As the stock market claws its way back toward the January peak, inflationary pressures and subtle market divergences continue to mount, explains Jim Stack, one of the nation's most respected boutique money managers and editor of InvesTech Research.
The Federal Reserve is walking a tight rope between too much and too little restraint, and the inflationary backdrop depicted in this issue 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 Buffet stated back in the heady days of the 1990s Tech Bubble back 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” in 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!
