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It’s been quite a run for the market over the last decade-plus, and after a little break for Covid-19 in the first quarter this year, the party picked right back up to hit new all-time highs. As Adam Button of ForexLive said, more and more people seem to be noting a “magical, non-stop rally.” The steady drip up is strange. If some big event happened, in theory, it should get priced in quickly. Found a Covid cure? That would be a big event. Let’s price that in at up 10% tomorrow and call it a day.

But that’s not what’s been happening. Instead, there’s been a relentless grind higher most every day on no news. That doesn’t even make sense, as if you’re so certain stocks will go up a quarter of a percent every day, shouldn’t you just go all-in on the first day?

This market is a complicated topic to write about, and I want to make this as understandable as I can, because I think it’s fairly important. I think there are a lot of investor actions coming together to create this strange market, but the biggest one is probably what’s been going on in the options market.

Sentiment has shown an awful lot of bullishness, and one way this is expressed is with a lot more people buying calls, betting a stock goes up, versus people buying puts, betting a stock goes down. Dealers have to hedge their exposure when they sell calls, and while the details are complicated, the basic way to hedge is to buy some of the underlying stocks on which they sold calls. Thus, of late, we’ve seen this virtuous cycle of ‘buy call options, cause stock to get bought by the call-selling dealers, stock goes up, more options get bought, which causes more stock to get bought.’ This has been happening at such a scale, particularly for the mega cap stocks, that it’s quite likely institutions are involved in buying calls, and I think it’s reasonable to think they’re doing it intentionally to force dealers to buy the underlying stock and push up the price. It’s like the options tail is wagging the stock dog.

There are, of course, problems with this. Is Apple really likely to go up 50-100% in the next couple of months, which is necessary for the purchased calls to be worth anything? At some point, the game fails. It’s also been happening on such a scale that it gets to be like you’re sucking the oxygen out of the rest of the market. Thus, you have days of late where one stock is responsible for the entire gain in the market. One stock goes up, while the average stock has gone down. This has gone to amazing extremes, with Apple recently becoming bigger than either the entire Russell 2000 small cap index or the FTSE index (Financial Times Stock Exchange, the principal index for the United Kingdom stock market).

In the week that ended September 4, we started to see some cracks in this system. Apple and Tesla (which I’ve heard some people refer to as ‘the most important stocks in the world’) have been soaring of late, purportedly due to their stocks splitting, something which I have to point out doesn’t really change anything. Are you richer with five $1 bills than you were with one $5 bill? At any rate, those stocks, which have been front and center of the options games, are starting to crack. Does that spell trouble? I can’t say for sure, as stocks have been saved so many times before, but I think it’s worth paying close attention to the potential risk.

That’s probably the most important thing going on right now, but it’s certainly not the only thing. While we had an earnings season that was touted as ‘better than expected,’ it still reflects a material slowdown both in sales and earnings. Hopes are extremely high for continued improvement, but can the slowdown challenges be so quickly overcome? Job losses continue, and the rate of improvement there has noticeably slowed down. The credit cycle marches on, and deferring these debts doesn’t make them disappear. Those are contracts, and debtor, creditor, or both have to pay. Government stimulus continues to fade.

We also have incredible valuations. Like we saw in the Roaring 20’s, the Nifty Fifty, and the TMT boom of the late nineties, valuation has been thrown out the window as a relevant concern. I admit valuation isn’t a great timing tool, but it does correlate well with future long-term returns. These high valuations people are accepting warn you to reign in your future expectations. That doesn’t mean pockets of the market can’t do well, but to expect something like Apple to treble your wealth over the next ten years is very unlikely.

One of the things that people are saying for why valuations deserve to be high is that it is due to very low interest rates. The problem is that the history isn’t robust on that at all. As Lance Roberts from points out, it’s just not true. The only other time we saw similarly low rates in this country was in the 1940’s, and valuations were low. I’d add that Japan has had low rates for a long time, but their stock valuations didn’t soar to the moon. Actually, today they are less than 50% of what they were in 1990, 30 years ago.

Will the Fed protect investors ad infinitum? Again, that basic idea has been tried in several countries and situations, and it hasn’t lasted. Will the dollar as the world currency save us? It never has seemed to matter in the past, and so there’s nothing but guesswork to tell us if having the world’s reserve currency is meaningful or not.

Next is the November election. Looking at betting markets, statements from both parties, and the likelihood of increased mail-in balloting, the odds of a contested Presidential election where the winner isn’t immediately clear seems very high. Both sides seem very aware of this, and have indicated they’ll be slow to concede. A contested election both seems fairly likely and very unhelpful to valuations come November. That’s another similarity to 2000, with the Bush-Gore election, except this looks much worse. If the election isn’t decided by Inauguration Day, on January 20th the current President leaves and the Speaker of the House becomes acting President until there is a winner. I’d like to think it doesn’t come to that, and I don’t think it will, but I wonder if that will become another worry.

The last topic I’d mention is it seems like everyone is in the pool, and they’re all-in. As noted above, options activity is heavily skewed to optimism – buying calls. Surveys show no one is willing to be a bear anymore. Shorting is low and few people are buying put options, while margin debt has bounced back strongly. On the one hand, none of that matters until it matters, but who’s left to buy? I’d add we’ve seen an awful lot of stock and bond issuance this year that’s needed to find a home with investors. How many optimistic buyers are left?

So what happens here? Is this just another couple-of-days pause, and we’ll see new highs in a week or two? Maybe, but more and more uncertainties are piling up against this market. Broadly speaking, this looks a lot like 2000 to me. For instance, the last time the market set a new high while the volatility index was so high was in 2000. Like in 2000, we’ve also seen a frenzy of stock and bond issuance, whether it be insiders selling, companies selling, or new companies selling. If the options game unwinds, logically we should see tech underperform, while value takes the performance lead.

If we don’t see a bounce back soon, what could we see? I don’t know, of course, but I do have guesses. My best guess is a repeat of 2000, where growth stocks underperform for a long while, and we see a rotation into value names. Of course, the situations aren’t identical. In 2000, the broad economy was set to improve, so a lot of traditional value names that had been cheap had a pretty easy path to looking better. I don’t think that’s so much the case here. If history follows, struggling cyclicals are likely to continue to broadly struggle in a weak economy for a while. That doesn’t mean they have to do poorly for the rest of the year; rather, consider whether they may be something you’d want to buy now and forget about for two or three years, which worked well in 2000?

The last thing I’d say is that the run-up to 2000 created a set of ‘true believers’ in tech who never changed their minds. They never stopped believing that the tech stocks had to bounce back, and suffered for that belief. Given the gut-check in March of this year and subsequent impressive rebound, I think that the true believers are going to have even stronger convictions this time. They can see tech stocks go down 30% and say ‘no problem, we’ve been here before.’ It’s easy to imagine that plenty of people will get burned badly when this market finally turns for good. At the least, maybe this is a good time to take a little out of tech positions. If you think they’re starting to bounce back to your satisfaction, by all means feel free to hop back on.

I’m just saying there are a lot of danger signs for the road ahead, and a lot of people will ignore them because of what’s happened in the last few months. Don’t be that investor.