The Market who "Cried Top"

"This shows how liars are rewarded: even if they tell the truth, no one believes them"

Most of my readers will be familiar with the story about the boy "crying wolf." A young sheep herder repeatedly tricks people in the village into believing a wolf is attacking the flock, and on the day his claim is true, no one believes him, no one comes to his aid, and his sheep are eaten. In the original story, the boy ultimately falls victim to his own devious behavior. But even armed with good intentions picking tops—or bottoms—too hastily in financial markets can lead investors and analysts down the same path as the unfortunate protagonist in Aesop's fable. 

At first glance the chart above should look ominous to even the most hardened equity bull, telling a story of four major peaks in the S&P 500 since 1979. The first came in late August 1987 two months before the Black Monday Crash, marking the start a drawdown which wiped out a third of S&P 500’s value in three months. The second was set at the end of 1999, and heralded the top of the dot-com boom with a peak in March 2000 [1]. The third came in the beginning of October 2007, two months after BNP had taken the subprime crisis global. It marks the beginning of the Great Financial Crisis, which almost destroyed the global financial system, provoking a staggering 56% loss on the S&P 500 between October 2007 and March 2009. The fourth, according to my markings, occurred March last year with a five-year trailing return of 174%, but a cursory glance at the S&P 500 quickly sends this prediction skirting. The current value of the S&P 500 just shy of 2100 is more than 10% higher than the “peak” in March last year. So what gives?

The shrewd reader will no doubt have identified the issue, and also, hopefully, understood that the choice of timeframe above is not random.  We could very well be seeing the contours of an equity peak now, but the spike above in March last year is no coincidence. It occurs exactly five years from the painful low in March 2009, merely telling us that investors who had the stamina, and cash, to buy at a time when despair had reached maximum have been amply rewarded. But we can say very little about what comes next. It is true that a trailing five-return of 174% is high compared to its median of 54%, and also higher than the peak in 2007. But it is lower than the trailing returns of the peaks in 1987 and 1999, leaving us with little evidence on which to place our bets from here. Indeed, the trailing five-year return of 94% in October 2007 was pedestrian compared to the peaks before it, and should not, in itself, have given investors cause for alarm.

Some will quibble over the choice of timeframe, but any analysis using momentum of past returns to pinpoint peaks and troughs will face the same obstacle. We can probably with a reasonable degree of certainty argue that we’re getting closer to a top—after all, this is now a six-year bull market—but not how close. This argument should be uncontroversial, but it tells a cautionary tale of the current bull market.

The road from 1130 in late 2011 to 2100 on the S&P 500 is littered with the carcasses of those calling the top. The methods have varied, but have been broadly based on the notion that the market had to fall simply because it, or some underlying sentiment indicator, were too high.  A bull market loves nothing more than a wall of worry to climb, and the crisis in 2008 gave it just that. A whole new breed of bears, spawned during the dark days of 2009, has made this one of the most hated bull markets of all time. Attempts to pick a top in U.S. equities have often looked like the equivalent of financial self-flagellation. Each dip in the S&P 500 failing to morph into a plunge has, curiously, hardened the bears’ zeal. Their almost religious belief [2] in the inevitably of a “crash” and the evisceration of “artificial” gains of money printing has come in various forms; most often an odd mixture of neo-Austrian economics and libertarianism. Add in a dose of survivalism, and even the most ardent pessimist would struggle to secure membership in the guild. This has, so far, been a disastrous creed for investors, and while a correction will eventually come, I doubt it will provide closure. The only vindication for this cult is a complete obliteration of the financial system; anything less won't do. But this is also its biggest problem; after all, the worst thing that can happen to someone preparing for disaster is that it never comes.

A healthy dose of scepticism is always warranted six years into a bull market with trailing returns in excess of 150%. But be wary of the argument that it has to end just because it has been a long one, and don’t accept the notion that it can only end in a cataclysmic destruction of the financial world as we know it. In other words, remember the moral of Aesop's fable, your portfolio will be better for it.


[1] On a weekly basis, the S&P 500 peaked at 1527 in the week ending March 24th 2000. But after an initial sell-off, it retraced almost its entire loss to reach 1520 at the beginning of September that year. It then finally gave up the ghost, and entered a bear market ending a gruelling 47% lower in September 2002.

[2] Of course, “faith based” investing is not confined to bears as Macro Man eloquently noted recently. This bull market has undoubtedly generated a new cult of cheerleaders and POMO-chasers, but we have seen this before, and they will eventually receive their comeuppance. I prefer to dish out my insults in measured doses, though, and the perma-bulls will have to wait their turn.