How Long Can This Rally Last? Here’s A Warning Sign…
In a little over four months, the S&P 500 has rallied about 18%. On an annualized basis, that’s a 54.3% return.
Sure, there are certainly times when the stock market should climb that fast. But based on the fundamentals, this is not one of those times.
This week, I want to consider the sustainability of the rally.
How Long Can The Rally Last?
Earnings season is underway, and about two-thirds of the companies in the S&P 500 Index have reported their results. On a year-over-year basis, earnings per share (EPS) increased 0.9%. That’s much slower than the 5% average we’ve come to see over the past 20 years. Analysts are optimistic that 2020 growth will be between 8% and 10%. But this optimism usually fades over the year, so the final number will realistically be lower.
Given below-average earnings growth, it seems like the market should trade with a below-average price-to-earnings (P/E) ratio. But that’s not the case. In fact, P/E ratios have been above average for most of the past 10 years.
Other fundamental metrics are also above average, indicating that it’s far more likely that stocks are overvalued and expensive rather than undervalued and cheap. That’s important. It means the fundamentals do not support an annualized rate of return of more than 54% in the S&P 500.
A stronger-than-average earnings season could provide enough gas to drive a theoretical 54% run. And we could see something like that if the economy grows quickly. However, rapid economic expansion is unlikely given that GDP growth is near 2%. And global growth will surely be slowed by the coronavirus outbreak.
Without fundamentals or economic expansion, all we have left to explain the quick rise is sentiment. For some reason, investors are bullish. They are displaying what the economist John Maynard Keynes called “animal spirits.”
My Income Trader readers know I like to talk about historical market figures like Keynes (as well as others). Keynes defined animal spirits as “a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”
Emotional markets like this one can result in big windfalls. But they can also turn suddenly. And there are indicators warning us that a change in sentiment — and, as a consequence of that, a change in the direction of the market trend — could be close.
One indicator flashing a warning sign is based on reports filed by large investors every week. In futures markets, the Commodity Futures Trading Commission (CFTC) issues a weekly report showing how many contracts various groups of traders own.
The CFTC assigns all positions to one of three groups — commercials, large speculators, and small speculators.
Commercials are producers and consumers of the commodity. In the oil market, commercials include oil producers and large consumers like airlines. These are companies that know they will always need to buy or sell oil. They use the futures markets to get the best price. When commercials believe prices are going up, they take large positions ahead of the rallies.
Typically, commercials are the “smart” money in a commodities market. But in the S&P 500, commercials are almost all hedgers and include investment banks and market makers. Their actions are driven by the positions large traders take, and the signals are less reliable than in other markets.
Large speculators are hedge funds. In the S&P 500 futures markets, large speculators tend to be trend-followers. They tend to buy more as rallies unfold and take larger short positions as bear markets drag on. This means large speculators should have their largest positions when markets top or bottom.
The COT report also shows what small speculators do in the market. These are individual investors who trade futures. In the S&P 500, the margin is so high (about $25,000 per contract) that few individuals trade the market. Therefore, their positions don’t tell us much.
The weekly report containing this data is known as the Commitment of Traders (COT) report. The raw data tells us the number of contracts each group holds and is difficult to interpret. To make sense of the data, I converted it to an index that ranges from 0 to 100, with 100 being the most bullish.
The chart below shows the S&P 500 in the top panel. The index for the most useful group in the report, the large speculators, is shown in the bottom panel.
What This Means
Remember that this group generally follows trends. Yet, they have been less bullish since December. In other words, they are using the rally to exit profitable positions.
One interesting aspect of this is that there is a high cost for being wrong. Hedge fund managers enjoy large paydays for beating the S&P 500. Reducing exposure in a bull market carries high career risks, and that could be the largest risk in the mind of a hedge fund manager.
(Also read: What The Army Taught Me About Risk Management)
And that’s our warning: We’re seeing managers risking income and careers in a bull market. Instead of chasing guaranteed bonuses for beating the market, these players are making sure they get out while the getting’s good.
Is it possible they’re seeing something on the horizon that we’re not? No one can say for sure. But if even this notoriously aggressive group isn’t willing to pursue multi-million dollar paydays, perhaps we should consider being a bit more risk averse as well.
Editor’s Note: When it comes to managing risk, nobody does it better than Amber Hestla. In fact, since beginning her Income Trader service in February 2013, she has delivered winning trades 91.3% of the time. That’s seven straight years of income, through bull markets and bear markets… without skipping a beat.
And to start the new year, we’re on a mission to put 1,000 smart investors on the path to generating $1 million in retirement income. And it’s all thanks to Amber’s award-winning strategy, which generates payouts of $330… $675… $720… and even $1,155…