As expected the markets rallied out of the gate Tuesday morning as mutual funds"window dressed" portfolios for the end of quarter reporting period. Outside of that, it has been fairly boring with both "bulls" and "bears" having settled into a staring contest waiting to see who blinks first.

In this past weekend's missive I went into detail about the technical deterioration of the markets overall.  Specifically, I noted that:

"While the S&P 500 has held its ground in light of the reduction of liquidity by the Federal Reserve, the internals of the market are beginning to show signs of weakness.  The 10-week average of the number of stocks on bullish "buy" signals has deteriorated as markets have marched higher. While such deterioration does not mean that a major market correction is imminent, it is a "symptom of an increasing illness" that needs to be monitored closely."

"The same goes for the net number of stocks hitting new highs.  (The chart below is smoothed with a 50-week moving average of net new highs)"

Despite this technical deterioration, the "bullish vs. bearish" argument continues. 

The Bullish Bias

The bulls currently have the "wind at their backs" as the ongoing push of liquidity from the Federal Reserve, combined with artificially low interest rates, have kept the "carry trade"alive and well. 

As shown below, the bullish trend has remained firmly intact since the onset of QE3 which brings two Wall Street axioms into play:

1) Don't Fight The Fed

2) The Trend Is Your Friend

Of course, the primary goal of the Federal Reserve's monetary interventions was to boost asset prices in order to stimulate economic growth, employment, inflationary pressures and consumer confidence. There is little argument that the Fed achieved its goal of inflating asset prices as the "bulls" have drunk deeply from the proverbial "punch bowl."

The continuous and uninterrupted surge in asset prices has driven investors into an extreme state of complacency. The common mantra is the "Fed will not let the markets fall" which has emboldened investors to take exceptional risks. The chart of volatility shows again that bulls remain clearly in charge of the markets currently.

Furthermore, while recent economic data has had a mildly positive tone to it, the overall data has been weak enough to persuade investors that the Federal Reserve will not begin rapidly tightening monetary policy any time soon. A continued easy Fed, low-interest rates and mild inflation is believed to be the key for a sustained bull market in the years ahead.

The Bearish Perspective

The bears counter the bulls with rational perspectives as well. 

Valuations, by all historical measures, are expensive. While high valuations can certainly get higher, it does suggest that future returns will be lower than in the past.

That statement of "lower future returns" is very misunderstood. Based on current valuations the future return of the market over the next decade will be in the neighborhood of 1.5%.  This DOES NOT mean that the average return of the market each year will be 1.5% but rather a volatile series of returns (such as 5%, 6%, 8%, -35%, 15%, 18%, 8%,6%,-17%) which equate to an average of 1.5%. Of course, as discussed yesterday, the declines are met by "panic selling" which makes forward long term returns far worse.

The bulls have continually argued that the "retail" investor is going to jump into the markets which will keep the bull market alive. The chart below supports the bears case that they are already in. At 30% of total assets, households are committed to the markets at levels only seen near peaks of markets in 1968, 2000, and 2007.  

Lastly, the number of individual and professional investors that are bearish on the financial markets currently is at some of the lowest levels on records. The dearth of"bears" is a significant problem. With virtually everyone on the "buy" side of the market, there will be few people to eventually "sell to." The hidden danger is that with much of the daily trading volume run by computerized trading, a surge in selling could exacerbate price declines as computers "run wild" looking for vacant buyers.

Managing Past The Noise

There are obviously many more arguments for both camps depending on your personal bias. However, it is YOUR personal bias that is most important as one of the "Cognitive Biases" that impair investor returns over time is "confirmation bias." 

"Confirmation bias, also called myside bias, is the tendency to search for, interpret, and remember information in a way that confirms one's preconceptions or working hypotheses. It is a systematic error of inductive reasoning."

Therefore, it is important to consider both sides of the current debate in order to make logical, rather than emotional, decisions about current portfolio allocations and risk management.

Currently, the "bulls" are still well in control of the markets which means keeping portfolios tilted towards equity exposure.  However, the deterioration in mid-cap, small-cap, international and emerging markets suggests that equity exposure be shifted towards primarily large capitalization holdings.

However, the "bears" concerns are also valid and while their case has yet to mature, it does not mean that it won't. Unfortunately, by the time the "herd" is alerted to a shift in overall sentiment, the stampede for the exits will already be well underway. 

Importantly, when discussing the "bull/bear" case it is worth remembering that the financial markets only make "record new highs" roughly 5% of the time. In other words, most investors spend a bulk of their time making up lost ground.

The process of "getting back to even" is not an investment strategy that will work over the long term. This is why there are basic investment rules that all great investors, in one form or another, have espoused when discussing the importance of portfolio and risk management.

1. Sell positions that simply are not working. If they are not working in a strongly rising market, they will hurt you more when the market falls. Investment Rule: Cut losers short.
2. Trim winning positions back to original portfolio weightings. This allows you to harvest profits but remain invested in positions that are working. Investment Rule: Let winners run.
3. Retain cash raised from sales for opportunities to purchase investments later at a better price. Investment Rule: Sell High, Buy Low

These rules are hard to follow because:

1. The bulk of financial advice only tells you to "buy"
2. The vast majority of analysts ratings are "buy"
3. And Wall Street needs you to "buy" so they have someone to sell their products to.

With everyone telling you to "buy" it is easy to understand why individuals have a such a difficult and poor track record of managing their money.  

The "bull/bear" debate is quite pointless. In fact, it is quite dangerous as individuals fall prey to their own "confirmation bias." The reality is that both camps are subject to thebroken clock syndrome, and eventually being biased to one or the other will hurt you.