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Abandoned Standards

America is going through a wrenching self-examination of male power, sexual harassment, and the bitter costs imposed on both the accused and accusers. It is by now widely known that powerful players in politics, media, and entertainment have used their positions to indulge their need for control and subservience that moves well beyond any need for sex. Emboldened by a small nucleus of women who were willing to risk their jobs, privacy, and reputations to reveal the sordid reality of their treatment by the old boys’ network, the trickle of harassment claims has turned into a flood. Weekly, women are stepping forward to reveal the years of harassment they have had to endure. The difference today is that those accused of these sexual improprieties are quickly meeting with harsh sanctions that have cost them their jobs, financial assets, and of course, knocked them off the pedestals of the professions that they once dominated. The simmering, suppressed tension that has been building between the men and women in the workplace is finally having its day of reckoning.

There are many reasons that harassment has been so widespread, but one underlying explanation includes the sense that the culprits have felt that they could oppress women with impunity. The fact that it has continued for so long speaks to the lack of punishment our society has imposed for sexual harassment. The absence of consequences for the guilty has altered their perception of reality. The prevailing attitude seems to be that as long as no penalties are imposed, it’s permissible to act reprehensibly. This is somewhat like the motorist who believes he has a right to run red lights, because he has always has, and never received a ticket for doing so. These bullies become warped into thinking different rules apply to them, and have abandoned any standards of ethical behavior that previously prevailed.

But it is more than just seeing what they can “get away with.” By looking around and seeing other powerful players indulging in the same behavior, it sends the message that sexual harassment is acceptable. This reflects the concept of “social proof” in action, and is a very potent influence on behavior. Social proof is the human tendency to look around us to determine proper behavior in situations of uncertainty. If a political leader models moral and ethical behavior during a crisis, it will influence citizens to do the same. In the case of the current wave of harassment claims, the offenders took their cues from others in power who took advantage not only of women trying to climb the corporate ladder of success, but also everyday women just trying to make a modest living: hotel maids, waitresses, restaurant line cooks. This is happening in all walks of life, and happens to men, too (Kevin Spacey). Clearly, sexual harassment has been an open secret in Hollywood, the media, and the halls of politics, so there were plenty of examples from which perpetrators could draw the social proof that harassment was fine, because many others were doing it.

But social proof can be a double-edged sword. The examples set forth by the women who have risked all to expose their harassers have provided the social proof needed to give others the nerve to come forth, resulting in the catharsis of disreputable revelations that is now reaching all levels of American society. Social proof has given women the courage to say they’re mad as hell, and not going to take it anymore.

Social proof is a powerful influence on crowd behavior, and we can see it working daily on Wall Street. Investors can’t help but be influenced by what they are being told by the media and the message being sent forth from the myriad indexes and performance benchmarks available today. If the market is going up, it is very hard take a contrarian position and hold cash. Likewise, when the market is falling, the advice to take a bullish stance falls on deaf ears. Perhaps in no other aspect of our lives are we so easily influenced by social proof than in our financial investments.

The current market has been remarkable for its persistent rise since Trump’s election, and its lack of volatility. It has seemed to be a one-way elevator to prosperity, with hardly a flinch during events that would have caused a correction in prior years (e.g. North Korean missile tests). Of course, it is easy to see why all traditional worries have been brushed aside, as the juicy plum of corporate tax reform is tantalizingly close to reality. It’s hoped that lower corporate taxes will unleash a flood of capital investment and hiring, sending profits up and share prices as well.

But rising stock prices have brought with them rising risks, in our opinion. Investors have succumbed to the siren song of tax reform and the relentless momentum of stock prices and have abandoned all pretense of embracing prudent investment standards. Valuation, leverage, and psychology all point to euphoric extremes in the stock markets.

Valuation levels are at the second highest levels over the last 117 years, trailing only the all-time extreme of 1999-2000. We highlighted this factor in the September Market Outlook, and this measure has only climbed since then. An average of four valuation measures available at now resides at 101% above the composite average. This is more than two standard deviations above the mean. High valuations do not “cause” low subsequent returns, but they are a condition that sets the stage for potential poor returns ahead.

Leverage, as measured by margin debt, is reaching epic proportions in today’s markets. Margin debt generally rises during bull markets, as investors are emboldened to leverage their bets and magnify their gains. Margin debt in and of itself is not a sell signal, but like valuation, is a condition that points to elevated risk. Leveraged stock investors don’t have the luxury of riding out a down market by simply making payments, as a highly mortgaged homeowner might do, because brokerages will issue “margin calls” to keep the leverage ratio of a client in check. An old saying on Wall Street is “Never meet a margin call,” meaning don’t throw good money after bad. If a stock is going down so much it triggers a margin call, just sell it. Thus, the risk with high leverage is that a down market can trigger an avalanche of selling, even if the economy is performing well. This is what happened in October 1987 during the infamous 22% one-day crash, but which did not presage a recession.

Bullish sentiment is at a 30-year high, and in fact, has recently matched the extremes last seen in the summer of 1987. Investor’s Intelligence has been tracking investor sentiment since the 1960s, by subscribing to over 200 investment newsletters and tallying the editors’ bullish or bearish opinions. This has the advantage of a written commitment; the publisher must take a stand one way or the other. After all, that is what the subscriber is hoping to glean from their expertise. Thus, this sentiment survey has the benefit of a regular opinion that must be expressed every issue, and we would view it as a long-term measure of sentiment.

Abandoned Standards Sentiment Graph

While sentiment usually focuses on the ups and downs of bullish opinion, a look at current bearish opinion is insightful. Bearish, i.e. negative, views have recently dropped down to less than 15%, as extreme as the bullish peak mentioned above. This is enlightening because it says that the bears have “thrown in the towel.” In other words, they have not been able to stay with their negative opinions in the face of a strong market. Pressure from subscriber cancellations, the very public embarrassment of being “wrong” (in writing!), and “fear of missing out” all compel the change of long-held bearish views when the pundit can stand it no longer. Past experience has shown that bearish opinion plummets to new lows near the top of the market. This is social proof in its purest form.

While the Investors Intelligence data require a subscription, readers of this newsletter can track sentiment on their own via a handy tool from news network CNN. The “Fear and Greed Index” is short-term measure of sentiment available for free to the public, and is updated daily. Rather than look at newsletters, it measures seven factors in order to determine whether fear, or greed, is dominating the markets at the moment. This has its own advantages in the sense that it measures how investors are behaving, not what they’re saying (after all, talk is cheap).

Abandoned Standards Fear and Greed Index

By looking at quantifiable indicators such as market momentum, put vs. call ratios, junk bond demand, and new highs vs. new lows (among others), the Fear and Greed Index creates an index from 0 (extreme fear) to 100 (extreme greed). A reading of 50 would indicate the two emotions are in some sort of balance, but of course, readings around 50 are rare and fleeting as markets oscillate between the two emotional extremes. CNN provides a three-year chart showing Fear and Greed Over Time, and it has accurately captured significant lows and highs in the market. You can learn more about the Fear and Greed Index here:

Abandoned Standards Fear and Greed Over Time Graph

There are three implications of today’s extremes in investor psychology. First, it indicates that investors have been swept up in the prevailing euphoria of the moment. While certainly true for stocks, we can see an extreme euphoria in the market for Bitcoin, a “cryptocurrency.” The price of Bitcoin has risen nearly vertically in the past month, breaking record after record, as people pile in. For both stock and Bitcoin, there is a “get me in at any price” mentality that has overtaken investor behavior, as traditional yardsticks of investment prudence are tossed aside.

High bullishness also implies that investors are fully committed to stocks, and their cash reserves have been invested. If someone believes stocks will rise tomorrow, they will buy today in anticipation. With corporate tax cuts fueling bullish outlooks for 2018, cash levels are at record lows, whether measured by mutual fund cash allocations or the level of margin debt on the NYSE. Since cash is what allows the demand for securities to be satisfied, low cash levels imply that this source of fuel for the market is running low. This is following the traditional script, where the lowest cash levels appear near the market top. Moreover, with central banks beginning their baby steps toward raising interest rates, and reversing their quantitative easing policies of the last nine years, markets will not have the unlimited spigot of cash creation they have enjoyed since 2008.

Abandoned Standards Schwab Cash Levels Graph

Finally, the relentless rise in stocks and commensurate rise in bullish sentiment has left little room for error on the downside. A well-worn truism is that “Wall Street climbs a wall of worry,” meaning that skepticism is a necessary ingredient for longevity. Uncertainty, and the bouts of selling that entails, provide a pressure relief valve for stock prices. As stocks go through periodic corrections, worried investors sell and raise cash, thus providing the fuel for the next leg up in prices. Currently, we have not had a correction of more than 3% for nearly two years. This is extraordinary, even in the era of easy money and central bank repression of interest rates.

The implication for investors is that bullish pressure has not been relieved, and that any decline may turn into a precipitous drop rather than an orderly sell-off. With nearly everyone on the bullish bandwagon, any whiff of panic may turn into a rush for the exits, especially as automated computer-based trading kicks in, mindlessly selling stocks into a falling market. Investors who believe they will be able to reallocate to a more conservative position once the decline starts may be in for a rude surprise, as they find they cannot act quickly enough when then bull turns.

For now, however, the bulls remain in control of the stock markets, as price momentum, advance/decline breadth, and other measure such as the NYSE Bullish % remain positive. The promises of tax cuts have kept investors buying, in the hopes of new highs to come in 2018. Thus, while the conditions are indicative of a market peak, we have not seen any general sell signals yet. It may take another six months or more for these to materialize, but when they do, our concern is everyone will see them at the same time, leading to a general rush for the exits. To that end, conservative investors may wish to consider taking advantage of today’s complacency to begin reallocating to a more defensive stance now while the sun is shining.

We cannot dismiss the human element in the markets, and the extremes in bullish psychology are part of the cyclical conditions, along with high valuations and high leverage, that were present at previous market peaks. The human willingness to abandon common-sense investing standards as the gold rush mentality takes over speaks to the power of social proof to influence our behavior. “Get me in at any price” seems to be the prevailing attitude toward stocks, real estate, and of course, Bitcoin. Investors should take a step back and ask themselves how much risk they are willing to take in the current environment, and perhaps heed the insight of American journalist Walter Lippmann, who observed, “When all men think alike, no one thinks very much.”

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