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Market Oracle FREE Newsletter

5 "Tells" that the Stock Markets Are About to Reverse

How To Survive and Thrive in a Zlatan Stock Market

Stock-Markets / Stock Market 2017 Oct 01, 2017 - 12:36 PM GMT

By: F_F_Wiley

Stock-Markets

REPORTER: “Who will win the World Cup playoff?”
ZLATAN: “Only God knows who will go through.”
REPORTER: “It’s hard to ask him.”
ZLATAN: “You’re talking to him.”

REPORTER: “What did you get your wife for her birthday?”
ZLATAN: “Nothing. She already has Zlatan.”

ZLATAN: “I can’t help but laugh at how perfect I am.”


In case you don’t pay attention to soccer, here are three things to know about Zlatan Ibrahimovic:

  1. He’s an excellent player.
  2. His ego, as you can see, is large.
  3. He doesn’t appear to have much in common with Yale University’s Robert Shiller.

I’ll start with the third point and the insightful Shiller, in particular. (I’ll get back to “Ibra” in just a moment.) Shiller wrote an article last week warning of the potential hazards of equity investment. As he often does, he shared a chart showing his cyclically-adjusted price-to-earnings (CAPE) ratio. He reminded us that the CAPE ratio is “somewhat effective at predicting real returns over a ten-year period.” But this particular article had little to do with ten-year forecasts. Here’s the conclusion (with my emphasis):

In short, the US stock market today looks a lot like it did at the peaks before most of the country’s 13 previous bear markets. This is not to say that a bear market is guaranteed: such episodes are difficult to anticipate, and the next one may still be a long way off. . .

But my analysis should serve as a warning against complacency. Investors who allow faulty impressions of history to lead them to assume too much stock-market risk today may be inviting considerable losses.

He likens today’s market to 1929, 2000, 2007 and other scary market peaks of the past, while pointing to characteristics he considers typical of market peaks. A high CAPE ratio stands at the top of his list, although he also mentions strong earnings and low volatility. Effectively, he says those three indicators should cause us to worry that a bear market could be right around the corner. And he makes useful observations about the CAPE ratio typically being high, earnings growth also somewhat high, and volatility low (although only slightly below average) just before bear markets begin.

With all due respect, though, I think Shiller’s pivot from long-term returns to a short-term outlook was incomplete. Sure, strong earnings and low volatility aren’t necessarily bullish—I get that—but I find it hard to call them bearish, either. My bigger objection, though, is with the CAPE ratio being part of a market-timing argument. (I applaud the “no guarantee” disclaimer, but still.) As a researcher and asset manager, I’ve never found valuation ratios useful for short-term horizons, nor have I found other researchers having much success using them as short-term indicators. From that experience, I would have recommended one more disclaimer for Shiller’s article—that valuation ratios stink for market timing. And I think my disclaimer is more than just a nitpick, for three reasons that I’ll explain with increasing “Ibra-ness.”

“A World Cup without me is nothing to watch, so it is not worthwhile to wait for the World Cup.”
—Ibrahimovic after Sweden failed to qualify for the 2014 World Cup finals

First, certain other indicators actually have helped foretell major market turning points. Nearly all of the past 13 bear markets, for example, were explained partly by some combination of sharply rising inflation, high interest rates, poor credit conditions or economic depression. I state that with conviction, but you can judge it yourself by reading our article “Riding the ‘Slide’: Is This What the Next Bear Market Looks Like.” Our research suggests that the most common bear-market conditions are mostly absent today. It uses Shiller’s data, by the way, although it covers bear-market conditions he didn’t consider in his article. Without being as bombastic as Ibra but being self-serving nonetheless, I recommend reading our research alongside Shiller’s for a more complete picture than either article offers on its own. (And while you’re at it, I highly recommend Eric Parnell’s latest for a third perspective.)

“I didn’t injure you on purpose and you know that. If you accuse me again I’ll break both your legs, and that time it will be on purpose.”
—Ibrahimovic responding to an accusation from Rafael van der Vaart

Second, the market’s current valuation is like Ibra’s ego—both are inflated. But if you’re Rafael van der Vaart or Pep Guardiola or Lucas Moura and hoping for Ibra to change, you’ll probably be disappointed. He’s not likely to become modest tomorrow just because he’s egotistical today, as if one state triggers the other. And the market won’t become a bear tomorrow just because it’s an expensive bull today. When Ibra’s skills finally erode, though, that’ll be a different story. That’ll be a change in the conditions that feed his ego, just as market forecasters should be concerned with the conditions that feed bulls and bears. In other words, market conditions (such as those mentioned in the preceding paragraph) seem more likely to predict the next bear than indicators calculated from market prices (such as the CAPE ratio).

“First I went left, he did too. Then I went right and he did too. Then I went left again and he went to buy a hot dog.”
—Ibrahimovic on how he dribbled around Liverpool defender Stephane Henchoz

Third, the market can be just as tricky as Ibra is with a ball at his feet, which is why you should choose your defenses carefully. In the big picture, your team (portfolio) should have an appropriate balance between attacking and defending elements. When you’re in the moment, though, I would suggest reading short-term outlooks with a degree of skepticism. If you’re prone to biting on feints and head fakes (overtrading), relying on the CAPE ratio for market timing might make it easier for your opponent to dribble around you. And where would that leave you? Apparently, you’d be found somewhere near the hot dog stand.

Conclusions

Like Robert Shiller, we would advise equity investors to have modest expectations for long-term returns (as we advised here). We also advocate diversifying across major asset classes to reduce the damage that could occur in a bear market. But having realistic expectations and diversifying won’t protect against the greatest risk many investors face—the risk of overtrading. Investors tend to sell risky assets at lower prices than they later repurchase them, suggesting that it’s important to build safeguards against overtrading. At a minimum, bullish and bearish indicators should be weighed carefully. By studying which indicators are most likely to predict bulls and bears, investors can build defenses against rash decisions. And that should be especially helpful today, as investors confront an unusually inflated and tricky mark . . . no, make that a Zlatan market.

Author’s note: Shiller’s article caught my attention because he wrote about 13 bear markets shortly after we, too, published an article about 13 bear markets. To identify bear markets, we used Shiller’s data, which he graciously includes on his website. But our 13 bears aren’t exactly the same as his 13 bears, because we defined them differently. If anyone would like to know the differences, just ask and I’ll discuss them in the comments when I have some free time. Also, I took the Ibrahimovic quotes from various websites, such as here, here and here.

F.F. Wiley

http://ffwiley.com

F.F. Wiley is a professional name for an experienced asset manager whose work has been included in the CFA program and featured in academic journals and other industry publications.  He has advised and managed money for large institutions, sovereigns, wealthy individuals and financial advisors.

© 2017 Copyright F.F. Wiley - All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2018 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


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