Authored by Vincent Delaurd via INTL-FCStone,
Melt-Up, FOMO, and Other Climaxes – A Technical History of Good Times
- Many strategists are calling for a year-end melt-up: I believe it already happened
- There have been 76 melt-ups since 1900: the current one is already the second longest on record
- Stocks have achieved a Sharpe ratio of 4.5 this past year – better than 99.7% of the times since 1900
- There is little sidelines cash and leverage levels are high • A re-allocation from bonds into equities could push the market higher
- I’d rather bet on higher rates than on a continuation of this over-extended bull run
Warren Buffett famously joked that “bull markets are like sex. It feels best just before it ends”. Based on my sometimes-unlucky experience of sex and bull markets, I would add another commonality: the climax is sometimes reached before every participant realized that the party had even started.
Market pundits have pumped the notion of a year-end melt-up with quasi sexual frenzy lately. This report will make the sobering case that the melt-up already happened. Defining a melt-up as the combination of new all time-highs and 20% + year-over-year gains, I documented 76 such explosions since 1900. The median melt-up lasted 45 days. The longest and greatest of these jubilations lasted a glorious 320 days. The current climax has lasted 311 days, and counting. This remarkably resilient market Nirvana also featured a 1-year Sharpe ratio of 4.5, enough to break the heart, mind, and soul of the most seasoned hedge fund manager.
Racy jokes aside, I do not want to join the bears which have broken their claws on the back of this soaring bull. Melt-ups alone do not portend future losses: the S&P 500 index has gained an average 6.8% in the year following the 76 prior meltups. Also, bond investors have poured about $10 trillion into bond funds since 2009, and almost nothing into equity funds. Even a small re-allocation could propel the stock market into an unprecedented jubilee.
But I’d much rather play the melt-up game by betting on rising rates, rather than a continuation of this overextended and overvalued equity bull market.
A melt-up is a subjective affair.
What If the Melt-Up Already Happened?
"Melt-up" seems like one of the most overused expression in market commentary these days. Yet, very few analysts bother to define what they mean by the term. The first step to analyze a phenomenon is to define it properly, so here is my suggested definition of a melt-up:
- A 20 % year-over-year gain – or about double the normal market gain
- New all-time highs: melt-ups are born out of optimistic sentiment getting more extreme. Bounces from corrections, no matter how large, do not qualify.
Hence, the start of a melt-event is met when these two conditions (a new ATH on year-over-year gains of 20% or more) are met. It lasts for as long as the market remains above its 6-month moving average. I measured the gain as the maximum price appreciation between the start and the end of the event. Using this definition, there have been 77 melt-ups since 1900. The S&P 500 index spent a total of 16 years in meltup mode, or about 14% of its time. This reflects the extraordinary performance of U.S. stocks, which have returned an annualized total return of 8.1% this past century.
What Could Make the Melt-up Last Longer?
Historical precedents clearly suggest that the melt-up is already behind us. But as the French say, “comparaison n’est pas raison”, and maybe it is different this time. In the short-term, only three factors can push a bull market higher:
1. More money coming into the market
2. Investors taking in more leverage
3. Investors rotating money from other asset classes
Let’s start with #1, sidelines cash. As bulls never tire of repeating, this is “the most hated bull market ever”. It may be so, but there are a lot of fully-invested bears out there. A decade of financial repression has turned cash into trash. Money market funds assets account for just 17% of the assets of long-term funds, a historical low. Similarly, the cash balance of equity mutual funds is at an all-time low 3.3%. Hence, there is not much sidelines cash left to push stocks higher.
How about leverage? Perma-bears love to point that margin debt has risen to a record $550 billion, up from $381 billion at the July 2007 peak. I believe that this statistic is misleading: asset prices are also much higher today, which would allow for higher absolute levels of leverage. Scaling margin debt by market capitalization adjusts for this bias. Margin debt accounts for 2.2% of U.S. stocks’ market cap, slightly above the long-term average.
Then again, margin debt may not be the best measure of leverage these days. Day-traders may use margin debt in their eTrade accounts, but the big boys have better ways to lever up. According a recent and excellent presentation of Fasanara Capital, U.S. corporate debt sored to $5.8 trillion in 2016, almost doubling in five years. Nearly 70% of the new debt issued in Europe and U.S. is “cov-lite” as investors are happy to pile into any instrument that offers a positive yield. Caveat emptor, as the Romans used to say.
The only prospect for significant inflows into the equity market would come from the bond market. According to the Fed’s latest Flow of Funds Report, bond mutual funds took in almost $10 trillion since January 2009, while equity funds have taken less than $1.1 trillion. Hence, it is theoretically possible that an accelerating economy, coupled with a more hawkish Fed and a progressive tightening of global central banks’ liquidity faucets, could convince investors to rotate from bonds into equities.
It is hard to estimate the impact of such a rotation on stocks’ valuations. Over the short-term, more money flowing into the stock market would be bullish. However, equities would eventually be impacted by higher rates – low interest rates and “TINA” have been the main justification for sky-high multiples. I doubt that the S&P 500 index would trade for 22 times earnings if bond yields normalized.
Hence, it is probably safer to play the “great rotation” by betting on higher rates than hoping for an extension of this stretched bull market. As I argued in “the Other, Bigger, ETF Bubble”, bonds are still much more overpriced than equities. At these valuations, I’d much rather be a bond bear than a stock market bull.
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