The Illusion Of Strength

This morning a portfolio manager friend of mine sent me an interesting note discussing the current mental attitude of professional investors:

“[There is] the resigned capitulation to the trend, going fully invested in order to survive, with low-risk paying nothing and ‘low risk’ being almost certain doom. Perhaps the most tangible example of principal-agent dynamics I have seen during my 30-plus years in this business.”

This attitude is not new, and something that has been entrenched in extended bull markets throughout history. The current bull move has lasted so long, despite weak macro fundamentals, geopolitical risks and sluggish economics, that no one can see its potential end.  As my friend stated:

“We’re like observers on 24 June 1812 watching Napoleon’s Grand Army march off to Russia, with victory certain.”

The chart below reiterates a point I made last week:

“There is an interesting phenomenon occurring in the financial markets that absolutely, positively, will not last indefinitely – the ‘Giant Shrinking Correction.’ The chart below shows the S&P 500 (weekly closing data) since the beginning of 2009, with all relevant corrections identified in terms of percentage.

There are two important points to note. First, each correction since the end of QE2 has been increasingly smaller. This is very much in line with a prediction made in November, 2013 by John Hussman when he stated:

“A discussion of bubble risk would be incomplete without defining the term itself. From an economist’s point of view, a bubble is defined in terms of differential equations and a violation of ‘transversality.’ In simpler language, a bubble is a speculative advance where prices rise on the expectation of future advances and become largely detached from properly discounted fundamentals. A bubble reflects a widening gap between the increasingly extrapolative expectations of market participants and the prospective returns that can be estimated through present-value relationships linking prices and likely cash flows.

 

As economist Didier Sornette observed in Why Markets Crash, numerous bubbles in securities and other asset markets can be shown to follow a ‘log periodic’ pattern where the general advance becomes increasingly steep, while corrections become both increasingly frequent and gradually shallower. I’ve described this dynamic in terms of investor behavior that reflects increasingly immediate impulses to buy the dip.”

 

Secondly, I have noted in the chart above (red vertical dashed line) the onset of the most recent QE program. As noted, corrections since December of 2012 have never taken the markets back to extremely oversold levels as had occurred previously. With the Federal Reserve now reducing monetary interventions, it is likely that volatility will increase, and corrections will once again become deeper.

 

The issue, as discussed by Hussman, is the current ‘risk on’ environment will most assuredly swing to ‘risk off.’ It is at this point that most investors are paralyzed into inaction as the realization of what was said ‘could not happen, does.”

This morning Brad DeLong posted a piece quoting Barbara Tuchmans “The Guns of August.”

“On August 20th, Brussels was occupied. Squadrons of Uhlans moving with lances at the ready appeared suddenly in the streets. They were but the heralds of a grim parade, almost unbelievable in power and grandeur, that followed. It began at one o’clock with column after column of gray-green infantry, shaved and brushed with freshly shined boots and bayonets glinting in the sun and their ranks closed to eliminate the gaps left by the missing. The cavalry appeared in the same gray-green with black and white pennants fluttering from their lances like horsemen riding out of the Middle Ages. The phalanx of their innumerable hoofs clattering in close order seemed capable of trampling to death anything in their path. Heavy guns of the artillery thundered over the cobblestones. Drums pounded. Hoarse voices in chorus roared the victory song, ‘Heil dir im Siegeskranz,’ to the tune of ‘God Save the King.’

 

On and on, more and more, brigade after brigade, they came. Silent crowds watching the parade were stupefied by its immensity, its endlessness, its splendid perfection. The exhibition of equipment designed to awe the onlookers accomplished its object…The parade kept to one side of the boulevards so that staff officers in motorcars and messengers on bicycles could dash up and down the line of march.”

The current occupation of the markets is both “unbelievable in power and grandeur.”  There is simply no denying the current bull market trend as “silent crowds remain stupefied by its immensity, its endlessness and its splendid perfection.”

The thought for the day is simply this:

“Like the many proud soldiers that occupied Brussels then, two or three years from now, how many investors will be alive to ‘tell the tale’ of the occupation of the bull market today?”

It is within “resigned complacency” that the risks to portfolios are easily dismissed with the conviction of strength and control. Yet, it is also within this illusion that the greatest defeats in history have been delivered.