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The Emperor’s New Clothes: Unveiling False Confidence in the Stock Market

By Madeleine Coe

Despite the markets closing out 2018 in a correction, many analysts are confident that pricing and performance will recover and thrive. Most major investment houses put forward predictions of high single-digit returns for the S&P 500. Rather than seeing the slowing economic growth as a sign that 2019 will be unkind to the stock market, they are instead forecasting the return to a bull market.

The 2018 market was marked by volatility with daily price swings that had traders urging investors to stay in cash as much as possible and patiently wait for the bottom. Stock opportunities were scarce and many attempted breakouts failed.

The Case for Growth
So, why do some believe that equities will be moving higher in 2019?

• Federal Reserve has signaled a pause to interest rate hikes, and to slow down “Quantitative Tightening”, the contractionary monetary policy massively applied by central banks during the 2008 recession to decrease amount of liquidity within the economy.
• Typically, if the stock market recedes after a mid-term election, the market performs positively the following year. Since 1962, the S&P 500 has fallen an average 19 percent in the year leading up to midterm elections. But in the year following the midterms, the index bounces back, rising more than 31 percent, on average. Investors hate uncertainty and the shifting of party lines definitely creates a feeling of unease, but once the votes come out, the market tends to calm down.
• Many investors are still expecting a late stage rally prior to pulling back. It is possible that money can still be made here if the investor is alert and agile and ready to pounce on this fluctuation.

Mega declines happen when there is extreme overconfidence in the market. This reminds me of the story of the emperor’s new clothes…

Just because analysts are predicting an upswing doesn’t mean there will be one, even though investors may choose to believe their story even when there’s evidence to the contrary. These overinflated, optimistic predictions create a misplaced sense of confidence in the market. The stock market hasn't been this bad in years, and there are still no signs that a big bull market is imminent. You might even say that they are selling a false hope…

The Case for Decline
There is also a case for stocks to continue to go down from here.

If we can’t expect there to be a turnaround, then the other option is continued volatility. You might ask, what makes us think that the negative trend will continue?

• Arguably, the valuations have been too optimistic. Versus the actual performance, the valuations seemed stretched and not reflective of the actual state of returns across many assets in 2018. I don’t imagine that 2019 will be any different.
• Additionally, those high valuations can in large part be attributed to internal stock buybacks. By reducing the number of outstanding shares, a company's earnings per share are automatically increased. This practice favored by blue-chip companies falsely elevates the value of the share price.
• Only a small handful of large companies (FAANG) are responsible for the vast amount of the stock market gains. Their gains do not reflect the performance of most stocks; the majority of stocks are struggling. Now, we are starting to see some of those “big, well-performing tech stocks” falter with sharp pullbacks due to industry privacy scandals in 2018. Despite these tech giant stocks going up in unison during the post Great Recession bull market, their performance is ultimately not tied together and we are starting to see that fall apart.
• Allow me to posit a theory. I honestly don’t think there’s much in the way of performance in corporate earnings. Have corporate earnings leveled out or grown? Yes. But, you have to keep in mind that a good bit of the earnings come as a direct result of tax cut benefits. Once that washes through, what is there to prop up earnings?

As a result, after 1st Quarter earnings are reported in April, you may very well see the emperor standing there with no clothes.

Conclusions
Either way, sentiment alone is not enough to decimate or lift up the market. What will most likely happen is volatility with a downward trend in the longer term. The best course of action right now, in uncertain times, is to make sure you have adequate wealth insurance.

And in times like this, when investors are encouraged to stay put with their stocks, many return to safe-haven assets like gold and precious metals. We are still in a bear market and gold’s tendency to be negatively correlated with the actions of the stock market make it a great way to protect your portfolio from market turbulence.

As we’ve been hinting at since the start of 2019, now is the time to put your money towards precious metals. Their prices are still low, but trending positively, and you don’t want to wait to get in after the breakout. Now is the time to get into gold as insurance against the broader systemic risks.