Signs Of A Late Stage Bull Market Which Means Euphoria Is Still To Come
Recently I discussed one of the important markets that will be important in highlighting when serious downside risks will emerge for global equity market – namely, the high yield corporate debt market. Otherwise known as “junk” and can be monitored by the US-listed High Yield Corporate Bond ETF (HYG.ARC).
This week billionaire investor Carl Icahn sounded a major warning on this market stating that it was in bubble territory and that investors should be cautious as the market (both junk bonds and equities) were heated.
We have also heard a lot about the poor performance in the Dow Jones Transport index which has entered correction mode and that this is a warning sign to equity markets according to traditional Dow Theory. Effectively Dow Theory states that the transport index leads the market higher and lower because of its effective proxy to economic activity and health. However, I strongly feel that these commentators and analysts are missing a key stage of the bull market cycle.
Dow Transports ETF
Most unseasoned investors believe sectors, stocks and most risk assets peak together and fall together in unison. Nothing could be further from reality. Having such a view will ensure that not only will you miss one of the best money making opportunities but you could also incur significant losses by shorting too early or shorting the wrong market.
To prove my point and my theory let’s look at previous bull markets and put it to the test.
The cause of the GFC in 2008 has been placed firmly at the feet of the US housing market where banks took money from unsuspecting investors and lent it to people with no money to buy a home. When these loans turned sour the world lost all its money. Contrary to popular belief this collapse didn’t just happen overnight. Shown below is a 10 year chart of KB Home (KBH) compared to the S&P 500. KBH like many other home builders boomed as a result of this home buying spree and reached its peak of $85 in 2005! In fact by the time the S&P500 peaked in October 2007 – two years later – KBH and other home builders had lost 77% of their value! The demise of the US housing market was foretold for two years prior to the broader markets peak.
KB Home (green) vs S&P 500 (blue) – 2005 to 2009
US banks themselves peaked in early 2007 as shown below by Citigroup. In fact by the time the S&P 500 peaked Citigroup had almost halved! And despite the US housing stocks collapsing in 2006 Citigroup managed to make a new record high in December 2006.
So why the disconnect? Because money doesn’t just flow in a one dimensional path from one asset class to another. It’s not just a simple case of money flowing out of equities and into bonds or vice versa. There is huge rotation between sectors and typically in late stage bull markets some sectors begin to gather more appeal than others. Money flows from the underperforming sectors into the very few sectors left that are still rallying. As that universe gets smaller the gains become larger and larger and a bubble builds. Think resources in 2008, think technology in 1999. In fact during one of the biggest bubbles in history – 1999 – the share prices of many of Australia’s best companies fell sharply. NAB dropped from $30 to $20, QBE and CBA also fell because investor’s purchases of technology stocks were being funded by traditional blue chip companies.
So even though equity indices peaked in late 2007, many of the sectors in decline over the prior years were fuelling a flurry into resources – especially coal, oil and steel.
Below we show some charts of where these stocks peaked relative to the S&P 500 and ASX 200 peaks, and also relative to their values in late 2007 and the ultimate heights they reached in mid-2008.
US Steel (green) vs S&P 500 (blue) – US Steel rallied 60% in mid-2008
Santos (green) almost doubled from Jan 2008 to June 2008
Coal producer New Hope gained 250% in the first half of 2008!
Funds flowed from traditional sectors – finance, property, industrials – and chased the China growth story in a final flurry. Even while the Shanghai Composite was plummeting at the same time.
The lesson here is that while some sectors in this bull market will begin to peak and enter corrections, it is not a sign to sell all equity holdings. Rather the first reaction is for an even greater rally in the best performing sectors. So utilities and property trusts suffering from an increase in interest rates is normal and will fuel a rotation into global cyclical stocks. The move lower in transports comes after oil has fallen to $60/bbl helping boost profits. Its time to take profits there and move into…………..biotech, pharmaceuticals, cyber security and social media stocks. These stocks are going to be where the next bubble emerges and some enormous gains are still to be seen. These are currently the best performing stocks in the US and have been reaching fresh record highs once again this week.
The biggest mistake I see (which also fuels the rally in these other sectors) is investors shorting the outperforming sectors because they haven’t fallen yet. This is a no-no strategy. Inevitably these shorters are forced to cover their positions as these sectors rally, which only adds to the euphoric gains.
So as some sectors begin to crack, the key is not to panic. It doesn’t necessarily mean every sector has peaked. Pay attention to the price action in the sector you have exposure to and only stick with the market leaders.
Greg is the Head of Proprietary Trading at Gleneagle Securities and has over 20 years of experience as proprietary trader and high level strategist for the major investment banks including Citigroup, Bankers Trust and Macquarie Bank. He has been involved across all asset classes including commodities, bonds, currencies and equities right across the globe.
After a 10-year career within the comforts of the large investment banks and research firms he branched out on his own to form his own proprietary trading firm successfully building the business into a multi-million dollar trading operation that turned over a billion dollars a year. This same team now runs the proprietary trading desk at Global Prime, risking their own money in line with the firm's and client's capital.
Greg has appeared on CNBC, Channel 9 - Business Sunday programme, a guest columnist for the Australian Financial Review, a regular author for Personal Investor, Wealth Creator and Shares magazine and is the former Treasurer of the Australian Technical Analysts Association.