In 1991 Billy and Akaisha Kaderli retired at the age
of 38. Now, into their 4th decade of this
financially independent lifestyle, they invite you
to take advantage of their wisdom and experience.
Last week, we discussed the increasingly bullish market
forecasts for next year. We also noted that the market tends to trade positively
heading into the Thanksgiving holiday, to which the market did not disappoint.
For the week, while there was a bit of sloppy trading along the way, the market
finished at new highs, eclipsing the 6000 level on Friday. Technically, the
market remains in a very bullish setup, holding support at the 20-DMA and then
breaking out to new highs. That rally reversed the short-term “sell
signal,” which gives the market room to trade higher into the first week of
December. The rising trend line from the August lows remains the likely peak to
any rally in December, and as noted last week, expect some weakness in the
second and third week of December as mutual funds make annual distributions. For
now, any corrective action in early December should be bought in anticipation
for a rally into year end.
As we discussed previously, the key drivers for December will be continued share
repurchases, portfolio manager rebalancing, and window dressing for year-end
reporting. These supports will continue into year-end, and with the Federal
Reserve likely to cut rates in mid-December, we expect market participants to
remain on the “bull
train” for now. As suggested last week:
While there is no reason to be bearish, this does not mean you should abandon
risk management. As we will discuss this week, investors are becoming
exceedingly optimistic once again.
“If you are underweight equities, consider minor pullbacks and consolidations to
add exposure as needed to bring portfolios to target weights. Pullbacks will
likely be shallow, but being ready to deploy capital will be beneficial. Once we
pass the inauguration, we can assess what policies will likely be enacted and
adjust portfolios accordingly.”
But we also see exuberance in overall equity allocations in the markets climbing
higher with the market.
Professional
investors are ramping up exposure to chase the market into year-end. The chart
below of the NAAIM Index highlights when professional investor allocations
exceed 97%. Such has historically been at or near short-term market peaks. In
other words, professional investors are no different than retail investors who ”
buy tops” and “sell bottoms.”
While allocation levels and optimism are certainly signs of market bullishness,
those levels are more of a function of a massive flow of liquidity. In other
words, there is “too
much money chasing too few assets.” However, it is crucial to understand
that “exuberance” is
a necessary ingredient for pushing asset prices higher. This is why “sellers
live higher, and buyers live lower.” In every market and asset
class, the price is determined by supply and demand. If there are more buyers
than sellers, then prices rise, and vice-versa. While economic, geopolitical, or
financial data points may temporarily affect and shift the balance between those
wanting to buy or sell, in the end, the price is solely determined by asset
flows.
Currently, rising liquidity
levels support investor optimism as asset prices continue to rise. However, as
we will discuss, such activity does not necessarily equate to more “extreme
speculation,” which often precedes significant market corrections. While
optimism can drive short-term gains, history shows that extreme speculation
detaches valuations from fundamentals, leaving the market vulnerable to
larger declines.
As we noted in that previous article:
“Risk isn’t always what it seems. When the market feels the safest, that’s often
when it’s often the riskiest. Think about it — when everything is going
smoothly, people tend to take more risks, which can lead to market bubbles and
crashes.”
However, when investor optimism morphs into more extreme speculative behaviors,
investors should consider a more cautious outlook.
Signs Of Extreme
Speculation
Following the 2020 pandemic shutdown, the Government and Federal Reserve went
into overdrive, providing round after round of fiscal and monetary support.
Money flooded into the economy, from PPP Loans to rent moratoriums, $1500 checks
directly to consumers, debt forgiveness, zero interest rates, and quantitative
easing. Unsurprisingly, much of that money entered the financial markets, and
retail investors plowed nearly $900 billion in market-related ETFs.
Interestingly, in 2024, most of those supports are gone, interest rates have
risen sharply, and the Federal Reserve is reducing its balance sheet. Yet,
somehow, investors figured out a way to push $913 billion (YTD) into ETFs, which
is a record inflow.
That surge of capital into ETFs has contributed to the outsized performance of
large capitalization companies, primarily the “Magnificent
7,” relative to the rest of the index.
However, it is not just U.S. investors dumping money into the financial markets.
Foreign investors have also been shifting capital to the U.S. financial markets
versus other countries.
As noted above, there is nothing wrong with investor optimism, which moves
markets higher. However, when markets continually rise, even in an environment
where they shouldn’t (high interest rates), such leads investors to throw
caution to the wind by taking on additional risk. As that risk-taking builds and
is rewarded by higher prices, risk-taking morphs into more extreme speculation.
For example, the surge of capital into 3x Leveraged S&P 500 ETFs has been
remarkable.
However, it isn’t just that one ETF that investors are aggressively piling funds
into. The chart below shows the surge in all levered ETFs.
In addition to the two examples of growing leverage and market speculation,
Michael Lebowitz noted in our Daily Market Commentary:
“We see surging volume in leveraged single-stock ETFs. An example of such an ETF
is Granite Shares NVDL. The ETF offers a 2x leveraged holding of Nvidia shares.
If Nvidia falls by 3%, the ETF will decline by 6%. Conversely, if Nvidia rises
by 5%, the ETF will climb 10%. Accordingly, leveraged single-stock ETFs can be
incredibly speculative. Furthermore, the massive surge in volume in such ETFs,
as we share below, further confirms speculative behaviors are growing. Leverage
and extreme speculation can drive markets higher than most investors forecast.
However, in the process, they create a divergence between fundamentals and
valuations, thus exposing the markets to risk. Increased leverage and
speculation are not reasons to sell immediately, but they indicate that markets
are getting frothy, warranting our close attention.“
As he notes, the problem with taking on leverage is that while leverage works to
your benefit on the way up, it will crush investors on the way down. A good
example is the levered 2x Long ETF (MSTU) for Microstrategy (MSTR), the 5th most
traded ETF on November 20th.
The problem is that MicroStrategy peaked the following day and has since wiped
out a large chunk of that more extreme speculation.
However, such is always the consequence of speculation, and the end results are
always poor. While speculation can last for some time, it always does end.
Unfortunately, what causes it to end is a failure of the underlying fundamentals
to keep up with the fantasy.
Signs To Watch To
Signal The End Of Extreme Speculation
This brings us
to the obvious question, “What
should I be watching for to signal a shift in investor
sentiment?”
Part of that answer falls into forward earnings expectations. Forward earnings
estimates are optimistic and well above their long-term historical logarithmic
growth trend. While such deviations existed previously, they were usually close
to the point where such optimism ended. The ends of those exuberant periods of
earnings growth generally coincided with a recession or a mean-reverting event.
However, while estimates are currently very elevated, they can remain that way
longer than you think possible.
The timing of an event that reverses extreme speculation is always the most
challenging part. However, as discussed this past week, credit spreads can
provide us vital clues as to a shift in sentiment that has not yet become
apparent in the equity markets. To wit:
“Watching spreads provide insights into the health of the corporate sector,
which is a major driver of equity performance. When credit spreads widen, they
often lead to lower corporate earnings, economic contraction, and stock market
downturns. Widening credit spreads are commonly associated with increased risk
aversion among investors. Historically, significant widening of credit spreads
has foreshadowed recessions and major market sell-offs. Here’s why:”
Corporate
Financial Health: Credit spreads reflect investor views on
corporate solvency. A rising spread suggests a growing concern over
companies’ ability to service their debt. Particularly if the economy slows
or interest rates rise.
Risk Sentiment
Shift: Credit markets tend to be more sensitive to economic shocks
than equity markets. When credit spreads widen, it typically indicates that
the fixed-income market is pricing in higher risks. This is often a leading
indicator of equity market stress.
Liquidity Drain:
As investors become more risk-averse, they shift capital from corporate
bonds to safer assets like Treasuries. The flight to safety reduces
liquidity in the corporate bond market. Less liquidity potentially leads to
tighter credit conditions that affect businesses’ ability to invest and
grow, weighing on stock prices.
Given the exceptionally low spread between corporate and treasury bonds, the
bull market remains healthy, so extreme speculation is being rewarded. However,
as shown below, such periods ALWAYS end.
“While there are several credit spreads to monitor, the high-yield (or junk
bond) spread versus Treasury yields is considered the most reliable. That spread
has been a reliable predictor of market corrections and bear markets. The
high-yield bond market consists of debt issued by companies with lower credit
ratings. Such makes them more vulnerable to economic slowdowns. As such, when
investors become concerned about economic prospects, they demand significantly
higher returns to hold these riskier bonds. When that happens, the spreads widen
warning of increasing risks. Historically, sharp increases in the high-yield
spread have preceded economic recessions and significant market downturns,
giving it a high degree of predictive power. According to research by the
Federal Reserve and other financial institutions, the high-yield spread has
successfully anticipated every U.S. recession since the 1970s. Typically, a
widening of this spread by more than 300 basis points (3%) from its recent low
has been a strong signal of an impending market correction.”
As investors, we suggest monitoring the high-yield spread closely because it
tends to be one of the earliest signals that credit markets are beginning to
price in higher risks. Unlike stock markets, which can often remain buoyant due
to short-term optimism or speculative trading, the credit market is more
sensitive to fundamental shifts in economic conditions.
The current bullish sentiment will continue to push asset markets higher in the
near term. However, extreme speculation like we are seeing in various areas of
the market will eventually end, and likely end badly for most. The timing of the
event is the most difficult part.
The views expressed by Lance Roberts are not
necessarily those of RetireEarlyLifestyle.com
Billy and Akaisha Kaderli are
recognized retirement experts and internationally published authors on
topics of finance, medical tourism and world travel. With the wealth of
information they share on their award winning website RetireEarlyLifestyle.com,
they have been helping people achieve their own retirement dreams since
1991. They wrote the popular books, The
Adventurer’s Guide to Early Retirement and Your
Retirement Dream IS Possible available on their website
bookstore or
on Amazon.com.
Retire
Early Lifestyle appeals to a different
kind of person – the person who prizes their
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want to mindlessly follow the crowd.
