Behavioural finance analyst Ken Norquay says when you have an investment plan that buys and sells securities in harmony with ever-changing financial risk, your portfolio is safest.
In the 1970s, when I was a rookie financial consultant with Merrill Lynch Canada, my manager used to say: “Do the math, Ken.” He was encouraging me to look at the stock market from the point of view of the numbers, not the stories. Now, in the spring of 2019, I would like to examine a certain mystery in the financial markets by doing the math. First, let us define that mystery by reviewing the financial markets from a “do the math” point of view.
■ US Stock Market: On the first day of spring, 2019, the S&P500 traded at 2,828. The first time it rose to that level was January 22, 2018, 14 months earlier. Since then, the US market has made several dramatic swings, but no progress.
■ Canadian Stock Market: On the first day of spring, 2019, the TSX Composite traded at 16,166. The first time it rose to that level was in December 2017, 15 months earlier. Since then, the Canadian stock market has made several dramatic swings, but no progress.
■ US bond market: US long-term interest rates dropped to their current first-day-of-spring levels in October 2011, eight years ago. Since then, long-term interest rates have made several dramatic swings both up and down, but no progress.
■ Canadian Bond Market: Canadian long-term interest rates first dropped to their current level in January 2018, 14 months ago. Since then, there have been some minor swings up and down, but no progress.
■ US Dollar vs. The Basket of non-US Currencies: The US Dollar first rose from the depressed bank crisis lows of 2008-9 to its current level in February 2015. Now, over four years later, the US Dollar has made a few swings higher and lower, but no progress.
■ Canadian Dollar vs. US Dollar: The Loonie rose from its post-oil-sell-off low in January 2016, to its current level in March 2016. Since that time, three years ago, it has made several swings up and down, but no progress.
■ Gold vs. US Dollar: Gold prices fell from over $1,900 per ounce in 2011 to a low of just over $1,000 in 2015. It then rose to its current level in May 2016. Since then, almost three years ago, it has made several swings up and down, but no progress.
■ Oil vs. US Dollar: Following the oil price sell-off that ended in January 2016, oil first rose to its current level in December 2017, 15 months ago. Since then it has made several swings up and down, but no net progress.
When we ‘do the math’ for these markets, we notice that four of them first rose to their current levels at around the same time: December 2017, January 2018 (14 or 15 months ago). The four are US and Canadian stocks, oil prices, and Canadian bonds.
Question: Was there an economic event at that time that might have caused such a coincidence?
Answer: It is relatively easy to observe the event that caused the stock markets to go flat: the post-Trump election rally. Donald Trump’s election triggered a stock buying spree, a parabolic rise in the US stock market. In a parabolic rise, not only do prices rise, but the rate at which prices rise also increases, producing a speculative blow-off.
In January 2018, that blow-off ended the liquidity-driven bull market that had begun in March of 2009. Then, a slam-dunk February 2018 sell-off was followed by a long, slow rally to modest new highs in September, resulting in the longest bull market in US history. There followed an even sharper sell-off in December 2018, followed by the subsequent slow rally we are experiencing today. The lack of long-term stock market progress was caused by the excessive speculation that followed Mr. Trump’s election.
Answer #2: Canadian house prices also produced a parabolic rise that ended in May 2017. Bitcoin also experienced a speculative blow-off ending in December 2017, 15 months ago. 2017 to 2018 was a time of over-zealous speculation in several markets.
In any free market, excessive speculation always causes a fall. It’s a law of human nature. And, right now, in the aftermath of excessive speculation in the US stock market and the Canadian housing market, we need to prepare ourselves for that fall.
Let’s get back to the math.
Was there any other economic event in the winter of 2017-18 that might have caused these four financial markets to simultaneously lose their upward momentum?
At first glance, there does not appear to be any coincident economic indicator accompanying the winter 2017-18 shift. Was there a lead economic indicator that might have played a part in it?
Consider the bond market, the reflection of long-term interest rates. US bond prices peaked in summer of 2016. In my stock market book, Beyond the Bull, I explain how bond prices lead stock prices. Normally, the bond market peaks about six months before the stock market. But not this time: this time 18 months passed between the peak in bonds and the peak in stocks.
Question: Why did stocks continue upward so much longer than normal? Why didn’t the stock market peak in January 2017, six months after the bond market peaked?
Answer: The Trump election occurred near the end of the six months lead time. That election sparked a wave of speculative excess in the form of a parabolic rise in US stock markets.
In any free market, excessive speculation always causes a fall. Please be ready.
Just be ready
Would you like to do even more math? Let’s look at US money supply growth. (For those who are not economists, money supply is an attempt to measure liquidity in an economy. When the central banks want to stimulate an economy, they try to increase the rate at which money supply is growing. When they want to cool off an economy, they slow down the rate of growth of money supply.)
In autumn of 2016, money supply (M2) growth was about 7%. Now it’s just under 4%. That means the Federal Reserve Board (FED) has been in ‘tight money’ mode since Mr. Trump’s election. That decrease in M2 growth tells us the FED is intentionally cooling down the economy.
Question: What part of the economy was so hot that it needed to be cooled down?
Answer: In the US it was the stock market. In Canada, it was real estate.
In the old days, most stockbrokers were dollar-store philosophers. They expounded their version of wisdom in corny old sayings. The reason money supply and interest rates are so important to stock market investors is that these indicators tell us the intention of the Federal Reserve Board (FED). And the corny saying that relayed the importance of knowing the FED’s intention was: “Don’t fight the FED.” If the FED wants to cool down the economy or the market, don’t resist: align your portfolio with the FED’s intention.
As a general principle, the FED tries to control inflation. Inflation takes various forms and expresses itself as excess speculation in various markets. For example, in the late 1970s and early 1980s, inflation was wide ranging. Its classic expression occurred in the gold and silver boom-bust and the bond market bust. In the 1990s and early 2000, the excess was in high tech stocks and the dot-com boom-bust. Then came US real estate/mortgage bust and the European banking bust.
In any free market, excessive speculation always causes a fall. The central bank’s job is to cool down excesses in the economy and avoid those falls. Don’t fight the FED.
‘The math’ is telling us to be cautious right now: take less portfolio risk. Money managers tell us that risk is inherent in the various investment classes. Stocks are riskier than bonds; bonds are riskier than cash; junior stocks are riskier than blue chip stocks.
But I would argue that, in the stock market, risk is in the minds of the investment community. When ‘the crowd’ is optimistic, risk is high. When ‘the crowd’ is fearful, risk is low.
I would further argue that portfolio risk is in the mind of the individual investor. When you’re not really concerned about risk, you’re in the most danger of losing. When you’re really focused on risk, your portfolio is safer. And when you have an investment plan that buys and sells securities in harmony with ever-changing financial risk, your portfolio is safest.
Ken Norquay, CMT, is the author of the book Beyond the Bull, which discusses the impact of your personality on your long-term investments: behavioural finance. He can be reached at email@example.com.
This is an edited version of an article that was originally published for subscribers in the April 2019/First Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.
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