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Could U.S. stocks be headed to a melt up for the end of the year?

posted on October 28, 2013 at 11:36 pm
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Are we looking at a yearend melt up?

I think the odds are good, very good indeed that we’ll see one of those big, all-animal-spirits-on-deck upward moves in U.S. stocks from now until at least mid-December.

Assuming, and at this point I think this is a relatively safe assumption after Monday’s report of a very disappointing 5.6% month to month drop in pending home sales in September, that the markets can get past this week’s October 30 meeting of the Federal Reserve’s Open Market Committee without a move by the U.S. central bank to cut back on its $85 billion a month in stimulus.

I think the Standard & Poor’s 500 stock index could easily break 1850—the index closed at 1760 on Friday, October 25, within the next six weeks. That would add another 5 percentage points of return to what is already an extraordinary year for U.S. stocks.  As of October 25, the year-to-date return for the S&P 500 was 25.4%.

But an end of the year melt up wouldn’t be all good news for traders and investors.

As the term implies, with its echo of “melt down,” stocks can fall hard after a melt up. In a melt up valuations run far away from any fundamentals in the economy, the market, or individual stocks. A melt up is driven by momentum as investors who have profited from the market’s gains greedily chase more and as investors who have been on the sidelines decide that they can’t take missing out any longer and join the party. Worries about risk go out the window and often it’s the riskiest assets that climb the fastest. In a melt up the last of every group of investors except the permanently bearish throws in the towel and finally puts cash into the market.

A melt up can be the last blow off before a market dive.

“Can be” is, of course, the key problem. Melt ups don’t have to end in corrections or market dives. Best-case fundamental wishes can turn out to be true, and provide support for valuations at exactly the right time. Extravagant hopes for the future can yield to even more extravagant hopes. Markets can calmly go through a period of consolidation rather than dropping to support levels.

Let’s start at the beginning and work through the important points one by one:

Why does this look like a melt up to me? What could make the difference between a dive, a consolidation, and a further extension of the rally? And what should you be doing now?

Let’s start with sentiment indicators that say it’s very hard to find a bear right now.

The American Association of Individual Investors Sentiment Index for the week ended October 23, for example, shows 49.2% of respondents are bullish—that’s up 2.9 percentage points from the previous week. More impressively, bearish sentiment is down to just 17.6%, a drop of 7.3 percentage points in the last week. The long-term average, by the way, for bearish sentiment is 30.5%.

It’s hard for a market to keep climbing when all the bears have already thrown in the towel and put their money to work on the bullish side.

Other indicators of sentiment and data on investor cash levels show a similar picture of investor enthusiasm. Margin debt, money borrowed to buy stocks where the loans are secured by the value of the stock, hit a 54-year high in September at $401 billion. (The New York Stock Exchange only releases data at month end so we don’t know what has happened to the total in October.) Margin debt as a percentage of GDP does not quite match the peak of 2007 but it’s in the neighborhood of previous peaks, according to Deutsche Bank.

You can see signs typical of a melt up by tracking the rise in popularity of riskier assets. For example, mutual funds and ETFs (exchange traded funds) that invest in junk bonds are popular again. Weekly flows into junk bond funds have tripled to $2 billion, according to Lipper. That has taken total cash flow for the year back into positive territory after investors moved out of the category earlier in 2013. Or take the willingness of Wall Street to buy what are called covenant lite loans. These corporate loans carry few covenants—rules, for example, requiring borrowers to meet specific credit ratios or limiting the amount of additional debt borrowers can take on. Covenant lite loans had climbed to 54% of all loans this year as of September, according to Standard & Poor’s. That’s a record.

So what could keep this melt up from ending badly? That is in a dive or a correction? (And remember that this market hasn’t seen a 10% correction since December 2011.)

This rally is predicated on a continuation of cheap money flows from the Federal Reserve and other global central banks. It’s hard to see the Fed delivering better news on that front than the financial markets now expect. The consensus is calling for the Fed to refrain from cutting back its purchase of $85 billion a month in Treasuries and mortgage-backed assets until March (or maybe May, depending on what survey of economists you read.) A decision by the Fed not to taper at the October 30 meeting of its Open Market Committee is mostly baked into stock prices. A December no-taper decision at the meeting that month is mostly in the consensus too. Getting the results that everybody expects will remove a bit of residual worry from the markets but this isn’t enough fuel to move keep the melt up running.

I can see three possible sources of fuel that could prevent this melt up from ending badly.

First, some other big central bank could step up its stimulus plans. The Bank of Japan probably doesn’t count since it is already committed to a massive weakening of the yen through big asset purchases. The European Central Bank could decide that the absence of inflation in the EuroZone—and low growth in Europe—justifies a cut in interest rates from their already historic lows. Given the bank’s history on fighting inflation that seems relatively unlikely. The People’s Bank of China could abandon its efforts to rein in growth, to damp financial speculation, and to control inflation and go shift back to stimulus. However, the bank has been relatively miserly about adding liquidity to the system in recent months. It’s hard for me to see the bank making such a huge shift in policy soon.

Second, the U.S. economy could show higher than expected growth. Nothing in the data right now points in this direction—housing numbers and forecasts on auto sales, for example—look weak. Granted recent data isn’t especially reliable thanks to the games in Washington in the last month. But with a replay of those games possible for January and February, it’s hard for me to see a spurt in U.S. growth in the fourth quarter of 2013 or the first quarter of 2014.

Third, investors could get an end of the year present of unexpectedly strong growth from China that suggests that China’s growth rate for 2014 might be significantly above the 7% to 7.5% band. Good news from China would be big enough to move global financial markets—since Chinese demand is the driver for so many sectors of the global economy. We have seen signs in recent numbers that China’s growth rate has stabilized in the 7% to 7.5% range, but it’s tough to see much in the way of solid evidence that growth is about to stage a meaningful acceleration.

Could we get good news—or at least news that would support an even more hopeful read of the future than the markets have now? Absolutely.

Do the odds favor that kind of news outcome? Absolutely not.

Which leaves investors and traders with the same conundrum that they’ve faced all year. If you do even a cursory Google search on “warning indicators” or “excessive valuations” for 2013, you’ll pull up lots of examples of posts and stories from earlier in 2013 pointing out that the market is cruising for a fall. But the market has kept climbing past all those worries to a gain of 25.4% for the year—and without a single 10% correction.

Over-valued markets can get even more overvalued. Warning signs can blare for an age before the danger they warned off materializes.

After talking to investors and traders and money managers at the recent Toronto MoneyShow, I’ve come to this conclusion: The real difference between bulls and bears in this market is timing. Bulls believe the current rally will run into the spring. Bears believe the current rally in will run for a while and then end badly.

Nobody that I heard was predicting—no matter how negative they were about the eventual future—that we were looking at disaster tomorrow.

So what do you do?

Now, it is certainly possible that the fact that nobody is expecting disaster tomorrow is an indicator of disaster tomorrow. But I tend to think tomorrow is a bit soon.

I think there’s still enough worry about the Fed in December and about economic near-term economic growth to keep the melt up melting through December. And I wouldn’t discount greed—a lot of professionals on Wall Street won’t abandon this market until a clear break in the trend forces them to do so.

I think riding this trend—even though this trend is way, way closer to an end than a beginning—is reasonable on a risk/reward basis through mid-December. If you are going to go with the melt-up, buy your ticket now. There is no point in waiting to play the trend until the trend is even older.

If you want to extend the potential life of this trend, you can consider what many Wall Street professionals are doing now and look for under-valued markets that haven’t melted up quite so strongly in the last few months. That’s one explanation for the recent strength in the Korean and Mexican markets. The iShares MSCI Mexico ETF (EWW) was up 3.77% in September and the iShares MSCI Korea ETF (EWY) was up 7.46% in that month. A caveat: I’d expect that if the U.S. market corrects, most other assets, especially risk-on assets—will correct as much or more.

In early or mid December, however, I’d re-evaluate the risk/reward ratio of staying with the trend. If it still looks like the melt up in solidly in place and you can see some positive catalysts for a move higher, stay on board. If you can’t see any catalysts and the risk indicators are flashing an even angrier red than they are now, I’d certainly look to start cutting back on some of the riskier holdings in my portfolio and to begin taking some profits in individual positions.

Remember, you’re not trying to time a top exactly. But you would like to stay on the right side of the risk/reward ratio.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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2 comments

  • dxia on 29 October 2013

    We might see a small pullback in the next few days. However, I don’t think the current market is that expensive, given that the P/E is only at its long term average. However, nobody can predict the market. Who knows what’s going to happen tomorrow. BTW, the aaii sentiment is often used as a contrarian indicator. The sentiment is too bullish is always a waring sign.

  • dxia on 29 October 2013

    Another short term waring sign – small caps and banks are not participating in the past few days.

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