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Are you telling me that you built a time machine… out of a DeLorean?
Of course not. It’s 2014 and the environmentalists would go crazy. We built one out of a Tesla Model S and we’re headed back to…
May 2007. The economy is humming along and we’re over five years into an expansion that began in late 2001. The S&P 500 is hitting new bull market highs almost daily and investors are looking forward to a fifth consecutive year of gains. The credit markets are booming, with record demand for risky debt and high yield spreads hitting new lows. There is some evidence of weakness in the housing market but this is surely a healthy development considering the incredible advance over the previous few years.
Given this backdrop, Investors are broadly optimistic, with Bulls outnumbering Bears in the Investors Intelligence poll by over 2.5 to 1. Also key to this bullishness is the new “low volatility regime,” with the VIX trading between 12 and 14 after crossing below 10 briefly in January and February. As long as volatility is low, Hedge Funds seem more than happy to increase leverage and net exposure to “boost returns,” creating a strong underlying bid beneath the market.
S&P 500, May 2007: What’s not to like?
While on the surface all is well in the markets, there is a subtle rotation going on underneath. Energy and Materials are the leading cyclical sectors while Consumer Discretionary and Financials are the weakest sectors. Together, this backdrop is classic late cycle behavior and not typically what you see in a strong economy.
S&P 500 Cyclical Sectors, May 2007:
The behavior in the homebuilders is particularly troubling, as the housing market tends to be a leading indicator for the economy. While the broad S&P 500 is well on its way to another up year, homebuilders are telling a different story.
S&P Homebuilders, May 2007:
Also notable is the behavior of Utilities, which had been the leading sector of 2007 through the middle of May and are widely outperforming the broad market. While the S&P 500 is hitting new highs, investors seem to be subtly transitioning into more defensive Utilities and out of more cyclical Consumer and Financial names.
It’s May 2014 and we are fast approaching the five year anniversary of the economic expansion that began in June 2009. The S&P 500 has posted five consecutive years of gains and investors are looking forward to number six this year. Credit markets are booming once again as investors are reaching for yield like almost never before. We are also observing housing market weakness, with housing stocks at multi-year relative lows and a slowdown in a number of indicators.
Investors are broadly optimistic and complacent, with a ratio of over 3 to 1 in the latest Investors Intelligence poll. Volatility is getting crushed on a daily basis and nearing levels not seen since 2007. With seemingly no risk, investors are increasing exposure and leverage with each move lower in volatility.
While on the surface all is well in the markets, there is a subtle rotation going on underneath. Energy and Materials are the leading cyclical sectors while Consumer Discretionary and Financials are the weakest sectors. This backdrop is classic late cycle behavior and not typically what you see in an economy that is supposedly running on all cylinders.
S&P 500 Cyclical Sectors, May 2014:
Homebuilders and recent housing data are also signaling weakness and telling a different story than the broad market. Thus far this weakness is deemed temporary and is being shrugged off by market participants.
S&P Homebuilders, May 2014:
Also notable is the strange behavior in Utilities, which is the leading sector in 2014 and widely outperforming the broad market. While the S&P 500 is hitting new highs, investors seem to be subtly transitioning into more defensive Utilities and out of more cyclical Consumer and Financial names.
S&P 500 Utilities, May 2014:
The parallels between May 2007 and May 2014 are unmistakable, with broad market strength masking underlying weakness. That is not to say what happens next will play out in the same fashion this time around as it most certainly will not. But at the same time, to completely ignore what the market is telling us here would be foolish as well. This may not be a repeat of 2007, but the persistent weakness in areas such as the Consumer Discretionary sector as we have seen this year is not likely a positive sign.
In the end, 2007 was still an up year for the markets (see chart below), but whether investors knew it or not, they were incurring a large risk for only a few percent reward. Importantly, it would have cost an investor nothing to behave in a more defensive manner back then; to the contrary, both long duration Treasuries and Utilities outperformed in 2007. The same has been true thus far in 2014, with both long duration Treasuries and Utilities significantly outperforming.
In May 2007, Buy and Hold was all the rage. A year and a half later, the investment world looked a lot different. What will the world look like a year and a half from today and how prepared are you for a change in the market environment from the recent past?
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of two award-winning research papers on Intermarket Analysis. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
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