Small investors have a knack for being in the wrong place at the wrong time. They are always chasing after yesterday’s winners or running away from yesterday’s losers. Here they go again. Last year, the S&P 500 roared ahead 32%, including dividends, and while small investors should think about pulling back, the Wall Street Journal reports that in March, stocks accounted for 67% of employees’ new contributions to retirement portfolios, the highest since March of 2008. Unsurprisingly, it looks as though retail investors are following their tried-and-tested but never abandoned mantra again: “Buy high, sell low.” The big move upward looks like it’s behind us, and the little guy is—as usual—late to the game. On average, the stock market has flattened out this year. Blue-chip indexes are up slightly, but the Nasdaq and small-caps are down modestly. Speculative small-cap stocks are plunging relative to large-cap stocks. So while the Dow is hitting all-time highs, retirement savers have their largest exposure to stocks in more than six years. In March, stocks made up 66% of the assets in the 401ks surveyed by Aon Hewitt, a company that tracks retirement accounts for over a million people at large corporations. That percentage is up considerably, from 48% in February 2009. Many conservative investors regret earning nothing on their bond portfolios over the last five years, and now they’re piling in to make up lost ground. But keep in mind that when the stock market peaked the last time, in October 2007, investors put 69% of new 401k contributions into stocks—just in time for a catastrophe. The S&P 500 went on to lose 57% of its value by March 2009. Thanks to the Fed’s easy-money policies, retirement investors have forgotten about the shellacking they took. If you are one of those people (or know someone) who is sitting on cash and getting ready to pile into stocks, you must read investment veteran David Hunter’s timely piece below. He reminds us of how the last five stock market cycles ended and makes a compelling case that the current bull market is not just beginning, but is exhausted. Enjoy. Doug French, Contributing Editor P.S. Save the date! Another reminder that the Casey Research Summit is coming up soon, September 19-21 in San Antonio, Texas. The team is currently working on lining up a star-studded faculty—the type of top-quality speakers you’re used to from our previous Summits. Sign up now and save up to $400 by taking advantage of our early-bird pricing. Click here for more info and to register. What Previous Cycle Tops Tell Us About Today’s Market By David Hunter, CFA I started working in the investment business in 1973, just prior to the market peak. In hindsight, it was a great time to begin an investment career, as I learned early on the importance of evaluating risk and preserving one’s capital. Watching a market drop almost 50% over an 18-month timeframe was a real eye-opener, and the lessons I learned during that period have stayed with me throughout my career. There have been five bull market cycle tops during my 40 years in this business. Each preceded a recession, and each was unique. However, all five tops shared some characteristics that I think can help us in analyzing current market conditions. I hear pundits suggesting that the current bull market is nowhere near a major top and could have years to run. I don’t agree with this, because I am seeing too many similarities to previous cycle tops. Let’s see what insights we might gain by looking at the similarities and differences between today and previous market tops. Cycle #1 Leader: The Nifty Fifty Prior to the credit crisis of 2008, the 1973-‘74 recession was considered the worst downturn of the post-WWII era. It lasted 16 months, starting in November 1973 and ending in March 1975. Back then, strong money flow into the equity markets came from defined benefit pension funds, and a substantial percentage of this money was managed by a handful of money-center banks, most of which were located in New York. In the latter stages of the bull market, more and more of this money was invested in a concentrated list of blue-chip stocks, which became known as the “nifty fifty.” This list included most of the largest corporations of that time, the leaders of their respective industries. They became known as “one decision” stocks because portfolio managers thought that, given the dominance of these companies, they needed only to buy and hold these stocks, and only rarely would have to make a sell decision. As more and more money flowed into this narrow subset of stocks, the performance gap in favor of the “nifty fifty” widened, attracting even more money into these same stocks. Momentum begot more momentum, and the stocks went parabolic. In hindsight, it’s easy to fault these managers for abandoning valuation principles. But at the time, investor psychology fed the madness, and the portfolio managers bought into the rationale that the valuation premiums were justified given the dominant position these companies held. Of course, as the economy started to slow, so did earnings. Eventually, the market rolled over, and portfolio concentration came back to bite these pension fund managers. While all stocks fell sharply, the “nifty fifty” stocks declined far more than the market. Furthermore, given the concentration, these stocks became very illiquid as the one-direction trade went in the other direction. Not only did these stocks suffer a disproportionate decline in the bear market, their upside movement in the next cyclical bull market lagged considerably, due to overhead resistance caused by investors looking to liquidate their holdings as the stocks moved up. This process continued for many years. Cycle #2 Leader: Energy Stocks The OPEC oil embargo of 1973, when the price of oil quadrupled in six months, was one of the major reasons the economy fell so hard in 1974. It was also an important factor in the inflationary cycle that followed in the late ‘70s. The Carter administration and the Fed made the decision to monetize the increase in oil prices, hoping to limit the damage done to the economy. As the Fed pumped money into the economy, interest rates began to rise, at first gradually, but then more sharply, as we moved into 1978 and then 1979. Inflation was heating up. G. William Miller, Fed chairman at that time, made the mistake of assuming that interest rates were moving up because of a restrictive monetary policy. The reality was that while interest rates were rising, so was the money supply. Miller was too focused on rising rates and failed to understand that money was expanding rapidly and fueling even more inflation. In July of 1979, President Carter appointed Paul Volcker to replace Miller as Fed chairman. Within a month, Volcker had announced a change in policy from targeting rates to targeting money. The purpose was to rein in the money supply and let interest rates go where they may. Almost immediately, rates spiked and continued to rise for the next two years. The Fed Funds rate and Treasury bill rates rose to 20%, and the long bond rate touched 15%. The economy went into recession in 1980, came back out of recession for a few quarters, and then returned to recession. Thus, the 1980-‘82 recession is referred to as a double-dip recession. During the late ‘70s, investors piled into stocks that benefited from inflation. Energy was the hot sector, as were most commodity stocks. Wall Street firms loaded up on oil analysts and oil service and equipment analysts. These guys were as popular then as technology analysts were in 2000. The energy stocks went parabolic, as did gold and silver. Portfolio managers loaded up on these stocks and wanted nothing to do with the slow-growing consumer stocks or utilities. With interest rates and inflation rising rapidly, price/earnings multiples were contracting, and so it was important to select stocks of companies whose earnings benefited from inflation. As the recession lingered, these so-called inflation-hedge stocks came under selling pressure, as once again a group of stocks that was accumulated over a full cycle was liquidated in a far shorter period of time. And as in the previous cycle, these inflation-hedge stocks endured more than a decade of underperformance in the ‘80s and ‘90s, due to the previous concentration and the subsequent distributive selling that took place. Cycle #3 Leader: Consumer Growth Stocks In the summer of 1982, I recognized that the Fed was determined to break the back of inflation, even if it took several cycles. The term disinflation had not yet surfaced, but that was indeed the direction we were headed. Few investors recognized this. The historic rise in inflation and interest rates was still the dominant focus, and portfolios were still heavily weighted in energy stocks. At the time I was able to buy the stocks of the leading food, beverage, tobacco, household product, and pharmaceutical companies at book or near book value, because investors were uninterested in companies that produced steady but slower growth. Over the next decade, these consumer growth stocks became the market leaders, in many cases rising 10- or 20-fold as interest rates and inflation fell from high double-digits into single-digit territory. In 1991, just prior to the next recession, these stocks went parabolic. By the end of 1991, the consumer stock valuations relative to capital goods stocks were well beyond previous records. As in the two previous cycles, the fact that the most popular and most heavily owned stocks had gone parabolic was a sign that the market was nearing another cyclical correction. Cycle #4 Leader: Technology Stocks There was a relatively short recession in 1990-1991, and afterward economists were forecasting several years of subpar growth. Influenced by these forecasts of slow growth, investors remained overweighted in the grossly overvalued consumer growth stocks. They should have been piling into the highly undervalued technology and capital goods stocks. Once again, investors were too backward-focused and failed to anticipate the upcoming cycle—a cycle that would take technology stocks from the most undervalued they had ever been relative to consumer goods stocks, to the highest valuations in stock market history… all in the course of eight short years. As in the previous cycles, the old leadership endured more than a decade of underperformance, as years of accumulation turned into more than a decade of distribution. Forward-looking investors were able to load up on semiconductor and semiconductor equipment stocks, as well as other tech stocks, at or near book value, and watch them appreciate as much as 20-fold in the next eight years. Dot-com stocks became the new darlings, and valuations soared into the stratosphere. One would have thought investors would be wary of parabolic patterns by now, but instead they repeated their mistake and piled into these stocks at valuations never seen before. Predictably, this momentum market crashed and burned like those before it. The Nasdaq fell 78%, peak to trough, between 2000 and 2002, and there were many tech stocks that declined by more than 90%. This time around, we not only had to deal with an economic downturn, but also the traumatic events and uncertainty of 9/11, which added to the volatility. Cycle #5 Leader: All Things Credit The Fed and the Bush administration, anxious to support the economy and help consumers get beyond the terrorism fears, pursued a policy of monetary expansion and easy credit. It spurred a housing and credit boom well beyond any in our history. This time, it was the housing and credit-related stocks that soared and ultimately went parabolic. As most everyone knows, the banks decided that subprime loans were a great way to grow their earnings, particularly since these loans could be packaged and sold to yield-seeking investors who had little understanding of the risks associated with them. Money flowed and real estate prices soared. As home prices rose and interest rates declined, homeowners discovered that by refinancing, they could extract equity from their home, supplement their income, and live a more extravagant lifestyle. Who said there was no free lunch? The banks and other financial stocks soared as their earnings continued to grow with the credit expansion. Homebuilders appreciated many-fold. Restaurants, luxury goods, and other beneficiaries of the free-spending consumers also ran up. The world was wonderful. Until, of course, the music stopped and the inevitable debt reversal began. Wall Street continued to downplay the risks right up until the eve of the worst downturn since the Great Depression. In mid-September 2008, days before the crisis, most every economist was still forecasting a soft landing, with no recession in sight. That is a lesson to be remembered. Once again, most economists, as well as most investors, were blind to a downturn that was right in front of them. Given the tremendous leverage in the system, the unwind was sharp and swift. The financial stocks went into freefall, as these heavily owned stocks faced questions of solvency and substantial operating losses. Just as before, the darlings of the cycle suffered some of the biggest losses in the bear market that followed, and have significantly underperformed the overall market in the subsequent recovery. Cycle #6: We’re Living Through It So what can we glean from all this history that might provide some clues about the current cycle? As we’ve seen, each cycle has its own unique characteristics that will favor certain industries or sectors. As a result, particular stock groups will come to be identified with a particular cycle. The current cycle’s leaders appear a bit more diverse than in the past, but certainly social media, health care, and biotechnology have captured investors’ fancy the most. Note that each of the six cycles, including the present one, was led by different industry groups. It is also worth noting that the leaders in each of the previous cycles always underperformed in the following cycle, and usually by a substantial margin. I expect the same to happen to the current crop of momentum stocks in the next cycle. These momentum stocks usually all follow a similar pattern. As the cycle progresses, they attract more and more favorable attention, the slope of their advance steepens, and they eventually go parabolic. Investors become attracted to these stocks more for their momentum and outperformance characteristics than for their fundamental strengths. Sure, a positive fundamental narrative will accompany the move, but momentum is really drawing the interest. That’s what I meant earlier when I said momentum begets momentum. Unfortunately, it also works in reverse. Once the parabolic slope is broken and the momentum reverses, investors stop accumulating these stocks and start distributing them. Also, once these leaders go in reverse, the broader market will follow. Thus, the recent break in the biotechnology and social media stocks, as well as other popular momentum stocks, is an important signal that the current market cycle is at or very near a peak—and that a cyclical bear market will soon follow. Certainly, other indicators like investor sentiment and margin debt are at levels that have signaled tops in the past. But the reversal of momentum leaders is the surest signal that this market cycle is near or at an end. And given the overconcentration in these market leaders, trying to exit these stocks once the distribution cycle begins will likely prove difficult. Cycles come and go, and every cycle has its own unique story. But investor psychology is ever present, and the late-stage momentum stocks are a manifestation of that psychology. In the end, the shifting back and forth between greed and fear is the primary determinant of market cycles.