.78, 5.84 and 6.64.  In the most recent collapse, PE levels only fell to 13.32, with the level actually higher than it should have been as many financials had negative multiples. It was a very ugly and scary period, but the trailing 10-year PE never fell to a level that would signify the secular bear was over.  We think this will happen, most likely by a collapse in the stock market.  The only other way for it to happen is a number of corrections with a poor performing stock market for years, bringing the multiple down to a level below 10.  Given it is just under 30 today, the market is seriously overvalued.

Now saying that many would argue the market should collapse.  And on paper, they would be right.  Revenues and earnings have been horrible for more than a year (although they seem to be improving now) and the market multiple is as expensive as it was in 1929, with only the 2000 level surpassing it.   Given we are in a secular bear market, fundamentals of the economy or stocks for that matter really mean very little. I will explain how fundamentals should be used.

Quantitative analysis provides little clarity in markets like this for investors. They are driven by mathematical formulas that have been shown to be very vulnerable.  Even many technical forms of analysis do not mean a great deal. I would be remiss not to say that we strongly believe in using technical indicators to get into and out of the market, as longer term indicators take all emotion out of the decision.  So what is the best way to tell if we should be invested or not – market sentiment indicators are key to understanding economies and markets.  Have a look:

This again is a fairly busy chart created by DS Short, but it notes some key observations in it.  First, let’s provide you a quick overview of the chart:

  • The blue line is the Consumer Confidence Index with an all-time high in 2000 at 144.7 and a low in 2009 at 25.6
  • The green and red bars show annual GDP growth or loss
  • The gray shaded areas are times of US recession
  • Regression line for Consumer Confidence is declining over time
  • The same is the case for GDP regression line, as lower levels of economic growth are occurring over time

Here are a few of the key findings from the chart:

  • Economic growth trend continues to slow – the primary reason is an overindebted society, both government, and individuals, which inevitably slows growth. We expect this trend to continue
  • Stocks peaked in January 2000 and October 2007 in this current secular bear market. Looking at the Consumer Confidence levels, they peaked at that time as well
  • The stock market double bottomed in October 2002 and March 2003, again a time when Consumer Confidence bottomed. In March 2009 both the stock market and Consumer Confidence bottomed
  • Clear inverse correlation between these indicators at peaks and troughs
  • Cyclical bull cycles rise as consumer confidence rises. Peaks come as sentiment reaches extreme
  • Current levels are as high as they were in October 2000 but remember that peaks tend to not be a one-time event but forming. The market is showing these characteristics now as is consumer confidence.

We do use other technical indicators to help us determine how overextended the stock markets are. We also use fundamentals but the timing of fundamentals is questionable at best. Where we feel fundamental analysis is best to use is determining the best companies to buy, in secular bull markets and the cyclical bull cycle in a secular bull market.

Other factors that are critical in the world today in determining the direction of stocks is the actions of Central Banks. Will they continue on the path of quantitative easing programs in Japan and Europe?  Once these programs end and they will have to as balance sheets of these Central Banks explode, this safety net for stocks will end. Also, interest rates are key, as rising interest rates are not good for stocks. Saying that we are far from convinced that interest rates will rise much at all.  We actually believe interest rates will fall once again, as world economies slow and stock markets falter.

So do not ignore sentiment, Central Banks, and interest rates. But do not get hung up by all the investment noise out there.  This includes the media, fundamental analysts, political actions, and economic data. We watch these signs but recognize that most are just noise that investors should ignore.  Only significant events or major deviations from the norm should be closely assessed. Examples here would be a major change in US corporate and personal taxes or a collapse in GDP.

We are moving towards a peak in stocks, but peaks are created over time, and overvalued markets can become more overvalued.  Use market sentiment and our proprietary market timing technical indicator to know when to leave the party and not wake up with a massive hangover like many will once the big picture secular bear roars again…

Matt Sammut