“This great virtue of a free market system is that it does not care what colour people are; it does not care what their religion is; it only cares whether they can produce something others want to buy. It is the most effective system we have discovered to enable people who hate one another to deal with one another and help one another out.”
Dr. Milton Friedman
Incredibly, the S&P 500 Index had gone a record 399 trading days in a row within 5% of its all-time high, topping the 394 days which took place in the mid-1990’s – making it the longest streak in history without a 5% correction, the last one (5% correction that is) taking place during June 2016 with the “Brexit” vote.
Of course, after the last couple days, we may have broken that streak as you read this commentary (the S&P 500 is down 3.9% off recent highs with Friday’s close). We mentioned in a previous piece that in 2018 we suspected volatility to pick up, and while we could get another 3 to 7% on the downside in the near term, with the U.S. (and global) economy picking up steam, I still think we have a ways to go in this bull cycle.
Recent market gains have had the feel of a “melt-up” or “blow-off” phase, but the ride has been accompanied by a significant improvement to corporate earnings, along with a steady rise in economic data. With an almost 7% gain in January, it is not unreasonable for the U.S. market to digest some of that.
(6-month S&P 500 Index Return from MarketWatch.com)
“Melt-ups” feel good at the time, but usually end up with more volatility and sharper down moves. Look at the violent moves that Bitcoin (down over 50% in 5 weeks) or the “pot” stocks (down 30-50%) have had, which have been carried by a small number of stocks led by the “FAANG” stocks (Facebook/Amazon/Apple/Netflix/Google). In fact, at their peak prices in mid-January, the four biggest “FANG” names (Facebook/Apple/Amazon/ Google) were market capitalized at an amazing 3.4 trillion dollars. The entire TSX 300 index in Canada at the time had a market cap of 2.2 trillion dollars. So, an investor could deduce either:
A) The FANG names were overpriced
B) The TSX is undervalued, or
C) Both A) and B)!
Melt ups can go on for a while as investors who sell too early miss out on decent gains in a short period, or by their nature, “melt-ups” usually draw in those investors who’ve largely sat in cash and missed the moves, finally throw in the towel and jump in. ETF investors, similarly, blindly buy thinking they don’t have exposure to volatility for some reason.
In all these cases, the market goes up as “FOMO” drives things: “Fear Of Missing Out”. And while the rally has been decent, I think it’s done so with a lot of skepticism, and I would add, cautious investor sentiment. And that’s a good thing.
The S&P 500 now trades at about an 18.5x earnings multiple, which thanks to earnings which have been accelerated with stock prices, while elevated, is still well below the 24-26x level in 2000. And that was three years AFTER Fed Chair Greenspan commented on how expensive markets were in 1996 with his “irrational exuberance” comment, only to have markets run another three years.
Historically, low volatility years (like 2017) tend to be followed by years with more volatility. And there are still lots of things which can cause that volatility to increase. The list includes (in no particular order):
- Rising U.S. interest rates. The 10 years U.S. Treasury has gone from a low of about 1.50% to 2.80% this week.
- Given #1, the 35 year bull market in bonds is nigh.
- Rising inflation.
- NAFTA talks go South = increased protectionism (?)
- Political dysfunction out of Washington, DC
- U.S. mid-term elections Nov. 2018
- Italian election on March 4th – more populism?
- Cash allocations are at the low end (see below)
…meanwhile investor equity exposure is rising at the fastest pace in 10 years
- OPEC/Oil price uncertainty
10. And many more…
So yes, we are long overdue for a pullback/correction. Just a question of how deep and how long, but any should be bought. This has been a record streak, but like the mid-1990’s when the streak was broken, the S&P 500 went to gain for another four years and more than doubled from when that streak ended. I think this cycle will be similar, and yes, will get very rocky at times along the way. But a similar move would take the S&P 500 close to 6000!
In other words, once this streak ends, don’t expect the bull market to end with it, just remain disciplined and stick to a strategy.
Stay tuned,
Vito Finucci, B.COMM, CIM, FCSI
Vice President and Director, Portfolio Manager
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