The Independent Market Observer

2/24/14 - Enjoying the Melt-Up

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Feb 24, 2014 10:44:25 AM

and tagged Market Updates

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There is a real asymmetry about how we treat market ups and downs. In the past couple of weeks, when the market dropped around 1 percent, I got phone calls from advisors and reporters asking why. How could this happen? Today, when the market is up about 1 percent, no calls at all. According to the Wall Street Journal, we are back at record highs, have erased all the losses so far in 2014, and all is right with the world.

If we look to behavioral finance, we understand why we react this way. Good things are assumed to be deserved—because we are smart. Bad things, on the other hand, must come from external factors outside of our control, which we could not have foreseen. We own the wins, someone—anyone—else owns the losses. Along with these tendencies, we also have the psychological fact that losses hurt much more than gains feel good.

The combination of these factors makes it necessary to look for an explanation of declines, while no explanation is needed for gains. This is particularly dangerous in investing because long periods of success can breed the conditions for eventual failure.

There are a couple of reasons for this. One of the biggest is that, if a little is good, more must be better. We saw this with tech stocks, with housing, with leverage, and with myriad other things. Arguably, we have seen this with Federal Reserve intervention in the economy—although the final verdict is not in yet. Right now, people are starting to believe the same thing about the stock market.

There have been multiple articles in various media over the past couple of weeks talking about how retail investors have been moving back into the market to chase performance. (I noted this as one of the major upside risks to the market at the end of last year.) I have also been talking with more and more advisors who have clients who are more focused on why they “missed” the market returns in the past two years. These clients are determined not to miss the next two—which they think will be just as strong.

They may be right. I have written many times about the reasons for concern, but let’s take a look at why the market may continue to rise. First are the fund flows. If retail investors really are moving back into the market in a big way, that alone could generate enough demand to lift prices. Second, the financing remains very cheap. The media has noted that more buyers are borrowing to buy stocks, and that is consistent with record levels of margin debt. Even so, as long as lenders remain willing, there is nothing to stop more borrowing—which can drive prices higher. Third, the economy may continue its expansion, which can make people more willing and able to take chances, such as putting more money into the stock market.

So the market could continue to rise indefinitely. There are no fundamental or technical reasons pointing to a decline in the short term.

Unless, however, things are different this time; at some point, we will move from a fundamentally sound level of prices to a more speculative one—and that raises the inevitable possibility of a decline. I personally believe we are already there, but, even if we are not, we will be at some point.

Which brings us back to the need to plan. Even as we enjoy the melt-up, we need to plan to keep the money we are making now. There are two parts to any investment strategy—making the money and keeping it. And the second is the more difficult.

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