Kass: Can You Handle the Truth About This Market?

As always these are solely my views based on my analysis and observation of the markets. The spread between current market prices and “fair market value” is more stretched than at any time in recent history and the downside risk dwarfs the upside reward.

The Church of What Is Happening Now Has Lost Its Congregation

“Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.”

— Bob Farrell

Breadth has deteriorated markedly and many other technical indicators are signaling trouble ahead. Many talking heads in the business media, investment “communities” (such as redditt, WallStreetBets and Robinhooders) have sold traders and investors a bill of goods by pushing and sanctioning speculative gewgaws (read: SPACs — loaded with unconscionable fees and questionable acquisition strategies that follow high fees — and collateral cryptocurrency plays) because they briefly were dramatically outperformers.

When I was critical and shorted many of these stocks (some that are now down 75% in value) I was ridiculed and criticized. A common refrain: “What, Dougie, these stocks are flying and you obviously don’t want to make money!” Most have swept these idiotic trades under the rug, but what is really scary thing is that they still think they were right.

Heck, even CEOs such as AMC’s Adam Aron have been fooled into suboptimal capital allocation strategies! In my view, he should be fired from his job for kowtowing to a bunch of day traders (the daily volume in AMC’s shares routinely trades near or in excess to its float) and those who supported him should admit their big mistake (they will not).

With their demise, traders and investors (and the entire business media community) have glommed on to Microsoft and FAANG, taking those stocks arguably to inflated levels with “little margin of safety.” Even bona fide antitrust issues (from both Republicans and Democrats) and threats have been entirely dismissed at this point.

The outperformance of these great franchises pose a potential threat to investors in them, for should a broader market decline occur they will become ATMs and could drop swiftly despite the protestations of many who are long them.

Remember, there is a pattern historically of the first becoming the last. In all likelihood we will see that pattern develop again, especially if interest rates gap higher from current levels.

Powell Poops

The Federal Reserve and our undisciplined political leaders on both sides of the pew have produced a potentially lethal and liquid cocktail that has lifted equities, fixed income, art, digital currencies and real estate to levels that are unsustainable and vulnerable.

The Fed is now behind the curve and its hastening readjustment to tighter policy likely lies ahead, and with it will be a hard hit to the markets at a time in which no one anticipates a large market drawdown.

The supercharged Fed put is about to expire.

Please Reread and Consider Bob Farrell’s 10 Rules of Investing

Markets tend to return to the mean over time.

Translation: Trends that get overextended in one direction or another return to their long-term average. Even during a strong uptrend or strong downtrend, prices often move back (revert) to a long-term moving average.

Excesses in one direction will lead to an opposite excess in the other direction.

Translation: Markets that overshoot on the upside will also overshoot on the downside, kind of like a pendulum. The further it swings to one side, the further it rebounds to the other side.

There are no new eras — excesses are never permanent.

Translation: There will be a hot group of stocks every few years, but speculation fads do not last forever. In fact, over the last 100 years we have seen speculative bubbles involving various stock groups. Autos, radio and electricity powered the roaring 20s. The nifty-fifty powered the bull market in the early 70s. Biotechs bubble up every 10 years or so and there was the dot-com bubble in the late 90s. “This time it is different” is perhaps the most dangerous phrase in investing. As Jesse Livermore puts is:

“A lesson I learned early is that there is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again.”

Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.

Translation: Even though a hot group will ultimately revert back to the mean, a strong trend can extend for a long time. Once this trend ends, however, the correction tends to be sharp.

The public buys the most at the top and the least at the bottom.

Translation: The average individual investor is most bullish at market tops and most bearish at market bottoms. The survey from the American Association of Individual Investors is often cited as a barometer for investor sentiment. In theory, excessively bullish sentiment warns of a market top, while excessively bearish sentiment warns of a market bottom.

Fear and greed are stronger than long-term resolve.

Translation: Don’t let emotions cloud your decisions or affect your long-term plan. Plan your trade and trade your plan. Prepare for different scenarios so you will not be taken by surprise with sharp adverse price movement. Sharp declines and losses can increase the fear factor and lead to panic decisions in the heat of battle. Similarly, sharp advances and outsize gains can lead to overconfidence and deviations from the long-term plan. To paraphrase Rudyard Kipling, you will be a much better trader or investor if you can keep your head about you when all about are losing theirs. When the emotions are running high, take a breather, step back and analyze the situation from a greater distance.

Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.

Translation: Breadth is important. A rally on narrow breadth indicates limited participation and the chances of failure are above average. The market cannot continue to rally with just a few large-caps (generals) leading the way. Small and mid-caps (troops) must also be on board to give the rally credibility. A rally that lifts all boats indicates far-reaching strength and increases the chances of further gains.

Bear markets have three stages – sharp down, reflexive rebound and a drawn-out fundamental downtrend.

Translation: Bear markets often start with a sharp and swift decline. After this decline, there is an oversold bounce that retraces a portion of that decline. The decline then continues, but at a slower and more grinding pace as the fundamentals deteriorate. Dow Theory suggests that bear markets consists of three down legs with reflexive rebounds in between.

When all the experts and forecasts agree, something else is going to happen.

Translation: This rule fits with Farrell’s contrarian streak. When all analysts have a buy rating on a stock, there is only one way left to go (downgrade). Excessive bullish sentiment from newsletter writers and analysts should be viewed as a warning sign. Investors should consider buying when stocks are unloved and the news is all bad. Conversely, investors should consider selling when stocks are the talk of the town and the news is all good. Such a contrarian investment strategy usually rewards patient investors.

Bull markets are more fun than bear markets.

Translation: Wall Street and Main Street are much more in tune with bull markets than bear markets.

Where I Stand

On Wednesday I wrote:

“It is important to note that while I believe the S&P 500 Index is measurably overpriced, I am still relatively small in exposure as measured in both gross and net terms.

This reflects (1) my respect for the unrelenting market strength, (2) my attempt to be more reactionary than anticipatory, and (3) a view that there is some possibility of a blow-off top at some point.

I currently think the highest probability scenario is that we are in a relatively narrow trading range with a bias toward profit taking (call it -3% to -5%).”

Bull markets die hard.

But given the ongoing market chaos, the remarkable narrowing of leadership and other technical conditions I am changing my highest probability scenario of a 3% to 5% market decline to a 5% to 10% decline.

Bottom Line

“Market vision is always 20/20 when viewed in the rear view mirror.”

— Warren Buffett

As Bob Farrell teaches us, there are no new eras or paradigms and excesses are never permanent.

Over history, markets reflect the balance between risk and reward. But it seems that we are in this new-world belief where risk doesn’t exist and the rewards are easy to be had.

I am not short enough.

Code Red.

(This commentary originally appeared on Real Money Pro on July 15. Click here to learn about this dynamic market information service for active traders and to receive Doug Kass’s Daily Diary and columns from Paul Price, Bret Jensen and others.)