The NYSE reports that margin debt has reached an all-time high in February of this year and then began to decline in March and April (margin debt is borrowing to buy stocks). While this may sound like good news, margin debt and the S&P 500 peaked in March 2000 and then the S&P 500 hit its final peak 5 months later in August of 2000 before it went on to lose over 45%. It also surged and peaked in July 2007 three months before the S&P 500 hit its peak prior to the start of a 50% decline. So here we sit with the margin debt hitting its peak three months ago along with the Russell 2000 small cap index and the S&P 500 hitting new highs today.
Are professional traders starting to reduce risk while the retail investors are moving the last of their cash into the market? Possibly. Markets do not peak when the news is bad; they peak when everyone is all in and the party is in full force. Will the market crash tomorrow? No, but the process of sentiment changing may have started. Market tops are not events, they are a process. Attempting to call a top and get out is difficult for professionals, let alone the average investor. Yes, some will get it right this time, but rarely twice. Some “analyst” will call multiple tops ensuring one will be correct.
John Hussman, President of the Hussman Investment Trust, provides the following insights this week on his weekly market commentary.
Last week, Investors Intelligence reported that bullish sentiment surged above 60%, coupled with a 5-year high in the S&P 500 and valuations beyond 18 times record trailing earnings. The same combination was last seen the week of the October 2007 market peak, last seen before that in January and May 1999 (which we should emphasize was good for only a 5% correction in the short run before a choppy run to the 2000 peak, but would still leave the S&P 500 more than 40% lower three years later), last seen before that the week of the August 1987 pre-crash peak, and last seen before that in January 1973, just before the S&P 500 lost half of its value.
He goes on to make the point that such losses do not always occur immediately and he is not making a timing call, but when the market completes its full cycle those who hold through it will see much of the recent bull market’s gains wiped out. Late comers to the party, usually retail investors, will be once again nursing significant losses.
The Sentiment Trader reports that the ratio of equity fund assets to money market assets has reached an all-time high of 4.05. The 2000 market peak reached only 3.09 and the 2007 peak reached 3.39. This means the average investor has 80% in equities and 20% in the money market. The zero interest earned in money market accounts today, thanks to the extreme monetary policy of the Fed, has a lot to do with forcing people out of cash and into the market. But it is important to ask from a contrarian point of view, where is the new money going to come from to keep driving this market higher.
I do not have a crystal ball, and do not plan to call a top. I am comfortable with my historically-informed strategy based off of over 100 years of stock market price progression. My models have us out of equities for the summer, not because of market valuations, margin debt or sentiment, but because historically we are in the 6 months of the year the market has had negative returns on average. While the market has occasional losses the other 6 months, they are mild compared to the corrections and crashes that occur during the summer and fall from time to time. Avoiding significant losses to your nest egg should be your most important objective no matter how old you are. Do not listen to anyone telling young investors to take more risk because they have more time to catch up.
Investors of all ages should aim to increase their returns over the full market cycle by reducing unnecessary risk. Our Seasonally-Modified Buy & Hold Strategy eliminates exposure during the seasonally weak season while holding during the seasonally strong season. Simple yes, but the key is knowing when each season starts because it is never quite the same. I will tell you we are out of this market and enjoying our summer and not worrying about the new highs because we know when the cycle completes we will get much better value for our money. Invest smart.