5 Charts for Fully Invested Bears

fully invested bear

While it seemed for a while that volatility had been completely eliminated from the market by an ever present Fed, I warned this was a dangerous assumption to make.

On Friday, volatility returned with a vengeance.”

The above excerpt is part of a discussion that Lance Roberts had on market volatility on the site realinvestmentadvice

fully invested bear

(I closed out my VXX long on Monday which served its purpose of protecting declines in portfolios this past Friday.)

“Analysts, the media, and Wall Street talking heads rushed to grab every excuse available to explain the sudden sell-off on Friday from the Fed, ECB, and Japan to interest rates and the dollar. However, the reality is I have been warning about a pending correction over the last month as market extensions had reached extremes.”-Lance Amstrong

Discussing the possibility of a market correction in the very near future may make one seem “bearish”. This is turn would mean that either one was out of the market completely, or shorting the market and missing out on previous advances, especially with the advances that were evident recently despite the expectations, which only served to leave investors even more indecisive.

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The situation brings to mind a quote from the esteemed Morgan Stanley strategist, George Minack, who once said:

“The funny thing is there is a disconnect between what investors are saying and what they are doing. No one thinks all the problems the global financial crisis revealed have been healed. But when you have an equity rally like you’ve seen for the past four or five years, then everybody has had to participate to some extent.

What you’ve had are fully invested bears.”

As a portfolio manager or any sort of investor for that matter, your biggest concern is the preservation of capital over time. Given that it is during bear markets that capital takes its greatest hits, it is important to develop the ability to stay in the market while keeping a lookout for any bearish movements on the market.

Contrary to all common sense, the present situation pushes portfolio managers to become fully invested bears in that despite being in full knowledge that the present market is over bullish, over extended and over-valued, we continue to stay invested. The alternative of risking your career by “underperforming” is one nobody is willing to contemplate.

Thus, it is very important to, as portfolio managers and investors, to pay attention to any changes in the current market situation so that we can react accordingly and quickly.  This is the reason why the following 5 charts for fully invested bears are so named and so important. The messages they are sending are important but are not being heeded by the market, but when the market takes notice of these messages, they are going to matter a lot.

Valuation

For far too long the main driving force behind this bullish market has been the reliance on “Fed Put”. The reliance on the Federal Reserve to bail out the markets should something go wrong, is the reason why investors have not been properly sceptical of investing in equities. This has in turn led investors to not only “chase yield” due to artificially suppressed interest rates but also to push valuations of stocks back to levels prior to the turn of the century.

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A recent note from Goldman Sachs testifies to this: “Stock valuations remain extended. The S&P 500 trades at the 84th percentile of historical valuation, while the median stock is at the 98th percentile.”

Keep in mind that these valuation extensions are taking place against a backdrop of deteriorating economic growth. From the chart above, you can see that this combination is one that has never ended well for investors.

Junk Bonds

With the help of the Federal Reserve, keeping interest rates at historically low levels, investors were quick to “chase yields” in the credit markets. Wall Street duly provided “high yield investment packages” for consumption, packages which many retail investors had no idea were actually “junk bonds.”

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The chart above shows the deviation between the S&P500 and junk bond yields, which has always been a warning sign.

With no concern for the risks being ploughed into portfolios in the hope of greater return, the yields on junk credits were pushed to historic lows. Those yields have begun to rally recently, an historically that has always been a sign that the period of grace for excess risk is near its end.

The chart below shows the ratio between high yield credits and government treasuries. When this ratio is rising, and overbought (shown by the blue dashed lined) it has generally been near corrective peaks.

Margin Debt Graph

Margin Debt

Margin debt on its own is not a problem. What is a problem is the excess leverage that is forced to unwind when asset prices start falling rapidly. In this case, like gasoline on a flame, margin debt amplifies the downturn as falling prices trigger margin calls which forces more selling. This vicious cycle is every investor’s worst nightmare as the decline gets more rapid and they watch in horror as their capital vanishes.

Deviation

The explosion in margin debt, which has led to historically large credit balances, was seen at both previous market peaks. We can hope that things pan out differently this time, but they don’t, there is plenty of fuel for that fire when the next market correction begins.

Deviation

What goes up must come down. This law applies even to the market. Stocks are tied to their long term trend that acts as a gravitational pull. When the prices of stock deviate too far from the long-term trend, they will inevitably revert to the mean.

investor sentiments

The current deviation is at its highest since the previous two bull market peaks. This does not mean the bull market is over, of course, but it is a situation worth paying attention to.

Investor Sentiments

When investor sentiment is heavily skewed, there is an abundance of those who want to buy. This in turn drives prices higher. The problem appears when this sentiments change and the buyers disappear. The resulting vacuum causes drops in prices that are made worse by margin calls as mentioned above, thus giving the last remaining buyers absolute control over the price at which they are willing to do business.
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With sentiment at very high levels, combined with high margins and low volatility, we have the stage set for a possible market reversal.

Does this mean the end of the world? Not exactly. But if you are fully invested, then it is very important that you understand thoroughly all the risks involved. That way, you stand a chance of seeing more of your expectations coming to fruition rather than the reverse happening.

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