Exploring The Bear Case

By now, just about everybody on the planet knows the key tenets of the bull case. In short, our heroes in horns contend that stocks are discounting better days ahead for the economy, and in turn, earnings, less regulation, a “phenomenal” tax plan, and an economic stimulus package sprinkled in for good measure. And since the all of the above suggest that earnings are going to be better than expectations, stock prices can continue to move higher, we’re told.

However, on the other side of the court, the bears too have a case. And while their voices have been quieted by the relentless rise seen over the past four months, our furry friends in the bear camp remind us that there are issues out there that investors will have to deal with – eventually.

Since being able to remain objective is the key to this business, I thought I put my bear hat on this morning and run down the bear argument – in a quick and easy-to-read, executive summary format.

Big-Time Overbought Condition

• The major stock market indices are overbought – very overbought
• One indicator suggests NASDAQ is most overbought since the late 1990’s
• This means stocks are “set up” to decline quickly if something negative comes out of the woodwork

Sentiment Is Not Exuberant, But…

• Sentiment indicators have reached extreme levels
• In and of itself, high sentiment readings do not cause market declines
• High sentiment readings simply indicate that most of the money that wanted “in” has likely been spent
• The key to a sentiment “signal” is for the indicators to reach an extreme (check) and then reverse
• Thus, we need to be on the lookout for something to trigger traders to exit the market

Stock Market Indices Are Overvalued

• We’ve been through this many times and nothing has changed…
• Traditional valuation metrics such as P/E’s are currently at very high levels
• Relative valuation metrics (those that compare stock valuations to the level of interest rates) are now neutral – and heading the wrong way
• This is another situation that provides a “set up” for the bears
• But ONLY if they can find a catalyst to get the ball rolling downhill

The Fed Is Tightening

• As the saying goes, “Don’t fight the Fed” (especially when they are on a mission)
• Remember, the Fed usually gets what it wants
• The Fed is currently in a tightening phase and will raise rates several times this year
• Historically, this has been negative for stocks

Inflation Is Rising

• Since 2008, the Fed has been trying to avoid a deflationary cycle by attempting to create inflation
• Thus, this time around, the “inflation problem” has been too little inflation, not too much
• But as the saying goes, “Be careful that the solution to the current problem doesn’t become your next problem”
• Inflation expectations are rising with our models now very close to the “strong inflation” zone
• Commodity prices have been the driver of the current surge in inflation
• Note: The Core Personal Consumption Expenditures Index (Core PCE) is the Fed’s primary inflation gauge

Trees Don’t Grow To The Sky

• The market travels in cycles. Bulls morph into bears and vice versa over time.
• Stocks are currently a little over year into a cyclical bull that is occurring within a secular bull trend
• The average duration of cyclical bulls is about 2 years
• The current cyclical bull began on February 11, 2016
• The average gain for cyclical bulls is 106.7% (Source: Ned Davis Research)

Potential For Policy Disappointment

• Despite all the superlatives used to describe the new administration’s plans, those plans do have to materialize at some point
• In other words, Trump’s policies must turn into economic reality in time – otherwise stocks have been bid up unjustly
• Therefore, there is the potential for disappointment if a purportedly “phenomenal” policy is merely “fantastic” when it actually hits the streets.

So there you have it; my take on the bear case (and for the record, I’ve probably left out a tenet or two) – in a nutshell. To be sure, there is a “yea, but” to almost every bullet point offered above. But that’s not what this exercise is about. No, the goal is to walk a mile in the other guy’s shoes every once in a while in order to make sure you understand their view.