Siren’s Song

Wall Street has become captivated by the prospects for easy money. News articles are filled with stories of individual stocks jumping by astronomical amounts in a single day, by wild first-day gains in initial public offerings, and by newbie bloggers instructing the rest of us on how to make a million. Day traders, in particular, have flaunted their successes on message boards such as Reddit creating a cult-like following for their favorite stocks. And they are not alone. Increasingly, major institutional investors are joining the day-trading crowd in throwing caution to the wind. The stock market bubble is proving to be an irresistible siren’s song of easy profits with seemingly no risk.

Bubbles have always grown on the suspension of disbelief by an incredulous population. Today’s markets are dominated by three ingrained assumptions that have by now become articles of faith for investors. First is the confidence that the Federal Reserve will always bail out Wall Street. Repeated bursts of money printing have certainly reinforced this belief since 2009, and the gargantuan increase in money supply in response to the pandemic’s shutdown of the economy has done nothing to dispel this assumption.

Fear Of Missing Out (FOMO) has become another overriding psychological phenomenon. Spurred on by tales of easy success, the market is drawing in more and more investors who now believe prices move only one way—up. This is feeding crowd behavior to get in before prices move even higher, and is fueling a get-me-in-at-any-price attitude. Of course, reports of losses are nowhere to be found. What happened to all those people who bought GameStop at the top of $483 a share?

Finally, investors have embraced the idea that There Is No Alternative (TINA) to stocks. With short-term bond yields being suppressed by central banks to near zero, and stock market corrections a quaint relic of days gone by, investors are piling into stocks using the rationale that they have no choice. This almost religious belief in TINA has many people in the market unprepared for a down cycle in prices, whenever that might occur.

These attitudes are prevailing on Wall Street despite well publicized measures that have identified periods of maximum risk in the past. Consistent with past bubbles, warnings from respected analysts are going unheeded as cash keeps piling in. There seems to be a willful blindness to many barometers that have historically marked market peaks, as investors disregard these measures as the lure of easy money is too powerful to ignore.

We believe there are three major risks investors must consider: leverage, valuations, and overly bullish sentiment.

Leverage, or the degree of debt taken on, has reached new highs on many levels. Federal government debt, of course, has mushroomed as pandemic spending packages were instituted in 2020 to stave off a profound recession as many people were thrown out of work. Corporate debt has also expanded as companies, backed by implicit guarantees from the Fed, have borrowed to get themselves through the pandemic recession. Corporate debt to cash flow has now exceeded the peaks of 2000 and 2008, and, in an indication of the borrowing frenzy (or should we say lending frenzy) among lesser-rated companies, the yield on the Bloomberg/Barclays High Yield Bond Index sank to a record low of just 3.96% in February. The siren’s song of easy money is alive in the junk bond market as well.

But it is margin debt that should be investors’ primary worry. Margin debt is money borrowed from brokerage firms against a securities portfolio and used to enhance returns. Like all forms of leverage, margin works great as asset prices rise, which they have done since the pandemic lows of 11 months ago. But margin becomes a burden if asset prices fall, and investors are forced to sell when they are subject to “margin calls” by the brokerage. Market peaks have been characterized by high levels of margin debt, and today is no exception, with margin levels at new all-time highs. Moreover, speculation in recent months has caused margin to rise in a parabolic fashion, as prospects for easy money have prompted investors to throw caution to the wind.

Stock valuations have been elevated for so many years that investors have come to accept them as the new normal. Since interest rates have been artificially suppressed by the Fed since 2009, it has been easy to justify high stock valuations using the TINA perspective. So it helps to use alternative valuation measures, such as market-capitalization-to-GDP, often called the “Buffett Indicator” (named for Warren, not Jimmy). It has the advantage of presenting valuations without the distortion of earnings “financial engineering” or artificially low interest rates.

We have now surpassed the 2000 highs on this measure by a wide margin. Valuation by itself is a poor buy or sell indicator. It does, however, provide perspective on the degree of risk present in the market, and from this view it is clear that investors have bid up stock prices to very expensive levels.

Finally, the prospects of easy profits are evident in the attitudes of investors and now the popular media. One interesting indicator of Main Street psychology has been the Magazine Cover Indicator. Popularized in the 1970s and 1980s by Paul Macrae Montgomery, it posited that bullish or bearish covers on mainstream magazines such as Time or Newsweek were often contrarian indicators. Negative covers about the stock market often occurred around major lows, after the bad news had a chance to percolate down to the household level, and tended to mark significant bottoms. Conversely, bullish covers tended to appear at market highs, again after the bullish news had a chance to permeate public perception.

While Time and Newsweek have seen better days, The Economist is a booming publication with wide current circulation. As such, it has upheld the magazine cover indicator role. Thus, the recent cover (Feb. 6th) of a masked day trader riding the Wall Street bull provides an unequivocally bullish view of public sentiment. Will this mark a high-water mark for stocks? We can only tell in retrospect, but it certainly captures today’s exuberant mood.

Today’s bullishness is a natural response to an improving economic backdrop, as covid-19 case are dropping, and vaccinations are becoming widespread. The two pandemic aid programs have helped maintain consumer consumption through 2020, and may soon be joined by Biden’s giant $1.9 trillion aid program. But stocks’ good fortunes have also been predicated on extremely low interest rates. Unfortunately, the economy has presented investors with a conundrum in the form of now rising inflation expectations and interest rates. Interest rates have suddenly moved back to their pre-pandemic levels of early 2020 as prices of everything from freight rates to oil have jumped. This has shaken the bond market out of its complacency of the pandemic era, and stocks also, as higher yields are beginning to offer an alternative to equities, weakening the bulls’ TINA rationale.

Since 2008, the Fed has been trying to raise price inflation with little success. Now, the massive “quantitative easing” efforts of the last 11 years, and especially the last 12 months, may be giving the Fed what they’ve wished for. At this point, nobody can tell whether the inflationary surge is a temporary blip brought on by recovering demand and consumption, or a longer lasting secular cycle ala the 1970s. Either way, it complicates the Fed’s policy of holding short-term rates down at near zero levels, and may force them to raise rates much sooner than they expected to. If so, then the effortless money investors expected to continue indefinitely may be harder to come by.

While valuations, debt, sentiment, and interest rates are all signaling caution, there is no arguing with the momentum of stock prices. The NYSE advance/decline line is positive, as are other slow-moving measures of momentum. However, we are keeping a close eye on our old friend, the NYSE Bullish %. This measures the percentage of stocks on the NYSE that are on point-and-figure buy signals, and thus measures the breadth of uptrends. As it rises, it signals more stocks are moving to buy signals, a bullish signal. Conversely, a reversal into an “O” column indicates more sell signals are occurring. Currently, the NYSE Bullish % has been oscillating between 70-76%, which has raised the sell signal point to 68% (circle). Should this signal be triggered, it would indicate that the siren’s song of easy profits may be coming to an end.

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