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Why Stocks Can Make New All-Time Highs

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Three reasons the 'Spring Switch' may be upon us.

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MINYANVILLE ORIGINAL

There are those who look at things the way they are, and ask why... I dream of things that never were, and ask why not?
-- Robert Kennedy

Let's face it, folks – we live in a world of zero interest rates, making our checking and savings accounts utterly worthless from the standpoint of earning any kind of inflation-adjusted return. We can thank the financial crisis and subsequent fallout for that. What does money do when it earns no interest? Well, in a bid to simply keep up with the rising price of goods, it takes "risk" to earn that return it can't get sitting around in a bank.

The primary way of measuring risk in stocks is beta, which is a fancy term for the sensitivity a particular equity issue has relative to a broad market average like the Dow Jones Industrial Average (^DJI). High beta stock tends to have more violent price swings.

In bonds, the primary way of measuring risk is duration, which is like beta in that it serves as a gauge of a bond's sensitivity to interest rate changes. A longer duration means bond prices and yields fluctuate more wildly in response to changing interest rate expectations.

It is clear from numerous sentiment surveys that no one likes stocks. It is also clear that the "negative narrative" is very seductive, as the world seems to "understand" exactly how Europe's crisis will play out (for a good explanation of this, check out this video). Psychology studies show that when you explain something in a narrative, the human mind tends to overestimate the odds that the story plays out the way its told. It rarely does. Yet, this alone likely explains why bond yields in the US Treasury market are at panic low levels, under the Fed's inflation target of 2%. Note that this is not just a US phenomenon; the UK, Germany, Finland, and Australia are all yielding record lows on their respective 10-year debt. Never mind Japan – the negative narrative has gone global.

Exactly when the Spring Switch happens is, of course, a major unknown. After all, it may not even happen in the spring. However, every day that goes by that pushes bond yields even lower in the face of a resilient stock market makes the odds higher and higher that the "Great Re-Allocation" will happen sooner rather than later.

There are three primary reasons to believe the Spring Switch may be upon us shortly.

First, sentiment surveys alone indicate that from a contrarian standpoint, it will likely be hard to not believe in the Spring Switch. The recent American Association of Individual Investors Sentiment Survey shows that expectations put a continuation of the bull market at 25.4%, down nearly 10 points, hitting the lowest level of optimism since late September 2011 just before the Fall Melt-Up and October low took place. Investors with a bearish view of the market came in at 42.1%, up 13.6% from last week.

This is not the only sign of stunning bearishness that is being expressed now by the crowd in the face of still elevated stock prices. The second reason relates to the fact that the equity/put call ratio is at its highest levels since the mid-August lows. A high put/call ratio means traders are bidding up the price of protection against a significant decline and are likely underestimating the potential for a significant advance. Complacency has transformed into paranoia over a repeat of the Summer Crash of last year. This means that, at some point, the seeds of fear might not bud, allowing stock markets to potentially grind higher in the coming months.

Third, the Spring Switch may occur purely because of where we are in the presidential cycle. If history can be a road map for our future destination, let's examine election cycle patterns to gain an understanding of why a seasonal sell signal in May may not be the right strategy this time around (see this video for more on the Sell in May strategy and a counterpoint to it). The following chart of the Democratic presidential cycle signifies the potential for the recent stock sell off to transform into a May buying opportunity. Moreover, dating back to 1926, the most powerful months for equities during an election year are June (1.63% average return), July (2.22% average return), and August (3.62% average return).



To sum it all up? There is no doubt that European situation remains a problem, and that the negative narrative remains a powerful reason to not believe in the stock market. Bonds have indeed performed well since early April following the best first quarter in decades for risk assets.

But the fact that (so far) US markets have been resilient is very telling. Sentiment and history remains on the side of the bulls, who may in one "aha!" moment decide to flip the "Switch" on the Spring Switch from bonds to equities once and for all.
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No positions in stocks mentioned.
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