“Bull markets are born on despair, rise on scepticism, mature on optimism and die on euphoria”

Sir John Templeton

In the computer age most investors rely exclusively on quantitative analysis. Whether it’s GDP and CPI data, company earnings results or chart based assessments, it’s the numbers that count. It’s understandable. Numbers are by definition precise, and easily compared one to another. However the numbers rarely help when it comes to one of the most important market calls.

Picking the market sea change from bull to bear market, and preparing accordingly, is a key to capital preservation and long term investment success. The difficulty with the focus on numbers is that they often lag the turn in the market. Unlike bull markets that unfold over months and years, share market sell downs can materialise very suddenly, and degenerate very quickly.

It’s one reason investors are prepared to listen to the perpetual prophets of doom. Despite the fact that some analyst have called for a “hard landing” or credit crunch in China for a decade, their solemn declarations of impending disaster still get a hearing. The same is true of the long touted meltdown in Australian housing markets and bank share prices. And over the same period many commentators have called a premature end to one of the longest bull runs in the US share market in history.

However looking at the wise words of legendary investor Sir John Templeton (above) there are qualitative signs that US stocks could be headed for trouble. Longer term investors may look for signs of euphoria as an indication a turn may be imminent. Consider this August 30 tweet by the President of the United States:

“For all of you that have made a fortune in the markets, or seen your 401k’s rise beyond your wildest expectations, more good news is coming!”

The US S&P 500 index is up more than 330% in nine years. As the market hovers near its all-time highs the White House is ramping up optimism. This was met with barely contained glee in certain investment circles. Some may see this as a marker of a sentiment shift into euphoria.

Further evidence lies in market responses to bad news. Interest rate markets in the US are indicating a 100% probability of a lift in official US interest rates on September 26, and a more than 70% chance of a further rise in December. Higher interest rates hurt corporate bottom lines and stock valuations, yet US investors continue to buy. The recent escalation of the trade dispute between China and the US is almost certain to slow global growth, but it seems even that can’t stop the bull. Energy is a key industrial input. Oil prices are back to four year highs. The investor response is to buy energy shares.

These positive reactions to developments that at other times in the stock market cycle could provoke selling are another possible symptom of investor euphoria.

Anticipating the trigger for a market correction is also a fraught practise. Nevertheless there are two potential fire starters on the near horizon. One is the US mid-term elections in the first week of November. If control of either house of the US Congress passes to the Democrats the further stimulatory legislation markets are expecting from the Republican Party is imperilled. This may see growth assumptions slashed, and share prices with them.

The other possible trigger is the US bond market. Ten year bond prices are at seven year lows. Bond yields move in the opposite direction to prices. If the ten year yield moves up through the highs at 3.126% it may spark a rout, and it rose to just a few basis points away from this level last week. There are currently around $15.5 trillion dollars of US government bonds in private and international hands, and the largest international holders are China and Japan. Selling of US bonds may be a rational response to escalating trade concerns.

The problem with qualitative measures is that are notoriously poor at predicting timing. All of this may come to nought. Concerned investors can still take action. One possible course is to maintain portfolios and buy put options. If markets continue to rise investors may lose the premium paid for the puts, but gain on their shareholdings. However if markets do tank the value of put options is likely to explode, potentially offsetting portfolio losses.

(This article first appeared in the Australian Financial Review)