Fifth wave reflections

With the S&P 500 index enjoying a strong start to 2018, Pierre-Henri reflects on the prospects for the remainder of the year. He notes that strong data, coupled with recent tax cuts and expectations for deregulation certainly provide a helpful backdrop for equity investor sentiment. However, at the same time, there is also growing evidence that we are in the latter stages of the bull market and firmly in the so-called called ‘fifth wave’ territory of Ralph Elliot’s wave model of behavioural finance.

12 JANUARY 2018

The S&P 500 has just enjoyed its best opening week of the year since 2006. While we’re not sure that there’s anything profoundly meaningful in the analysis, we looked back at every year since 1950, and noted an extraordinarily high correlation between a strong opening week and overall performance for the year. Of the sixteen years in which the market has opened up more than 2%, there have been no down years and only two years in which the index returned less than double digits. The average return for a year that opens up more than 2% is 19%. 2018’s first week was up 2.77%.

Another data point that adds to the sense of remarkable bullishness surrounding the dawn of 2018: as of the 11th of January, 387 days have passed since the last 5% drawdown in the S&P 500. This means that the current period of stability has overtaken 1965, and only once since 1920-1995 has the market enjoyed a longer run without a 5% fall. There’s positive economic news wherever you care to look for it and both CEOs and investors appear to be embracing the wave of optimism.

On the back of Trump’s raft of deregulation and tax cuts, the NFIB (National Federation of Independent Business) survey of U.S. small business sentiment just rose to its highest level since the index was founded in 1975. US 401k plans are more invested in equities than ever before and on January 4th, the AAII (American Association of Individual Investors) sentiment survey jumped to its highest level in 7 years. Bullish investors now make up just shy of 60% of those surveyed, well above the historical average of 30%. In the more than 30 years – just under 1600 weeks – since the index started, it has seen fewer than 50 weeks with higher readings. Remarkably, the index has risen more than 30 percentage points since its low-reading of 29.5% at the end of November, just seven weeks ago. 2017 saw USD 299bn inflows into equity funds, the second highest year on record. The chart below gives an idea of how forceful this recent bout of market euphoria has been.

Figure 1. Lots of optimism priced in

Source: Bloomberg, 11 January 2018.

It feels like we are moving into the fifth instalment of Ralph Nelson Elliott’s wave model of behavioural finance – characterised by total investor consensus. As a reminder, this model posits that market cycles move in predefined patterns:

  1. The first wave of a bull market is an initial movement higher. This can be for technical or fundamental reasons, but crucially it is short-lived and little heralded. Investors tend to dismiss the rise in stocks, seeking to explain away any positive signs as coincidental or evanescent. People have been used to bad news and so write off any good news as mere noise.
  2. Inevitably, the second wave is a retrenchment, with much of the initial move higher being lost and the nay-sayers crowing “I told you so.”
  3. The third movement is the most dramatic. Some event catalyses the market, underlining and accentuating whatever it was that drove the first wave of the bull run. The rise in stocks here is more significant and far-reaching, though, and sees far more widespread acceptance of the positive momentum. The move higher here is on average more than 1.6x greater than the first wave.
  4. In wave four, the markets tread water, waiting to see if the bull market is sustainable. Liquidity is down and trading becomes difficult.
  5. Finally, there’s the fifth wave, the moment when everyone stands firmly behind the positive news. Earnings estimates are constantly revised upwards, and anyone seeking to question the optimism is ridiculed. While the fifth wave can last for weeks, months or even years, it inevitably prefaces a significant market correction, on average giving up between 38% and 50% of all gains.
Figure 2. Elliot Wave Model

Source: Bloomberg, 11 January 2018.

To underline our position firmly in the fifth wave of Elliott’s model, I’d call upon a meeting I had with financial journalists a few days ago. One of them told me that he feels he can no longer write articles questioning the sustainability of the bull market – people simply aren’t interested in negativity at this point in the cycle and he doesn’t want to develop a reputation for being the kind of terminal bear who waits for the stopped clock theory to prove him right.

And yet there are still rumblings of discord. In a note released in early December, Morgan Stanley suggested that the top of the market might coincide with Trump signing his tax bill (he put pen to paper on December 22nd). When we had our regular beginning-of-the-year meeting with the regional strategists at Goldman Sachs, the message was bullish, but guardedly so. Partly it’s the threat of interest rate rises – the market is pricing in two rises from the Fed this year, although Goldman suggests there may be as many as four. They justify their continued optimism by saying that there is currently sufficient global growth momentum to compensate for these rises, but it’s clear to us that the path ahead is not clear of obstacles.

There’s also a more subtle and abstract disquiet that comes from the artificial stimuli that lie at the heart of this bull market. There’s the unsettling sense that the central banks might be behind the current run up in stocks. Of course one can point to growth in Emerging Markets, deleveraging and positive earnings momentum, but there’s something troubling in the disconnect between current market ebullience and the fact that Japan, Switzerland and the EU are still undertaking asset purchase programs. It lends conceptual complexity to any sense of optimism.

Finally, and most difficult of all to quantify, is the fact that so many of those at the coal-face of the markets right now forged their careers against the backdrop of the 2008 financial crisis. A whole generation has had its ability to maintain hope badly damaged by what happened at the end of the last sustained bull run. There are many who – even if they don’t necessarily express it in the positions they take – are just waiting for the next 2008 to strike.

The vertical charts we’re currently seeing in everything from cryptocurrencies to certain tech stocks declare loudly that we are living through a period of end-of-cycle irrationality. We’re not putting a time limit on any eventual unravelling – these periods of exuberance can last months or even years. We certainly believe that there’s enough real earnings growth behind the current bull market to give it momentum into the first quarter of the year, absent any extraneous shocks. What we also believe, though, is that the psychological fragility that stalks this latest period of market optimism will mean that volatility is likely to return in 2018 – no more directionless, fourth-wave indecision. We also believe that the seeds are being sown for a particularly vicious correction if the fifth wave spends itself out and crashes upon the shore.


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