Nothing Persuades Like Success

Professor Kamila Debowska-Kozlowska from Adam Mickiewicz University , Poznań has written extensively about rhetorical persuasion and how winning a certain point increases the likelihood of winning subsequent points. She focuses a lot on behavioral patterns. Investors like success too. The more investments succeed, the more investors are willing to invest. The trouble is that success can carry one away from the fundamental discipline that produced the early success. It develops a good-feeling momentum of its own.

Bullish sentiment is high. According to Investor’s Intelligence, it is surging. The herd is feeling great.

Warren Buffet told CNBC, “We are not in bubble territory or anything of the sort.” He later added, “Measured against interest rates, stocks are actually on the cheap side.” Buffet saying the market can go much higher is a serious red flag. Markets don’t top when everyone is worried that they’ll correct; they top when everyone is euphorically optimistic. Buffet’s is a loud voice.  But not everyone is bullish. We have become increasingly cautious as prices have risen. Marc “Dr. Doom” Faber calling for a huge melt-down is helpful but not enough to counter Buffet.

All of these comments are more about sentiment.  Valuations are high.  They may go higher, but they are high.  Stocks were expensive in 1997 during the boom at 8,000, but they still rose through 11,500 over the next three years.  Had you declared the market too expensive and sold in 1997, you would have been correct in your analysis and very expensively wrong in your approach.

In this environment, we stay pretty fully invested but we are trying to “hit ’em where they ain’t.”  After increasing our exposure to banks in early 2016, we now see them as fully valued and heavily dependent on developments outside their control (higher interest rates, lower regulatory oversight, more robust economic growth).  Investors should take note that the S&P 500 Financials index is up 25% since the election.  Outside of Financials, we would be concentrating on the less cyclical industries that have lagged as a “risk-on” mentality has dominated since the election.  We are seeing most value in the Consumer Staples and Healthcare sectors.  On the other hand, we would be avoiding the highly cyclical, ultra-high beta and high-P/E names that have been responsible for a sizable chunk of the gains in the overall indices over the past few months.

Again, the market is expensive.  Prices are anticipating and incorporating many positive developments over the coming months while ignoring the risks, which appear to be accumulating by the day.  To be sure, stocks could have more upside in the event that the President is able to implement his ambitious plans to boost economic growth.  These plans include tax cuts for businesses and individuals, repatriation of cash held overseas, a reduction in regulatory oversight in a number of industries (most importantly, the banking and energy industries), up to $1 trillion in infrastructure spending, and a large increase in spending on defense.  However, the President is encountering an unprecedented amount of distractions – in the form of both partisan attacks and self-inflicted blunders – that will wind up costing him political capital and voter support. This is support he may need in order to build enough Congressional consensus to implement his policies. Last but certainly not least, the market is pricing in a seamless removal of unprecedented monetary stimulus as the Federal Reserve continues to increase interest rates.

A few additional key points:

  • The economy is not in danger of recession at present.
  • The market is due for a correction, but it could be years in the making.  It could also begin today.

When valuations are high so is enthusiasm.  Do your research.  Focus on fundamentals.  Know what you own.  Strive for a reasonable return with reasonable risk.  Market risk has increased with valuations, make sure you limit your risk in keeping with your tolerance and goals.  Swing for the fences and miss, and your flat on your back.  Stay standing!