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Be Adaptive

“One of the things I most want to emphasize is how essential it is that one’s investment approach be intuitive and adaptive rather than be fixed and mechanistic.” -Howard Marks

One huge trend I’ve noticed in financial social media lately is the use of statistics and market history to project future price movements. This is really cool stuff, actually, and it’s data that most investors haven’t had access to at all until now.

What I’m specifically referring to is all the traders out there, and there are plenty of them now, that see the market do x and then pull up all the times it’s done x in the past to see what it’s meant going forward.

This type of quantitative analysis is great in that it helps you become more objective and less emotional with your trading or investing.

But it looks to me like investors are beginning to rely on it a bit to heavily. It’s use is becoming a bit too “mechanistic,” as Howard Marks put it in his book, The Most Important Thing.

A great example of how traders can be overly reliant on this sort of thing was the Russell 2000 death cross a few weeks ago. Last month the index’s 50-day moving average was close to crossing below its 200-day moving average. This is known as the death cross because it sometimes signals that the overall trend is changing from bullish to bearish.

Traders ran all the previous times in history these moving averages crossed down and found that, historically, it has actually been a more bullish development than a bearish one. In fact, it got so popular to poo-poo the “death cross” that even CNBC and Jim Cramer ran with it calling it a “bull signal.”

The index has lost nearly 10% in the 3 weeks since then.

“To achieve superior investment results, you have to hold nonconsensus views… and they have to be accurate. That’s not easy.” -Howard Marks

Once the crowd takes up an idea it’s just probably not going work out. Once everyone viewed the Russell 2000 death cross as a buy signal – and probably positioned themselves that way, who was left to buy and provide the incremental demand to make the signal work out? Nobody.

Right now traders are looking at all kinds of bullish signals for stocks based on the “history” of the past two years. And as much as I appreciate the value of a quantitative approach, I worry that this type of analysis may have become too consensus and “mechanistic” for my liking.

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Today is the 25th anniversary of the launching of the Vince and Larry crash test dummy public service campaign, and donated artifacts are welcomed at a ceremony at the Smithsonian American History museum in Washington, DC.
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Desperately Seeking A Margin Of Safety

Back in 2000, I had one of my best years as an investor. You may remember that year marked the peak of the greatest stock market bubble in history. Anyhow, while everyone and their mom was buying internet stocks I was loading up on the exact opposite.

One of the unique things about that time was that the bubble was really concentrated in the technology sector. Outside of that there were some great values to be found in the old “bricks and mortar” types of companies.

I found a couple of those great values in Abercrombie & Fitch and Washington Mutual. I think ANF was trading around 8 times earnings despite the fact that it was still growing pretty fast and had incredible returns on new stores. And this was back when WaMu was still just a boring old thrift trading for 5 times earnings. When investors finally gave up on the high flyers they took refuge in names like these and both ANF and WaMu soared.

In 2007, things were very different. Although valuations didn’t get anywhere near those 2000 levels, there was even more pain felt as a result. There just wasn’t really anywhere to hide during the financial crisis as everything seemed to get hammered to the same degree.

Today’s market feels like a combination of these two and it honestly worries me. We currently have even higher valuations than we did in 2007 – in some cases, even higher than in 2000 (median price-to-sales ratios at all-time record highs). And the overvaluation feels just as pervasive as it did in 2007, maybe even more so (note record “median” valuations, not “mean”).

In other words, the diving board (valuation) is higher now and there’s even less water (pockets of value) in the pool than there was.

This is why I’ve spent so much time researching ways to avoid the next major bear market. Because I think it’s gonna be a doozy. So I think it’s probably wise for most investors in US stocks, at this point, to switch from buy-and-hold to a trend-following approach. Still, this assumes that the selling window, when it comes, will be wide enough and open long enough for everyone to casually exit through which is not always the case.

An alternative or complementary solution I’ve spent some time looking at is a “global value” approach. I got turned on to Meb Faber’s work a few months ago and I think this idea of his has so much merit, especially for investors in US stocks right now. There may not currently be those pockets of value within the US stock market that will help to weather the next storm but there are pockets around the world that may fit the bill.

Do yourself a favor and go read Meb’s book. It just might help you manage the next market meltdown.

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Seeing The Forest For The Trees

Yesterday morning I came across a piece over at Harvard Business Review titled, “To Make Better Decisions, Combine Datasets.” I began reading it and realized that’s exactly the key to investment success and what I’ve tried to do with my market timing model: combine a variety of predictive datasets to create a holistic forecasting and timing model.

The stock market is driven not just by fundamentals or sentiment or technicals alone but by all of them in concert with one another. It follows then that an investor should try to incorporate each of them into her investment process in order to maximize its effectiveness.

And this is where I think many investors get lost. They try to focus on only one of these three. Fundamentals alone may work over the long run but cheap stocks can always get much cheaper in the short-term or they could just be cheap for a very good reason (I’ve learned this lesson more than a few times). Sentiment can also be very helpful but the crowd isn’t always wrong and markets can ‘stay irrational longer than you can stay solvent.’ And, as many traders know, the ‘trend is only your friend until it comes to an end.’

What I’ve found in my 20+ years of observing and trading markets is that looking at the forest, by putting all of these together, rather than the trees alone is absolutely crucial to making good decisions. So I thought it might be fun to look at the individual components of the model to see not only what they are saying about the markets but how they might be misleading when taken on their own.

For my fundamental component I use Buffett’s favorite valuation yardstick, total market capitalization-to-GDP. On its own it has roughly an 83% negative correlation with future 10-year returns in the stock market (based on 65 years worth of data). This means higher levels for this indicator are correlated with lower future returns and vice versa. Here’s what it looks like over the past 65 years or so:

Screen Shot 2014-09-05 at 9.38.05 AMEven considering the fact that the internet bubble has pushed the average higher over the past ten or fifteen years, this measure still suggests stocks are priced significantly above their historical range. Based on its high correlation with future returns this suggests investors should expect a very low return from present levels over the next decade.

BUT… this has been the case for most of the past 20 years! An investor looking at this measure alone might have sat out a couple of major bear markets but also would have missed a couple of the most massive bull markets in history! So it’s probably not smart to use this measure in isolation. Adding other related asset classes (like bonds – we’ll come back to that) and other, unrelated indicators should help give a bit more clarity.

My sentiment measure tracks the percent of household financial assets invested in equities. Believe it or not this measure is even more highly negatively correlated with future returns than Buffett’s valuation measure above (closer to 90% – hat tip, Jesse Livermore). Here’s what it looks like over the same time frame:

Screen Shot 2014-09-04 at 12.54.35 PMIt’s also currently sitting significantly above its long run average suggesting returns should be far below average going forward. As I mentioned this is a better forecasting mechanism than the fundamental measure but even if the incredible euphoria of the internet bubble got you out of the stock market you may not have gotten back in over the past 15 years because we haven’t seen anything like the pessimism witnessed at the 1982 low.

Finally, I’ve added a third component to the model, inspired by Doug Short: a simple trend regression model based on Robert Shiller’s data going back nearly 150 years. With a negative correlation of roughly 74%, it’s not quite as effective at forecasting future returns as these other two but I think adding it, as a third independent component based on a very long-term trend, helps to make the model more robust. So here’s what the S&P 500 looks like relative to a regression trend line over the full time period:

Screen Shot 2014-09-04 at 1.01.27 PMOnce again this indicator shows the stock market to be trading very close to the top of its historical range. Still, like the fundamental model this one might have had you sitting out of the stock market for perhaps the past 20 years!

So even though we have three independent models we need a way to put them together and then to put them into some sort of context. What I’ve done is used each indicator individually to create a 10-year forecasting model. Then I’ve simply averaged them together each quarter. All told, the combination results in a correlation to future 10-year returns of about 90%. Here’s a chart of the model’s forecast returns as compared to actual 10-year returns for the stock market:

Screen Shot 2014-09-04 at 1.05.21 PMWhere the model is farthest off the mark (where you see the yellow line far above the blue line) is in the late 80’s early 90’s. Stocks surged further and faster during the internet bubble than the model forecast they would. Removing those years, the model’s correlation value rises to about 94%.

So we know what the individual readings look like. What’s the model saying about future returns from here? As the chart below shows, the model forecasts a return of just 1.2% per year over the next decade:

Screen Shot 2014-09-04 at 1.10.16 PMTo add some context, in addition to the 10-year forecast I’ve put the yield of the 10-year treasury note on the chart, as well. Investors don’t look at potential returns in a vacuum; they compare potential returns of different opportunities, many times looking at the “risk-free” rate of treasury notes in the process. This next chart shows the difference between the model’s forecast return and the yield on the 10-year treasury note:

Screen Shot 2014-09-04 at 1.17.48 PMWhen the blue line is above zero, stocks offer the better return; when it’s below, bonds do. And as I’ve shown before in “How To Time The Market Like Warren Buffett” this timing model works very well. Just buy whatever asset class is more attractive – trading only once per year – and you’ll kill a buy-and-hold approach.

I think this alone is validation of a multi-disciplinary approach. But adding one more super-simple component makes it that much more effective: before we go and sell our stocks because bonds are more attractive, we want to make sure we don’t sell too early in a bull market or buy to early in a bear market. As the chart above shows this model would have had you sell your stocks and shift into bonds all the way back in April of 1996 and then miss all the gains of the next 3 1/2 years.

Adding a very simple trend-following approach solves this problem (hat tip, Meb Faber). Rather than sell right when bonds become more attractive it’s much more advantageous to wait for the trend to end. And as a representation of the trend, we can simply use a 10-month moving average. Below is a chart of the S&P 500 and this moving average:

Screen Shot 2014-09-04 at 1.23.36 PMTo be clear we’re not trend followers all the time with this model. We buy-and-hold until the model tells us that stocks are not attractively priced and then we become pure trend followers. Once the model tells us stocks have become less attractive than bonds we wait for the S&P 500 to close at least 1% below its 10-month moving average at which point we sell our stocks and sit in cash, buy bonds or even short stocks (the latter generates the best returns over the period studied).

Should the index at any point close back above its 10-month moving average by at least 1% we buy stocks again. Like I said, so long as stocks are less attractive than bonds we are pure trend followers. Only when the model suggests stocks are once again more attractively priced than bonds AND the trend has turned up (as indicated by a monthly close above the 10-ma) do we buy stocks and abandon trend-following for buy-and-hold.

Ultimately what this produces is a combination buy-and-hold/trend-following model that owns stocks roughly 80% of the time and seeks to avoid major bear markets precipitated by high valuations, high levels of bullishness and prices extended far above their regression trend. It doesn’t avoid losses entirely, though.

The model didn’t recommend a move out of stocks prior to the 1987 crash which resulted in a decline of roughly 26% (its largest drawdown). It did, however manage to avoid the ’73-’74, ’00-’02 and ’08-’09 bear markets, the latter producing about a 50% decline. In fact, this is where all of the model’s outperformance is generated: in recognizing these major turning points fairly early on – essentially giving a warning signal – and then switching from buy-and-hold to trend-following when that strategy is more effective.

The next chart shows the results of three different investors. The first is a simple buy-and-hold strategy (blue line). The second goes to cash when the model indicates (red). The third, rather than going to cash, shorts the index (green):

Screen Shot 2014-09-04 at 1.50.13 PMClearly there is significant benefit to abandoning buy-and-hold for a trend-following approach when our model suggests stocks are unattractively priced. Over the period the investor who just sits out major bear markets in cash ends up with twice as much as the investor who holds through the entire decline. And the investor who gets short, in turn, fares far better still.

I truly believe these superb results, hypothetical though they be, can be attributed to the holistic nature of the model. It combines datasets that are valuable independent of one another into something greater than its parts.

As of now, the model is telling us that stocks have once again become unattractive relative to bonds. However, the uptrend is still in tact. So it’s probably valid to be bearish for fundamental, sentiment and regression reasons. But the trend is also a valid reason to be bullish – even if it is the only reason. So I’m still looking at the market through a bearish lens right now but I’ll be watching for a monthly close at least 1% below the index’s 10-month moving average for the trend to validate the fundamentals and sentiment.

For reference I’ve put up all the spreadsheets, calculations and charts I used on a public Google Drive sheet here: Market Timing Model. I’ll be updating it as new data comes in.

Finally, I need to make the same disclaimer I’ve made over and over again during this series: because this is a hypothetical model that doesn’t incorporate taxes, transaction fees, etc. it is not representative of any real returns. It is merely for educational purposes. Clearly, past performance may not be indicative of any future results.

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A Holistic Approach To Market Timing That Crushes Buy-And-Hold

This is part 3 in my market timing series that began with “How To Time The Market Like Warren Buffett”:

“…the big money… is not in reading the tape but in sizing up the entire market and its trend.” -Jesse Livermore, Reminiscences of a Stock Operator

That’s exactly what I’ve been doing with my market timing series over the past few weeks: “sizing up the entire market.” But I haven’t yet gotten to the “trend” part – which, as Jesse testifies, is absolutely critical.

Before I get to that let’s just briefly recap how we got here. I first looked at Warren Buffett’s favorite valuation yardstick to get an idea of how stocks were valued. Comparing the prospective return from stocks (as forecast by the market cap-to-GDP model) to the simple yield on the 10-year treasury note gives us a great idea of which asset class we should own at any given time: the one the offers the greater prospective return! Voila, we have a very successful market-timing model. (See “How to Time The Market Like Warren Buffett“)

Then I looked at a measure of investor sentiment as the basis of a similar model. When I wrote it, I used Buffett’s famous ‘fear and greed’ quote. Since then, however, I really think this one from Sir John Templeton is even more apt: “Help people. When people are desperately trying to sell, help them and buy. When people are enthusiastically trying to buy, help them and sell.” Anyhow, this model worked in a very similar manner to our fundamental model and both had similarly successful results. (See “How to Beat The Market By Being Fearful When Others Are Greedy“)

At the end of the day, the thing that made both of these models successful was helping our hypothetical market timer avoid major bear markets. Where they suffered was when they got our market timer out of stocks (or back into stocks) too early (something that is all too common for the fundamentally-focused investor like yours truly). This is where the trend comes in.

Inspired by the likes of Meb Faber, Cliff Asness and Michael Covel, I’ve been studying trend following for a few months now. Maybe the most common indicator of the intermediate-term trend (1-3 years) that I’ve found is the 200-day moving average. This is simply the average of the last 200 days’ closing prices. A closing price above the average signals an uptrend; a closing price below signals a downtrend.

Many studies have shown that when an investor simply adds a trend-following component to their portfolio using this indicator for the S&P 500 they can reduce drawdowns, aka losses during bear markets, and improve overall results. Depending on transaction costs and taxes, however, the benefits may be negligible. But because I prefer a more holistic approach, I decided to look at what would happen if our hypothetical market timer added this simple trend-following approach to our existing models.

Here’s how it works. Our hypothetical market timer annually (at year-end) checks the 10-year forecast returns provided by our fundamental and our sentiment models and compares them to the yield on the 10-year treasury note. If both models suggest stocks offer the best return she does nothing; she merely holds the stocks she already owns. Should one of the models, however, suggest that the 10-year treasury offers a better return she… doesn’t sell her stocks and buy bonds just yet.

This is where she becomes a trend-follower. On a monthly basis, she begins checking the S&P 500’s 10-month moving average (roughly the same as the 200-dma but easier for me to calculate with the data available) and watches for a close below that level. Should the index close below its 10-month moving average while one of our models suggest stocks are not attractive she shifts from stocks to cash. Here are the results. This strategy is in yellow, labeled “Fundy-Trend.”

Screen Shot 2014-08-26 at 11.15.03 AMSo from 1950-2014 our buy and hold investor turns $1,000 into $785k (if she can hang on through the big drawdowns). Our straight trend-following friend finishes with $690k (using the method Jeremy Siegel uses in “Stocks For The Long Run“). Our fundamental market timer finishes with $1.56 million (compared to $1.15m for our fundamental model and $1.25m for our sentiment models alone), almost twice as much as the buy and hold investor.

Not bad, eh? But what’s that green one that’s over $2.2m?! Well check this out: I also decided to see what would happen if our hypothetical market timer, instead of going to cash, decided to shift from owning stocks to getting short stocks once the trend turned down. Clearly, she kicks everyone’s ass. She makes nearly 3x as much as our buy and hold investor, 2x as much as our simple fundamental and sentiment market timers and more than 40% more than our holistic (fundamental, sentiment and trend) market timer.

Warren Buffett, Sir John Templeton and Jesse Livermore weren’t successful for no reason. They individually used fundamentals, sentiment or the trend to crush the markets. Putting them together into a simple, quantitative and holistic process yields similarly spectacular results. So don’t buy the buy and hold line of BS if it doesn’t suit you. There are systematic ways like this to protect yourself from large losses and enhance your overall returns.

Soon I’ll be putting up a page on this site to keep track of these models. But again, I’d like to emphasize that this is merely for educational purposes. It doesn’t include transaction costs or taxes which should be major considerations for real-world investing scenarios.

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Have Analysts Morphed Into ManBearPigs?
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Here’s Why You Can’t Be Too Bullish Or Too Bearish Right Now

If you couldn’t already tell I’ve been thinking about cognitive biases and logical fallacies a lot lately. And while I’ve been fairly bearish for quite some time now I haven’t been, “sell everything and hide your cash in the mattress bearish.” Those who are that bearish are suffering from clear biases or fallacies I’ll get to in a minute. By the same token, those who are rip-snorting bullish right now are also suffering from a similar condition.

By being overly bullish right now, you’re simply in denial over a plethora of evidence that suggests the risk/reward equation is heavily skewed toward the risk side without much potential for reward at all. But what I really think bulls are relying on most heavily right now is a little something called “recency bias” or, as the Fed likes to put it (emphasis mine):

If asset prices start to rise, the success of some investors attracts public attention that fuels the spread of enthusiasm for the market. New (often less sophisticated) investors enter the market and bid up prices. This “irrational exuberance” heightens expectations of further price increases, as investors extrapolate recent price action far into the future. – “Asset Price Bubbles” FRBSF

That’s all “recency bias” is: investors ‘extrapolating recent price action far into the future.’ In other words, Mr. Market has been flipping a coin that just keeps coming up heads (big gains) so investors begin to believe that it’s just going to be heads forever. Tails (corrections or bear markets) are a thing of the past.

Obviously, this is just faulty logic. But when BTFD becomes so ingrained into the broader market psyche it just becomes painfully clear that investors are relying on nothing but the trend. Which is fine, of course, until the trend comes to an end. Just don’t pretend there are any other reasons to be bullish aside from the trend because there just aren’t.

On the flipside, uber-bears are suffering from a similar ailment called “gambler’s fallacy.” They believe that because Mr. Market has flipped heads so many times in a row (how long have we gone without a 10% correction?) that the likelihood of him flipping tails is now much greater which is also bogus logic but something people do all the time. The likelihood of flipping heads or tails is still 50% no matter what sort of streak has come before this flip of the coin.

Despite the fact that the odds haven’t changed at all, bulls believe there’s a near 100% chance the next flip is gonna be heads once again (because it’s just persisted so long) and bears believe there’s a near 100% chance it will be tails (because the ridiculous streak of heads just can’t persist). Both are wrong. So what’s an investor to do?

To me the fundamentals, sentiment and the macro backdrop are clearly bearish right now. But I grant that these are not timing mechanisms. These are just the shade of the lens we should be looking through right now. In 2009, you wanted rose-colored glasses because all three of these indicators were flipped. Today, you want the opposite, whatever that is (brown-colored glasses?).

Still, you probably don’t want to express that view in your investments to any great degree simply because Mr. Market is still, in fact, flipping heads… for now. So don’t get me wrong; I’m bearish. Clearly. But I’d recommend waiting until Mr. Market flips a tails or two to before jumping feet first into your bear costume.

Next week I’ll post the third in my “market timing” series which will make this much more clear.

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Mania

“The United States stock market looks very expensive right now. The CAPE ratio, a stock-price measure I helped develop — is hovering at a worrisome level…. above 25, a level that has been surpassed since 1881 in only three previous periods: the years clustered around 1929, 1999 and 2007. Major market drops followed those peaks.” -Robert J. Shiller, Nobel Prize-Winning Economist and Author of “Irrational Exuberance”

Popular response: the CAPE ratio is flawed and valuations don’t matter anyway; stocks are only worth what someone else is willing to pay.

“George Soros Just Made A Huge Bet That US Stocks Might Fall” -Business Insider

Popular response: he’s not betting stocks are going lower; it’s just a hedge against his long exposure.

“Yellen’s [recent] comments suggest, and I agree, that we are in an asset bubble.” -Carl Icahn

Popular response: 1999 was a bubble; this isn’t a bubble.

Rationalize. Rationalize. Rationalize.

Time and time again investors flat out deny what’s staring them dead in the face: stocks are extremely overvalued and at risk of yet another major decline. The last time I can remember investors rationalizing bearish data points as much as they are today was during the height of the internet bubble. ‘P/E’s don’t matter any more; it’s a new economy,’ was the battle cry back then. Today it’s, ‘it’s impossible to value a stock or the market,’ and ‘this is nothing like the internet bubble.’

To an outsider, someone who has nothing to do with the markets, the logical fallacies must be painfully obvious.

Criticizing the CAPE is a classic straw man. Tobin’s Q Ratio, a valuation measure used by the Fed, along with Buffett’s favorite yardstick, total market capitazliation relative to GNP, both confirm that the stock market is extremely overvalued, using three totally unrelated valuation methods. Another thing the bulls fail to mention is that these three measures are highly correlated to future 10-year returns for stocks and suggest the potential risk at this point is far greater than the potential reward. These are just facts!

And comparing today’s market to the internet bubble is a clear Red Herring. Just because today’s market is not exactly like that of 1999 doesn’t prove that we’re not in a bubble today. In fact, it’s totally irrelevant. Today’s market should be judged on the full measure of the data available to us. And just like Shiller says, there have only been a very rare number of times stocks have been this overvalued: 1929, 1999 and 2007. These are just facts!

Then we get into the Ad Hominem attacks. ‘Shiller’s just a professor; he’s not a market practitioner so he doesn’t know what he’s talking about’ or ‘Soros and Icahn are just like all the other hedge fund big wigs out there using the media to make short-term profits; you can’t read anything into what they do or say,’ not to mention the attacks on John Hussman that completely ignore the merits of his research on its own.

I get it. It’s extremely difficult to listen to reason when the madness of the crowd is simply deafening. At the end of the day, though, it’s all just a huge sign that investors are desperate to believe, to keep hope alive that 30%-per-year profits can happen again this year and the next.

So if you didn’t know what a mania was before now, just take a look at the financial blogs and social media sites. The rationalization is everywhere. And it may be the best indicator of all that we are, indeed, in the midst of yet another bubble.

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Investing, Markets

The Calm Before The Storm

It seems like volatility always dies down in the summertime as traders retreat to the Hamptons and focus more on sunscreen than stock screens. And you’re not supposed to short a dull market but…

When volatility gets as low as it has recently I take it as a sign of dangerous complacency, especially with the growing potential risks to stocks right now. Bianco research recently noted that over the past 25 years there has only been one other period where volatility has been as low as it is today: July 2007. This marked the beginning of a volatility pick up that ultimately peaked manifold higher during the height of the financial crisis.

Normally, low volatility is no reason in and of itself to become worried about stocks. In fact, low volatility is typically bullish. However, when complacency reaches an extreme like this it does suggest that investors are usually in for some sort of ‘surprise’ that sends volatility higher. And there’s a very good argument to be made that prolonged periods of low volatility actually create more extreme, pent-up volatility.

It works like this: A stock market that goes months and months without anything more than mild pullbacks lulls investors into a sense of security or confidence that stocks just don’t go down anymore. They extrapolate the recent benign price action far out into the future; they start believing things like the “great moderation” line of bullshit. This causes them to become overconfident and over-commit to stocks. When a pullback greater than just a few percent finally happens these investors are surprised by the ‘extreme volatility’ (which is really just normal volatility that has been dormant) and they reduce the undue exposure they put on when they believed volatility was dead. Add this to the normal selling that occurs during and you get a greater than average sell off. Multiply all of these effects (to account for record low vol) from the beginning and that’s how you get a crash like we saw subsequent to the record low vol mid-2007.

Now there were all sorts of other issues that compounded to create the worst financial panic in a few generations and that’s not about to happen again. But history does look like it could be rhyming in some ways right now.

Any major dude will tell you” about not just the record low vol but also that record high margin debt has finally and ominously begun to reverse. A few months ago Jeff Gundlach warned that we could expect a double digit decline once this happened. And @jlyonsfundmgmt shared a great chart the other day showing the correlation between margin debt and the peaks of the past few bubbles.

I know: Correlation ≠ causation. Still, it makes a great deal of sense to me that margin debt is greatly responsible for blowing up an equity bubble in the first place and when it peaks it’s a good sign that the bubble has run out of fuel.

And we’ve seen some canaries croaking in this coal mine over the past couple of months. Biotech stocks, MoMos and the Russell 2000 have all taken it on the chin lately even while the major indexes have hovered near their all-time highs.

As for the latter, @ukarlewitz noted late last week in his excellent “Weekly Market Summary” that, “RUT [Russell 2000] recently ended a streak of more than 360 days above its 200-dma, its longest ever. Every prior instance when a long streak in RUT ended has led to SPX also breaking its 200-dma in the weeks ahead.” That level lies >5% below its current number but there’s a good chance stocks could fall at least twice that much. Again @ukarlewitz:

At more than 5 years, the current bull market (defined as a gain uninterrupted by a drawdown of more than 20% on a closing basis) is both longer and more powerful (on an inflation-adjusted basis) than either the one from 1982-87 or 2002-07. It is, in fact, longer than every bull market in the past century except the ones ending in 1929 and 2000. In other words, this exceptionally long advance without a 10% correction is occurring at the point where virtually every bull market has already ended.

No. This doesn’t mean stocks are about to fall 20%+. But with record low vol over this span how many investors are prepared for such a scenario?

There are also divergences galore. Toddo, calls our attention to the weakness in the banks along with the small caps in contrast to the majors. Maybe more important is what the smart money is doing. We haven’t seen a divergence this large between “emotional buying” and rational buying since… you guessed it. Yep, 2007.

Another noteworthy divergence/canary can be seen in junk bonds. Risk appetites there have also begun to reverse and this is typically a prelude to equity risk appetites reversing as well. So what to junk bond investors see that equity investors don’t?

Maybe it’s that the latest episode of “reaching for yield” is about to come home to roost.

Maybe it’s the weakness in retail. TJX, HD, WFM, BBY, PETM and others have all disappointed investors over the past couple of weeks and we all know consumers make up 70% of the economy.

Maybe it’s the bursting of the bubble in profit margins.

Maybe it’s the bursting of the housing bubble in China.

Or maybe it’s just the fact that this cycle has run its course and is about to swing the other direction. Who knows?

In any case, I’d argue that the record low vol shows investors aren’t looking ahead as much as looking behind and reminiscing at how good things have been over the past five years or so. They’re expecting more of the same even though it’s mathematically impossible. But people love to believe things even when they know they’re not true. And you know what? According to the Fed, this is the very definition of a bubble.

It might not be your father’s bubble but just because we haven’t matched the p/e’s achieved during the internet bubble doesn’t mean that we aren’t ridiculously overvalued today. And it’s increasingly likely this is just the calm before the storm.

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