"History doesn't repeat itself, but it does rhyme."--Mark Twain

Mark Twain's wonderful comment resonates on Wall Street.  We who attempt to predict the future course of equity prices are always searching for the perfect indicator. That indicator would embody the concept of "all and only."  That is, ALL sought after outcomes are preceded by the indicator and ONLY sought after outcomes are preceded by it.   In other words, there are no false negatives and no false positives.  Alas, there are no perfect indicators, only those that "rhyme."

Those who have read my previous posts know that I am a contrarian investor.  I tend to sell when there is an extreme of bullishness and buy when there is an extreme of bearishness.  During my career, I have    found the most reliable sentiment indicator to be the Investors Intelligence Sentiment Index Survey   published by Investors Intelligence ("II").

For fifty years the people at II have scrutinized weekly more than a hundred independent financial market newsletters and categorized each writer's outlook for the stock market into three groups--bullish, bearish, and  expecting a correction. Each category's percentage of the total is published.  Rarely do these weekly numbers have predictive value -- they're just noise.  At extreme levels, however, they do have significance.  Since we are in a bull market and want to know when to cut back our risk exposure to equities,  we should be looking for an extreme high percentage of bulls  and an extreme low percentage of bears.  To me,  the combination  of 60% or more bulls and 20% or less bears defines "extreme".

During the last 25 years, there have been only five previous occasions when this  extreme occurred.  The percentage change in the Standard and Poor's 500 Index ("the Index") one year afterward (excluding dividends) was plus 4.3% from January 22, 1992,  plus 12.4 % from June 18, 2003, plus 5.9% from February 25, 2004, plus 3.4% from December 29, 2004, and MINUS 39.0% from October 17, 2007.  Overall,  the average change was MINUS 2.6%, which is much lower than the 6% to 7% average annual appreciation (excluding dividends)  during this period.

Another way of describing these results is that there were four false positives, of which three were of  minor significance, and one, plus 12.4%,  a glaring error. Overall the predictive value was  good because this indicator nailed the bull market peak in 2007.  A cynic might grouse that "this sentiment indicator has forecast five of the last one bear market."  I should also mention that there was one glaring false negative.  This indicator failed to detect the bull market top in March 27, 2000, from which the Index fell 25.3% in one year!

This reminds me of an incident that occurred during a tour to China.  Every time our group left our bus, we were besieged by vendors.  Once, a fellow traveller boarded our bus with an ear-to-ear grin. She exclaimed with glee, "I just bought a Gucci bag for a dollar!" As she walked by me, I noticed that the brand name on the bag was spelled "G-u-c-c-e".  When I called that to her attention, she responded without missing a beat, "CLOSE ENOUGH!"

While this sentiment indicator is far from perfect, it is "close enough." The latest reading is 59.6 % bulls, 14.1% bears.   While not quite my threshold point of 60% or more bulls and 20% or fewer bears, it is unique over the last 25 years.  I back-tested how often more than 59%  bulls and fewer than 15% bears has occurred during that lengthy time period.  NEVER!!  Furthermore, the last time there were only 14.1% bears was in March, 1987!   I have brought my equity risk exposure down from 42% of my financial assets to my core level of 30%.

A reminder: for reasons I have explained in earlier posts, I have determined that a core equity holding of 30% is appropriate for me, given my other asset holdings and age.  Among investment advisors, the standard core holding for equities has been roughly 60%, with around 40% in bonds, and little, if any, cash.   With bond returns negative during 2013 and the Index up  30%, the stock/ bond relationship is seriously out of whack.  If unadjusted, the stock portion of the portfolio has grown to 67% of financial assets.

Following this great equity surge, you might say "Let me get this straight!  After such a year, you are asking me to sell  my equities  down to my core of 60% and put the money in cash equivalents, returning nothing?  The Fed is tapering, so they think the economy has achieved escape velocity. Earnings are growing.  Things couldn't get much better!  Are you crazy?" Here's why I recommend lightening up.


The Current Situation

Let's look at the three most important forward-looking variables: sentiment,  the Federal Reserve's future action, and valuation.


Sentiment

As noted above, sentiment has reached a level of extreme bullishness.  That doesn't happen UNLESS  things are great.


Federal Reserve

On December 18, the Federal Reserve announced its initial tapering.  They softened the announcement by saying that they intend to keep their Federal Funds rate at zero for a long time.  While the Fed has far more input on  how the economy is faring than I,  their forecasting record has been far from stellar.  If  the expectation of future inflation picks up and the long end of the bond market experiences a ratcheting up in yields, then the Fed may be forced to raise the Fed Funds rate.  In other words, the Fed will be "behind the curve".  This has happened often in the past and has given rise to the phrase "bond vigilantes." No matter how the Fed has couched its action last week, it is still a tightening.

The Fed's target for inflation is 2% or slightly more.  While the nominal yield on the U.S. Treasury 10 year note is currently 2.9%, the real yield, adjusted for the current 1.1% inflation,  is closer to 1.8%.  For many years, the real yield on that security averaged 3 percentage points.  Add that to the Fed's inflation target of 2.0 %, one would expect that the yield on the 10 year note would ultimately reach 5%+. How long that will take is crucial!  For purposes of discussion, let's assume the absurd case that the yield adjusts immediately.  Then, in my opinion,  the result of the yield's breaking convincingly through 3.0% would mean a 10% correction in the Index;  through 4%, a 20% bear market; and through 5.0% as much as a 30% decline. However, this will be spread over time.  The longer it takes, the less downward impact on the Index, because the effect will be mitigated by annual normalized earnings growth of 6% to 7%.


Valuation

At 1833 the Index is 40% overvalued. At the peak of the bull market that ended in March, 2000,  the Index was 100% overvalued; at the peak of the next bull market in October, 2007, the Index was 80% overvalued.  So there could be a lot further room to run, particularly since individual investors seem to adjust their equity exposure while looking in the rear view mirror.  As bond yields rise and investors continue to lose money,  the inclination is to sell bonds and buy stocks.  That rotation may only be in the early innings.  However, if bond yields rise quickly, the institutional investor, at some level, will sell overvalued stocks to take advantage of good yields.  This downward pressure on the Index will cause the individual investor to halt his rotation into stocks.

If the last bull market's peak 80% overvaluation were to repeat, then there is 30% more upside in this bull market.  My rebalancing now will have, in hindsight, been a mistake.  However, I will still have my core equity position working on the upside.