The Hubris Of The Bulls
Pride goeth before destruction, and an haughty spirit before a fall. Proverbs 16:18
I spend a good portion of my time trying to figure out the mood of the market. That isn’t just so I can bet against it although that is the proper strategy at times. John Maynard Keynes likened the fluctuation of stock prices to a beauty contest in which entrants were asked to pick among six photographs of women which is most beautiful. Those who pick the most popular face win a prize. An entrant in this contest could just choose the face they think is most beautiful but a better method would be to choose the one he thinks other entrants will choose. In other words, the key to winning the contest is to focus on the other entrants rather than the photos they are viewing.
Since asset prices move based on the urgency of buyers and sellers – the other entrants in our contest – deciphering their moods is all important in determining the short term movements of markets. When buyers are scrambling to buy, prices go up. When sellers are scrambling to sell, prices fall. Turning points in markets are so difficult to pinpoint because these moods can change quickly and on seemingly small changes in perception. As markets rise, the bulls ranks swell and the bear population shrinks until the anxiety of the bears is relieved. The bears relieve their psychological pain of being wrong by buying. We see this today most prominently in heavily shorted stocks such as Netflix and Tesla. The shorts’ pain can only be relieved by buying and closing out their short position which causes a further rise in the price that further pains the remaining bears. Once all the shorts have capitulated and closed their positions the urgency is gone. After that, the long term performance of the stock will depend once again on the performance of the company itself which would worry me a lot if I were long Tesla.
Monitoring the population and mood of the bull and bear camps is important because when the imbalance between the two is extreme the urgency that drives stocks to bottoms and tops ends and a reversal becomes more likely. It doesn’t have to happen immediately but when either camp is depleted the odds of a reversal rise. If there are no more bears feeling pain, the pool of urgent buyers is depleted. If there are no more bulls, the pool of urgent sellers is depleted. Sentiment extremes are, however, very difficult to pinpoint which is what makes short term trading so difficult.
For long term investors, sentiment is a useful tool in making investment decisions (as opposed to trading decisions). Over the long term, stock prices are determined by more concrete measures which we refer to as fundamentals. Corporate earnings and revenue are a derivative of economic growth and the price one pays for them is dependent on several other factors. What is the reliability of the earnings stream? What is the discount rate one uses to value in the present a stream of cash flows that extends into the far future? What is the durability of the economic expansion – current or prospective – that underlies the earnings and revenue growth? For the long term investor these fundamental criteria are the most important factors whether investing in a single stock or a market. Sentiment is useful in the timing of these long term investment decisions. When stock prices have been falling and the bears reign supreme, investors have an opportunity to make long term investments at depressed prices. When stock prices have been rising and the bulls are running, long term investors can defer buying and sell positions elevated in price by emotional buyers.
While there is no way to pinpoint exactly these sentiment extremes there are clues we can use in the timing of our decisions. One of the best known is the magazine cover indicator which posits that by the time a market trend makes the cover of a popular magazine it is nearing its end. The most famous example is the BusinessWeek cover that buried the stock market under the headline, The Death of Equities. Many have cited this example as marking the bottom of the great 1970s bear market but it is interesting to note that the issue in question was from August 1979, a full 3 years before the commonly agreed on starting date for the great bull market to come. In other words, the cover was a sign of extreme sentiment but it still took another 3 years for its predictive value to start paying off. A long term investor buying in August of 1979 was still well served though even if it was a bit early. And yes, bulls have been making a comeback as magazine covers with Barron’s and The Economist the most recent examples.
Another sign of a sentiment extreme is what I like to call the hubris indicator. It isn’t as easy to identify as the magazine cover indicator but it is always obvious in retrospect. I remember clearly the hubris the tech bulls demonstrated in 1999. At the time I was still working at Oppenheimer and our strategist, Michael Metz, was bearish on stocks in general and tech stocks in particular. It seemed that the only reason CNBC invited him to their studio was to provide the bulls with someone to ridicule for his outdated beliefs about value. It got so bad that our owner at the time, CIBC, relieved him of his duties as strategist. That’s not what they told us but we all knew why he got the axe. Metz got the best kind of revenge; he was right and regained his strategist post after CIBC sold Oppenheimer to Bud Lowenthal and was the toast of CNBC until his untimely death. I also remember the hubris of the housing bulls in 2006 when normally rational people were camping out in tropical storms to get a shot at a pre-construction condo in Miami. I remember one rotund fellow in particular who couldn’t bring himself to sell his condo at a multiple of his purchase price even though he was unemployed at the time. I don’t know whatever happened to him but his waterfront condo wasn’t as immune to the downturn as he imagined.
What prompted the title of this commentary is a feeling I’ve been getting from observing the beauty contest judges. I have detected a certain amount of hubris from the bulls that I haven’t seen since 1999. There is an underlying gloating in their dismissal of the bears that smacks of overconfidence. This perception on my part may be a function of the fact that I’ve joined the bear camp since late last year and I’m taking some of this as a personal slight. I acknowledge that possibility and also that a lot of the bulls vitriol has been aimed at the perma-bears who are only right in the way a stopped clock is accurate as a timepiece twice a day. But still the feeling I get when I do my daily rounds of the financial press and blogs is that the bulls are really feeling their oats right now.
What that means to me is not that I should go out and sell everything but rather that I should lean toward selling and buy only very selectively. It also makes me want to hold more cash than normal as an option on the time when this rally ends and the bears start irritating me as much as the bulls do today. As Josh Brown points out in this post, by many measures this is not 1999 when it was obvious to any sentient being that stocks were overvalued. I would just point out to all the bulls out there that it sure as hell isn’t 1979 either. The fact that this market isn’t as overvalued as the one in 1999 is not a reason to go all in on the buy side (not that Josh is suggesting that; I have no idea what his asset allocation is right now). The fact that we’re not partying like its 1999 tells us nothing. It is true that we don’t have the public participation today that we had in 1999 but if that is what you are waiting for as a sell signal, I suspect you’ll be waiting a very long time. We lost an entire generation of investors with the last two bear markets and they are not coming to this party no matter how crazy it gets.
It isn’t just sentiment that makes me wary. I am skeptical of the durability of this rally because the economic outlook is so uncertain. We have not addressed the problems that forced the 2008 crisis and in many ways we’ve made them worse. Too Big To Fail banks are larger than they were prior to the crisis. Our debts have been shifted, somewhat, from the private sector to the public sector but we are still highly indebted. The Fed’s QE programs have exacerbated inequality by raising asset prices and had, so far, little impact on the real economy which means the current “recovery” is narrower and I would suggest more fragile than past ones. Like our tax system, our economy is now very dependent on how the upper income cohort is doing. As we saw in the last recession, when the high earners do poorly, tax revenue falls through the floor. If anything happens to negatively affect the wealth or incomes of the top 10% the economy and the Federal budget will have severe problems.
At Alhambra we invest based on the economic environment. The most favorable for stocks is a stable or rising currency and accelerating growth. The most negative for stocks is a rising currency and decelerating growth. Right now, the dollar is rising; gold is falling, commodity indexes are falling and the dollar index is rising. It is the second component that has us worried – growth. We don’t see anything that gives us any confidence that growth is about to accelerate. In fact, everything we see points to a deceleration and that has us on edge. It may be that there is a growth spurt coming and that is what stocks are telling us right now. Or it might be that the bull case – which amounts to TINA (there is no alternative) – is flawed. We’ll find out in the course of time. I’d just warn the bulls not to get too comfortable in the warmth of the crowd. It often turns on you when you least expect it.
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