View from the bear’s lair

View from the bear’s lair

Now that markets have rebounded back to their highs, we’re hearing a whole lot about the bullish case for stocks. In light of this, I thought it might be helpful to hear from one of the smarter bears.

So, I checked in with John Higgins of the esteemed boutique research firm Capital Economics to learn his point of view.

It comes down to this …

Although the S&P 500 has now rebounded above its previous record high, Higgins does not expect the rally to last. Instead, he forecasts that the index will slump again by year-end.

Split the “fall and rise” in the S&P 500 since its previous closing high on Sept. 20 last year into three phases, he says.

The S&P 500 is now trading right where it was on Sept. 20.

At the outset of the first phase, concerns grew that the Federal Reserve would kill off the recovery at home against a backdrop of weak demand abroad if it tightened policy further. So stock prices fell sharply. Investors sent the Fed a message not to overdo it by factoring out more rate hikes.

In the second phase, they were reassured by the Fed’s pledge to be “patient.” So stock prices rebounded. Investors even began to price in monetary easing.

Finally, in the third (current) phase, interest-rate expectations have rebounded a bit, without derailing the stock market. This is presumably because the Fed has not changed its tune, and because growth in the U.S. and the rest of the world — where S&P 500 firms make many of their sales — has begun to stabilize.

Higgins does not expect this third phase to last …

This is partly because he thinks the Fed has not “saved the day” and that the U.S. economy will struggle … even as it eventually cuts rates by more than investors are projecting.

And it is partly because he thinks that growth in the rest of the world will not bounce back.

He notes that the S&P 500 would continue to climb if a drop in earnings were more than offset by a rise in the index’s price-to-earnings ratio. But he observes that the last time this happened during an earnings contraction was in the late 1980s and early ’90s, when the starting level of the P/E ratio was lower than it is now.

Finally, he doubts that a resolution to the trade war between the U.S. and China would prevent the S&P 500 from coming under fire again. For a start, the recent weakness in the economies of both countries has had little to do with protectionism. And in any case, a lot of optimism about an end to their dispute now seems to be discounted in the markets.

The upshot is that he is sticking to a forecast that the S&P 500 will end 2019 at 2,300, which is more than 20% below its level now, before recovering in 2020 as the Fed’s policy easing rekindles investors’ appetite for risk.

Play on.

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Mom and Pop Still Glum

Despite the epic strength of the market this year, the individual, mom-and-pop investors in the AAII survey are anything but bullish. Even with a new all-time high in the S&P 500, there are fewer than 35% bulls in this week’s survey.

Following similar “wall of worry” moments where individual investors shunned a market at new highs, stocks have tended to do well. Six months later, they were up 82% of the time, averaging 6.1%, according to research by Jason Goepfert at

Hedge Funds Glum, Too

Hey mom and pop, you have some pretty high-falutin’ company. observes that hedge funds have been incredibly hesitant to buy into this rally. In fact, they are betting this has been a rally for suckers.

Macro hedge funds and commodity trading advisers tend to use trend-following strategies. But clearly some of those programs are still considering the trend in equities to be negative. These funds are still net short the stock market, says.

Equity hedge funds tend to be consistently net long, weighting their long ideas more heavily than shorts. But lately, they’ve maintained net exposure at the lowest level of the past five years.

Over the past few years, extremes in exposure among these equity-only funds have been particularly contrary, suggesting this is a good sign for stocks here, the analysts argue.

Even funds that traditionally don’t correlate as much with the stock market are showing very low implicit exposure.

Market-neutral funds, which employ strategies like arbitrage, are net short for one of the few times since the financial crisis. While less correlated to stock than other strategies, this has mostly been a good sign.

Looking at the entire broad-based universe of hedge funds, the analysts say, it’s been seven years since the professionals had exposure this low to stocks.

Goepfert concludes that our response should not come in the form of mocking the masters of the universe for being really wrong and assuming that now they have to buy stocks to catch up.

Most of these strategies became very defensive in 2007-’08 even when stocks attempted rallies, and ultimately, they were rewarded when stocks finally crashed.

Still, the long-term record across these strategies is contrary. When funds are heavily exposed, stocks tend to decline; when they’re lightly exposed or net short, stocks tend to rally.

Don’t get too smug, as smart money got that way for a reason. But for now, full-bore bulls appear to be in strangely in short supply — which is good from a contrarian point of view.

Best wishes,
Jon D. Markman

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