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Paraphrasing Yul Brynner of old, “Financial Markets are a puzzlement!”

Did anyone else out there grow up watching Yul Brynner cavort across the stage in the classic movie musical, “The King and I”? With his Russian accent and shaven head, Brynner was an impressive figure on the Hollywood scene, but he is best remembered for his role as the King of Siam, opposite Deborah Kerr, his English tutor in the film. As he tries to learn Western ways, he is frustrated and expresses his bewilderment in a song about the confusing path of life, ending with “But is a puzzlement!”

The same can be said of today’s financial markets. The entire community of financial analysts that toil everyday trying to make sense of it all have suddenly begun to sing a chorus from “The King and I.” They are just as confused as the monarch of Siam was more than sixty years ago. Confusion reigns, especially with stocks, as market values continue to head north, and pundits continue to stoke the fires by shouting that everyone had better not miss out on this once in a lifetime opportunity. Can outright fear truly drive investor sentiment in a positive direction?

Market-Confusion

Technically speaking, aren’t our markets supposed to obey fundamental forces and form patterns that repeat? One has been led to think as much, but as one analyst confessed, “Most believe in the exogenous causation theory of markets, yet history does not support their perspective. Time and again we see how markets move exactly opposite to what we would “logically” believe would be the normal reaction the market should have to a terrorist attack or to North Korea firing a rocket over Japan. Yet, we still maintain the same beliefs despite being shown quite often how wrong those beliefs to be.” When markets do head south, however, these same pundits will claim success.

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At the same time that this consternation about current events has set in, other pundits are screaming, “Buy at any price. And, not only that, they’re telling you that your life depends on it.” And what’s more, these are not analysts from the fringe that are suggesting something outlandish. The latest prognostications are coming from some of the most respected experts on the Street. These gurus are suggesting that, “With technology set to make further inroads into society, buying tech stocks is the only thing you can do to preserve your livelihood.”

Whether you invest in robot-related industries or take a gamble on crypto-currencies, the advice remains the same — Buy now or regret it forever: “We could be in the midst of the first fear-based investment bubble in American history, with the masses buying in not out of avarice, but from a mentality of abject terror. Robots, software and automation, owned by Capital, are notching new victories over Labor at an ever accelerating rate.” If you have been lucky enough to be in the right place at the right time, it has been a thrilling joy ride. If not, “it’s a horror movie in slow motion.” Is it too late to jump onto this train?

What are our most trusted indicators saying at the moment?

None of our most respected recession models are predicting anything that could derail this incredibly long bull market. It now ranks as “Number Two”, but is quickly honing into the top slot. The most reliable indicator for giving us fair warning of a stock downturn has always been Shiller’s CAPE index. Here is a long-term annotated version of it:

CAPE Ratio Annotated
The highest peak occurred during the “irrational exuberance” period that preceded the bursting of the Internet bubble, even higher in value than before the Great Depression. Today’s value, 30.5, is also above the level achieved before the Great Recession, but ten years of central bank machinations have so distorted market dynamics and constrained natural economic forces that even the best models cannot be relied upon in this day and age. One comes away with the opinion that something has to got give, but when and what will trigger such an outcome is up for debate.

In order to participate in this debate, many analysts have chosen to extend the premise of the CAPE index and take it to the next level. Here is one promising attempt to do just that by combining CAPE data with accepted measures for market volatility:

CAPE VIX ratio indicator
If markets truly move in waves and produce predictable patterns over time, then the above depiction should appear in every technical analysis textbook known to mankind. In the “something-has-got-to-give” context, 2018 is not looking very healthy. Even though this diagram depicts a convincing argument for doom in the year ahead, these same experts were also predicting last year that gloom and doom in the latter part of 2017 was a sure thing. From a technical perspective, however, the “megaphone-topping pattern” is a fairly reliable technical indicator.

What other leading indicators are forecasting storm clouds on the horizon?

Goldman Bear Index
The chart presented above comes to us from Goldman Sachs. As one analyst relates, “Goldman Sachs probably won’t be winning any awards for having the most ethical business, but they still produce some great investment research. Their Bear Market Risk Indicator has done incredibly well at predicting market sell-offs in the past. We are now approaching levels that almost certainly indicate that a bear market is near.” Is there more room for the current Bull to run? We suspect so, but the Bear may come out of hibernation sooner than you might think. Caution is advised.

Another measure that has been a good precursor of problems ahead has been the level of margin debt on Wall Street. When investors get leveraged out on a major debt curve, then panic can set in quickly, as margin calls take their toll. The following chart suggests that current debt levels could only exacerbate a dramatic market sell off when and if that horrible day should materialize:

NY Margin Debt

Once again, a “megaphone-topping pattern” is shouting its message to the unsuspecting throngs. As another pundit puts it: “Consumers and corporations are not the only ones loading up on debt. Wall Street investors have pushed their margin debt levels much higher than in the previous two stock market bubbles. One of the reasons that the market crash of 1929 was so severe was because of the excessive use of margin debt. When the stock market eventually does turn lower, heavily indebted investors will be in serious trouble as prices fall below their loan amount.” Gulp!

Amidst these dire forecasts, where is the U.S. Dollar going to go?

Aficionados of TA can often get carried away, especially if they have a liking for Elliott Wave Theory, which can get overly complex and convoluted in its predictions. The following chart, however, grabbed our attention as one that truly looked long term to gain a better perspective on what could transpire in the near term. Accept for the moment that matching ellipses that convey correlation is a bit farfetched, but the depiction does look good on paper, and that is worth something. Here you go:

usd
The chart literally takes us back to the dawn of free-floating currencies in the late seventies and seeks to explain the movement of the USD index within the context of two mirror images of an ellipse. The firm that produced this chart is prognosticating a dip down to “90” in 2018, where it will touch the elliptical boundary, designated by the concentric blue circles and intersecting blue line. It will then take dramatic shot northwards, perhaps during an economic recovery, arriving at “110” one year thereafter. The authors admit that these curves are not absolute, but do reflect market pressures.

What are a few other prevailing opinions about what may be around the corner?

For the last few years, there have siren calls on the Internet and even on televised programming that tempt you with the latest thinking that the sky will surely fall and very soon, and, if you do not get this guru’s expert advice on how to survive Armageddon, then you will surely perish. These cries of advice for a simple monthly billing rate have generally been from the outliers, those that creep about in the shadows trying to make a fast buck. Today, however, these opinions are becoming more main stream. Here are just a few comments from the more moderate middle ground:

 

  • “This sort of “it doesn’t matter what you pay for an asset” is the type of thinking that prevails at tops. The idea of a new paradigm also permeates market participants’ thinking. Owning an asset regardless of price is what created the dotcom bubble. It didn’t work then, and it won’t work now.”
  • “If this isn’t your first rodeo, you know that the bond market is far more keen than the stock market when it comes to reflecting what is really going on in our economy. As the stock market indices are achieving new highs, long-term interest rates (10-year Treasury yield) continue to decline in a series of lower highs and lower lows, implying slower rates of growth and inflation. This runs counter to the outlook for a reacceleration in the rate of economic growth.”
  • “The president and the financial media are celebrating as stocks keep hitting new all-time highs. The unemployment rate just hit the lowest level in 16 years while consumer confidence has also hit its highest levels in 16 years. It seems as if things could not be going much better. But as is often the case with economics and investments, it is often calmest right before the storm.”

 

Lastly, we include a quote from Bernard Baruch, who passed away in 1965, but who succinctly described today’s context to a “T”: “All economic movements, by their very nature, are motivated by crowd psychology. Without due recognition of crowd-thinking … our theories of economics leave much to be desired. … It has always seemed to me that the periodic madness which afflicts mankind must reflect some deeply rooted trait in human nature — a trait akin to the force that motivates the migration of birds or the rush of lemmings to the sea … It is a force wholly impalpable … yet, knowledge of it is necessary to right judgments on passing events.”

Concluding Remarks

Analysts, investors, professional investment advisors, and the “Average Joes” on the street are all confused by today’s financial markets, yet, the never-ending cry to “Buy-Buy-Buy” has not died down one iota. The “Greater Fool Theory” contends that, “The price of an object is determined not by its intrinsic value, but rather by irrational beliefs and expectations of market participants.”

Is it time to get real?

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.


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