What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital.
There are preconditions to this current phase of the bull market that will only become obvious in hindsight to most investors. Those preconditions involve the price that is to be paid for the nearly unbridled enjoyment of the past several months by a majority of investors. That enjoyment is a marked change over any rally of the past several years, going back to 2009.
As with any change, there are tradeoffs to be made for beneficial conditions that involve new participants with a completely reformed mental attitude towards the markets. Whereas from 2009 to late 2016, there was the perpetual hum and sway of skepticism towards the markets, the rally from November 2016 to present has disposed of skepticism, fear and trepidation, in exchange for optimism, jubilation and to a certain extent, greed. The entire framework of the rally, therefore, has been altered from November 2016 forward.
The price to be paid for this alteration in the framework or code, if you will, that is underlying the current rally is likely one that most investors are unprepared to face. That price comes in the form of increasing, sudden volatility on the downside that will become more frequent and pronounced as the rally continues.
Gone are the days of simple 5-7 percent pullbacks with the occasional 10 percent pullback that is met with an almost immediate trembling fear taking over market participants. The fundamental backdrop does not justify getting scared after a 10 percent pullback any longer given that investors now have concrete fundamental facts from which to justify buying dips. Since the markets are hell bent on inflicting the maximum amount of pain to the maximum number of participants, the shakes have to increase in amplitude. The dips have to command the emotions of investors before they reverse.
The same investors that were hedging, selling and selling short stock after a 5 to 10 percent dip in the markets now have the following logical assumptions to draw from that simply didn't exist at anytime from 2009 to late 2016:
- I will buy the dip in financials because deregulation will increase profitability
- I will buy the dip in financials and insurance because increased interest rates expand profitability
- I will buy the dip in industrials because there is a resurgence in domestic manufacturing
- I will buy the dip in industrials because infrastructure spending will boost earnings
- I will buy the dip in oil & gas names because domestic energy production is a priority for the current adminstration
- I will buy the dip in oil & gas names because renewed international partnerships will be cultivated by top adminstration officials who have a background in the oil & gas industry
- I will buy the dip all companies because the corporate tax rate in the U.S. is going to be cut
- I will buy the dip in large cap blue chips because a repatriation of their cash domestically provides opportunity for expansion on multiple levels
- I will buy the dip because stocks are going up
- I will buy the dip because the Dow is over 20,000 now
From 2009 to late 2016 the impetus to be frightened off after a small dip in the markets revolved around one perception:
- A bear market is right around the corner because monetary actions have run their course
Given that it is the markets inherent duty to create streams of doubt on occasion that seek to rebalance the psychological equilibrium so that greater heights can be observed, the effort required to rebalance the psychology of participants from 2009 to 2016 was fairly simple and straightforward due to the fact that market participants didn't have much of anything from a fundamental standpoint to hang their hats on. Over the past several months market participants have walked into a virtual Nevada brothel of economic fundamental reasons to remain invested in equities. They won't leave unless they are pushed out because there are so many reasons to stay and frankly, everyone is having too much fun.
This puts the equity markets in a position of having to exert increased viciousness in order to create levels of psychological equilibrium that must be rebalanced occasionally in order to insure that markets continue to function with optimal efficiency. The 5 to 10 percent corrections investors have become accustomed to in recent years now have reasons to be bought instead of sold. They no longer have the efficacy necessary to produce the psychological equilibrium that they once did.
Therefore, it's not unreasonable at all to expect the markets to exert themselves more forcefully going forward being that investors are anchored into positions due to an optimistic, fact based mental framework that hasn't existed at anytime during the entirety of the march up from the 2009 lows. Contrary to what would seem like logical wisdom regarding this new found dynamic, the conviction of investors will lead to increased volatility on the downside as markets inherently revolt against heavily anchored positions backed up by fact based assumptions in order to create the doubt and uncertainty necessary to rebalance the markets.
In fact, it should be noted that the more heavily anchored investors are into logical ideas of why an asset should increase in value, the more the prospect of declines taking place that lead into long-term bear markets. While we haven't reached that point yet, we are now in the middle phase of a long-term secular bull market that will see much more vicious punishments handed out to those who are overleveraged, late to the party or in an excessive number of momentum names. I expect we will see the first examples of vicious punishment during the second half of the year, as the Fed continues to raise rates while execution of an ambitious economic policy fails to match expectations.
Regards,
Ali Meshkati
