With near-record highs in the major averages, historic lows in unemployment and strong economic growth, it's not surprising that advisor and investor optimism is at a bullish extreme. Nevertheless, three leading market timers and MoneyShow.com contributors believe it is increasingly important for prudent investors to recognize potential negatives on the investment horizon.
As the stock market claws its way back toward the January peak, inflationary pressures and subtle market divergences continue to mount. The Federal Reserve is walking a tight rope between too much and too little restraint, and the inflationary backdrop shows how precarious that balancing act may turn out to be.
If underlying pressures in the form of manufacturing costs and wage increases continue to rise, the Fed's strategy of "gradualism" in interest rate increases could go by the wayside.
Another risk that will surely blindside investors when the final market turning point comes is the excessive concentration of assets and recent gains in large-cap growth stocks, courtesy of today's indexing phenomenon.
Although the Advance-Decline Line continues to hit new highs, indicating that a broad number of stocks are participating in this recovery, investors are concentrating on the large-cap favorites, driving them further into momentum territory.
Yet, these high-growth stocks -- like Netflix (NFLX) , Facebook (FB) , and Amazon (AMZN) -- are clearly priced on lofty expectations, and history tells us that the current momentum-driven leadership won't last. Ultimately, value stocks will come back into vogue, and perhaps sooner than anyone thinks.
As Warren Buffett stated back in the heady days of the 1990s Tech Bubble in November 1999, "The fact is that markets behave in ways, sometimes for a very long stretch, that are not linked to value. Sooner or later, though, value counts."
And he was right. While technology stocks and large-cap growth funds dominated the landscape during the late 1990s, the tables turned abruptly in March 2000. Over the next 31 months, the S&P 500 Growth Index lost half its value, dropping 49.1%, nearly twice the decline in the Value Index.
Although value holdings won't come through a severe bear market unscathed, it's a historical fact that momentum stocks, which typically lead prior to market peaks, will be among the first and the hardest hit when the music finally stops.
Consequently, with this bull market likely in its ninth year, this is not the time to reach for excess profits, particularly with companies where growth projections rely on a booming economy.
It's fine to have growth-oriented sectors in the portfolio, but they should be kept to less than market-weighting and be balanced with a healthy allocation to defensive sectors. Most importantly, the overall portfolio allocation to the stock market should be in line with the current risks, with an emphasis on traditional late-stage and less cyclical sectors.
Over my decades of investing experience, I have found that every bull market has "a hook" that keeps even the most intelligent and diligent investors fully committed and invested at the top.
In 1972 it was the "one-decision" Nifty Fifty stocks that you could buy and hold forever. In the Tech Bubble of the 1990s, it was the almost universal belief that "this time is different" and that valuations didn't matter.
And at the last market top in 2007, bullish market pundits clung to the fact that the Federal Reserve had already made their first interest rate cut before the market peaked, and that a bear market had never started when interest rates were falling.
After listening to Charles Schwab's top domestic and international strategists at a recent Schwab conference for principals of money management firms, we may have found the hook that traps even the brightest minds this time around.
The dangerous relationship between a flattening yield curve and a probable bear market has become widely known on Wall Street. In fact, it has all the top analysts watching for the inevitable inversion of the 10-year T-bond yield minus the 3-month T-bill rate that would confirm the next bear market and recession.
Theoretically, we would have to see this yield spread turn negative before the next bear market or recession. At least that is what everyone on Wall Street believes.
As devoted market historians, we have to question whether this misplaced confidence could turn out to be the ultimate hook in this current bull market. If so, there are going to be a lot of very perplexed and frustrated analysts, money managers and investors on the bear market ride down!
I'm frankly appalled by what I'm seeing in the IPO marketplace right now. Start with the fact total IPO volume is surging thanks to the "Everything Bubble" financing environment.
A whopping 120 companies have raised just over $35 billion through the first half of the year on U.S. stock exchanges. That puts 2018 on track to be the second-busiest IPO year (besides 2012) since the 2000 peak of the dot-com bubble!
If the companies coming out of the chute were solid ones with long histories of profitable operations and time-tested business models, I wouldn't worry. But the sludge that's running down Wall Street is entirely different!
Take a company called iQiyi (IQ) . It's a Chinese video streaming service majority-owned by Baidu (BIDU) that's been operating since 2010. Unfortunately, in every single one of those eight years, it lost money.
Dropbox (DBX) lost $325.9 million in 2015, $210.2 million in 2016 and another $111.7 million in 2017. Yet it went public in March, raising $756 million. Spotify (SPOT) racked up red ink of $268 million in 2015, $629 million in 2016 and a stunning $1.45 billion in 2017. Yet it went public through a direct listing in April that valued the company at around $27 billion.
HyreCar (HYRE) managed to raise $12.6 million last month despite the fact it sported operating losses of $800,000 in 2016 and $4.1 million in 2017. Domo Inc. (DOMO) , a cloud computing company, raised $193 million in June despite losing $176 million in fiscal 2018 and $183 million in 2017.
Then there's Bilibili (BILI) , a Chinese provider of online entertainment. It lost $57 million in 2015, $129 million in 2016, and $34 million in 2017, yet still managed to raise $483 million in its March IPO. Chinese used car e-commerce platform Uxin (UXIN) , followed Bilibili with its own $225 million IPO, despite racking up operating losses of $188.5 million in 2016 and $270 million in 2017.
Of course, money-losing, traditional tech companies aren't the only wing-and-a-prayer firms with their hands out. Money-losing biotechs have been raising gobs of money, too. In a single 24-hour period -- June 20-21 -- five biotechs raised a total of around $460 million, yet not a single one of them was profitable.
That included Avrobio (AVRO) , with full-year 2017 losses of $18.6 million, Aptinyx (APTX) , with 2017 losses of $32.1 million, Magenta Therapeutics (MGTA) , with losses of $35.5 million, Kezar Life Sciences (KZR) , with losses of $8.5 million and Xeris Pharmaceuticals (XERS) , with losses of $26.6 million. For good measure, Eidos Therapeutics (EIDX) went public a day earlier. It lost $11.9 million in 2017.
So, what do I think about the IPO mania? Well, more than half the dot-com darlings of the late 1990s eventually went up in smoke. Not every one of the companies I just mentioned is destined for the dustbin of history. But given the gobs and gobs of red ink they're racking up, there will be financial carnage. Lots of it. This IPO frenzy looks exactly like what you'd expect to see in the final death throes of a deflating "Everything Bubble."
But with the yield curve collapsing, the Federal Reserve raising rates steadily and signs of credit stress increasing by the day, mark my words: Those ultra-high-risk companies are likely headed straight into a brick wall. So, the only sensible course of action in my book is to maintain a much higher cash position than in years past. (Our model portfolio currently has about 40% in cash, up sharply from our previous fully invested stance.) And move up the quality scale for any remaining stocks you hold and edge against weakness -- or target downside profits -- using specialized tools like inverse ETFs.
Valuations are not just high, they are at historic extremes. Leverage remains insanely high at $647 billion, 55% higher than at the 2007 double housing and stock bubble peak and 116% higher than the 2000 tech mania peak. Total margin debt has exceeded 3% of Gross Domestic Product only three times: in 1929 as the madness of the Roaring Twenties peaked, last year and this year.
Leverage may seem like magic on the way up but the effects are horrifying when prices fall. The unwinding of margin debt between 1929-1932 resulted in an economic depression as the phenomenal wealth driving the nation's economy evaporated.
While we do not expect a repeat of the 1929-32 period when excessive leverage led to a crash and a collapse into an economic depression, the current environment is way too similar to past manias and in certain aspects -- primarily leverage -- is far worse than the prior two peaks in March 2000 and October 2007. As such, we have zero comfort for the long side.
Meanwhile, total dollar trading volume (DTV) now stands at yet another record high. Over the last 12 months, total DTV is now $81.24 trillion, up nearly 15% from last year's record, roughly 75% higher than at the 2007 double bubble peak and 150% higher than at the tech mania peak.
The trend to trade more has kept average holding periods for U.S. stocks to just over four months. When stocks are held for the long term, valuation becomes a primary consideration. The shorter period one holds stocks, the less likely one is to rely on valuations, hence valuation methodologies are now routinely shunned and scorned in favor of chasing momentum.
Sentiment is perhaps the most significant driver of price, but it is not mere excessive optimism that makes the current environment so dangerous. Excessive valuations have been in place for so long that they are now accepted as entirely normal.
In a CNBC survey of 19 top Wall Street firms, every strategist forecast higher prices and an average gain of another 10.6% through the remainder of the year. We are far more comfortable on the other side of the fence. Risks on the long side continue to be insanely high.
History has shown 30% downturns occur on average, roughly once every nine years. We are astonished how little attention is paid to risk parameters, even at this point when it is so ridiculously obvious how much leverage is built into stock prices and how overvalued stocks are. We expect a bear market and our target remains Dow 14,719. Be careful. A storm is brewing.
-- This commentary was originally published Aug. 3 on Real Money.