The S&P500, in an eerie continuation of a patter established six weeks ago, inched up another 0.3% on historically light volume. Volatility, diverging from the rise in price, climbed slightly, but still closed near record lows, levels that imply a prevailing belief that nothing can go wrong.
And in a nutshell, the sentiment in risk asset markets is precisely that—why NOT be bullish because the Federal Reserve will simply NOT allow markets to fall? As a result, bullish indicators are showing that investors in stock markets are as bullish as—or even more bullish than—they were in mid 2007. As a reminder, that was only months before the Global Financial Crisis exploded in August 2007, which then morphed into the financial meltdown in 2008 and the Great Recession.
Surely this time is different?
In US macro news, factory orders fell. That’s not good, especially when they were expected to rise. ISM services essentially met expectations. Initial jobless claims disappointed, rising more than expected. Productivity fell much more than expected—and this is bad because it suggests that labor costs, as a percentage of sales, are rising for corporations, and this will hurt corporate profits. International trade was less bad than predicted but wholesale trade disappointed. Bottom line—the US economy is still stagnating, and certainly not booming the way the risk asset markets, especially the stock markets, are.
Technically, the S&P500 is even more overbought than it was in the last two weeks. The VIX index is diverging (rising) which is a caution sign and internals (breadth indices such as the McClellan Oscillator) are also diverging to the bearish direction. Yet prices are still rising.
What about a broader assessment of the markets’ temperature? What are some of the long-term gauges reading and implying about the current state of the risk asset markets? Note that this is in no way an attempt to predict the future direction of market prices which is very hard to do consistently; it is, instead, an attempt to assess the current—actual—condition of the markets which is not very difficult to do.
Starting with corporate profits, they are still near record highs. Interest rates, while rising lately, are still near record lows. Bond yields, both investment grade and high yield, are hugging historically low levels. Real ten-year Treasury rates are actually slightly negative. S&P optimism is near record highs. Asset owners are buying (as opposed to holding, much less selling). Capital is plentiful (the opposite of scarce). Asset prices are high, relative to recent and not so recent history, and the market psychology is certainly optimistic, as measured by multiple bullish percentage indicators.
Where does this leave the markets, today?
There is very little doubt that markets today are priced at levels implying that prospective risk is HIGH and that prospective returns are LOW.
Could prices rise further? Of course, but over the next five to ten years, any investor fully invested in risk asset markets must be prepared for historically lower returns.
Sadly, most—including experienced professionals—are not.