Equities: The Triumph of Greed Over Fear, Part 2
While a market correction almost never occurs when a large number of investors are anticipating (or hoping for) a drop in stock prices, it’s hard to imagine that many big money players (fund managers, sovereign wealth funds, even central banks these days) are holding back at this stage. If a fund manager is not 100% in equities by now, for example, we doubt that more expensive equity prices will draw him/her into equity markets. Perhaps a deeper equity market correction will be needed at this stage to pull cash off the sidelines. But this is logical reasoning…emotions play a strong role in investment decisions and even professional investors breakdown and throw everything in when prices seem like they won’t fall. And this is why equity bull markets peak in a buying climax.
We updated two versions of our margin debt charts below. Margin debt, or borrowing money to invest more than the nominal value of a portfolio, is a classic warning sign at the end of bull markets. Margin debt also provides the fuel to accelerate a market decline as leveraged investors and funds are forced to close positions as they slip underwater. Data through the end of April shows that NYSE Margin Debt relative to GDP is once again above the ratio peaks in March 2000 and October 2007. A true long-term investor would only want to engage in buy-and-hold positions when the ratio falls at least below 2%, and preferably below 1.5%.
In the next chart we create a “real” measure of margin debt, normalized for inflation, and compare it to real household income. With this ratio now at record highs, we can surmise that greed is at an extreme.
The ratio of blue chip S&P 100 stock to riskier small cap stocks comprising the Russell 2000 is another decent, market-based metric of greed and fear. We calculated that 89% of the S&P 500 gains since the 2009 low have occurred when the S&P 100 has been in a relative downtrend compared to the Russell 2000, as shown by the red 50-day moving average line in the chart below. The 50-day moving average of the ratio of these indexes has passed an inflexion point in recent weeks. As long as small cap weakness persists, it is unlikely that equities will charge higher.
Finally, we noted in our Commentary, “The S&P 500 or The S&P 495”, that just five stocks have been driving large cap index gains. Another classic sign we tend to see at market tops is narrowing leadership. Our last chart looks at the percent of stocks on the NYSE closing above their 200-day moving average (blue curve). Two points of interest. First, the percent of stocks above their 200-day moving average recently peaked on February 21st at 72.3% (currently at 57%). In other words, the U.S. equity gains since mid-February have occurred with narrowing participation. Second, comparing the percent above 200 curve to the NYSE Composite index price index (red curve), we see that the two major corrections in this bull market occurred when the percent above 200 has formed a negative divergence with the index price.
In the very near-term, risk-on sentiment remains healthy, but below the extreme readings our Composite Market Risk Indicator showed in the weeks following the U.S. election. We doubt that equities are currently at a sentiment top.
We are dealing with a bull market on steroids, built on central bank asset purchases and inappropriately low interest rates. Some have speculated that about 800 points on the S&P 500 are attributable to central banks. That’s a lot of air under the market. Greed today has been driven, to a large extent, by faith in the ability and willingness of central banks to administer financial markets. Nevertheless, we do not believe that “this time it’s different”. Central banks can neither eliminate economic recessions nor create a permanent plateau of prosperity in equity markets. Indicators such as margin debt shown above and valuations will triumph in the end. In the meantime, financial market distortions continue longer than anyone could have expected. For those buying equities today, heed these trader words of wisdom: “If stock prices fall a little, go ahead and buy. If stock prices fall a lot, then sell”.