If you turn your television channel to CNBC in the morning or tune your car radio to the Bloomberg Surveillance show on the way to work, there is a good chance you’ll hear a stock market guru telling you that “we are in the seventh inning of this bull market”, implying an inevitable change in market direction in the near future, as – using the same baseball analogy – there are only two innings left to play. But is it true?
As all baseball fans know, a game typically lasts nine innings, but can extend well beyond that in the event of a tie. Real baseball history buffs will remind you of a 1984 contest between the Chicago White Sox and the Milwaukee Brewers that went for 25 innings, or a 1920 Brooklyn Dodgers and Boston Braves’ escapade that lasted 26. Just because most games end after nine innings does not mean all of them do.
And so it is with bull markets. The current bull market has lasted 84 months and provided a total return of almost 250%. It has exceeded all but two other bull markets in length and all but three in amplitude. However, the longevity and level of returns alone are not sufficient to signal the end of the bull market.
Every long term stock market direction is determined predominantly by the mood of its participants. It is the constant struggle between our desire to win and our loss aversion, the never-ending brawl between our greed and our fear that drives the market up or down. In terms of this collective investment psychology, every bull market has three phases – disbelief, acceptance and euphoria.
Phase 1: DISBELIEF
When the previous bear market bottomed a little over seven years ago, on March 9, 2009 specifically, the collective wisdom exhibited the classical example of disbelief when the market went up. Investors refused to acknowledge the sustainability of the market’s rebound, dubbing it “a bear market rally”. As we’ve mentioned in one of our previous Market Commentaries, the bull market that started in March of 2009 was the most hated bull market in history. All through this market advance there was doubt and disbelief in the upturn, and huge amounts of cash were sitting on the sidelines in anticipation of the imminent downturn. It was not until the market recovered all the losses and reached a series of new highs in 2015, that investors finally accepted that the financial crisis and the bear market it caused was finally behind us.
Phase 2: ACCEPTANCE
All the “doubting Thomases” of the last six years finally started to participate in this magnificent bull market, and sidelined cash finally started entering the market system, albeit slowly and gradually. We believe that we are in the middle of this second stage, when every pullback, however elongated, is seen not as a reason to panic, but as a buying opportunity.
Phase 3: EUPHORIA
The last euphoric stage is when investors start to buy into the new era and prices are on a one way trajectory – higher, when over-optimism and over-confidence is unleashed, leading investors to over-estimate potential gains, underestimate the risks, and generally deceive themselves into thinking they can control the situation. With this amount of confidence, buyers are fully invested, and if anything, even leveraged to maximize the gains they are “certain” are coming.
So, why do we believe we are in the Acceptance but not the Euphoria phase? Because we have no signs of investor behavior exhibiting great enthusiasm, over confidence, etc. In fact, there is still a tremendous amount of cash on the sidelines, yet to be deployed. It could be said, “well, that is money allocated to bonds” and we would agree. The issue is that even though bonds are yielding such low rates, most investors cannot afford to hold significant money market positions indefinitely. That brings us back to stock prices – although stocks are selling at the higher end of their valuation range but, when compared to a 10 year U.S. Treasury bond yield at 1.80%, a 2.50 to 3.00% stock dividend is very attractive and makes stocks a preferable option compared to fixed income securities. The interest rate earned on cash is much less and although the safest of investment choices, it offers no rewards and as we all know, doing nothing brings its own set of risks.
When transitioning from Acceptance to Euphoria cash levels shrink as investor psychology goes from the “fear of losing money” to fears of “missing opportunity” or FOMO (fear of missing out). Both institutions and individual investors alike are sitting on records amounts of cash and are only just now starting to show signs of FOMO. The market’s performance over the last 18 months has been the definition of a “fear of losing money” as the stock market has gone nowhere, but none of the signs of Euphoria have come to fruition.
The Euphoria phase starts when the “experts” stop talking about a major market decline and an economic disaster. Our view is that we are not there yet. If we are in the seventh inning it could be a long seventh inning. We are investors not traders. Market history suggests that we not try to outsmart the market on a short term basis as it rarely works. When we get into the Euphoria state we will gradually reduce our exposure to equities but we will not sell out out of equities totally. We control risk and volatility with a well-balanced, well diversified portfolio. Remember, historically long-term investors always win out over short-term traders. We expect modest single-digit returns given current valuations and interest rates, and recommend we stay invested at current allocations to equities.