What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital.
Obsession
An obsession with endings is something deeply rooted in human psychology. We fear endings to such a great degree that we forget to recognize what is occurring here and now. The fear creates an impetus to agonize, slowly dissolving into a misery-inducing, melancholy study of psychological frailty and worry.
The fear of a relationship ending. The fear of a prosperous period coming to a close. The fear of health suddenly disappearing. But most of all, the fear of death. The ultimate ending, I suppose.
Reluctance to participate in a bull market because it will one day end is akin to not getting out of bed in the morning because one day you will die. There is a whole generation of current investors who are refusing to get out of bed because they see death as being the inevitable destination of the current march upwards.
Much as the man who refuses to get out of bed because of the inevitability of life ending, investors who refuse to participate in the current bull market are missing out on all the creation occurring around them. The fact that investors have been scorned with great repetition over the past 15 years has created a psychological aversion with respect to equities to the point where the specter of an eventual ending supersedes the benefits gained in the meantime.
That aversion shows no signs of abating as the ever faithful long-term moving average of the put/call ratio is just now beginning to drop off of 3 year highs. Meaning that investors, as a whole, have been prone to put buying in order to either hedge their portfolios or outright speculation on the downside at a pace not seen in 3 years.
Then there is the AAII survey which seems to be populated with investors who prefer not to get out of bed in the morning. AAII is a survey of investor opinion about the direction of the stock market and economy. In a recent June survey, investor's bullish sentiment remained below the historical average of 30% for a seventh consecutive week. You have to go back 12 years to January-February of 2003 to find a similar stretch.
But you know what the difference was between January-February of 2003 and now? In the 3 years prior from 2000-2003 the S&P 500 had fallen 39%. Investors had every right to be bearish. Their hopes of Pets.com and JDS Uniphase providing for retirement in Bordeaux, France had been replaced with the reality of having their jet-skis repossessed while worrying if they could afford the timeshare in Lake Tahoe the next year.
Here is what the S&P 500 looked like at that time:
In stark contrast to 2003, the S&P 500 is up more than 50% over the past 3 years. A near unmitigated climb to a chorus of crickets from the retail investor class. They don't care. They don't trust. Death is inevitable so in bed they remain.
If you are a student of the markets, as I attempt to be on a daily basis, then this news of perpetual bearish sentiment should be a harmonic symphony of sorts to your ears. The reason being that retail psychology that is either not participating or only has one foot in the door is not too far detached from the current mentality of the institutional investor class. They are ready to flee at the first sign of distress.
As discussed many times in the past, this hesitancy to remain invested puts a floor beneath the market which can only be penetrated by unexpected macro or geopolitical shocks. Therefore, as long as we remain in a fairly tame macro environment, downside in the market will remain cushioned because of the confluence of short sellers, hedging and outright selling taking place after a 2-3% decline off the highs, leaving very little room for the markets to move down more than 5% and allowing even less room for the dreaded 10% decline. In other words, the anticipation alone creates the bearish sentiment necessary to temper any decline. This has been the case over and over again since the inception of this bull market. I don't see any signs of this changing during the second half of 2015.
A Near Perfect Market
Perfection is a subjective quality dependent on individual perception. With respect to the financial markets, arguments can be had for a seemingly endless number of hours about what constitutes the perfect bull market. In most cases, you will find that investors seem drawn towards reaching a conclusion based on fundamental data rather than sentiment or technical driven analysis.
While fundamental data has it uses within the grand scheme of investment analysis, it tastes best when blended as opposed to taken straight. Those who incessantly cite fundamental pieces of data regardless of how many times the market proves them wrong are most often in love with their own intellectual capacity or ego, if you will, rather than making money in the markets.
It is true that quoting fundamental data points such as GDP growth, current account deficit and inflationary forces at work surrounding the fluctuations in the Chinese Renminbi make you seem much more intelligent and even interesting at cocktail parties or panel discussions. Unfortunately for the many individuals that like to partake in such activities of intellectual prowess, it does not translate into investment success above and beyond the most relevant benchmark.
More often than not, markets like to take on a counter-intuitive quality that renders traditional fundamental analysis useless by itself. Those who have studied bull and bear cycles of the past realize the importance of price and sentiment analysis in constructing a well thought out thesis with respect to both duration and quality of a bull or bear cycle in the markets.
While no method of analysis is perfect and finding exact tops or bottoms during any cycle is near impossible, utilizing price and sentiment in an appropriate fashion leads to the simple benefit of being less prone to foolish decision making based on popular pieces of fundamental data.
The current market, while having dozens of supposed fundamental forces working against it, has one simple tailwind that has been evident since 2009....doubt.
It is true that markets climb a wall of worry. With respect to the wall of worry that has been built around this bull market, it is near endless in height and massive in scale. It has investors of all classes buying into its legitimacy, fearing the consequences of embracing this bull market.
And then there is price. There are two ways for a financial instrument to digest large gains:
1. It pulls back a substantial amount until the buyers and sellers are balanced to the degree that it allows for the next leg up
2. It moves sideways, digesting the gains to the point when buyers and sellers are balanced to the degree that it allows for the next leg up
The voracity of this bull market hasn't allowed for a pull back in 2015. Instead, the major indices, such as the S&P and Dow have moved into a rather tight sideways range, in what is obviously a digestion of the substantial gains that have taken place over the past several years.
All the meanwhile, bearish sentiment has shot through the roof as investors are confusing digestion for imminent extermination of capital. The cycle of negative fundamental news to justify this bearish stance only grows by the day: Greece, European Union, rate hike, liquidity, bond market, GDP contraction, Chinese stock bubble, earnings slowdown, retail sales, stock valuations, Russia. Intellectual catnip in other words for the cocktail party and panel discussion crowd.
I never get called on for panel discussions. I'm not very popular at cocktail parties either. All I can offer is that investors are too bearish in the face of price action that is very bullish. And that simply is what makes a perfect market.
Regards,
Ali Meshkati
