So when can we say markets are euphoric? The Dow hit a new all-time record high earlier this week, joining the S&P 500 and Nasdaq at record levels. Sir John Templeton famously stated, “Bull Markets are born in pessimism, grow on skepticism, mature on optimism and die on euphoria.” The current Bull Market was certainly born in pessimism in March 2009, as many observers feared a global depression was underway. We remember lots of pessimism in 2010-2012 as most observers were expecting a “double dip” recession. Even in 2016 we had the “Bearish Billionaires,” the wealthy, successful investors like George Soros who were calling for markets to crash from bubble levels. Today we still see anecdotal signs of bearishness. The AAII survey of investor sentiment, among others, tells us that a small percentage of investors were proclaiming themselves as “bullish” in early autumn, as we wrote about. There remain a few skeptics that must still capitulate, such as Morgan Stanley’s Chief Equity Strategist Mike Wilson who maintains a 2700 year-end price target on the S&P 500 (NYSEARCA:SPY).
We see (and feel) lots of optimism in U.S. equities today. Consider the following:
- Phase 1 of the U.S.-China Trade Deal is stirring investor optimism. Optimism on getting back to the status quo in trade relations? If a full trade deal gets done and stocks pop 10%, this would be massive euphoria, in our opinion. We, and other astute investors, know that man-made (political) problems will eventually find man-made solutions. Of course, it is natural to observe investor optimism over a trade deal and getting back to some status quo in trade.
- Markets are rejoicing that the Fed and other central banks will be friendly forever. In Europe we have the “do whatever it takes” ECB, while in the U.S. the Fed has pledged not to raise rates until inflation remains above 2% for a prolonged period of time. In other words, never. Optimism over a friendly Fed is permeating markets as we write.
- Macro data is suddenly positive. The October payrolls report showed solid job creations, in addition to upward revisions for prior months. Equities rallied on the news. The Chicago PMI surprised negatively, falling into contraction territory. Equities fell initially, but then forgot about the number and rallied. The ISM Manufacturing index contracted for a second month in October, and equities rallied straight away. Our point: there still is weak data, but that majority of market participants are willing to look past this weakness in anticipation of a stronger manufacturing economy in the future. This is our definition of optimism.
- Seasonality will also be a cause for optimism, as the November to April period has historically seen the most equity gains. The U.S. President wants to get re-elected and has claimed the stock market as his own success. If U.S. stocks are at record levels, it’s because of the President, as Trump has made clear in no uncertain terms. Trump will support equity prices in any way he can prior to November 2020. His reelection depends on it. The Presidential Election Cycle is also reason to expect equity markets to be in the optimism phase.
We are unable to predict the zigs and zags of the S&P 500. The interest rate market, macro data, and even chart technical analysis have all been unreliable indicators of the next move in equities. However, if this bull market will only die once euphoria has been reached, we would not guess the S&P 500 is at the final peak today. Our gut instinct, however, tells us that more swings are in store for equities before the ultimate top is in, whenever this is. Currently, we believe that the current move off October lows has come too far, especially given the propensity of the S&P 500 since January 2018, to overshoot the prior record high and then pull back. The VIX is getting dangerously low, suggesting investor complacency.
With the VIX back to the 2019 floor, the observed pattern suggests a bounce in the VIX, which will almost certainly correspond with a pullback on the S&P 500. If the VIX plows through this red box, we can start talking of euphoria.
Should we see a swift move up to 3200 on the S&P 500 in the next weeks, from today’s levels at around 3080 – and provided that there are no material changes in the investment backdrop – this may equally qualify as euphoria on equity markets. For us, an S&P 500 racing up to 3200 in the next weeks would be an invitation to aggressively raise even more cash and buy safe havens.
Another dynamic in play, with the S&P 500 set for a strong year of gains, is the fund manager catch-up and framing trade. As readers know, fund managers are judged on their annual performance relative to the S&P 500 on December 31. Many managers need to “create performance” in this robust year for stocks, meaning that buying of cyclical stocks and the winners (notably Tech) should characterize the next 7 weeks. As such, any pullback in the S&P 500 should be shallow.
Markets are not likely in a final euphoric phase consistent with a major market top. Dips in the S&P 500 will still be bought quickly as fund managers chase performance into year-end. In the event of a linear move in the S&P 500 above 3200 and a VIX fear index back down to 10, we’ll move into cash and take a long vacation.