Was last week the beginning of something worse? … three “euphoria” signals … John Jagerson and Wade Hansen remain cautiously bullish
Last week’s chaos surrounding the Reddit-traders, GameStop, and the Robinhood trading platform overshadowed something important …
The S&P fell nearly 3.5%.
Now, this isn’t a colossal drop by any stretch of the imagination. Historically, such a decline is well within the range of normal market volatility.
However, when we view this pullback through the lens of what else is happening in our world, it feels bigger. And it prompts a question …
Is this the start of something worse?
Today, stories of “investor euphoria” abound … stock valuations are amongst the highest in history … the economy still faces stiff headwinds … a vaccine rollout — while promising — is experiencing hiccups … and all of this is happening against, as I heard it called recently, an American “bull market in anger.”
From this perspective, we’d be wise to examine even a 3% drop with greater scrutiny.
Today, we’ll do this with the help of our technical experts, John Jagerson and Wade Hansen.
In Strategic Trader, John and Wade combine options, insightful technical analysis, and market history to trade the markets, whether they’re up, down, or sideways.
In their update from last week, John and Wade looked at the “froth” in the market, as many news outlets have been calling it. They also provided their two cents about whether this market is about to roll over, or keep churning higher.
Today, let’s dive into these details as we see how our technicians are viewing the issues that matter to your portfolio.
***What market “froth” is really telling us
Let’s jump straight to John and Wade and their latest update:
Over the last week or so, we have noticed the press (and traders in general) throwing out the term “froth” when describing recent market activity.
“Froth in Retail Options Markets Now Dwarfs Levels of August Boom” — Bloomberg
“Tencent bulls are betting on both froth and fundamentals.” — Reuters
“The danger for those of us calling out frothy markets isn’t only that high prices could be justified by fast-growing profits, but that bubbles can always become more extreme.” — The Wall Street Journal
“A red-hot reception for initial public offerings may offer another sign of froth in a rallying stock market.” — MarketWatch
The term is a catchall for irrational volatility (usually bullish) that isn’t backed up by the underlying fundamentals …
So, is froth a sell signal?
No.
Or at least it’s not a very good one. However, we would argue that it is an important indicator to help us manage risk exposure.
Now, even though John and Wade don’t view “froth” as a sell signal, they do write that there are other signals today indicating that market euphoria is getting out of control. They then walk through three examples.
Here’s what they’re watching.
***Signal #1: Small retail traders creating feedback loops
As you’re likely aware, Gamestop (GME), Blackberry (BB) and AMC (AMC) all experienced dramatic short squeezes last week as the Reddit-traders mobilized in unison.
Here’s John’s and Wade’s take:
The reason that last week’s short squeezes are a concern is that they are being driven by an organic rush of small, individual traders who are chasing momentum rather than any legitimate news …
The short squeezes aren’t limited to a few heavily shorted retail companies either. There are more and more penny stocks traded outside the normal exchanges that are doubling (or halving) in just a few minutes lately.
The available evidence strongly points to a large number of very small traders who are distorting prices. Sounds familiar, doesn’t it?
As I write Monday morning, the saga continues. GameStop stock is down 30%, but it’s still trading above $225 per share.
Meanwhile, it appears the Reddit-traders now have silver in their crosshairs. On Friday, nearly $1B flowed into iShares Silver Trust (SLV), which is the world’s largest ETF backed by silver.
The precious metal is trading roughly 9% higher as I write.
***Signal #2: Financial “innovations” absorbing capital flow
John and Wade begin explaining this point by looking back to 2008.
Leading up to the global financial crisis crash, traders were cannibalizing the market by buying Mortgage-Backed Securities (MBS) and Credit Default Swaps (CDS) on those securities.
Back to John and Wade:
These assets had the hallmarks of classic bubble investments. They were difficult to trade, complex, poorly understood by most professionals and had asymmetric risk.
These days, we have Special Purpose Acquisition Companies (SPAC) popping up all over the place with very similar problems that caused the MBS/CDS crisis.
There are even SPAC ETFs now for traders who want to invest in a pool of these companies that have no operations and exist only to potentially acquire some other firm and launch it as a public company or complete some other financial transaction.
Since no company would ever willingly sell itself to a SPAC for less than it was worth, these are almost guaranteed money-losers for the investors on average. And yet the funds are flowing in.
John and Wade highlight how there has been more than $18 billion raised by SPACs in just the first three weeks of 2021. That puts the market on track to set new all-time record.
That alone is noteworthy. But what’s interesting is how the overall perception of SPACs has changed over the years.
Back to John and Wade:
We remember when the ancestors of these kinds of companies operated on the shadier side of the financial world. So-called “blank check” companies and reverse mergers had a pretty bad reputation for positive returns for anyone who wasn’t collecting fees from the transactions themselves.
And the amount of fraud associated with the old companies led to big crackdowns on the industry in the 1980s and 1990s.
I would guess that “fraud” isn’t even in the top 25 adjectives most investors would use to describe SPACs today. Rather, they’re one of the most in-demand investment vehicles in the market.
***Signal #3: Rich valuations
Here in the Digest, we’ve highlighted today’s historically-high valuations on repeated occasions. John and Wade echo this point — but then things take an interesting turn:
… there are a few key differences with valuations today versus prior bubbles, which we think help justify our “wait and see” strategy.
For one, corporate profits have staged a surprising comeback.
As you can see in the following chart, the St. Louis Fed is tracking corporate profits (even with capital consumption and inventory adjustments) back to pre-pandemic levels.
This is very unlike the crashes in 2001 and 2008 where the recovery took much longer.
Fig. 2 — Corporate Profits — Chart Source: FRED & St. Louis Fed
Also, interest rates are very low and fiscal stimulus is very high, which is supporting profits (and probably helping to fuel the bubble) in the short term.
We don’t know yet whether these measures can bridge the market all the way until the economy and employment normalize or not, but it gives us another reason to maintain bullish exposure to stocks.
***It’s not time to get out of the market, according to John and Wade
To paraphrase an old quote attributed to John Maynard Keynes: The markets can remain frothy longer than you can remain bullish.
Yes, signs of froth abound. But as John and Wade have noted, “froth” doesn’t mean “sell,” and there are still plenty bullish factors at play.
I’ll let the Strategic Trader give us the bottom line:
… for now, we feel that the risks are offset by the potential for income. Our plan continues to be remaining flexible about our exposure with contingency plans to take advantage of any declines.
Market conditions don’t look good for chasing some of the runaway stocks and sectors where risk is the highest, but there are plenty of opportunities in other areas.
Have a good evening,
Jeff Remsburg
