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At the end of May I took you back in time to 2007, showing the many similarities between 2014 and 2007. Since then, the S&P 500 has continued to march higher, leading many to question whether the parallel still exists. They ask: how can it possibly look like 2007 if the market is hitting new all-time highs every single day?
Well, as I wrote in that piece, 2007 was still an up year for the markets, we did not see the first meaningful correction until mid-July, and the ultimate top did not occur until October. So to say because the S&P 500 is up year-to-date that conditions aren’t deteriorating as they were in 2007 would be a mistake. The purpose of the comparison to 2007 is not to predict a precise top which is impossible and therefore unhelpful to investors. The goal is to identify when underlying market conditions are weakening, thus favoring a more defensive posture going forward.
Let’s go back in time once again.
It’s July 2007. The S&P 500 is up over 9% on the year and investors are broadly optimistic as it has been almost a year since the S&P 500 has tested its 200-day moving average and the bull market is nearly five years old. The market is hitting new multi-year highs almost daily with little volatility and the overwhelming consensus is that the economy is accelerating.
Meanwhile, the intermarket action is telling a different story, with late cycle sectors such as Energy and Materials leading while Consumer Discretionary, Financials and Housing names are lagging.
Collectively this is highly defensive behavior and while the broad market largely ignored it until July and finished higher on the year, the risk/reward was clearly changing.
Back to July 2014 and we are seeing a very similar backdrop. The bull market is over five years old and the S&P 500 has not experienced a pullback to its 200-day moving average since November 2012, the longest stretch in history.
Like July 2007, the S&P 500 is enjoying year-to-date gains with little volatility.
Given this backdrop, Investor sentiment is broadly optimistic, with the spread between Bulls and Bears in one prominent sentiment poll (Investors Intelligence) near its highest level in history.
Meanwhile, the intermarket action is telling a classic late cycle story, with Energy and Materials leading while Consumer Discretionary, Financials, and Homebuilders are lagging.
We are also seeing defensive areas such as Utilities (XLU) and long duration Treasuries (TLT) significantly outpacing the average stock this year as represented by the flat returns in the Russell 2000 (IWM). This is important because strength in Utilities and long duration Treasuries tend be precursors to a more difficult market environment for equities (click for links to our research papers on Utilities and Treasuries).
The parallels between July 2007 and July 2014 are unmistakable, and go well behind what I have outlined here, including a desperate reach for yield, a spike in merger activity, record margin debt, etc. Like 2007, broad market strength is masking this late cycle behavior and underlying intermarket weakness.
This is not to say what happens next will exactly mirror what happened in 2007 as it most certainly will not. History rhymes but it rarely repeats. The main takeaway from this comparison is that conditions today are weakening, just as they were back in 2007.
Yes, it is true that despite these weakened conditions back then, 2007 was still an up year for the markets and they did not ultimately peak until October. But whether investors knew it at the time or not, they were incurring a very high risk for only a few percent reward that year.
There are undoubtedly many investors today who will gladly buy into equities here in search of that few percent reward, as the Federal Reserve has driven yields on all competing asset classes down to historic lows. These investors will also point out that QE is not ending until October and the Fed is not expected to raise rates for at least another year. In their minds, a lot can happen between now and then, including a final blow-off run a la 1999-2000.
While this is certainly possible, I would not say it is probable and I would simply caution these investors that you rarely see a period of strong long-term returns following valuation extremes this late in the cycle. At the very least, with a Cyclically Adjusted P/E (CAPE or Shiller P/E) ratio of 26, nearing the 90th percentile of historical valuations, expectations for future returns from here should be tapered.
There is an unquestionably strong relationship between long-term S&P 500 returns and beginning CAPE levels (see chart below). Many critics misinterpret an elevated CAPE ratio as a short signal and disregard its value because the market does not immediately go down when it registers an overvalued level. These critics are missing the point of the CAPE. It is neither a short-term indicator nor short-selling indicator. It is merely a gauge of risk/reward for long-term investors and when it reaches extremes as it has today, it tends to indicate higher risk and lower reward going forward.
Similar to July 2007, the risk/reward in US equities is changing, and not for the better. Just because a market is at or near an all-time high, it doesn’t mean it is without risk. To the contrary, if it is near an all-time high and underlying conditions are deteriorating, it can be highly precarious situation, as we saw back in 2007. Buy and hold investors today should be mindful of the risks they are incurring at this point in the cycle and ask themselves whether their expected reward is commensurate with those risks.
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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