Stock Markets Overheated - Consolidation Expected

Stock markets are overheated - consolidation expected, the mainstream press and its investment recommendations - why is it so often wrong, gold before new all-time highs.

Chart of the Week

The graph shows the average return of the S&P 500 in the fourth year of a president's term who is standing for re-election (black since 1949, blue excluding the Covid election year 2020). The current year's return of the S&P 500 is shown in green.

Why This Matters

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Election years are usually quite good for the stock market in the USA. Candidates often promise new investment programs or tax relief to their voters, which leads to a positive stock market sentiment.

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However, the S&P 500's return has already risen by 7%, which is much more than usual. If this pace continues, the markets would gain 42% by the end of the year.

It is highly probable that we will enter a consolidation phase in the coming weeks. Many other indicators, which we will explain below, lead to the same conclusion.

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Stock Markets Overheated - Consolidation Expected

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The graph shows the S&P 500 compared to the ISM in the USA. The ISM Manufacturing Index, also known as the Purchasing Managers' Index (PMI), is a monthly indicator of economic activity in the USA, based on a survey among purchasing managers of more than 300 manufacturing companies.

Historically, this has been one of the most reliable leading indicators. In 2023 and 2024, the S&P 500 has significantly decoupled from the ISM. A consolidation or adjustment of the two indices is expected.

The reason for the decoupling lies in the trend of Artificial Intelligence. Companies like Microsoft, Google, or NVIDIA, which benefit greatly and dominate the stock market, are not included in the ISM since they do not belong to the manufacturing sector. Optimists argue that the ISM is therefore outdated and loses its predictive power. However, we are not convinced by this argument.

Warren Buffett is one of the most successful investors there is. Anyone who entrusted Warren Buffett with USD $1,000 in 1962 would have a fortune of USD $48 million today.

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The graph shows the Warren Buffett Indicator. The indicator is strongly in the overvaluation area, which also indicates a consolidation of the markets. This is probably also the reason why Warren Buffett's investment vehicle, the holding company Berkshire Hathaway, has one of the highest cash reserves in its history at USD $162 billion and is currently not investing.

The Buffett Indicator, also known as market capitalization to Gross Domestic Product (GDP), has gained significance as a long-term stock valuation indicator, mainly due to Warren Buffett's endorsement. In an interview with Fortune Magazine in 2001, Buffett described the indicator as "probably the best single measure of where valuations stand at any given moment".

To calculate the Buffett Indicator, the total market value of all publicly traded stocks of a country is divided by the country's GDP. By comparing the size of the stock market with the total economic output, this ratio provides insight into the market's relative valuation.

When measuring the risk appetite of investors, credit spreads are often looked at. This is the difference in yield between government bonds and riskier corporate bonds. If this difference is low, it indicates that investors are greedy and underestimate risks.

The graph shows the difference between B-BB bonds and government bonds. Bonds are rated based on the creditworthiness of the issuers. The best rating is AAA. The scale then goes down to AA, A, BBB, BB, B, and C. Depending on the rating agency, the scale might vary slightly. Pension funds and foundations are legally allowed to buy only higher-rated bonds (Investment Grade, AAA to BBB) in most cases.

The graph thus shows the credit spreads of lower quality bonds, just below the Investment Grade rating. Investors are currently willing to take on high risks for a very low premium. Normally, this is a bad sign and signals a market turnaround.

The Mainstream Press and Its Investment Recommendations - Why Is It So Often Wrong

To look at the long-term success of the mainstream press in investment recommendations, one often looks at the covers of Time Magazine or The Economist. These two magazines have been around for a very long time.

The graph shows the development of the S&P 500 from 1995 to 2020 and highlights some of the covers and main headlines of Time Magazine.

After a 30% correction in 1998, the headline was "Is the boom over?". Not really. In the following two years, the stock market rose by 58%.

The financial crisis began in 2007, and stock markets fell by 50%. Then in 2009, the headline was "The new hard times". However, these were not so hard. In the following 5 years, the stock market rose by 170%.

Numerous other examples can be added.

But why does such a respected magazine with trustworthy journalists often get it so completely wrong?

This is due to two points. The markets themselves and how the press decides on headlines.

Stock markets are both very complex and very simple. They are a place where people buy and sell things. If more people are buying than selling, prices go up; otherwise, they fall.

The market can be divided into 6 layers of buyers, who invest in a new trend in the following order:

• Hedge Funds
• Institutional Investors
• Pension Funds
• Banks for investment mandates
• Informed Private Investors
• Mainstream Press Readers
• Taxi Drivers

So, when the mainstream press publishes a headline "Markets at Record Highs - Why Investing Still Makes Sense", caution is advised. After the readers of this article have bought stocks, only the taxi drivers are left.

If you take a taxi and the driver asks, "You look like a banker, do you have any investment tips?", it's time to sell. The first investors, such as hedge funds and institutional investors, begin to take profits, and there simply are no more investors left who haven't already invested.

We are therefore critical of the current cover of The Economist magazine:

In 2020, just 2-3 weeks before the 30% crash due to the Covid lockdown, the headline was why one should continue buying technology stocks. A typical example as mentioned above.

This week, the headline is "How High Can Markets Go?". Our answer: Probably not much longer.

The second point for the poor predictive power may be based on how the press operates:

Every piece of information is checked and at least three sources are sought to confirm a statement. Therefore, for a new article, the press calls their contacts among institutional investors or banks to verify whether there is indeed a new trend. Journalists receive this confirmation relatively late in a trend.The mainstream press sets the front page based on what they think will interest many and thus boost sales. If all investors have made losses, a negative front page will often sell better than a positive one.There is also a way to observe the sentiment of buyer layers without looking at magazine covers.

Hedge funds are very opaque. There is a paid site that provides insight. However, there is a good internet site that looks at the entire market and all buyer layers. That is the CNN Money Fear and Greed Index.

The first graph shows the current state of the index, and the graph below shows the timeline. The numbers are solidly calculated, with subindicators like momentum, price strength, market breadth, put/call ratio, volatility, and junk bond demand.

Currently, we are in the highest category but not quite at the maximum. Investors are greedy and careless. This means they forget about risk management. Normally, this is a harbinger of a correction.

Another good source is the AAII, an organization for individual investors (American Association for Individual Investors).

The graph shows a survey among individual investors about their investment sentiment. The number of bulls (investors expecting rising markets) is almost twice as high as the share of bears (investors expecting lower markets).

An additional free source is the NAAIM (The National Association of Active Investment Managers), i.e., the association of actively investing asset managers.

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The graph shows at the top/left the value of a survey among institutional investors (who are members of NAAIM) and at the bottom/right the price development of the S&P 500. The index has excellently recognized the lows from October 2022 and November 2023. This index also suggests that markets cannot rise forever.

Gold Price Close to New All-Time High

The gold price is about to surpass the highest value of August 2020 and May 2023.

The graph outlines the two major gold rallies since 1970 and the main arguments that led to the rallies at those times.

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What currently speaks for gold, in our opinion, are primarily the following points:
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• Decreasing gold production

• Central bank purchases of gold

• State deficits worldwide at new highs

• Possible recession

• Geopolitical uncertainties

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The graph shows that central banks have been steadily increasing their gold share since 2012. We expect them to continue doing so in the future.

Having a 5% gold position in the portfolio can't hurt. However, one point to note is that gold is traded in USD, and there is a currency risk.

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