The general consensus seems to be that central banks, after unleashing a flood of money over the last several years, are now looking to tighten conditions. The Fed has already raised rates and the ECB and Fed are both talking about letting their balance sheets run off, or something along those lines.

That’s fine, and one would think that happens eventually. What I find amazing is the idea that there’s no concern about this reversal of course by central banks not being reflected in markets. What happened to risk assets during this very accommodative period of the last several years?  They soared, far more than either GDP growth or earnings growth would typically allow. I’ll admit that in the short term valuations don’t matter, but how confident should we be that the next five years will be just like the last five years? That’s not a bet I’m comfortable making.

As central banks begin to reverse course, the narrative I seem to hear the most is that the economy and business is improving, so one should aggressively buy high beta stocks that will grow even faster than the improvement. In addition, higher rates will allow financials to earn a better return than they’ve been able to of late. A lot of that sounds seductive, but let’s break it down piece by piece and show why I’m uncomfortable with this line of thought. First, the economy has been improving modestly for a few quarters, as have earnings. Is that likely to last? I think it’s hard to say, as there has been some early business cycle data, such as sentiment data, that’s improved since the election, but at the same time late business cycle data, such as actual production data, never went down and is only now starting to roll over. We pay attention to the late cycle data because it tends to be very steady – late cycle trends are unusually sticky, and late cycle trends like delinquency rates are starting to roll over. While I personally haven’t done the work yet, Hoisington & Hunt believe that 2017 economic growth will ultimately slow from the growth seen in 2016.

Second, earnings have been improving, but it hasn’t been anything dramatic and a lot of the improvement is due to energy, which may not represent a lasting trend, as energy prices seem to have stalled. Further, while I have no reason to be particularly out-of-consensus for the Q2 results that are coming out shortly, Q3 earnings estimates are pretty aggressive and Q4 is almost impossibly aggressive. So, while I have no particular reason to believe that Q2 will be particularly bad, I wonder if forward earnings results may be disappointing, and that will be particularly true for Q4.

Third, as for financials, that hope has been going on for a while now. Revenue and earnings remain tepid, but hope remains strong. Shouldn’t we already be seeing the improvement? Raising rates is not all good. Banks eventually may have better prospects from making money off of loans and the yield curve, but they also face greater delinquency risk, which is not great in a highly leveraged economy. In addition, other metrics, such as loan growth and capital market activity, haven’t been encouraging. I think banks can be simply described as a sliver of equity sitting on top of an enormous pile of debt, trying to extract earnings. If I had to guess the future, I’d say the next few years are likely tougher for most banks than people expect currently – they seem to be counting the good and ignoring the bad. I expect there will be some winners, but also a number of losers.

(An alternative central bank narrative I hear (with the same positive ending) is that central banks are only bluffing about tightening, will not reverse course, and will continue to be accommodative. Hmm… Remember when they said that about the most accommodative Fed chairman around, Alan Greenspan? How’d that work out in 2000? Remember Ben Bernanke’s accommodative stance when he took over in 2006? How’d that work out in 2008? History doesn’t have any more support for a positive outcome from the bluffing narrative than it does from the tightening narrative.)

Here’s what I do think about the road we are on. Why have stocks gone up so steadily for the last several years? I don’t know for sure. My best guess, though, is central bank support. That’s the steady commonality through the years. What should you expect to happen when that goes away? Should you worry? The market sure isn’t, but I am. I think the central bank support has enabled things like Tesla (TSLA,) a money losing company that primarily seems to be a very needy funding vehicle. They admit they’ll need billions more in funding. People were ready to take a flyer on them when conditions were loose, but what about when conditions tighten? I wouldn’t be so confident there.

In general, being highly accommodative encourages speculation. As an aside, over the last 25 years there’s a decent negative correlation between rates and stocks (when rates go up, stocks likely go down.) We have already been getting tighter, and I think it’s appropriate to be nervous. Doesn’t it make sense that doing the opposite activity (rates up) should result in the opposite action (stocks down)?

I think there are a few things that are keeping the market in the air right now. First is recency (rearview mirror) bias – we can’t go down because we haven’t gone down. I don’t think that makes any sense – wouldn’t that imply that we never go down again? It’s one thing to say that momentum has an effect, and another to say that momentum never changes. An early sign of nervousness is the recent sharp drawdowns that we’ve seen where the dip gets bought sharply. That can be viewed as an early warning system of potential problems. The sharp dip gets bought until it doesn’t.

Next is the free rider problem. Early in a bull market everyone is scared, suspicious, and worried. They’re doing their work, careful not to get caught by more of that destruction they just saw. Eventually, if a significant upturn comes, people get lazy. Observe the dramatic example of companies connecting themselves with the ‘.com’ craze around 1999. That becomes a free rider problem eventually. People stop doing work, they just assume the future is the past. To me, that sounds like a Minsky moment waiting to happen. To remind people, I’d basically describe a Minsky moment as the point where people become overconfident and overleveraged, assuming that future gains are assured. When they don’t, the Minsky moment happens.

Ultimately, I’d say at this point people seem very confident that the present is the future. I don’t think it’s a good idea to assume that. Where’s the wall of worry to climb? For those that say it’s people like me who represent the wall, I’d consider history. Leading up to the Great Depression, there were two camps of people – the speculators who were making money and the doubters who weren’t. You didn’t need universal bullish opinion to have the market fall by about 80% over the years to come. Not that I’m calling for anything like that, just that volatility over time is mean-reverting. To the people who expect this current market to repeat and repeat, I’d encourage some caution.

How do we invest? I always like to buy “sad” stocks no one wants – that’s where you have the potential for good risk/reward propositions. At this point, people have thrown risk to the wind as they buy risky stocks and stop buying puts as short interest goes down and down. That’s not a market where I’d want to add risk – you’re putting yourself at the end of a long line of buyers, and exiting gracefully could be very difficult. As people have embraced risk, high quality and low volatility styles have been tossed aside. I think that’s a good place to hunt for bargains.

Will the market crash? At this point I don’t really think so. There’s not enough solidly negative data out yet and stresses are pretty small. I suppose this could be a top, though, as many sentiment measures are showing high levels of optimism, the market has drifted higher on low volume, and earnings comps may start getting worse soon. What does that mean? I could definitely see a 10-15% correction, but given current expectations, at that point it is probably better to buy selectively. Not on the expectation of new highs, but that there will probably be opportunities at that point, as the data hasn’t gotten bad enough that there won’t be people willing to buy a dip like that.

At core, all I’m saying is that markets are increasingly acting like they can never go down again. and that’s unrealistic. Better to think about the likelihood of that eventuality, about if it can happen soon, about how to be positioned, and about how to react.