What’s Your Confirmation Bias?
The current U.S. equity market has something for everyone. Whether you are bullish or bearish, there is no shortage of indicators or charts you can use to support your thesis. Let’s run through both the Bull and the Bear case here. In the spirit of Confirmation Bias, feel free to skip ahead to the part that best supports your current positioning.
The Bull Case
Bull Thesis: The economic expansion remains intact.
- Unemployment Rate at cycle lows (6.3%).
- US Manufacturing steadily improving over past few months (last reading: 54.9).
- Jobless claims at new cycle lows (297k), back to 2007 levels.
Bull Thesis: With the Bernanke/Yellen “Put” still firmly in place, “don’t fight the fed.” Tapering ≠ tightening and even if the Fed continues with its QE reduction they will still keep rates at “exceptionally low” levels for a long, long time.
- Over 5 years of zero interest rate policy (ZIRP) and a Fed balance sheet of over $4 trillion. S&P 500 up 185% over that time so the two must be closely related.
Bull Thesis: Stocks are cheap and nowhere near the bubble valuations early 2000. The S&P is trading at only 18.6x TTM earnings and 13x 2015 expected earnings. With interest rates near historic lows and earnings at new all-time highs, P/Es should be much higher. If we assume only a 15x multiple on next year’s expected earnings ($144), we get to 2160 on the S&P 500, or 15% above current levels.
- Earnings are at new highs and growth is expected to be strong next year. Earnings drive stock prices.
Bull Thesis: Credit markets remain strong with junk bonds at new all-time highs. This is good sign for the economy (companies have easy access to credit) and as credit typically leads, it should be good for the stock market as well. Low yields in general make equities the more attractive asset class.
- Bank of America-Merrill Lynch High Yield Master II at new highs. Ditto the HYG & JNK ETFs.
Bull Thesis: The S&P 500 is at all-time highs. New all-time highs are bullish. The “trend is your friend” and the trend is still up.
- The S&P 500 since early 2013. A low volatility, smooth advance and the market quickly recovers from any minor dip.
- The NYSE Advance-Decline line is at new highs, an indication of strong breadth and further gains to come.
Bull Thesis: The wall of worry persists which is contrarily bullish. This has been the most hated bull market in history and until more investors come back in, the market will go higher.
- Despite new all-time highs last week, the CNN Fear & Greed Index is showing a reading of “Extreme Fear.”
Bull Thesis: Seasonality is bullish from here until early September.
- On average, the annual cycle for the S&P 500 shows a bottom in late May and rallies until early September.
The Bear Case
Bear Thesis: The economic expansion is long in the tooth. It will reach 60 months this June versus an average post-war expansion of 58 months. Signs of a slowdown are beginning to emerge.
- Economic growth has come to a standstill, with real GDP at 0.1% last quarter.
- An important part of the economy, Housing, is weakening. The Housing Market Index has moved down to 45, its worst level over the past year and Existing Home Sales have contracted in 7 out of the last 8 months.
Bear Thesis: Quantitative Easing (QE) and zero interest rate policy are no longer helping the economy and the Fed knows this and wants out. The last two times we saw the Fed end QE programs were followed by significant market corrections. Japan has also proven over the past year that endless QE does not necessarily mean stocks only go up.
- In 2010 and 2011, the S&P 500 saw 17% and 21% corrections following the end of QE. With the Fed set to end this round of QE in October, will market participants wait for QE to end or start selling in advance?
- In spite of endless QE and no tapering in Japan, the Nikkei is down over the past year and down -13% in 2014.
Bear Thesis: Stocks are overvalued. If you look at metrics like the Shiller P/E, it shows that the S&P 500 is currently trading at a higher valuation than 92% of other times in history. At the current level above 25, it is predicting lower equity returns going forward.
- The Shiller P/E has only been higher in a few other time periods in history. All of these time periods were followed by weak returns looking out over the next 7-10 years.
Bear Thesis: The Treasury market is warning of a slowdown in the economy. In the fifth year of an expansion, you should not be seeing long duration bond yields falling as they have persistently throughout this year. As bond investors are the “smart money,” this is negative for equities.
- The 30-Year yield has moved down from close to 4% at the start of the year to 3.3% currently.
Bear Thesis: The trend is extended and the market is tired. There hasn’t been a real correction in almost 2 years and we are long overdue. Underlying weakness is widespread with small caps, growth stocks, cyclicals (especially Consumer Discretionary), and housing stocks underperforming.
- The S&P 500 has gone 376 trading days without a cross below its 200-day moving average.
- The Russell 2000 is down over 10% from its early March peak and has given up all of its 2013 relative outperformance versus the S&P 500.
- This is the most persistent weakness in the Consumer Discretionary sector that we have seen since the Bull Market began in March 2009. Similar weakness was seen in 2000 and 2007.
- Homebuilder stocks are telling a very different story than the S&P 500.
Bear Thesis: With the stock market at all-time highs, complacency is high. These extreme bullish levels of sentiment are often followed by below average returns going forward. The market needs a correction to “refresh the fear.”
- Bulls (55.1%) outnumber Bears (19.4%) by 35% in the Investors Intelligence poll, a historically high level of optimism.
- The VIX is at the low end of its historical range.
Bear Thesis: Sell in May and go away. It is Year 2 of an election cycle and we are in the most bearish part of the 4-year cycle.
- Year 2 of the election cycle is typically weak from May through early October.
What’s your Confirmation Bias?
Depending on your current positioning, you were more likely to focus on and agree with either the Bull or the Bear case. This is the essence of Confirmation Bias and as humans we are all inherently biased in this way. Where this can be problematic for investors is when they exclusively seek out information that supports their view, leading to suboptimal investment decisions when they are on the wrong side of the trade. Examples are not hard to come by. We all know of Bears who have remained stubbornly bearish over the past five years, and have done so by only reading bearish-leanings publications. Those with a longer memory will also recall the many Bulls that remained bullish from the 2007 top to the 2009 low by only seeking out bullish-leaning publications.
For our part, having a quantitative process helps us in avoiding the perils of Confirmation Bias. Being a tactical manager also helps in that we are not wedded to a permanently bullish or bearish view. This makes more sense in our view as the markets and relative attractiveness of different asset classes are constantly changing. That is not to say that we are immune to the innate desire to confirm our views, just that such a desire has no effect on our investment decisions.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
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