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.
I am back from traveling, and we have a good bit to catch up on since our
last report. If you missed it, I provided
an update on
Tuesday, updating all the weekly technical and statistical
data we produce. Most noteworthy in that report was the sharp increase in
money flows into the market despite the tariff announcement by the Trump
administration and the latest inflation reports.
On Thursday, the market broke out of the bullish consolidation over the last few
weeks, successfully retesting and holding support at the 50-DMA. Notably, the
bullish trend remains intact, and retail investors continue to pour money into
the market, with money flows reaching typical peak levels. With the market
elevated, downside risk over the next few weeks will likely be contained to
recent January lows. What would cause such a correction is unknown, but if money
flows begin to reverse, such will likely provide the evidence needed to
rebalance risks accordingly.
The bullish bias is evident, as witnessed by the recent surge in retail money
flows into leveraged ETFs and speculative options trading. However, as is always
the case, whenever investors are crowded on “one
side of the boat,” it is often a decent contrarian signal to be a bit more
cautious. Furthermore, while there is currently no evidence of a catalyst for a
correction, it is worth noting that we are entering into the seasonally weak
part of February.
While this is the average of daily market returns, it does not guarantee that
market weakness will present itself. But it is worth being aware of the
potential possibility of such a development.
Speaking of excess, Sentiment Trader recently did a great piece on the market’s
Sharpe ratio. The conclusion of their report is worth considering.
“When the
going gets easy for investors, it’s natural to let one’s guard down and
become complacent. That’s a dangerous condition for all but the
longest-term, long-term, unleveraged investors. Markets can be their most
dangerous when they look the safest.
Using the
Sharpe ratio as a proxy for how good it’s been for U.S. investors, we see
above that there aren’t many times in history when it’s been better than the
past six months, and there are signs that it’s ending. That can mean more
volatility, but it doesn’t necessarily mean negative returns. The biggest
takeaway has been moderate returns, with much more of a two-way market than
investors had gotten used to in the months prior.”
An extended period of speculative complacency in the markets has markedly
increased the Sharpe ratio. The problem is that long periods of complacency, a
function of price stability, are often followed by periods of instability.
Such is the core of our discussion this week.
Stability Leads To Complacency
“Only those
that risk going too far can possibly find out how far one can go.”– T.S.
Eliot
As discussed on Tuesday, retail
investors are currently “all-in” in
the market. Such is not surprising given the long period of stability in the
markets with continually rising prices.
“The market
defies more negative news because retail investors continue to step in
and “buy the dip.” In our recent Bull Bear reports, we discussed the push by
retail investors, but looking at retail sentiment is quite remarkable. Since
the pandemic, retail investors have never been this bullish on the stock
market. Such is amazing, given that their mailboxes are not being stuffed
with government stimulus checks”
“At the same
time, their optimism about stock market returns is supported by putting
their money where their mouth is.”
These periods of stability have always led to high levels of investor
complacency concerning risk. However, historically speaking, such periods of
complacency are often built on rationalizations with weak underpinnings.
Investors are confident that the Fed will continue cutting interest rates,
easing monetary policy, and supporting higher future stock valuations. However,
that expectation may be misguided as the Fed remains unconcerned about any
near-term recessionary impact. However, policy actions by the current
Administration to reduce the deficit, cut Government employment, and impose
tariffs are factors that could slow economic growth rates more than anticipated.
Such is particularly the case now as evidence of weakening employment and
consumers is emerging.
” While labor
market data is generally good, there are signs the labor market is at a
standstill. Continuing jobless claims are steadily rising at their highest
level in over three years. The JOLTS hires rate is at ten-year lows. While
the number of layoffs remains low, employers aren’t hiring either.
Accordingly, the broad labor market data may seem good, but the chart below
and other data should give the Fed pause so that consumers may start to
spend less and save more. As if the chart below wasn’t concerning. It shows
employment expectations are also plummeting. Similar changes in expectations
have led to a higher unemployment rate previously.”
Furthermore, expectations of real household incomes do not suggest a robust
consumer backdrop.
The rise in part-time employment, slowing hiring rates, and increased continuing
jobless claims indicate a weaker labor market. Historically, overestimating
employment strength has led the Fed to delay necessary rate cuts. Once economic
conditions deteriorate further, the Fed is forced to reverse course.
Unfortunately, the
Fed is often “behind
the curve” in anticipating such risk, leading
to more aggressive monetary policy actions. In other words, market
stability leads to policy complacency, which eventually evolves into
instability.
The
Stability-Instability Paradox
This is the problem facing the Fed.
Investors have been led to believe that no matter what happens, the Fed can bail
out the markets and keep the bull market going for a while longer. Or rather, as
Dr. Irving Fisher once uttered:
“Stocks have
reached a permanently high plateau.”
Interestingly, the Fed depends on market participants and consumers believing
this idea. With the entirety of the financial ecosystem now more heavily levered
than ever due to the Fed’s profligate measures of suppressing interest rates and
flooding the system with excessive liquidity over the last 15 years, the “instability
of stability paradox” is now the most significant risk.
“The ‘stability/instability
paradox’ assumes that all players are rational and such rationality
implies an avoidance of complete destruction. In
other words, all players will act rationally, and no one will push ‘the big
red button.‘”
The Fed is highly dependent on this assumption as it provides the “room” needed
to navigate the risks that have built up in the system. The risks of something
breaking have increased substantially from elevated market valuations to
exceptionally low credit spreads. As we saw in March 2023, the rise in interest
rates nearly took down the regional banking sector until the Federal Reserve was
forced to step in with the “Bank
Term Funding Program.” Fortunately, that banking risk did not become a
financial contagion, and the Federal Reserve maintained stability across the
markets.
However, the key to that stability depends
on“everyone
acting rationally.”
Unfortunately, maintaining permanent stability has never been achieved over the
long term.
The Fed’s
Problem – Being Late
The most
serious risk facing the Fed is individuals’ behavioral biases. Throughout
history, the market has been plagued
with unexpected, exogenous risks that fell outside the Federal Reserve’s
regulatory abilities. Despite the best of intentions, changes to monetary
policies, combined with investor complacency, preceded mild to disastrous
outcomes.
In the early
70’s, it was the “Nifty Fifty” stocks,
Then, Mexican
and Argentine bonds a few years after that
“Portfolio
Insurance” was the “thing” in the mid -80’s
Fed rates led
to the bond market crash in 1994.
Dot.com
anything was an excellent investment in 1999
Real estate
has been a boom/bust cycle roughly every other decade, but 2008 was a doozy
The risk to this entire house of cards is a credit-related event. As Michael
Lebowitz noted recently:
“Despite the
tight corporate spreads, the difference between the S&P 500 earnings yield
and corporate bonds is negative 2%. The Bloomberg graph on the right shows
that the spread hasn’t been that tight since 2008. Stocks are riskier, yet
corporate earnings yield less than corporate bonds. The graph further
confirms very high equity valuations, suggesting investors’ earnings growth
expectations are much loftier than historical earnings growth rates.”
“People are
skewing toward assets that are giving you more and more upside. You’re
really just trying to see people hit home runs here more and more.” – Bloomberg
What happens if, or should I say when, passive funds become large net sellers of
credit risk? In
that event, those indiscriminate sellers will have to find highly discriminating
buyers who–you guessed it–will be asking lots of questions. Liquidity
for the passive universe–and thus the credit markets generally–may become
problematic. Furthermore, the significant decline in market liquidity indeed
suggests rising risks.
If there is a
liquidity issue, the risk to “uninformed
investors” is substantially higher than most realize.
Risk concentration always seems rational initially, and those early successes
create a self-reinforcing behavioral sentiment.
As noted, stability is an illusion of everyone acting rationally. Unfortunately,
when it all goes “pear-shaped,” rational
calm quickly turns into irrational panic.
Investors Are Ignoring The Cracks In Stability
Stability is acceptable until something occurs that causes instability. Since
October 2022, the market has steadily risen despite higher interest rates,
inflation, and slowing economic growth. Changes to the Fed’s outlook, or as
recently as tariffs and Deepseek, have caused market pullbacks. However, market
stability has primarily been contained to a relatively narrow range of +/- 1% in
daily price movements.
The chart below shows the importance of paying attention to volatility. As is
always the case, periods of “low
volatility” beget “high
volatility.” For example, following the 2020 “Pandemic
shutdown,” a period noted by increased ranges of daily price movements (high
volatility), investors experienced an 18-month winning streak with low
volatility. That period ended with the Russian invasion of Ukraine and the
Federal Reserve embarking upon one of its most aggressive rate hiking campaigns
since the late 70s.
However, alternating periods of low to high volatility and vice versa have been
a hallmark of the financial markets since the turn of the century. What should
be obvious is that these periods of low volatility are truncated by unexpected,
exogenous events that cause market participants to reevaluate consensus
expectations. For example, in 2000, the collapse of Enron called into question
the entirety of the “Dot.com”
thesis. 2008 Lehman’s failure ended the belief that “subprime
was contained.” Today, the market is highly confident in superior economic
growth and sustained and elevated levels of earnings growth due to “Artificial
Intelligence.” What disrupts that thesis is unknown but is the most
significant risk to investors today.
It is also worth noting that periods of stability have historically been
truncated by the Federal Reserve and its rate-cutting cycle.
The reason, of course, is that by the time the Federal Reserve is cutting rates
aggressively, something has broken in the financial system. While that has not
happened yet, it does not mean it won’t.
The Single
Biggest Risk To Your Money
In extremely long bull market cycles, investors become “willfully
blind” to the underlying inherent risks. Or
rather, it is the “hubris” of
investors that they are now “smarter
than the market.”
Yet, the list of concerns remains despite being completely ignored by investors
and the mainstream media.
Growing
economic ambiguities in the U.S. and abroad.
Political
instability
The failure
of fiscal policy to ‘trickle down.’
A pivot
towards easing in global monetary policy(global
economic weakness)
Geopolitical
risks from Trade Wars to Iran
Un-inversions
of yield curves
Potential
deteriorating in earnings and corporate profit margins.
Record levels
of private and public debt.
None of that matters for now, as the markets hope for continued easing in
monetary accommodation. The more the market rises, the more reinforced the
belief that “this
time is different” becomes.
Yes, our investment portfolios remain invested on the long side for now. (Although
we continue to carry slightly higher levels of cash and hedges.)
However, that will change rapidly at the first sign of the “instability
of stability.”
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
independence, values their time, and who doesn’t
want to mindlessly follow the crowd.