When "Show Me Now!" Becomes "The Sky Is Falling!"

I don’t know about you, but for me, pretty much everything between Thanksgiving and Christmas is a blur. Family, traveling, shopping, cooking, family, more traveling — it’s a lot in a short amount of time.

I think it’s worth taking a moment to look back on the year behind and forward to the one ahead…

As you may have heard, it’s been an exceptional year for the bulls – and maybe the longest year ever when it comes to political firestorms. I hope you successfully avoided any knockdown, drag-out fights over turkey and football this year, and wish you the best of luck for Christmas.

I don’t doubt that this year’s holiday cocktail parties will be filled with no small amount of joy as folks boast of their stock and bitcoin gains. I might even hear some of that myself at the upcoming Dent Research party.

As a professional short-seller, I think the last 13 months since the presidential election were the hardest I have ever seen – and that’s saying something.

I began my journrney on the short side in 2000. Since then, there have been two bloody bear markets and a couple of sharp rebounds. I survived each rebound quite well, but, for the last 13 months or so, the market has been very unforgiving to short-sellers who make bearish bets on deteriorating fundamentals.

The warnrning signs have only gotten worse. But who knows what they mean for 2018.

I wrote during the last earnrnings season that there’s very little stock-picking done at a level that actually drives volume in the markets. Volume is now often created by computers looking to make a 10th of a penny off a transaction. High-frequency trading programs have exploded since the last crisis nearly 10 years ago.

As I said: Fundamentals don’t matter to computers. Small profits from trading stocks do. In other words, big market moves are rarely the result of clever people sitting in a room and yelling into phones. Faceless algorithms are the real beasts of burden, here.

That might not make for good chatter by the cooler or at the cocktail party, but it’s the elephant on the exchange room floors.

Research from Credit Suisse suggests that as high-frequency trading has become more prevalent, investments in passive indexing strategies have exploded. Since indexes are indiscriminate, they buy all the stocks in the index even if the fundamentals of a particular stock are a disaster.

This means it often doesn’t matter if a short-seller pinpoints a failing stock; on its own, it’d be ripe for a profit on the short side, but since it’s bundled up in an index, it gets to tag along for the ride.

I guess it’s not that crazy, then, that market sentiment has been so high, and stubbornrnly so. In past issues I’ve noted that the Ned Davis Sentiment Index has exceeded 70, which historically has been met with market losses before investor sentiment becomes too pessimistic.

While it might be different this time, I’ll bet alongside the historical averages – because while the drivers of markets change, human nature never does.

The Davis sentiment index has backed off slightly from 73.5 to 70.8. We can only see the top in the rearview mirror once sentiment normalizes. But if 73.5 ends up being the top, it will be the third-most excessive mark ever.

The next warnrning sign is that volatility has hit 50-year lows. I really don’t know how low it can go, but it can’t go to zero. Plenty of hedge funds have made huge gains betting against volatility, but they’ve done it in typically leveraged fashion.

With so many people leaning in one direction, anything that spooks the market could lead to a massive snapback in volatility and quickly evaporate those gains.

Liquidity has been awash in the market as central banks have been extremely accommodative to the markets in recent years. But now, at least at the margin, liquidity is being reigned in. It’s almost a certainty that the rate of change of liquidity will fall in 2018 – and perhaps dramatically.

(It can seem impossible to figure out where the hidden gems are right now, with off-the-chart valuations and bizarro-world financials wherever you look, but you might be interested in this little presentation I put together about how you still find serious gains in this crazy market.)

Valuations are also extreme. The median price-to-earnrnings ratio (P/E) on the S&P 500 is around 24. This compares with the 54-year average of about 17. It’s also approximately 1.5 standard deviations above normal, and it implies an “overvalued” market based on historical measures.

While that’s not the highest level of P/E ratio ever compared to the late 1990s, the median price-to- sales ratio is at the highest level ever at 2.5 times. That’s about three standard deviations above the norm. You don’t have to be a math whiz to know that three standard deviations are way outside of normal bounds. Bad things happen when the rubber band is stretched that far.

Despite these warnrning signs, momentum favors the bulls. The trend is up, so it does need to be respected, albeit grudgingly.

So why have any short positions on at all?

If the market keeps marching higher, despite all of these warnrnings signs that valuations are stretched and market sentiment is too bullish, what’s in it for the short seller? In the short term, it’s painful to have hedges on, as they detract from performance. We very much live in a “show me now” world where very few think and plan for the long term.

But consider hedges as insurance. You have insurance for your house, but it’s unlikely to burnrn down. You have insurance for your car, but people don’t get in an accident every day.

Few people have insurance for their portfolio. Ultimately, it helps smooth the ride. Most people can’t stomach the big losses that come with a bear market, even though they know that, over time, the market trends higher.

The proof is in the actions of investors. At the 2009 lows, which was the ideal time to plunge head first into the markets, investors had the lowest allocation to equities.

Now, with everybody bragging about their gains, it’s best to start thinking about risk and how to manage it.

Good investing,

John Del Vecchio

Editor, Hidden Profits

John Del Vecchio

Using his proprietary forensic analysis, John does all the hard work of digging, weeding out and analyzing the few rare stocks that most of the market has overlooked, but are set to pay out handsomely in the months and years to come.