Amazingly, valuations and concentrations continue to grow. While investors are benefitting today, there are always consequences down the road.
That serves as the inspiration for this week's musings, the 1987 movie, "The Princess Bride." This is one of my favorite movies and star-studded to be sure.
This movie was a moderate success by 1980s standards. The budget was manageable at $16 million and garnered more than $30 million at the box office. However, the film has reached borderline "cult" status with its popularity after the fact.
The role of Inigo Montoya has been cited by Mandy Patinkin as his personal favorite of all the roles in his career.
Director Rob Reiner and actor Cary Elwes would have to leave the set during filming Billy Crystal's Miracle Max scenes because they would laugh so hard.
The "Dread Pirate Roberts" referred to in the movie existed in real life. Bartholomew Roberts, also known as Black Bart, operated in the Caribbean in the 18th century.
Actors Cary Elwes and Mandy Patinkin performed all of their own sword-fighting after many hours of training. Only the one flip was performed by Elwes' stunt double.
Here's what we've seen so far this week..
Inconceivable. While stocks do have an upward long-term bias, stocks can, in fact, go down. Like the character Vizzini in "The Princess Bride" who continues to use the word "inconceivable" when faced with results he did not expect, investors should be taking the approach of Inigo Montoya who said, "You keep using that word. I do not think it means what you think it means."
Over the past two years, stocks have been on fire, but there are headwinds that may affect stocks later this year. For now, it appears the FOMO trade may be still intact. While it's still early in 4th quarter earnings season, so far, 79% of S&P 500 companies have reported earnings above estimates. While AI and Mag 7 have been all the rage, even those companies outside of Mag 7 have produced solid earnings. To-date, companies not in Mag 7 have generated earnings growth of at least 9.7%. Even among the S&P's top 10 earnings contributors, a few are outside of Mag 7 - such as J.P. Morgan, Citigroup, Bank of America, and Merck.
Despite stretched valuations and concentrations within the indices, earnings drive stocks. As long as earnings continue at the current pace, it's likely stock prices will follow. But for how long? When we look at anomalies, it's easy to see several that would make you want to scratch your head. For example, the Nasdaq 100 has traded for 467 consecutive trading days above its relative 200-day moving average. That marks the 2nd longest period going back to 1998. During the Dot-com era, the index only traded above its 200 DMA for 400 consecutive trading days.
From 2016 to 2018, the index achieved its longest streak above the 200 DMA with 572 consecutive days. So, what does that mean for 2025? The index was very close to losing the current streak in August of last year. Given the fact that we've had two years of relative low volatility and the third year of a bull market tends to under-perform the previous years, it's highly likely the streak could end this year. That doesn't mean that the index would end the year in negative territory, but a considerable pullback is probably overdue. If we also consider the movement in bonds, there is additional room for concern. The world's bell weather bond, the U.S. 10-year Treasury, has been on a losing streak of late. In fact, it's had its worst performance trend in the past 90 years. Much of this has to do with what the Fed has done with regard to fighting inflation. However, the fact that the government flooded the market with easy money during COVID, investors have been acting like stocks can't go down, leaving bond in unpopular territory. However, trends eventually reverse or revert to the mean which should also give equity investors who have piled into stocks with heavy concentrations pause about markets moving forward. Is it inconceivable that bonds and equities could switch places later this year?
Prepare For The Road Ahead. We have been pounding the table over the past few months that investors should take profits in concentrated equities and get more diversified. This doesn't mean to get out of the market, but allocations at this point should match long-term risk profiles. For the majority of "The Princess Bride" the audience is hopeful that Montoya will finally face his father's killer.
In the end, even though he is faced with adversity, he is able to look the killer in the eye and say, "Hello. My name in Inigo Montoya. You killed my father. Prepare to die." When investors are no longer fearful, they usually get themselves into trouble. Thankfully, we have some tools to measure volatility and can recalibrate our portfolios to match our reasonable risk tolerance. For example, the VIX has been trading well below its average the past two years. When we compare the VIX versus the sentiment indicator, AAII Bulls, we get some interesting results. The American Association of Individual Investors provides a weekly survey to investors to determine how bullish they are on stocks over the next six months.
When that sentiment index rolls over, as indicated in the chart, volatility (VIX) typically picks up - with the only two exceptions being 1992 and 2004. The AAII Bulls index most recently rolled over in October of last year, which may indicate that higher volatility could be on the horizon. So what should investors do? Consider moving into those asset classes where valuations may not be as much of a concern, as volatility will certainly harm highly appreciated assets that are over-valued most. The asset classes to the far right of the chart as shown were already over-valued relative to historical standards at the beginning of 2024 and have only worsened since. Conversely, asset classes on the left of the chart are more reasonably priced or are under-valued.
This is where investors can recalibrate their portfolios by taking profits in those asset classes that are over-valued and look to under-valued classes that could have higher upside potential or, at worst, less downside risk potential moving forward. In addition, rebalancing after periods of excessive gains can also help keep things in perspective and reduce risk over time. With the considerable gains in equities over the past few years, a 60:40 portfolio that is not rebalanced would have a very different risk profile than when it was initially implemented. If an investor allocated to a 60:40 portfolio in 2019 and did not rebalance over the past 5 years, their current mix would have gone from 60% equity to 74% equity just with the appreciation in the stock market. The downside risk of a portfolio with 74% in equities is much different than a portfolio with only 60% in equities. Investors have a window of opportunity to stay invested, yet prepare for increased volatility.
Here's the famous scene with Billy Crystal as Miracle Max...
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Disclosures
The information contained herein is for informational purposes only and is developed from sources believed to be providing accurate information. The opinions expressed are those of the author, are for general information, and should not be considered a solicitation for the purchase or sale of any security. The decision to review or consider the purchase or sell of any security should not be undertaken without consideration of your personal financial information, investment objectives and risk tolerance with your financial professional.
Forecasts or forward-looking statements are based on assumptions, may not materialize, and are subject to revision without notice.
Any market indexes discussed are unmanaged, and generally, considered representative of their respective markets. Index performance is not indicative of the past performance of a particular investment. Indexes do not incur management fees, costs, and expenses. Individuals cannot directly invest in unmanaged indexes. The S&P 500 Composite Index is an unmanaged group of securities that are considered to be representative of the stock market in general.
Past Performance does not guarantee future results.
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