As of Tuesday’s close the rally in equities has officially lasted 44 sessions. That’s long by historical standards, but a look under the hood shows some remarkable bullishness. This persistent bullishness is best exemplified in the Nasdaq 100. There are a few indices that are notoriously high beta. This is one of them. And this is where the high beta junkies come to get their fix. In the last 44 sessions there have been just 15 negative sessions in total with 29 positive sessions. That’s a 3:1 ratio – very high by historical terms. What’s amazing is that the Nasdaq 100 has experienced just ONE 1%+ decline during the last 44 sessions. And in total, there have really only been three damaging sessions that totaled declines of 2.89%.
It’s always amazing to me how investors can be so confident in returns after a rally has occurred and so scared after a market has declined. If you watch financial TV these days it appears as though everyone and their mother has subscribed to the David Tepper “everyone’s a winner” thesis. The only two beliefs currently existing are that stocks will either go much higher from here or they will decline briefly before going much higher. Stocks are seemingly infallible. Currently, small investors are displaying their highest level of confidence in the market since March of 2008 – just weeks before an epic collapse began. Today, this unending faith in equities is obvious in the Nasdaq 100 where the high beta junkies have now all hurdled together hoping to get their next fix of higher prices.
The beauty of mean reversion is its simplicity. If we take a graphical look at the current environment we can visualize the imbalance that occurs in a market. Market peaks and troughs tend to occur when a market enters a state of disequilibrium with its underlying fundamentals. This can be due to a number of varying factors, but psychology tends to be the primary driver. I often say that it is always brightest at the top. The current environment is not only displaying excessive bullishness, but the general equity mentality has become one of extreme complacency. You either think the Fed is going to push the market higher or you think the economy is on the path to recovery. As Tepper said, it’s a “win win”. The problem with a market and its mean reverting nature is that investors place their bets before the cards are dealt. This is why markets always peak on good news and bottom on bad news.
The last time I was net short was back in April 2010. Regular readers from that period will recall similar charts to the one below. The Nasdaq 100 is currently on a 22.7% tear that sets it on course for a 150% annualized return. But more importantly, this index, which is an important indicator of risk appetite, is now 8.5% above its 50 day moving average. This has occurred just two other times in the last 3 years and both events were in the early stages of the incredible move off the 666 lows – an outlier if there ever was one. At the May high before the flash crash we were just 6.4% above the 50 day moving average and the market had rallied an astounding 20.25% in just 55 sessions. If you’ll recall the mentality was eerily similar. Small investor bullishness was at 48.5% (currently 51.1%) and the consensus widely believed that we were in the midst of a sustained economic recovery.
I think the market has now priced in an extraordinary amount of optimism heading into the election and QE2. Neither will prove to be a panacea. In fact, I believe gridlock will cause more harm than good during a balance sheet recession due to a move towards austerity and that QE2 remains the greatest monetary non-event. In addition, investors are largely pricing in an economic recovery. The price action proves that there is extraordinary optimism about future equity returns. This has resulted in an extreme disequilibrium and in my opinion creates substantial downside risks. Unless the Fed is successful in reinflating the equity bubble (which they very clearly have stated they are interested in doing) it appears to me that the market’s natural mean reverting tendencies will dominate price action in the coming months.
* Author is short equities, but not short any securities mentioned in the above piece.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.