Belief in the bull is overdone: investors should prepare for the coming correction.
Stockmarket history suggests that while stocks (in the UK and the US, certainly) have nearly always risen over time, they also tend to "mean revert", with booms followed by periods of weak performance, or even declines. However, the US market seems to have broken free it just keeps going higher and higher.
The mini-crash at the start of last month already seems like a different era. The market not only stabilised rapidly, but has made up nearly all of the ground that was lost. Indeed, investors seem willing to pounce on every piece of good news, while ignoring every setback. Belief in the bull market, now nearly a decade old, remains extremely strong.
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However, I'm not nearly as optimistic. The past few weeks strongly suggest that Donald Trump is going to follow through on the protectionist rhetoric of his campaign, with his more sensible advisers, such as Gary Cohn, walking out of his administration. Such protectionism would not only hit global growth, but would also cause problems for the large global companies that dominate the US (and British) stockmarket. As well as direct retaliation in the form of US tariffs, there's also the possibility that the Chinese could start dumping US Treasury holdings in retaliation, which would drive US interest rates up.
Rises are inevitable
Even if China hangs on to its stocks of US debt, it looks as though US interest rates are going to rise anyway. They're already at levels not seen since early 2014. Given the current inflation rate of almost 3%, longer-term interest rates should be closer to 4% or 5% to be in line with historical norms. Any sort of rally to anywhere near those levels would force investors to think hard about things like opportunity cost, and whether companies are generating sufficient returns on capital.
As a result, a lot of the weaker and more speculative companies, especially those that haven't generated consistent earnings, are likely to see their share prices fall. Throw in the fact that the US market is one of the most expensive in the world, and it feels as though the only questions are when the correction will begin, and how much damage it will do.
However, shorting an index is risky as was amply demonstrated by the fact that the last time we suggested you short the market, it bounced back almost instantly. So this time I'm going to hedge my bets a little. I suggest you short the S&P 500 at £5 per index point with the caveat that you should only do so after it has fallen below 2,679, the current 100-day moving average. You can do this by placing a sell stop order at that level. I would cover the trade at 2,829, giving you a maximum downside of £750.
How my trades are doing
The last fortnight has been pretty good for this column's paper portfolio. At the moment we have five long positions (IG Group, Petrobras, Renault, Hammerson and Micron Technology). Spread-better IG Group has gone up to 803p, increasing our overall profit to £465. Carmaker Renault has also risen to €94.98, so profits on that trade now stand at £604. Chip maker Micron Technology has risen by over 10% in the last fortnight alone, which means it is £188.40 in the black. And while oil group Petrobras has fallen a tad to $13.73, this still works out to profits of £737.50. Only commercial property group Hammerson is in the red, on a loss of £188.40.
It's also been good for our one short position in digital currency bitcoin. Over the past six weeks the price has started to rally, wiping out a lot of our initial profits. However, it has now fallen back to $9,800, well below the price at which we began to short it at $11,225. This means that our profits on this trade are a comfortable £356.25. Overall, our open positions are making a net profit of £2,111. This is over £1,000 more than the losses from our closed positions of £1,014.
I've already raised the stop-losses on IG Group, Petrobras and Renault, so I'm going to keep those as they are. Micron Technology hasn't gone up enough to justify modifying the stop loss, and bitcoin is simply too volatile to set a stop at a sensible level.
However, I've decided to close out my position in Hammerson, which I took out in Issue 871 (1 December), as it's fallen quite a bit since then and doesn't look like it is going to recover anytime soon, especially since it is being evicted from the FTSE 100 in this month's reshuffle. This is likely to force many funds that track this index to sell the stock.
Trading techniques: how to use a put/call ratio
We previously looked at whether the short interest (the number of open short positions relative to the total number of shares) can predict future price movements. Similarly, many people use something called the put/call ratio to gauge market sentiment.
A "put" option gives you the ability (but not the obligation) to sell a share or index at a fixed price in the future, while a "call" option gives you the ability to buy at a fixed price in the future. So those buying puts on an asset are bearish, and those buying calls are bullish.
To calculate the put/call ratio, divide the total volume of puts by the total volume of calls traded on an exchange such as the Chicago Board Options Exchange (CBOE). A high put/call ratio suggests market sentiment is bearish; a low figure suggests that investors are bullish. Contrarian traders view a high put/call ratio as a sign that people are too pessimistic, implying that prices are about to rise. Conversely, a low put/call ratio is seen as a sign of over-optimism, signalling that you should adopt a more conservative position. On average, the ratio for US equities sits at roughly 0.65 (see chart).
Much like the short interest ratio, there seems to be evidence that the contrarians are wrong, and that you should go with the crowd, at least in the short run. MIT's Jun Pan, and Allen Poteshman of the University of Illinois at Urbana-Champaign found that individual stocks with a low put/call ratio (signalling bullishness) tend to beat the market over the following week. But the American Association of Individual Investors found that a contrarian approach to the ratio on the US market as a whole would have helped you spot most market tops from 2005 to 2011, including the crash in 2008.
Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.
He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.
Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.
As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.
Follow Matthew on Twitter: @DrMatthewPartri
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