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5 Reasons Why The Market Won’t Crash Or Will

5 Reasons Why The Market Won't Crash Or Will

5 Reasons Why The Market Won’t Crash Or Will

Paul LaMonica, whom I have spoken with several times, recently wrote a piece for CNN Money entitled “5 Reasons Why The Market Won’t Crash.” One of the biggest mistakes that investors make is falling prey to cognitive biases that obfuscate rising investment risks. This is why I am particularly fond of articles, such as Paul’s, as it allows us to look at both sides of the investment argument.

So, while I do not disagree with Paul’s arguments for a continued bull market, I will provide the counter-points.

[Disclosure: As a money manager my portfolio models are fully allocated to the markets currently. However, it is less important for me to understand why the markets will continue to rise, as I am already allocated to equity risk, than to know what could potentially subtract a significant portion of my client’s capital. Getting back to “even” is not a long-term investment strategy I choose to employ.”

What if I told you this is only the beginning of a great run for stocks which may last another dozen years? And that while the bull may be aging, it’s — like Jake LaMotta — still raging?” – Paul LaMonica, CNN Money

1) No Recession In Sight.

Paul states:

“Bear markets often occur around the same time as severe economic downturns. The 2008 credit crisis. The 2001 recession following the dot-com meltdown. The oil shock of the mid-1970s.

There aren’t any signs pointing to a recession now. The U.S. economy has pretty much plodded along for the past four years. Yes, it’s a frustratingly weak recovery. I’ve called it the low and slow barbecue recovery since 2010. But it’s still a recovery.”

While Paul is correct that major market corrections tend to coincide with recessions. However, recessions are never been identified in advance, not even by National Bureau of Economic Research which is the agency that dates the start and end of recessions. This is due in part to:

  1. Building optimism (particularly in sentiment survey’s such as the Fed regional manufacturing surveys) that tends to run ahead of underlying economic realities, and;
  2. The heavy revisions to past data.

For example, in December of 2007, I wrote an article that stated:

“We are either in, or about to be in, the worst recession since the Great Depression.”

It was until December of 2008 that the National Bureau confirmed that the recession started a full year earlier.

Alan Greenspan saw no recession going into 2001.  Ben Bernanke stated “subprime was contained” and that the U.S. was in a “Goldilocks economy” in 2007.  Both were dead wrong.  In fact, going back in history, no one ever saw a “recession” coming until is was after the fact.

 SP500-GDP-Rates-Recessions-071714

What is important to notice is that the current trend economic growth is no longer advancing, but declining.  While this is not “absolute” evidence that a recession is on the horizon, it has been a precursor more often than not.

2) The Fed Is Still Your Friend

Paul:

“The risk of the Federal Reserve crashing the stock market with huge interest rate hikes is virtually non-existent. It’s painfully clear to investors that the Fed will start raising rates next year.

The Fed’s key rate has been near zero since December 2008. So even if the Fed pushes it back towards 1% next year, that’s not cripplingly high. And market experts said investors will be ready for rate hikes since Fed chair Janet Yellen will go out of her way to foreshadow them in speeches and Fed policy statements.”

Recessions occur due to several factors that affect the underlying drivers of economic growth. Rising interest rates and inflation are two of the most important. While Paul is correct that the Fed will likely start raising interest rates, what is potentially missed is that while 1% may not seem like much, it is all relative to the rate of underlying growth.  If the economy was growing at 3-4%, then a 1% increase in borrowing costs, which creates a drag on economic growth, could likely be absorbed. At a very sluggish 2% growth, such an increase is far more insidious.

I recently discussed the following chart in “Analyzing The Impact Of Fed Rate Hikes,”

Fed-Funds-SP500-071514

While not every set of rate hikes led to a recession as I stated;

Most importantly, the number of times that Federal Reserve has hiked interest rates without a negative economic or market impact has been exactly ZERO.”

3) Sentiment Still Skittish

Paul:

“CNNMoney’s Fear and Greed Index, which tracks the VIX volatility gauge and six other indicators of sentiment, is back in Fear mode. It was showing Extreme Greed signs just a month ago.  This might actually be a good thing.”

Since I don’t know how the CNN constructs their “Fear & Greed” index, I can not directly comment on its current readings. However, sentiment readings are not useful in determining long-term market trends as the swings from “greed” to “fear” occur over very short time frames. As I addressed in: “Stocks Will Rise and 3 Trades You Can’t Make,”

“Yet, despite these warnings, individuals are as heavily allocated to the markets currently as they were prior to the financial crisis.”

AAII-Asset-Allocation-071714

[Note: This goes heavily against the “cash on the sidelines” theory.]

“Furthermore, while individual investors are fully allocated to the equity markets, professional investor sentiment has rocketed in recent weeks to astronomically high levels.”

INVI-BullishSentiment-071714

“While excessive bullish sentiment, low volatility, and a perceived blindness to risk are certainly noteworthy; “irrational exuberance” can drive markets higher would logically be expected.”

4) Market Isn’t Cheap But Isn’t Overvalued Either

Paul:

“Stocks are not amazing bargains anymore.  The S&P 500 is currently trading at 15 times 2015 earnings estimates — roughly in line with what many strategists view as fair or full value for the market.”

There are several problems with using forward “operating earnings” due to value the market.  Most importantly, is that forward estimates are overly optimistic by 30% on average.  For a full analysis of why using such measures leads to bad investment outcomes read:  “The Problem With Forward P/E’s.”

However, the counter to the market is “cheap” argument is contained in a quote in “Shiller’s CAPE – Is It Just B.S.?,”

“Ten-year forward average returns fall nearly monotonically as starting Shiller P/E’s increase. Also, as starting Shiller P/E’s go up, worst cases get worse and best cases get weaker.

If today’s Shiller P/E is 22.2, and your long-term plan calls for a 10% nominal (or with today’s inflation about 7-8% real) return on the stock market, you are basically rooting for the absolute best case in history to play out again, and rooting for something drastically above the average case from these valuations.”

asness-shiller-pes

“It [Shiller’s CAPE] has very limited use for market timing (certainly on its own) and there is still great variability around its predictions over even decades. But, if you don’t lower your expectations when Shiller P/E’s are high without a good reason — and in my view the critics have not provided a good reason this time around — I think you are making a mistake.” –Cliff Asness

 5) Corrections Have Happened In The Bull Market

 Paul:

“And even though it’s technically, uhh, correct, to say there has been no correction in nearly three years, Connaughton reminded me that the market did have another near correction in 2012. Stocks fell 9.94% between April 2 and June 1 of that year. You can be a stickler for the rules and declare that 9.94% is not 10%. But that’s really silly.

So there have been interruptions to this recent bull run. There will probably be more.”

I can’t argue against this point.  Paul is correct.  However, as I started out in this missive, I am currently long the markets in my models and intend on staying that way for the time being.  However, the difference is that I am paying attention to the rising risks in the market and am not ignoring the fact that another major correction in the market, or potentially even a crash, will eventually occur.  Even the famed John Bogle of Vanguard stated that investors should prepare for at least two declines of 25-30 percent, maybe even 50 percent, in the coming decade.

While the “buy the dip” mentality is deeply embedded in the current market, it will be understanding the difference between a “dip” and a full blown “correction” that will eventually separate winners from losers.  As Seth Klarman of Baupost Capital recently stated:

“Can we say when it will end? No. Can we say that it will end? Yes. And when it ends and the trend reverses, here is what we can say for sure. Few will be ready. Few will be prepared..”


With that, I will leave you to your own conclusions. Can this “bull market cycle” indeed last another 12 years? Anything is possible, however, such an advance has never occurred given the current economic and fundamental variables. However, what is truly important is understanding that all investors have one “commodity” that once lost can never be regained –“time.”

While we can eventually recover from a market crash, it only took 14 years to get back to even from 2000, we can not regain the time lost to save, and grow, our investments to fund our retirement. It is critical to remember that what the “index” does from one year to the next is far less important than understanding what the ramifications to your long term investment and financial planning goals will be if you are “wrong.”

 
Courtesy: Lance Roberts

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The views and opinions expressed herein are the author’s own, and do not necessarily reflect those of Commoditytrademantra.com or Moneyline.co.in.

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