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News, research and market insights from our team of experts.
“Bull markets are...
Born on Pessimism,
Grown on Skepticism,
Mature on Optimism,
And Die on Euphoria.”
- Sir John Templeton
Anatomy of a Melt-Up
Coming into 2018 investor enthusiasm had clearly slipped into a new gear. With the global economy finally hitting on all cylinders and corporate earnings running strong, President Trump’s year-end tax reform was the final death blow for an already endangered species: market bears. Suddenly, concerns over nuclear missiles, government shutdowns and trade wars took a back seat to a more primal fear – the fear of being left behind.
It wasn’t just “unsophisticated” individual investors getting caught up in the stock market jubilation. Even Grantham, Mayo, Van Otterloo & Co.’s (GMO) widely-followed value sage, Jeremy Grantham, wrote of a market melt-up that was likely to last another six months to two years. This bold prediction coming from a man whose firm has consistently bemoaned the extreme overvalued state of the market. Within days “melt-up” had become the latest Wall Street buzzword.
So what is a market melt-up? While no formal definition exists, a melt-up is generally described as the final phase of a bull market - a phase characterized by increasing investor enthusiasm and exceptional price gains. Or, as the late Sir John Templeton might have described it, a melt-up is when the last skeptical investors have given up and optimism gives way to euphoria.
According to many pros, melt-ups are not to be missed. This final phase of a bull market can yield spectacular returns. The 1998/1999 technology sector melt-up was a classic example. While less pronounced, a period of strong gains also proceeded the 2008 market collapse. Longer-term studies confirm this pattern, with only the off-the-bottom early phase of a bull market typically outperforming its ending phase.
No wonder then that a great value investor like Grantham would want a piece of the melt-up action, despite his own firm’s dire long-term equity return forecast. Get on board or get left behind.
As any casual observer of the markets knows by now, melt-up enthusiasts were recently dealt a major setback. From January 27 to February 8, the Dow Jones Industrial Average twice fell more than a 1000 points, a startling wake-up call for investors that had been lulled into a state of complacency by record-low volatility. By the time the dust settled – and we hope that it’s settled - the US stock market experienced its first correction in two years. Other “risk” asset classes also declined meaningfully. High quality bonds, despite feeling the pressure of rapidly rising yields, still served as a source of relative portfolio ballast.
Ironically, the major catalyst for the market correction was a US jobs report that came in just a little too strong. The February 2 report showed a better-than-expected 200,000 increase in new hires, but more importantly, also showed average wages had increased a surprisingly robust 2.9% since last year. This seemingly good economic news was not received well by investors, as fears spread that the inflationary embers would force the Federal Reserve to raise interest rates more aggressively. Suddenly, the not-too-hot/not-too-cold economic narrative was in jeopardy.
While a whiff of inflation started the selloff, we suspect certain technical trading factors exacerbated it. The S&P 500 was experiencing its longest span in history without either a 3% or 5% decline. Human nature being what it is, investors had started betting on a continuation of recent trends. One popular exchange-traded product that profited from low market volatility essentially went to zero as volatility exploded higher (see chart below of the Velocity Shares Daily Inverse VIX ST ETN). With such trend-following investors forced to run for cover, markets became unhinged. Volatility created more volatility.
So What Happens Next?
The debate on Wall Street now is whether the market will resume its happy melt-up ways or if the recent correction is the start of a new bear market. Honestly, nobody knows, but the case for a melt-up remains reasonably solid. Fourth-quarter corporate earnings reports have sizzled and analysts are ratcheting up their forecasts for 2018 and beyond. Further, the IMF recently revised up its global economic growth forecast to a healthy 3.9%. It would be unusual to experience a bear market during such supportive conditions. Sure, a hint of inflation is in the air, but isn’t strong growth and a little inflation exactly what’s needed for the Fed to finally “normalize” its interest rate policy? Grantham’s melt-up prediction could still prove correct.
As good as a melt-up may sound to investors, it may not be something to cheer for. As the last phase of a bull market, a melt-up, by definition, means a bear market can’t be too far behind. When investor psychology finally shifts, markets can reverse suddenly and violently.
We at Oxford are neither rooting for a melt-up or for a meltdown. We view the recent market correction as a healthy and overdue event that could prolong the duration of the current bull market. After a period of strong gains marked by exceptionally low volatility, some volatility and sideways market action could be just what this bull market needs to dampen smoldering investor enthusiasm before it burns out of control. With the market’s price-to-earnings ratio, or “P/E”, on the high side of history, a flattish market might also allow time for the “E” to finally do some catching up with the “P”.
With all due respect to Mr. Templeton, investor psychology does not follow a predetermined path. The mood of the market will oscillate back and forth based on any number of unforeseeable events. One day investors can be euphoric (as they arguably had become in January) and then backtrack to a merely optimistic or even skeptical state (as may be the case now). Pessimism and the next bear market could still be some ways off – or not.
Now is a great time for investors to think about their own emotions during the “euphoria” of January and the “skepticism” of February. If you found yourself frustrated by a feeling of missing out during the January run up, or if you were tempted to bailout during February’s selloff, a review of your portfolio’s asset allocation mix may be in order. Oxford can help guide you through this important discussion.
We believe a well-diversified portfolio is the key to navigating successfully the ever-changing moods of the market. A full discussion of what constitutes a well-diversified portfolio goes beyond the scope of this article, but we find four diversifying strategies particularly relevant today:
Most importantly, we advise investors to not get too caught up in the daily gyrations and news flow of the market. Stay tuned but stay calm. If you already have a well-diversified portfolio, doing nothing may just be the smartest move you can make.
The above commentary represents the opinions of the author as of 2.22.18 and are subject to change at any time due to market or economic conditions or other factors.Print