When it seems too good to be true…

The general sense one gets by paying attention to the mainstream and financial media recently is that “Happy Days are Here Again”.  (BTW..The song is probably best remembered as the campaign song for Franklin Delano Roosevelt's successful 1932 presidential campaign. Even though stocks had risen in the summer of 1932, stocks did quite poorly after the 1932 election-- so his emotional appeal was a bit early.) There is no shortage of pundits telling us that “stocks are cheap” and “we are in a bull market”.  Despite bad news about the economy—since it’s not getting worse, according to some it seems to make sense that “it must be getting better”.  And as long as the Fed is pushing QE, markets “have to” go up. (Not true!) It is claimed that based on P/E or price earning ratio’s, stocks are cheap compared to historical averages.  It is claimed that we are a special situation where TINA (There is no other alternative) to stocks because interest rates are so low. Kind of makes one wonder if we are being left behind and the “train is about to leave the station”.

All of these pundits might be right—there is a possibility. But, I am very skeptical. Based on my observations and experience, there is a better than 80% probability they are very wrong. Bull markets do in fact “climb a wall of worry” as new, previously skeptical, buyers enter the market over time. So mixed opinions are normal and healthy. And, although you don’t hear many skeptics on CNBC, just pay attention to the bond markets and cash on the sidelines.  Interest rates are not rising like you would expect in a bull market. The bond market tells us there is a lot of very negative sentiment.

Bull markets are the result of a re-pricing of assets based on expectations of an expanding economy. Rising stock prices almost always are accompanied by rising interest rates caused by an expanding economy. Expanding economies also tend to cause commodity prices to rise—not fall like they have since the first of the year.

In the current situation, we have a slowly recovering economy, but nothing to justify the dramatic rise in stock prices since the first of the year while interest rates continue to be low, taxes have risen, and government spending is falling.   A slowly rising economy should result in a slowly rising stock market.

 

 

So what is going on? 

 

 

Markets are affected by fundamentals in addition to greed and fear.  While fundamentals are slowly recovering, justifying a steady rise in stock prices over time since 2009, markets have fluctuated significantly based on swings in psychology from extremes of fear and greed.   I believe that there is a high probability that we are at the extreme on the greed scale.

Most people realize that markets today are strongly influenced by institutions and their money managers who use very complicated derivatives that affect markets in ways that are counter-intuitive. (Warren Buffet has said that derivatives are weapons of potential mass destruction.) When traders expect markets to rise (because of QE for example) they buy call options—an option to buy stock later at a fixed price. The seller of the option is now at risk---if stocks rise more than the premium he charged for the option.  To hedge that risk, many option sellers will buy the underlying stock—an action by itself that drives the price up—especially if market volumes are relatively low.  The rising price attracts more gamblers and can sometimes cause prices to rise significantly--until the options expire.  As soon as the options expire, there are no more buyers—only sellers and prices can drop significantly.    

While the gamblers are playing, the rising market can sometimes attract the unsuspecting individual long term investor who history shows tends to buy late and too high.  

Sometimes old fashioned advice is quite valuable. “When others seem greedy—be fearful”…and “When it seems too good to be true—it probably is” should be remembered. I’m currently fearful and skeptical.

BTW—options expire May 17-22 and again June 19-28.  One or both times may turn out to be buying opportunities for the long term investor.  

 

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.