The bears are capitulating

Last week, I discussed the professional career risk challenges in this market (see What professional career risk looks like).

During these unusual periods of severe bifurcation between valuation and macro risk and price momentum, the investment professional is forced to make a decision based on what he believes the dominant investment regime will be in order to minimize career and business risk. This amounts to the classic Keynesian investing beauty contest, where investors do not try to determine the winner based on some investment criteria, but based on what he believes other investors think will be the winner.

I highlighted the differences in thinking between the fast-moving hedge fund manager, Stanley Druckenmiller, and the cautious approach of Jeremy Grantham, whose firm, GMO, reduced its target equity weight from 55% to 25%.

This week, it seems that even Grantham has capitulated and called this market a bubble in a CNBC interview.

“My confidence is rising quite rapidly that this is the fourth ‘Real McCoys’ bubble of my investment career,” Grantham, co-founder of GMO, told CNBC’s Wilfred Frost on Wednesday in an interview which aired on “Closing Bell.” “The great bubbles can go on for a long time and inflict a lot of pain.”

The previous three bubbles Grantham referred to were Japan in 1989, the tech bubble in 2000 and the housing crisis of 2008.

Not only has Jeremy Grantham capitulated and called this market a bubble, but also the latest BoA Global Fund Manager Survey shows signs of capitulation by cautious bears. Even though a record net 78% of survey respondents acknowledged that equities are overvalued, which is the highest reading since the survey began in 1998, their investment outlooks turned less bearish between the May and June survey.


As global stock prices continue to grind upward, managers are giving greater weight to their career risk, and reluctantly turning bullish. The bears are capitulating. How should investors approach this market?

I am not prepared to call the current market environment the start of a bubble just yet. Technical price momentum indicators are insufficiently bullish to declare this a new mania. Our bubble trigger is the monthly MACD indicator. Until the monthly MACD histogram turns positive, our inclination is to still call this a bear market rally.

If I am wrong and this is a new bubble, we may need a second aftershock of rising insolvencies and white-collar layoffs for investor psychology to change.

Fundamental and macro backdrop

Let’s begin with the fundamental and macro backdrop of the market. Federal Reserve Jerome Powell’s Senate testimony last week tells us everything we need to know about the economic outlook.

Recently, some indicators have pointed to a stabilization, and in some areas a modest rebound, in economic activity. With an easing of restrictions on mobility and commerce and the extension of federal loans and grants, some businesses are opening up, while stimulus checks and unemployment benefits are supporting household incomes and spending. As a result, employment moved higher in May. That said, the levels of output and employment remain far below their pre-pandemic levels, and significant uncertainty remains about the timing and strength of the recovery. Much of that economic uncertainty comes from uncertainty about the path of the disease and the effects of measures to contain it. Until the public is confident that the disease is contained, a full recovery is unlikely.

Moreover, the longer the downturn lasts, the greater the potential for longer-term damage from permanent job loss and business closures. Long periods of unemployment can erode workers’ skills and hurt their future job prospects. Persistent unemployment can also negate the gains made by many disadvantaged Americans during the long expansion and described to us at our Fed Listens events. The pandemic is presenting acute risks to small businesses, as discussed in the Monetary Policy Report. If a small or medium-sized business becomes insolvent because the economy recovers too slowly, we lose more than just that business. These businesses are the heart of our economy and often embody the work of generations.

Here are the main takeaways from his testimony:

  • There are signs of stabilization, but
  • Economic activity levels are far below pre-pandemic levels.
  • Much depends on the trajectory of the pandemic, and efforts to control the disease.
  • The longer the downturn, the bigger the risk of permanent damage.
  • Low-income Americans, and small and medium sized businesses are especially vulnerable in a prolonged slowdown.

To put the current recession into some perspective, a World Bank report pointed out that this is the four global recession as measured by per capita GDP growth since 1876, exceeded only by the Great Depression, and slowdowns sparked by two World Wars, and it is worse than double-dip of 1917-1921, which was exacerbated by the Spanish Flu.


In terms of sheer global breadth, this is the worse recession ever.


Meanwhile, the market is trading at a forward P/E ratio of 21.9, which is a level last seen in 2002. Past major market bottoms have seen the forward P/E at about 10. Even if we were to look forward to 2021 by acknowledging the utter devastation in 2020, the market is trading at a 2021 P/E of 19.1, which is not cheap.


The stock market response has only a brief hiccup, which sounds like fantasy in light of the global macro disaster. So, why are we seeing the formation of a possible bubble, and signs of capitulation from the bears?

A study of psychology

We will never know why bubbles form, but one possible reason can be found in human psychology. The investor class has largely been insulated from the bulk of the economic shock, and they reacted by shortening their time horizons and focusing on short-term fundamental momentum.

Let me explain. The study of economics is based on homo economicus, a race of people with rational expectations. As the study of behavioral finance discovered, people are not always rational. Morgan Housel at Collaborative Funds observed that people behave differently based on their own experiences. He described Pavlov’s famous experiment where he conditioned dogs to drool by ringing a bell, because he rang a bell before he fed them. What is less known is what happened next.

A massive flood in 1924 swept through Leningrad, where Pavlov kept his lab and kennel. Flood water came right up to the dogs’ cages. Several were killed. The surviving dogs were forced to swim a quarter mile to safety. Pavlov later called it the most traumatic thing the dogs had ever experienced, by far.

Something fascinating then happened: The dogs seemingly forgot their learned behavior of drooling when the bell rang.

The dogs were suffering from PTSD because of the flood, and their behavior changed.

Ever the curious scientist, Pavlov spent months studying how the flood changed his dogs’ behavior. Many were never the same – they had completely different personalities after the flood, and learned behavior that was previously ingrained vanished. He summed up what happened, and how it applies to humans:

Different conditions productive of extreme excitation often lead to profound and prolonged loss of balance in nervous and psychic activity … neuroses and psychoses may develop as a result of extreme danger to oneself or to near friends, or even the spectacle of some frightful event not affecting one directly.

People tend to have short memories. Most of the time they can forget about bad experiences and fail to heed lessons previously learned.

But hardcore stress leaves a scar.

Here is how Housel generalized this experience to human behavior.

It’s why the generation who lived through the Great Depression never viewed money the same. They saved more money, used less debt, and were weary of risk – for the rest of their lives…

It’s why countries that have endured devastating wars have a higher preference for social safety nets…

It’s why baby boomers who lived through the 1970s and 1980s think about inflation in ways millennials can’t fathom.


The economy isn’t the stock market

Here is why this analysis matters. The economy isn’t the stock market, and the investor class is not reacting to economic shock because it has largely been insulated from job losses. The burden of unemployment has fallen unevenly among the American population. It was mainly the low-wage workers who lost their jobs, or were furloughed. It has been the low-wage workers who would be suffering from economic PTSD.


Investment managers belong to the white-collar worker class who have largely been untouched by pandemic-related layoffs. While the work-at-home regime may be an inconvenience, their economic circumstances are less affected than low-wage workers who have either lost their jobs, or need to risk their health to go into work. It is therefore little surprise that CNBC reported that the middle class used some of their stimulus money to play the stock market.


The white-collar investor class, which includes retail investors, and institutional and hedge fund managers, are reacting by staging a bullish stampede by focusing on the Fed stimulus, and the momentum of the recovery.

What could pop the bubble?

If this is indeed a market bubble, then what could pop the bubble?

The Citigroup US Economic Surprise Index (ESI), which measures whether top-down economic releases are beating or missing expectations, has surged to its highest level ever, buoyed by upside surprises such as the May retail sales month-over-month advance of 17.7%. Past ESI retreats from elevated levels have usually seen stock prices stall with minimal upside potential. One bearish trigger would be a deterioration in ESI readings.


One trigger for ESI to fall is another wave of layoffs. Politico reported that Powell urged Congress to engage in more fiscal stimulus, and pointed out that state and local authorities are running out of money. Without federal support, this could mean mass layoffs, which would affect higher paying white-collar workers as well as low-paying positions.

He declined to give specific recommendations on further spending by Congress, but noted that millions of people are employed by state and local governments, many of which are experiencing fiscal crunches.

“It’s certainly an area I would be looking at if I were you,” he said. “That’s going to weigh on the economy.

Jerome Powell’s stated in his Senate testimony that the Fed is taking steps “to support the flow of credit in the economy”, but Fed policy has its limits. Quantitative easing does not prevent defaults, it only postpones them. Already, corporate defaults are rising. As defaults rise, so will job losses that hit broad swaths of the labor market.


Similarly, household sector finances are coming under increasing stress. Credit card delinquency rates are also rising to levels last seen during the GFC.


Remember, a well-functioning market needs price signals, and too much Fed support can obscure the process of creative destruction. Already, the number of zombie firms, defined as those whose debt servicing costs are higher than their profits but kept alive by easy credit, is rising rapidly. If allowed to proliferate, zombie firms are a drag on productivity. They seldom hire people; they shun new business investments; and they create a “dead zone” in the economy.


Another negative trigger could be a second pandemic wave, especially in the US. American public health policy has lagged other developed economies. The US population is roughly 330 million, while the EU’s population is 446 million. Europe has decisively bent the curve, while America has flattened the curve. What happens in a second wave, and what are the economic consequences? As a reminder, Jerome Powell stated in his Senate testimony, “The longer the downturn lasts, the greater the potential for longer-term damage from permanent job loss and business closures.”


Politico reported that Powell reminded lawmakers during his testimony that Fed projections assumes there is no second wave of infections.

Powell also said the Fed’s projections for economic performance this year, including a 9.3 percent unemployment rate by the end of 2020, didn’t factor in a potentially worse outcome if there is a second major outbreak of the coronavirus.


Not a bubble (yet)

Is this the start of a new market bubble? I am not prepared to make that call just yet. Technical price momentum indicators are insufficiently bullish to declare this a new mania. My bubble trigger is the monthly MACD indicator. Until the monthly MACD histogram turns positive, my inclination is to still call this a bear market rally.


Nevertheless, the adage that the economy isn’t the stock market may be especially true today. Despite enduring the fourth worse recession since 1876, the stock market reaction to the slowdown has been extremely mild. While the Fed has been swift to cushion the shocks, it cannot prevent bankruptcies and insolvencies, otherwise policy makers risk the rise of a class of nearly dead zombie companies which will be a drag on productivity.

Moreover, the burden of losses has been uneven, which is a factor that’s affecting investment psychology. The brunt of the economic shock has largely been borne by low-wage workers, and the investor class, consisting of middle and high-income households, have mainly been spared.

If I am wrong and this is a new bubble, we may need a second aftershock of rising insolvencies and white-collar layoffs for psychology to change. Investors are focused on the prospect of a V-shaped rebound today.


They should be wary of the risks of a pandemic second wave, or an economic second wave of rising insolvencies and layoffs. Already, weekly job postings are falling off after a business reopening related surge. Is this just a data blip, or something more serious? Stay tuned.


Also please stay tuned for our tactical trading publication tomorrow.


34 thoughts on “The bears are capitulating

  1. Even Hussman has backed off from full throttle bear posture:

    ‘Presently, our long-term and full-cycle market outlook remains profoundly negative, but our immediate outlook is rather agnostic because of the shift in market internals that we observed in response to the May jobs report. My impression is that this may prove to be a very brief whipsaw, given the similarity of current conditions to those of May 2001 and May 2008, but we don’t ignore shifts in internals on that basis. If you want a near-term forecast, I don’t have one. We’ll respond to the evidence as it comes.

    ‘My overall investment view is this: I continue to expect profound market losses over the completion of the current cycle, but my immediate market outlook is fairly neutral. My preference is for investment positions that have little sensitivity to “local” market movements, but ideally have the ability to benefit from large market movements in either direction. Until we observe a fresh break in internals (which could occur as early as next week, but may occur later), I wouldn’t be inclined to “fight” an extension of the recent market rebound with fresh bearish positions.’

  2. Some thoughts sparked by this. Sorry for typos on a small keyboard.

    100% agree on focusing on disparate impact on the investor class. I’d also add huge regional disparities.ALl politics is local and investing is somewhat too. If you live in New York, you are in the “whew, we’re past the crisis” relief phase. If you are in Texas, you are still in the “virus, what virus???” denial phase, but on the precipice of a slide into your own regional crisis. The NYTimes coronavirus map and state charts is a good way to track those regional variations. Many states are still in the “the virus is something on TV, not something close to home” phase. That will change for certain. Which will spread caution in general.

    I’d also note that investors seem a little to self-consciously aware of a “bubble” phenomena. You can’t get a decent bubble going without a “it different this time” narrative behind it. maybe that is supplied by the “TINA, don’t fight the Fed” narrative, but that is inherently self-referential. It only works as long as the market is working. And it keeps everyone with one eye on the exits because they know it is a bubble.

    A final thought is the Robinhood traders. There is this naive assumption they are naive. Right no they are buying calls (and making money). But nothing stops that herd from buying puts (and making money). They could well be the catalyst that pops this bubble, selling out to the pros and leading the slide down like they led the charge up. They come in in for scorn, but they have traded this brilliantly so far. In that, they remind me of hedge funds in the “good old days” of the 1990’s and 2000’s. You’d get a posse together, push up a stock with some scrap of plausible-sounding information, and then sell into the cresting wave. With the necessary (ahem) collusion managed by various discreet back channels. That all got a lot harder with higher regulatory scrutiny etc… THE ROBINOOHD CROWD IS DOING THE SAME THING. Look at the manufactured run in Tesla earlier this year pre-virus. The loosely coordinated pushes into call options in other stocks all point to a group that has mastered “flash mob” dynamics in an arena where that can be extremely lucrative. But that dynamic only works with volatility. If the market is trading sideways and refusng to go up much (like now) then why not get the herd running the other direction? THis would also fit the “maximum pain for most people” that the market tends to solve for. The Robinhood crowd would wrong-foot the pros on the way up and, now, on the way down. Some tidy narrative symmetry in that if nothing else.

    1. Good comments. This is regional and I can add to your thoughts on mindset. I’m in CA and work for a company in TX. My CA clients (tech and biotech) were ahead of the curve and got cautious in January when they saw what was happening. In early March Costco’s were full as people stocked up. It’s be a lower steady state since then, capital investment continues just at lower level. TX HQ first downplayed the virus as a “west coast issue” then cavalier “we’ll kick COVID ass” to capitulation “we’ll get through this” once they had to send everyone home. Now they are back to normal “if you’re not making your number you need to be in your office making calls” while clients in CA are telling employees they won’t be back in the office until end of year at earliest. Meanwhile TX rapidly is catching up with CA on daily virus growth. At some point, the second shoe drops, and that will be a shock for those that have ignored or wished this away.

      Not to say I don’t completely understand that wish!

      1. Thanks for these insightful comments, skwork, Livewell.
        Rxchen2, I discount Hussman’s missives as he has been bearish for a while now.

        1. Which makes his current change in tone all the more notable. (Actually, I don’t know if the change is abrupt, as I haven’t been following his takes on a weekly basis.)

          1. Agree, when a bear changes his or her stripes, and hops on to the bullish camp, I see it as a contrarian bearish signal.
            John Hussman, Marc Faber, Jermey Grantham, David Rosenberg, David Tice, Gary Shilling, Peter Schiff, Robert Prechter, are all notable bears. I have been a humble student of all these notable figures! Go figure.
            Statistically, if a person is bearish all (100%) the time, they are likely to be correct sometime! Now, you have been warned of doom and gloom!

          2. Right. However, they’re not fully bullish…yet. If and when that happens (which may take years), then we may be near the end of a phenomenal secular bull.

            Personally, I think we’re in the initial stages of a CYCLICAL bull within a much larger SECULAR bull. JMO, of course.

    I quote from the above:

    “Remember, the stock market is a leading indicator—typically starting its move into a bear market in advance of the economy entering a recession; and typically starting its move into a bull market in advance of the economy exiting a recession. Although the latest moves have occurred at warp speed, history shows that the stock market has actually had its best performance in the highest zone of the unemployment rate, the weakest zone of real GDP and the weakest zone of S&P 500 earnings growth”.

    See the table below from the above publication:

    To be sure, Urban Carmel, has shown evidence that stock market prices are not correlated to interest rates (see Cam’s earlier link regards this). That said, Liz Ann Saunders missive gives a more granular book at this idea and in my opinion, is a better analysis than Urban Carmel (Both, in my books are up there when it comes to stock market analysis).

    So far, the morphia delivered by the US Fed is working. At some point, it will stop working. In the mean time, the “bears are capitulating”!

    How long will this “virtuous” cycle last? A few years or a decade? No one knows, but I hope there will be a long warning of sentiment/euphoria that will tip our hand. So far, my “shoe shine boy” is not telling me to buy stocks in bankrupt companies issuing IPOs (but my “shoe shine boy” does not trade on Robinhood that I know of).

    In the mean time, the price of the barbaric metal (gold) has been quietly raised, by none other than the (wo)man of Gold (Goldman Sachs). The Ruskis, Indians and Chinese have not been buying gold lately, and despite their lack of buying, gold has not come down below 1710 in the last few months. Gold is showing significant strength here, though at key resistance level of 1750. Despite strength in the US stock market, gold remains quite strong. Cam will tell us that gold prices are related to “real interest rates” and we shall wait to see his analysis when he turns his hand to it.

    To be sure, the Indian central bank is holding 500 Billion USD of foreign exchange reserves, last I checked. This number is the highest ever that I am aware of. It is possible that such reserves may be used to buy arms to bolster India’s defenses against China, but I very much doubt whether there will be an armed conflict with China. Even if a few 100 Billion $s comes into the gold market, it would be a positive for Gold prices. If there is an armed conflict between India and China, I am sure, it would be bullish for Gold prices. Central banks like India do not usually step into gold market unless they have another seller willing to sell gold by the tonne, for fear of price dislocation.

    The narrative that famous (but now tarnished) investor like Marc Faber have outlined is to hold stocks until the music stops playing (i.e. money printing stops levitating stock prices). We may be at that point, where with a few hiccups, stocks could well rise into the next decade, by 5x from the bottom of 2200 (13% per annum). He is on record that one should cut stock market holdings to zero and buy gold with it (that said, he has also advised holding 20% net worth in gold).
    Use your dollar cost averaging approach to reach “your land of net worth”, as recommended by Christine Benz from Morningstar (see Jarrad’s post last “comments” section).
    Enjoy your weekend, and do not forget to have some phun!

  4. If it’s a bubble, then we need to be long, and hope that Cam will tell us when to get short.

    If it’s a bear market rally, then we should be neutral or long, and hope that Cam will tell us when to get short.

    If it’s a new bull market, then… I’m probably probably too old for this craziness.

  5. With my limited perspective of the 1960s, what is happening currently in the US seems to be similar to what happened back then (?), with worsening news overnight.

    Politics aside, I asked the question how stocks did during the Civil Rights movement, and sure enough, the market discounted all the violence and upheaval that happened back then.

  6. People miss the boat more often than not. Both on the way up and down. Nothing extraordinary there. But, as humans, we need to rationalize the failures. The rationalizations are as varied as people doing it. No one really has a consistent edge.
    What is one to do? Don’t get off the boat! The free lunch in the market is asset diversification and rebalance. Within that hold good businesses and assets.
    The trader in you then can go for alpha.

  7. The number of cases is rising in some states. So far, the market has ignoring it. I think the expectations are for rising cases but no lockdowns. At the same time, Apple closing some stores in the affected states on Friday led to a small decline in the market.

    What do you think will cause the sentiment to shift? The continued rise in new cases, death count or businesses retrenching from re-opening?

    1. It just seems as if everyone anticipates a bearish outcome – a second wave, an extended shutdown, and/or further job losses.

      What if none of the above actually comes to pass? Perhaps we’re still working our way through the first wave, and by the time a second wave might have transpired one or more vaccines will be available. Or businesses continue operating as people find smarter ways to work and interact.

      I don’t think current sentiment is bullish – it’s generally bearish. The market seems to disagree – perhaps none of the negative scenarios making the rounds will come to pass.

      1. AAII survey for 6/17 shows 47.8 bearish vs 30.5 average. Probably Robinhood traders are not part of the survey.


      Ciovacco retweet of Michael Santoli’s observations re ‘persistent skepticism,’ ‘predominance of AAII bears over bulls,’ ‘money flowing out of stock funds,’ and ‘a sense among the public that “everything has changed” [because of Covid-19], and not for the better.’

      All of that fits with what I see. There’s very little optimism right now.

      1. CIovacco posted that statement just now. Do we know when Michael Santoli made those observations?

        1. Not exactly sure, but the tweet below offers a clue.

          M F Hussey CFA CMT
          Replying to
          this week’s video = one of your best. great coincidence that it arrived same day as Santoli’s article. there’s a bubble in the use of the word “bubble” IMHO.

        2. The above tweet was a reply to Ciovacco’s original retweet – you’ll find it in the thread underneath.

          1. Mike Santoli has not been a raging bull over the years that I have known him. He has always been on a cautious/bearish side and I would categorize him as another bear that has thrown in the towel.

        1. So, if a group of investors sold stock worth 25.5 billion $, does it mean 25.5 billion $ of stock was purchased by another group of buyers?
          Does that mean, net cash on the sidelines did not increase?

    1. It’s the difference between equal weight and float/cap weight. The Value Line Geometric Index rebalances its components continuously, so it gives more weight to the smaller stocks.

      The S&P 500 and even the broader Wilshire 5000 are float and cap weighted, and give more weight to the bigger companies.

      This says that the bigger companies have steadily outperformed the smaller companies. It’s a winner take all environment.

  8. Describing Jeremy Grantham’s actions and comments (reducing stock allocation by more than half, calling current conditions a bubble) as ‘capitulation’ is certainly a novel take.

    1. What Grantham says and what Grantham does are different things. He acknowledges that he fought the bubble in his portfolios in the past (Japan, dot-com, and subprime) . GMO is known to have a value style, and they are not deviating from that style.

      The managers in the Fund Managers Survey are also not doing what they believe. They acknowledge that the market is overvalued, but they are holding their noses and buying.

  9. Ia anyone aware of sentiment survey data by demographic breakdown? It seems to me that people in 50 plus age group have disproportionately more wealth, are more risk averse, likely to be members of the AAII. Millenials are probably more optimistic, more risk takers but have less wealth. That would shed light on bearish sentiment survey results and Robinhood trading activity.

    1. Not sure what’s going on with the AAII survey. Their numbers have been out of step with other sentiment surveys, e.g. Investors Intelligence, NAAIM, etc.

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