“There are things known and there are things unknown, and in between are the doors of perception.” ― Aldous Huxley
In my last writing, I discussed a number of defensive signals (credit weakness, small-cap weakness, late-cycle sector behavior, Treasury strength, etc.) pointing to increased risk in the U.S. equity market. Last week, we saw these defensive signals start to spill over into large cap stocks, with the S&P 500 declining -2.7% in its worst week since May 2012.
There were a number of interesting market developments during last week’s decline, but what I found most intriguing is the continuing divergence between investor perception and reality.
Listening to the financial media this year, one might assume we were still in 2013. We’ve been hearing all year about “all-time highs” in U.S. equities, a “rising rate environment,” and an emerging market “crisis.” Surely it must be 2013 again if these are the most prominent headlines.
Additionally, most pundits and advisors are still recommending an “overweight” to U.S. equities and are more bullish on the U.S. economy than anywhere else in the world. Indeed, this seems to be the perception of most, as evidenced by the extreme optimism with respect to U.S. equities in various sentiment measures such as Investors Intelligence.
But perception is not reality. We are now over seven months into the year and while investors remain highly bullish the average U.S. stock is down on the year. You read that word correctly: down. The cap-weighted S&P 500 has been masking underlying weakness for the entire year. The median total return of stocks in the Russell 3000 is actually -1.7% in 2014.
In addition, in spite of the “rising rate environment” talk, we’ve actually seen a persistent decline in interest rates for the entire year, with the 30-year Treasury Bond yield moving from 3.9% to 3.2%.
We’ve also seen all of the "Fragile 5” emerging market countries (Turkey, Brazil, India, South Africa, and Indonesia) outpace U.S. equities this year.
And yet, if you speak with most investors or their advisors, they continue to be more bullish on U.S. equities than any other asset class. They remain highly overweight U.S. equities and early cycle high beta sectors (particularly consumer discretionary and financials) and underweight bonds and late cycle sectors. This positioning was to be expected in January, but after seven months of returns illustrating nearly the exact opposite of 2013, one would think that perception would be shifting. Anyone who is objective would look at the table below and understand that U.S. equities are not always the best asset class and those that maintained a diversified portfolio and rebalanced after 2013 have been rewarded in 2014.
Goodwill Bias: Investors Still Living in 2013
So why is it, then, that the unconditional love for U.S. equities continues? My opinion is that there are a few factors at play. First, much of this bullishness is due to what I call ”goodwill bias,” where investors are still giving U.S. equities the benefit of the doubt after their historic run-up in 2013.
The second factor is that most investors only pay attention to the Dow and the S&P and are likely unaware that the average U.S. stock is actually down this year. To start to get their attention, you would need to see these large cap indices go negative on the year.
The third and perhaps most important factor is that volatility remains very low and the historic streak above the 200-day moving average (426 trading days and counting) that began in November 2012 continues today. Investors love nothing more than low volatility as it provides the illusion of safety and stability. Until the streak is broken, investors will naively assume U.S. equities are “risk-free” and therefore preferable to all other asset classes.
Eternal Sunshine of the Spotless Mind?
But why is any of this a problem? Why not leave perception well enough alone and forget about reality for while? Why can’t we have eternal sunshine in U.S. equities with 0% interest rates and QE forever?
Trust me, I would love nothing more but alas, our minds are not spotless and those of us who were investing before the end of 2012 remember that markets are cyclical. I would be all for ignoring reality if we were early on in the market/economic cycle and U.S. equities offered the prospect of compelling returns, but that is simply not the case today. As I wrote recently in “Has the Fed Doomed Buy and Hold?,” we are approaching the 90th percentile of historical valuations in U.S. equities and returns going forward are likely to be significantly below average.
If market participants were accepting this reality of lower returns going forward, that would be fine. But judging by the sentiment extremes we’ve seen this year, expectations are anything but tempered here (see Tearing Down the Wall of Worry). This is likely to lead to a rude awakening in the coming years as reality bites.
But do not despair, the market is a fluid system that is constantly changing and there will be a better risk/reward opportunity in the future. Until then, be more careful out there. For despite the widely held perception, it’s not 2013 anymore.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
CHARLIE BILELLO, CMT
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of two award-winning research papers on Intermarket Analysis. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
You can follow Charlie on twitter here.
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