Another day, another Dow milestone. It took a little more than 2 months to go from Dow 22,000 to Dow 23,000, even if we closed a few points shy.
In the last 18 months, the Dow has gone from 18,000 to 23,000, which means the Dow has moved 1,000 points every 3.6 months on average. You’d think a lot of thoughtful people would say at some point it’s time for the markets to pause.
And many have bet that the markets would pause. They have bought puts and they have gone long volatility. And they have all lost money. A lot of money.
The S&P 500 has not had a drawdown greater than 3 percent this year. Why? Why doesn’t anything bother anyone anymore? It is a little strange, why nothing seems to move the needle:
1) not low volume/low volatility (historically a sign of complacency);
2) not geopolitical events (the North Koreans say nuclear war is moving closer, the British appear to have hit an impasse with their Brexit talks with the EU, fighting is expanding in the Middle East);
3) not an impasse in Washington that threatens tax reform;
4) not even markets moving in directions that are unexpected (the yield curve is flattening, not steepening).
Let’s talk about the complacency/low volume/low volatility first.
1) The ETFs are to blame. I don’t think it’s a coincidence that the rise in passive investing has corresponded with the rise in low volume and low volatility. Passive investing, by definition, is a low volatility style of investment. Here’s the issue I have: I don’t think it’s a huge part of the equation. The rise from $1 trillion in assets under management (AUM) to today’s slightly more than $2 trillion AUM took seven years (from 2010 to 2017), and despite that rise, ETFs are still only a tiny part (about 3 percent) of the roughly $63 trillion total value of the U.S. stock and bond markets. Look elsewhere for the main causes.
2) The Fed Nanny State. Call it whatever you want, but the Federal Reserve is likely the biggest cause of the low volatility market, and most traders agree with me.
“A large part of it is we are conditioned not to be afraid of anything on the downside, because we believe the central banks will come to the rescue,” Academy Securities’ Peter Tchir told me. Normal market cycles have been disrupted by the Great Ocean of Liquidity that global central banks have provided, and what fool would argue against that?
No one will fight the tide of that Great Ocean, so the much-sought after Great Blowout keeps receding into the horizon: “People have been burned enough to learn not to chase the Great Blowout,” Tchir said.
3) Stuff has worked out for so long, it will just continue to work out. I call this the Cheech and Chong defense: “Chill, dude, it all works out in the end.”
It’s stoner logic, of course, but when you’ve had nearly 10 years where precious little has gone truly wrong (even with a full-blown European crisis) you can’t help blaming everyone for having poor memories.
Under this scenario, stuff has gone right for so long that it must continue to go right.
There’s not going to be any real conflict with North Korea because everyone believes the Chinese will work with us.
Tax cuts will pass because everyone believes the Washington impasse will be resolved.
The Fed will not make any “policy error” because everyone believes the Fed will remain just dovish enough not to rattle markets.
The record earnings will continue because the global economy will keep expanding and tax cuts will add another 2 or 3 or 5 percent (pick one) to earnings next year.
All of this, of course, could reverse. Global growth could slow and reverse. That would cause the record earnings rise to stop and we could fall back into another earnings recession.
Tax cuts could fail. A global crisis — think North Korea or Iran — could erupt.
But my guess is it’s the Fed that will end the party. The Fed could get overly aggressive by raising rates too fast, and many traders feel this so-called policy error remains the biggest threat to stocks. Just the talk of picking John Taylor for the Fed has sent short term rates much higher.
And with someone like John Taylor in charge (should that happen), will the Fed really come to the rescue? Would they come to the rescue for a simple recession caused (partly) by a withdrawal of their own liquidity?
But hey — it’s impolite to ask this question. At this rate, we are at Dow 25,000 just in time for spring of 2018. Sell in May? You didn’t hear, that doesn’t work anymore either?