Feb. 2016

When I use the term irrational exuberance everyone seems to know what I mean. On the other hand, the expression irrational pessimism results in listeners expressing a puzzled look on their faces. It is as though they think investors can get carried away when stock prices move higher, but they're dead on when it comes to pricing stocks down, even way down.

I'm not sure why this is except that fear is a stronger passion than greed. Greed is simply a desire to have more of something. It becomes excessive when we desire more of something than we need. What is "more than we need" when it comes to providing for our family's welfare or our retirement, especially when it comes to an asset that fluctuates in price every second and is subject to mark-to-market pricing? Greed does not paralyze us, fear does. Making money can excite us, losing it terrorizes us.

That puts us near the bottom of a cliff looking up. The NASDAQ broad index has had four sharp plunges in just the past six months (down -19.23%). They are identified in the following chart:

Are we near the bottom looking up, or are we on a ledge awaiting further declines? How markets got to where they are is important to understand, but it seems the more urgent question to answer is where should we expect markets to go from here? Up or down? I have some colleagues in our industry who just last week jumped out of the bullish camp into a bear.


At this point you hear rumbles about a recession. When someone like me points out we've never had a recession without first having an inverted yield curve, someone gets on television and says the yield curve doesn't matter anymore. That kind of statement generates fear because it brings into question an economic axiom we've come to trust. There's something out there we don't understand that's going to gobble us up. My reply is poppycock. Globalization may have altered the landscape but the Federal Reserve remains the most important central bank in the world.

Someone else warned me that the stock market is telling us a recession is ahead. Yes, the stock market does look ahead, but there's this saying that the stock market has forecast all twelve of the last nine recessions.

On October 29, 2014 the Fed ended its QE3 program and the stock market has gone nowhere since except ultimately down.

How do you make a direct connection between the ending of QE3 on October 29, 2014 and what happened to stocks in late October 2015 and January 2016? We know that monetary policy has a lag time. So to suggest the 0.7% GDP growth in the 4th quarter of last year was due to the end of QE3 is a major stretch and erroneous.

New unemployment claims last week fell to 269,000. That is contrary to a recession because these claims usually spike just before a recession or in the early stages of a recession. The opposite is happening now. Jobs continue to grow and consumers are gaining in purchasing power. Wages are up +4.7% over last year.

Another plus for the consumer is his/her debt burden. Their share of after-tax income needed to service mortgage payments and other consumer debt is now at its lowest levels since the early 1980s.

The share of household debt where borrowers are "current" (or not delinquent at all) increased for the sixth year in a row in 2015, and that includes student loans. After peaking in 2009 at 2 million, the number of consumers with new foreclosures fell to 400,000 in 2015, the lowest on record going back to 2001.

The median credit score on auto loans is down from 2009, but it's equal to where it was in 2003 and higher than every other year between 2000 and 2008 which reflects improved household finances.

Home builders started 1.1 million homes last year, including both single-family homes and apartment units. That's roughly double the bottom in 2009, but still well off the 1.5 million homes we need to start each year just to keep up with household formations and "scrappage" from voluntary knock-downs, fires, floods, hurricanes, tornadoes, earthquakes and such.

Inflation will usually spike before the arrival of a recession and there's no evidence that inflation is building systemically.


As a result of market capitulation since the Feb. 11 market low (1810.10 S&P), investor sentiment has improved our optimism for the future of stocks. With the current combination of sentiment, valuation and monetary reading, this is probably the best time in the past two years to put money into the market. This looks like a great time to buy stocks.

If you look at where smart money is going, first day IPO trading is excellent. That's a big plus for the investor sentiment category. There were zero IPOs issued in January but December trading gave +33% gains for the first day.

Based on the American Association of Individual Investors Survey, it appears individual investors have deserted stocks. For those of us who want to be long the stock market, this is a positive sign and adds to our investor sentiment measurements:

If individual investors are really deserting stocks, it should show up in the Rydex Ratio, a measurement of bulls / bears in index funds, and that is exactly what we see:

The bull/bear ratio is at the highest level it has been since the formation of the bottom in the summer of 2013 and has exceeded the bottom formation of August/September 2015. Investors who have abandoned equity funds did not go to money market accounts, but to inverse funds, those funds that go higher when markets decline. This means these investors who are most often wrong are firmly expecting stock prices to continue to decline and are betting their money on it.

Let's look at one other issue-----the level of fear in the market. One would expect a bottom to be accompanied with a higher level of fear. In other words, when the washout comes and the herd is stampeding to the exit gate, panic should be at its peak. Sorry, that's not the way it works.

We've looked at this before but let's refresh our memory. Something very important can be seen in the next charts for 2010 and 2011. Take note of the decline when the VIX (the official fear gauge) reached its highest levels. That was not the bottom of the market's decline. When the bottom was reached, you will note that the VIX was not as high. There was not as much fear in the markets as would have appeared from the price movement. So it is incorrect for us to expect a higher level of fear when the market reaches its bottom.

The next chart shows you where the market and fear gauge were as of last Thursday before stocks had their three day bounce:

We can see in the upper portion of the chart that we have a market that has pushed prices lower than where they were back in August/September, but the level of fear is actually less. Back in August the VIX reached a level of 55 while today it is only 28. Fine, but compare that with 2010 and 2011. The comparison is an elevated level of fear and a market that has moved lower than when fear was higher. We do not have to wait for fear to go higher before this market can have a bottom. We think the VIX has already passed its test. It has allowed investors to push the market to lower levels with less fear. That should be a win for stocks and could likely pinpoint a bottom.

Neither the DOW nor the S&P 500 have fallen to the level that officially qualifies as a bear market. But as we've pointed out, the average stock and other indices have fumbled to those levels. Let's take a look at these and consider what could be next as prices head higher.

The bears just won't give up, growling ferociously at every speck of financial and economic news and market price movement. The bulls are having a tough go. They are more like Rodney Dangerfield, getting no respect. How can anyone be a bull after the NYSE and Russell 2000 have already been pulled down to their June 2013 lows and thousands of individual stocks are already in their own bear markets, having dropped by -30% to -60%? If the S&P 500 were to follow the NYSE and Russell 2000 to its June 2013 low, it would fall to 1560.

The broader New York Stock Exchange has already fallen to its June 2013 level:

So has the Russell 2000 of smaller stocks:

This points to how much farther the S&P 500 could fall, but more importantly, it shows how stealth this "correction" has been, its breadth being camouflaged by the more common indices like the S&P 500 and NASDAQ. The average stock is down more than -20%, down much more. Even the NASDAQ has declined -19.23% during this "correction / bear":

When markets rebound from corrections or bear markets, it is usually the small / midcap stocks that outperform.

The next chart compares the S&P 500 vs. Small / MidCap indices coming out of the 2008 bear market:

The same generally holds true coming out of a "correction":

Now comes the big question. Are we coming out of a correction or bear market? Has this market seen its bottom? There's no doubt stocks are on sale, but who's buying? As we saw on page 8 the Russell 2000 has already declined -27% from its recent high, the NYSE is off 21% and the NASDAQ -19.23%. Those are uncomfortable declines, but are they over?

We've already seen evidence of a bottom formation on pages 3-6. Now let's turn our attention to another sign. When financial markets are in a bottoming formation the volume is usually higher than average.

The chart to the right shows the New York Stock Exchange (NYSE) where volume has increased in 2016. Here's what could be expected from this index. It will likely work its way up to around 9600 and stall. From there it could trace its way back down to around 9250, move higher to the 50 day moving average (blue line) and once it breaks through that level, continue higher.

The next chart shows the NASDAQ:

For the NASDAQ to reach its recent high, it will need to advance 17.25% from Tuesday's close. I've had investors sit before me and express disappointment that they did not buy such and such stock at some point in the past: 1987, 1998, 2002, 2008 or whenever prices were down significantly. You can see in the blue boxes in the two charts above that volume increased as stock prices were sliding down. That's because investors were terrified and were selling (herd rushing to the exits), but at market bottoms there are an equal number of buyers. Volume has remained high as stocks bounced, then went even lower and have now started back up. That means buyers came in and overpowered sellers. That's where we are this week----buyers offering to pay more than sellers are asking. Can this last and can prices continue higher? Not every day, but we think the direction of prices has changed.

People don't remember now but Apple was at one time in the 1990s on the verge of bankruptcy. Don't you wish you had bought Apple back then? That was when Steve Jobs returned to the company.

There was also the time Lululemon went public at $25 per share in 2007 and by March 2009 was trading at a price of $4.57. How would you now like to have gobbled up all the shares you could afford back then? The trouble is the vast majority of investors were afraid of Apple and Lululemon.

There's more to making a decision about buying shares in a company than price movement, but these two examples show investors can misprice stocks. Apple also illustrates the necessity of patience which is something the vast majority of investors do not have.

On October 16, 2008 Warren Buffett wrote in Opinion for the New York Times. Here is some of what it said:

"A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month - or a year - from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over."

October 2008 was early, wasn't it? Stocks didn't hit bottom until March 2009. Do you think Buffett is now regretting he didn't wait another five months? Probably not. What is very interesting is that at a time when profits were in the tank and the economic future of America was uncertain, Warren Buffett wrote, "But most major companies will be setting new profit records 5, 10 and 20 years from now."

It is not easy to invest the way Warren Buffett does. It's not easy to buy anything "when fear is widespread, gripping even seasoned investors."

If indices are telegraphing their direction, it is up. There's no evidence in the indices themselves or internally in the market that points to additional declines. The evidence points to last week having been a bottom. That's the evidence, but the jury has yet to render a verdict. Deliberations will last quite a while and when the announcement is made, it will be too late. We must decide now.

Allen R. Montgomery
Chief Investment Strategist


This periodic newsletter is prepared for our Financial Planning and Advisory Clients to provide current market analysis and perspective. The information contained herein is intended solely for informational purposes. It should not be viewed as investment advice, or a solicitation to buy or sell any securities. Capstone and/or the Investment Adviser Representative (IAR) may perform advisory services or take action for other clients and for themselves that differ from the opinions given or the nature of any action taken for the client. Any historical charts were obtained from public websites. All investments involve risks. It is not possible to invest directly in an index. Past performance is no guarantee of future results.