Few investors are likely appreciating just how rare the last 18 months have been. The S&P 500 has now gone 373 trading days without a test of its 200-day moving average, an extraordinary feat. In fact, the record over the past 50 years was set in the historic run-up of 1995-96, where the S&P 500 would go 385 trading days without a test of this long-term moving average.
Where do we go from here?
Judging by last week’s Investors Intelligence sentiment poll, most investors seem to be betting that the record will be broken and we will see more of the same (a low volatility advance) going forward. In the poll, we saw 55% Bulls and 19% Bears for a spread that is on the high end (88th percentile) of historical readings.
This unbridled optimism is certainly understandable given the seemingly unrelenting advance over the past 18 months, but is it sustainable? The Bulls will argue that it is using Federal Reserve policy and the idea of a “Fed put” as their prima fascia evidence. At first blush, they seem to make a strong case, as indeed, there has not been a significant correction in over two years during which time the Fed has maintained the easiest monetary policy in history.
But upon further examination, the argument begins to break down. First, if we look at the most extreme example of Quantitative Easing (QE) which is Japan, their equity market is beginning to diverge from additional QE. The Nikkei started out in 2013 with a vertical advance through May. Since then, the BOJ has not tapered their QE program at all, but the Nikkei has been unable to push higher. The Nikkei is down 5% over the past year and is currently down over -12% year-to-date. If the market cannot go down in the face of endless QE, how do we explain Japan?
Second, our Fed has already embarked on a reduction of the latest round of QE, which, if they stay on the present course, will end around October of this year. If you recall, when similar QE programs ended in 2010 and 2011, large corrections of 17% and 21% followed. These corrections occurred despite the fact that short-term interest rates were still being held at 0% and despite the fact that the Fed balance sheet was not declining. As I wrote last month, can we really expect market participants to patiently await the end of QE this time around? Game theory would suggest this is not a high probability as some investors will begin to cheat and sell early. They are likely already doing so as evidenced by the 10% decline in small caps (the small cap canary) and larger declines in high momentum names in the biotechnology and social media spaces.
Overall, while they may have delayed it, I don’t believe the Federal Reserve has the power to repeal mean reversion. It is simply too great a force. That is not to say that the Bull Market necessarily has to end here, just that a return to a more normal market environment is likely in the coming months. Such an environment should be more favorable to active asset managers and those that employ risk management as part of their investment process.
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