Actually Returns Are Good When Fund Managers Are Taking Risk

In a previous article, I showed the chart below without the 3 year forward S&P 500 returns. Some bears were claiming the fact that fund managers are taking more risk than ever meant impending doom. As I mentioned, there have been times when the fund managers were very bullish and stocks did well afterwards. The red line supports this point. As you can see, the returns were high 3 years after fund managers were very bullish in 2003, 2009, 2010, and 2013. The takeaway is that this optimism from fund managers doesn’t necessarily mean stocks will crash soon. It’s important to avoid being persuaded by the title of a chart. Instead analyze it in a non-biased fashion to get a better idea of what it says.

Despair From A 1% Fall

The S&P 500 is down 1.15% from its all-time high on November 8th; the bears are celebrating. This would be a normal few days if we weren’t in 2016 or 2017. Shockingly, this is the biggest selloff in about 3 months. It’s tough to draw any conclusions from such a small move. The chart below shows the Bloomberg Fear/Greed index. It must be very sensitive to movement because it has already switched to showing fear as it tests its 50 day moving average. The other popular Fear & Greed Index is put out by CNN. I’ve followed that one for a few years. It shows a 49 reading on a scale of 1 to 100, meaning the market is neutral. This is the lowest reading in a few months. As I mentioned a few times in previous articles, these sentiment readings can crater after small moves. If you are a short term trader, capturing this decline is profitable meaning you should follow these indexes. If you’re a long term investor, these signs of modest fear are great. It means the market doesn’t have much euphoria. I have been talking about how the biggest concern this year is the lack of any pullbacks. If this selloff turns into a 5% correction, that would be a great buying opportunity.

Inventories Rear Their Ugly Head

One of the reasons many investors like me were bearish on the economy in 2016 was because the inventory to sales ratio was near the level last seen during the financial crisis. The part which may have made the prediction futile was that there was a high inventory to sales ratio in the 1990s without a recession as you can see in the chart below. It turns out that the concern in 2016 was somewhat accurate as the inventory to sales ratio is falling in concert with the stabilization of C&I lending growth. The inventory to sales ratio still has further to fall which could mean a decline in C&I lending is coming. The main issue with lending this year has been a lack of demand, not standards being raised to the point where borrowers can’t qualify for them. The slowness in C&I lending was the main concern for investors worrying about a recession in 2016. Since then, the growth resumed and now it’s stabilizing. A return to moderate declines would bring back yellow flags for a recession.

Junk Is Bunk

Many bears have been clamoring over the fact that the junk bond indexes have been falling. They use these trends to make the forecast that stocks will fall. However, that’s not a good idea because the makeup of the junk bond indexes and the S&P 500 aren’t the same. Not surprisingly, the companies that make the most profits aren’t in the same industries as the companies that have the most debt. We saw the telecom sector bring down the junk bond index, but it isn’t a big sector in the S&P 500. The failed Sprint & T-Mobile merger would never be able to affect the S&P 500 because neither firm is in the index. The technology sector is 25% of the S&P 500, but a small part of the junk bond market. Therefore, if you don’t do your due diligence on which high yield bonds you are looking at, you will misinterpret the signal. The chart below shows there’s a direct relationship between the high yield bond market and the stock market when you match the bonds with the stocks. As you can see, in the past few weeks there has been slight weakness in high yield bonds. The stock selloff is more material than the junk bond selloff because the blue square is below the line.

Fed Has Seen A Decline In Academics

The easiest change to see at the Fed is that there will be an emphasis on removing burdensome banking regulations. The regulations that may have been overzealous after the financial crisis because policymakers were overanxious about preventing another crisis will be eliminated which will help the banks. The monetary policy will probably be similar since some hawks, doves, and moderates will be picked. The big question is what the chart below means. As you can see, from 2000 to 2016 there were between 16 and 12 PhDs in the FOMC. That number will fall to 8 when Powell replaces Yellen. This decline is partially because there are so many vacancies. However, if recent precedent continues, Trump will fill them with more economists without PhDs.

I think the lack of PhDs means in times of despair the Fed won’t go with crazy policies like buying stocks or corporate bonds like the ECB and the JCB have done. PhDs tend to think in a creative way which doesn’t have limits. These limits will matter to economists with more business experience as they will probably realize the damage that buying stocks or corporate bonds can do to the free market. In the long run, this is good news as the Fed won’t ruin the free market. In the short run, the fact that no solution which kicks the can down the road will be given could be stressful for the stock and bond markets.