Tag: Robert Shiller (page 1 of 2)

It’s A ‘Turkey’ Market

Authored by Lance Roberts via RealInvestmentAdvice.com,

With Thanksgiving week rapidly approaching, I thought it was an apropos time to discuss what I am now calling a “Turkey” market.

What’s a “Turkey” market?  Nassim Taleb summed it up well in his 2007 book “The Black Swan.”

“Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race ‘looking out for its best interests,’ as a politician would say.


On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.”

Such is the market we live in currently.

In a market that is excessively bullish and overly complacent, investors are “willfully blind” to the relevant “risks” of excessive equity exposure. The level of bullishness, by many measures, is extremely optimistic, as this chart from Tiho Krkan (@Tihobrkan) shows.

Not surprisingly, that extreme level of bullishness has led to some of the lowest levels of volatility and cash allocations in market history.

Of course, you can’t have a “Turkey” market unless you are being lulled into it with a supporting story that fits the overall narrative. The story of “it’s an earnings-driven market” is one such narrative. As noted  by my friend Doug Kass:

“Earnings are there to support the market. If we didn’t have earnings to support the market, that would be worrying. But we have earnings.”
Mary Ann Bartels, Merrill Lynch Wealth Management


“Earnings are doing remarkably well.”
Ed Yardeni, Yardeni Research


“This is very much an earnings-driven market.”
Paul Springmeyer, U.S. Bancorp Private Wealth Management


This is very much earnings-driven.”
Michael Shaoul, Marketfield Asset Management


“Equities have largely been driven by global liquidity, but they are now being driven by earnings.”
Kevin Boscher, Brooks Macdonald International


“Most of the market action in 2017 has been earning-driven.”
Dan Chung, Alger Management


“The action is justified because of earnings.
James Liu, Clearnomics


In another case of “Group Stink” and contrary to the pablum we hear from many of the business media’s talking heads, the U.S. stock market has not been an earnings-driven story in 2017. (I have included seven “earnings-driven” quotes above from recent interviews on CNBC, but there are literally hundreds of these interviews, all saying the same thing)


Rather, it has been a valuation-driven story, just as it was in 2016 when S&P 500 profits were up 5% and the S&P Index rose by about 11%. And going back even further, since 2012 S&P earnings have risen by 30% compared to an 80% rise in the price of the S&P lndex!

He is absolutely right, of course, as I examined in the drivers of the market rally three weeks ago.

“The chart below expands that analysis to include four measures combined: Economic growth, Top-line Sales Growth, Reported Earnings, and Corporate Profits After Tax. While quarterly data is not yet available for the 3rd quarter, officially, what is shown is the market has grown substantially faster than all other measures. Since 2014, the economy has only grown by a little less than 9%, top-line revenues by just 3% along with corporate profits after tax, and reported earnings by just 2%. All of that while asset prices have grown by 29% through Q2.” 

The hallmark of a “Turkey” market really comes down to the detachment of price from valuation and the deviation of price from long-term norms. Both of these detachments are shown in the charts below.

CAPE-5 is a modified version of Dr. Robert Shiller’s smoothed 10-year average. By using a 5-year average of CAPE (Cyclically Adjusted Price Earnings) ratio, it becomes more sensitive to market movements. Historically, deviations above 40% have preceded secular bear markets, while deviations exceeding -40% preceded secular bull markets.

The next chart shows the deviation of the real, inflation-adjusted S&P 500 index from the 6-year (72-month) moving average.

Not surprisingly, when the price of the index has deviated significantly from the underlying long-term moving averages, corrections and bear markets have not been too distant.

Combining the above measures (volatility, valuation, and deviation) together shows this a bit more clearly. The chart shows both 2 and 3-standard deviations above the 6-year moving average. The red circles denote periods where valuations, complacency and 3-standard deviation moves have converged. 

Of course, with cash balances low, you can’t foster that kind of extension without sufficiently increasing leverage in the overall system. The expansion of margin debt is a good proxy for the “fuel” driving the bull market advance.

Naturally, as long as that “fuel” isn’t ignited, leverage can remain supportive of the market’s advance. However, when the reversion begins, the “fuel” that drove stocks higher will “explode” when selling forces liquidation through margin calls.

While the media continues to suggest the markets are free from risk, and investors should go ahead and “stick-their-necks-out,” history shows that periods of low volatility, high valuations and deviations from long-term means has resulted in very poor outcomes.

Lastly, there has been a lot of talk about how markets have entered into a new “secular bull market” period. As I have addressed previously, I am not sure such is the case. Given the debt, demographic and deflationary backdrop, combined with the massive monetary interventions of global Central Banks, it is entirely conceivable the current advance remains part of the secular bear market that began at the turn of the century.

Only time will tell.

Regardless, whether this is a bull market rally in an ongoing bear market, OR a bull rally in a new bull market, whenever the RSI (relative strength index) on a 3-year basis has risen above 70 it has usually marked the end of the current advance. Currently, at 84, there is little doubt the market has gotten ahead of itself.

No matter how you look at it, the risk to forward returns greatly outweighs the reward presently available.

Importantly, this doesn’t mean that you should “sell everything” and go hide in cash, but it does mean that being aggressively exposed to the financial markets is no longer opportune.

What is clear is that this is no longer a “bull market.”

It has clearly become a “Turkey” market. Unfortunately, like Turkeys, we really have no clue where we are on the current calendar. We only know that today is much like yesterday, and the “bliss” of calm and stable markets have lulled us into extreme complacency.

You can try and fool yourself that weak earnings growth, low interest rates and high-valuations are somehow are justified. The reality is, like Turkeys, we will ultimately be sadly mistaken and learn a costly lesson.

“Price is what you pay, Value is what you get.” – Warren Buffett


This Is What A Pre-Crash Market Looks Like

Authored by Michael Snyder via The Economic Collapse blog,

The only other times in our history when stock prices have been this high relative to earnings, a horrifying stock market crash has always followed. 

Will things be different for us this time?  We shall see, but without a doubt this is what a pre-crash market looks like.  This current bubble has been based on irrational euphoria that has been fueled by relentless central bank intervention, but now global central banks are removing the artificial life support in unison.  Meanwhile, the real economy continues to stumble along very unevenly.  This is the longest that the U.S. has ever gone without a year in which the economy grew by at least 3 percent, and many believe that the next recession is very close.  Stock prices cannot stay completely disconnected from economic reality forever, and once the bubble bursts the pain is going to be unlike anything that we have ever seen before.

If you think that these ridiculously absurd stock prices are sustainable, there is something that I would like for you to consider.  The only times in our history when the cyclically-adjusted return on stocks has been lower, a nightmarish stock market crash happened soon thereafter

The Nobel-Laureate, Robert Shiller, developed the cyclically-adjusted price/earnings ratio, the so-called CAPE, to assess whether stocks are likely to be over- or under-valued. It is possible to invert this measure to obtain a cyclically-adjusted earnings yield which allows one to measure prospective real returns. If one does this, the answer for the US is that the cyclically-adjusted return is now down to 3.4 percent.


The only times it has been still lower were in 1929 and between 1997 and 2001, the two biggest stock market bubbles since 1880. We know now what happened then. Is it going to be different this time?

Since the market bottomed out in early 2009, the S&P 500 has been on a historic run.  If this rally had been based on a booming economy that would be one thing, but the truth is that the U.S. economy has not seen 3 percent yearly growth since the middle of the Bush administration.  Instead, this insane bubble has been almost entirely fueled by central bank manipulation, and now that manipulation is being dramatically scaled back.

And the guys on Wall Street know what is coming.  For example, Joe Zidle says that this bull market is now in “the ninth inning”

Joe Zidle, of Richard Bernstein Advisors, is arguing that the bull market has entered the bottom of the ninth inning.


“This is a late-cycle environment,” Zidle said on CNBC’s “Futures Now” recently.


“In innings terms, they’re not time dependent. An inning could be shorter or they could be longer. It just really depends,” the strategist said.

This bubble has lasted for much longer than it ever should have, and everyone understands that a day of reckoning is coming.

In fact, earlier today I came across an article on Zero Hedge that contained an absolutely remarkable quote from Eric Peters…

“We are investing as if 1987 will happen tomorrow, because it will,” said the CIO. “But we need to be long, or we’ll be out of business,” he explained, under pressure to perform. “So we construct option trades that are binary bets.” Which pay X profit if stocks rally, and cost Y if markets fall. No more and no less.


“What you do not want is a portfolio whose losses multiply depending on the severity of a decline.” That’s what most people have today. “At the last stage of the cycle, you want lots of binary bets. Many small wins. Before the big loss.”


Are we at the start or the end of the ‘Don’t know what I’m buying’ cycle?” asked the same CIO. “No one knows.” But we’re definitely within it.


“When their complex swaps drop 40%, and prime brokers demand more margin, investors will cry ‘It’s not possible!’ But anything is possible.” The prime brokers will hang up and stop them out.

In case you don’t remember, in 1987 we witnessed the largest one day percentage decline in U.S. stock market history.

When it finally happens, millions upon millions of ordinary Americans will be completely shocked, but most insiders know that the other shoe is going to drop at some point.

In particular, watch financial stock prices very closely.  Last month, Richard Bove issued a chilling warning about bank stocks…

One of Wall Street’s most vocal bank analysts is troubled by the rally in financials.


The Vertical Group’s Richard Bove warns that the overall market is just as dangerous as the late 1990s, and he cites momentum — not fundamentals — as what’s driving bank stocks to all-time highs.


“If we don’t get some event in the economy or in politics or in somewhere that is going to create more loan volume and better margins for the banks, then yes, they would come crashing down,” Bove said Monday on CNBC’s “Trading Nation.” “I think that the risk in these stocks is very high at the present time.”

It isn’t going to take much to set off an unstoppable chain of events.  Our financial markets are even more vulnerable than they were in 2008, and the right trigger could unleash a crisis unlike anything we have ever seen in modern American history.

Unfortunately, most Americans keep getting fooled by the artificial boom and bust cycles that the central banks create.  Right now most people seem to have been lulled into a false sense of security, and they truly believe that everything is going to be okay.

But every time before when the market has looked like this a crash has always followed, and this time will be no exception.

*  *  *

Michael Snyder is a Republican candidate for Congress in Idaho’s First Congressional District, and you can learn how you can get involved in the campaign on his official website. His new book entitled “Living A Life That Really Matters” is available in paperback and for the Kindle on Amazon.com.


Three Easy Pieces

Authored by 720Global's Michael Liebowitz via RealInvestmentAdvice.com,

If someone told you that the President of the United States in 2028 would be a Democrat and a woman from the state of New York, could you guess who it might be? We highly doubt it. In 1998, ten years before being elected president, Barack Obama had just been re-elected to the Illinois State Senate and was on no one’s radar as a Presidential candidate. In fact, had you been told at that time an African-American Democrat from Illinois would be president in 2008, it’s likely you would have assumed that two-time democratic presidential nominee Jesse Jackson would be the 44th President. In 1990, George W. Bush had just bought the Texas Rangers baseball club and was still four years from becoming Governor of Texas. In 1983, Bill Clinton was ten years out of law school and serving his second term as Governor of Arkansas. We could keep going down the line of presidents, and you would realize that even armed with some key details about the future, it would be extremely difficult to predict who a future president might be.

Stock investing is a little different. If you know the future level of three simple data points, you can calculate to the penny the price of any stock or index in the future and the exact holding period return. This precise prediction will hold up regardless of wars, economic activity, natural disasters, UFO landings or any other event you can dream up.

Unfortunately, those three data points are not readily available but can be inferred using historical trends, future expectations and logic to project them. With projections in hand, we can develop a range of price and return expectations for an index or an individual stock. In this paper, we provide an array of projections based on those factors and provide return expectations for the S&P 500 for the next ten years.

Factor 1: Dividends

Dividends are an important and often overlooked component of stock returns. To emphasize this point, an investor guaranteed a 3% dividend yield based on the current price, receives a 30% gain (non-compounded) in ten years. In other words, the investor has at least a 30% cushion to guard against price declines over a ten-year period.  That is what Warren Buffett refers to as a “moat,” and it is a wonderful benefit of investing in dividend-paying stocks.

The scatter plot graphed below compares the S&P 500 dividend yield to the Ten-year U.S. Treasury Note yield since 1980.  This historic backdrop helps project the S&P 500 dividend yield for the next ten years.

Data Courtesy: St. Louis Federal Reserve (FRED)

From 1980-1999, Treasury yields and dividend yields behaved alike. The trend line above, covering these years, has a statistically significant R-squared of 0.84 (84% of the move in dividend yields can be explained by moves in the 10-year yield). Since the year 2000, that relationship has all but disappeared. The R-squared for the post-financial crisis era is a meaningless .02.

Around the year 2000, dividend yields appear to have hit a floor ranging from 1-2%, despite a continued decline in Treasury yields. The reason for this is that many companies want to entice investors with higher dividend yields. As such, they raised dividends to keep the dividend yield relatively attractive. Had the regression of the 1980-1999 era held, dividend yields would be below 1% given current Treasury yields.

The graph above makes forecasting the future dividend yield relatively easy. As long as Ten-year U.S. Treasury yields stay below 5-6%, we expect dividend yields will range from 1-2%. Accordingly, we simplify this analysis and assume an optimistic 2% dividend yield for the next ten years.

Dividend Yield – Base/Optimistic/Pessimistic = 2%

Factor 2: Earnings

Over the long-term, earnings are well correlated to economic growth. Our ten-year analysis easily qualifies as long-term. Over shorter periods, there can be sharp variations due to a variety of influences such as regulatory policies and tax policies all of which influence profit margins. To arrive at reasonable expectations for earnings growth, we first consider economic growth. The following chart plots the declining trend in GDP growth since 1980.  Given the burden of debt, weak productivity growth and the obvious headwinds from demographics, we think it is likely the trend lower continues.

Data Courtesy: St. Louis Federal Reserve (FRED)

Next, we consider S&P 500 earnings growth rates. Earnings growth over the last three years, ten years and since 1980 are as follows: 3.18%, 4.38%, and 5.93% respectively. Given the economic and earnings trends, we believe a 3% future earnings growth rate for the next ten years is fair, 5% is optimistic, and 1% is pessimistic.

Earnings Growth – Base/Optimistic/Pessimistic = 3.00%/5.00%/1.00%

Factor 3: Valuations

Robert Shiller’s Cyclically Adjusted Price-to-Earnings ratio (CAPE) is our preferred method of valuation as it averages earnings over ten year periods. In doing so, it avoids short-term volatility of earnings and provides a more consistent baseline reflective of a company’s or indexes true earnings potential.  Currently, the CAPE of the S&P 500 sits in rare territory, as shown below. In fact, outside of the late 1990’s tech boom, there were only two months since 1881 when the Shiller CAPE was higher than today’s level – August and September of 1929.

CAPE has a history of extending well above and below its mean. Importantly, it also reverts to its mean after these long stretches of time. It does not seem unreasonable to expect that, over the next ten years, it will again revert to its mean since 1920 of 17.29. An optimistic scenario for 2028 is a CAPE reading of one standard deviation above the mean at 24.77. The pessimistic case is, likewise, one standard deviation below the mean at 9.70. Further, as shown below, we also present an outlook assuming CAPE stays at its current level of 31.21.

The graph below shows CAPE and the three forecasts along with the current level.

Data Courtesy: Robert Shiller http://www.econ.yale.edu/~shiller/data.htm

CAPE – Base/Optimistic/Pessimistic = 17.29/24.80/9.70

What does 2028 hold in store?

The following graph and table explore the range of outcomes that are possible given the scenarios outlined above. To help put context around the wide range of expected returns, we calculated an equity-equivalent price of the 10-year U.S. Treasury Note and added it to the graph as a black dotted line. Investors can use the line to weigh the risk and rewards of the S&P 500 versus the option to purchase a relatively risk-free U.S. Treasury Note. The table below the graph serves as a legend and reveals more information about the forecasts. The color shading on the table affords a sense of whether the respective scenario will produce a positive or negative return as compared to the U.S. Treasury Note. The far right column on the table indicates the percentage of observations since 1881 that CAPE has been higher than the respective scenarios.

Data Courtesy: Robert Shiller http://www.econ.yale.edu/~shiller/data.htm and 720Global/Real Investment Advice

As shown in the graph and table above, only scenarios 8 through 12 have a higher return than the ten year U.S. Treasury Note. Of those, three of the five assume that CAPE stays at current levels. Scenario 8, shaded yellow, has a negligible positive return differential.


The bottom line is that, unless one has a very optimistic view on earnings growth and expects valuations to remain elevated beyond what historical precedent argues is reasonable, the upside is limited, and the downside is troubling. The odds favor that a risk-free investment in a 10-year Treasury note will provide a better return through 2028 with less volatility. With current 10-year note yields at roughly 2.25%, that should emphasize the use of the term “troubling.”

The lines in the graph above are smooth, giving the appearance of identical returns each period. Markets do not work that way. These projections do not consider the path taken to achieve the expected total return and they most certainly will not be smooth. The best case scenario, and the one least likely to occur is for volatility to remain low. This would generate the most orderly path. Given that the post-crisis VIX (equity market volatility index) has averaged 17.7, current single-digit levels are an aberration and it does not seem unreasonable to expect more volatility in the future.

Even if one of the scenarios plays out exactly as we describe, the path to that outcome would be very choppy. For instance, if the worst case scenario played out, an investor may lose 60-80% of value in a matter of one or two years. However they would most likely have better than expected annual returns in the years following.

In a follow up to this article we will take this thought a step further and discuss the so-called path of returns. We show you the expected and actual path of returns from 2005 to 2015 and argue that an investor armed with the three factors, and a little discipline, may have generated much better returns than those earned by investors using a buy and hold approach.


“The Nightmare Scenario” Revisited: Albert Edwards Lays Out The Next “Black Monday”

Is it the onset of a recession or the fear of a recession that causes a crash? That is what SocGen’s bear (or, as he calls himself this time, wolf) Albert Edwards contemplated on the 30th anniversary of Black Monday, before reaching the conclusion that it’s the latter. Having taken several weeks off from publishing his ill-named global strategy “weekly” report to meet with clients, Edwards finds that most clients “seem to harbour similar fears as I, namely that the QE-driven bubble will burst at some stage and lay low the global economy, just as it did in 2007.” Yet where clients differ, is on the timing of said burst:

“despite my bearish (or is it wolfish) howling, virtually no clients think the denouement will come any time soon and that the equity bull market should have at least 12-18 months left to run. Most can see nothing on the immediate horizon that might burst this bubble.”

So, doing his public service to boost the overall sense of dread, and perhaps fear, Albert takes it upon himself to reprise recent discussions with clients, and in his latest letter explains “what might catch them out in the near term.” To do this, Edwards focuses first and foremost on the catalysts behind the abovementioned 1987 “Black Monday” crash.

A retrospective macro-narrative was inevitably wrapped around the ?Black Monday? 19 October 1987 equity market crash. My 30-year recollection is pretty good: 1987 saw a buoyant equity market rising briskly through most of the year as the oil price recovered from the previous year?s collapse (from $30 to $8, see chart below). After a year in the doldrums the US economy started to accelerate notably through 1987 as the impact of 1986 interest rate cuts and a lower dollar worked. By the time of the Oct crash the US ISM had surged from 50 at the start of the year to over 60 – a level seldom ever reached (see chart below). Amazingly the ISM has just last month exceeded 60.0 for only the second time since 1987. Spooky!


While one may disagree on the causes, Edwards makes one thing very clear: to hime it was all painfully memorable, and he recalls events from 30 years ago “as if it were yesterday (actually I can?t remember yesterday.)” And whether it was the fear of a recession, or something else, once the selling started, it wouldn’t stop until a fifth of market values were wiped out.

Of course the machines took over the selling in the form of Portfolio Insurance programmes, but speaking to my colleague Andrew Lapthorne, he reminds me we also have similarly pro-cyclical ?doomsday? vehicles today – with so much money being run by volatility targeting, risk parity and CTA/trend following quant funds. A fascinating article by stockmarket guru Robert Shiller in a NY Times article to mark the 30th anniversary of the crash, suggests that it was not the Portfolio Insurance that was responsible for the crash, as most official post-mortems suggested, but fear passed by word of mouth. Shiller thinks, in the internet age, there is even more scope for fear to spread like wildfire to set off a market crash – which would of course be limited to 20% in any one day due to circuit breaker rules.

Putting it together, Edwards concludes that “the trigger for the 1987 crash was the fear of US recession caused by the likelihood of US rate rises to stem a hypothetical dollar collapse.”

I am clear in my mind both at the time and now, that the US equity market was priced for a continuation of rapid economic and profit growth and this was under threat. The Dow was on nose-bleed valuations, especially as it had ignored the bond sell-off for most of 1997 (was it really 30 years ago that US 10y yields briefly crawled back above 10% – the last time we would see double-digit yields). None of this would have mattered if the US equity market had been cheap. In my view the record 25% ‘Black Monday’ October 19 decline was due to a horrendously expensive equity market suddenly confronted with the fear of recession. Equity valuations matter.

Fast forward to today, when equity valuations matter again; in fact, as Goldman and virtually all other banks agree, company valuations have never been higher.  And yet nobody cares, at least none of Edwards’ clients. He admits that at this moment, SocGen’s clients fear “very little it appears in the near term.” Oh, everyone knows stocks are a bubble, but after nearly a decade of crying valuation bubble wolf, so to speak, with no effect whatsoever, “oe thing we hear consistently is that they are not interested in being told equity valuations are expensive. They have been for a while and that does not seem to stop the market going up!”

But, “valuation DOES eventually matter” Edwards writes, as it did 30 years ago, in 1987, when “in the immediate aftermath of the crash, the extreme expense of US equities certainly was clearly a major contributing factor.”

So could 1987 happen again, and if so, what would be the catalyst that nobody can see?

The answer to the first, according to Edwards, is that “of course it could. It could happen tomorrow given the extreme expense of US equities and the near universal consensus of a continued acceleration in the economic cycle ? despite the Fed also in the midst of a tightening cycle.As the excellent David Rosenberg of Gluskin Sheff points out, of the13 post war Fed tightening cycles, 10 have ended in unexpected recession.”

And, as observed above, one may not even an actual recession, just the fear of one, to start the next 20% plunge: “at these extremes of equity valuation it might not even be an actual recession that produces the next precipitous equity bear market, but the fear of a recession, however misguided that fear may or may not be.”

* * *

And yet, as Edwards started off his letter, while “fears” may be pervasive, few clients (or traders, or analysts, or pundits) believe there is a catalyst for a quick and sudden reversal in the market’s nearly 9 year momentum is in the immediate future. But is that accurate?

Is there anything out there that can cause a rapid change in market expectations of future economic growth? Not according to most investors we speak to. But let?s try and think of some things that we maybe need to watch out for.

Here, in addition to the latent overhang of overvaluation, one main concern is “the expectation, or more importantly the fear of more rapid Fed rate rises threatening the economic recovery might be one thing to watch out for.” Yet while Janet Yellen’s replacement at the Fed will hardly seek to pursue tighter monetary policy, they may have no choice if the recent spike in averae hourly earnings proves to be long-lasting and widespread:

wage inflation has been the dog that didn?t bark this year – or indeed the wolf that didn?t howl. Wage inflation actually slowed this year against the expectations of some naysayer commentators (ie me) of an acceleration (and yes I do mean an acceleration rather than a rise). But it was notable that in the September payroll release, average hourly earnings jumped sharply to 2.9% – a high for this cycle (see chart below).

While many have explained the recent spike in inflation as being a transitory consequence of the two Hurricanes to slam the US this summer, “if for whatever reason it is not an aberration and the Phillips Curve is reasserting itself, similarly high wage inflation data in the months ahead could cause a rapid reappraisal of the pace of Fed rate hikes. At these high equity valuations, that could really scare investors.

Going back to what Deutsche Bank discussed two weeks ago, namely that the Fed is trapped in the 60 bps of space between the short and long end, Edwards writes that any expectation of faster rate hikes will impact the yield curve, which has already been flattening rapidly – a usual prelude to decelerating economic activity. Furthermore, “the dollar is likely to reverse the weakness we have seen since the start of this year, which was in large part a result of an unwinding of ultra long speculative dollar positioning against the euro (as suggested by the CFTC data).”

That has now completely reversed and speculators are very short the dollar. The catalyst for the resumption of the dollar?s rise may have been a sharp recent widening of the US 2y spreads with both Germany and Japan as investors embrace the near certainty of a December US rate hike, but this could go considerably further if investors actually begin to believe the Fed?s own forecasts of future interest rates (ie the Fed dots).

Which brings us to a topic Edwards discussed most recently at the end of August, namely the “Nightmare Scenario” for investors.

The nightmare scenario for equities would be if US wage inflation flickers back to life and investors not only decide that they are too far behind the Fed dots, but they also decide that the Fed itself is behind the tightening curve. In that scenario yields would jump sharply higher across the curve, but especially at the short end and the dollar would soar.

Ironically, as an aside, two weeks ago New River’s Eric Peters defined the “Nightmare Scenario” – from the perspective of the next Fed chair – as the opposite: a world in which inflation and wages do not rise, effectively boxing the central bank into continuing to inflate the biggest asset bubble ever leading to a historic crash. To this, we imagine Edwards’ response would be that the crash – as is – would be devastating enough.

How to determine if the market is on the verge of said “nightmare scenario” looking at market indicators? “Two critical long-term trend-lines to watch: First our head of technical analysis, Stephanie Aymes, highlights that the breakout point for the 30y downtrend in the dollar against the yen is around Y123/$ (chart left below). Second, as 10y US yields ?smash? above the multi-month support of 2.4%, they can rise all the way to 3% and still be in a bull market (see below).”

Indeed, while many have pointed out the recent breakout in the 10Y above the critical – for the past 6 months – support level of 2.42%, a stronger dollar may be as much, if not more, of a negative factor.

The equity markets? rise this year has been fuelled by profits growth and the expectation of a continuation of the current [weak dollar] trend. Much of that rise in US profits is the direct result of the dollar’s weakness so far this year. Take a look at the two charts below, both comparing US and Japanese profits. On the left, we show forward earnings expectations (TOPIX and S&P500) while on the right we show whole economy profits measures. The key difference is that the stockmarket profits measures have considerably more exposure to overseas earnings and the currency as well as not including smaller and unquoted companies. Hence it is notable that Japanese whole economy profits have considerably outperformed Japanese stockmarket profits, while on the other hand it is startling how US whole economy profits have underperformed US stockmarket profits. I think it?s mainly down to dollar weakness this year.

It’s not just nosebleed valuations, rising rates, a spike in the dollar, however: Edwards also brings attention to the bubble in corporate credit markets, or as he puts it, “corporate debt will be the 2007-like vortex of debility in the next downturn. Even the moderate, reasonable, and usually well behind-the-curve, IMF suggests a staggering 20% of US corporates are at risk of default in the next economic downturn.” More:

I certainly believe QE has also inflated US corporate debt prices way above what they otherwise should be. Indeed looking at the top left-hand chart, it is clear that typically, the corporate debt market would be in revolt by now in the face of the cyclical debauchment of corporate balance sheets. The fact that both yields and spreads are near all-time lows is, like over-extended equity valuations, a ticking time-bomb waiting to go off. (The chart on the left uses top-down corporate balance sheet data from the Federal Reserve Z1 Flow of Funds book. But the right-hand chart is stockmarket data from Datastream and shows a higher peak recently for quoted stocks, tying up closely with Andrew Lapthorne?s bottom-up analysis. )

There is one last catalyst: China.

Finally a word on China…which does not seem to concern clients at the moment. Incredible when you consider that a little over a year ago China was investors? number one concern. What changed was that the dollar?s weakness this year subdued jitters about renminbi devaluation and the plunge in Chinese reserves…. although on the surface the Chinese economy looks stable, increasingly volatile swings in credit policy are necessary to keep the show on the road ? most apparent in the boom and bust cycle in house prices (see left-hand chart below). A stronger dollar may necessitate another shift towards easy Chinese policy, including a weaker renminbi. That could cause trouble.

And, of course, the overarching factor behind all of the above is the Fedral Reserve. Which brings us to the conclusion:

So a reappraisal in the market?s expectations on the pace of Fed rate hikes, perhaps because of higher than expected wage inflation data, would likely trigger both a rise in yields along the length of a flattening curve and a resumption in the dollar bull market. When the equity market is ridiculously expensive and priced for profits perfection, these events (or indeed as in 1987, the FEAR of these events) could prove catastrophic for QE inflated equity markets.

Which, for those who have followed Edwards’ warnings, is in line with his long-running narrative, and which – one day – will prove prescient. For now, however, just do what the algos do and BTFD.


Why The Next Stock Market Crash Will Be Faster And Bigger Than Ever Before

Authored by Simon Black via SovereignMan.com,

US stock markets hit another all-time high on Friday.

The S&P 500 is nearing 2,600 and the Dow is over 23,300.

In fact, US stocks have only been more expensive two times since 1881.

According to Yale economist Robert Shiller’s Cyclically Adjusted Price to Earnings (CAPE) ratio – which is the market price divided by ten years’ average earnings – the S&P 500 is above 31. The last two times the market reached such a high valuation were just before the Great Depression in 1929 and the tech bubble in 1999-2000.

Some of the blame for high valuation goes to the so-called “FANG” stocks (Facebook, Amazon, Netflix and Google), whose average P/E is now around 130.

But there’s something different about today’s bull market…

Simply put, everything is going up at once.

Leading up to the tech bubble bursting, investors would dump defensive stocks (thereby pushing down their valuations) to buy high-flying tech stocks like Intel and Cisco – the result was a valuation dispersion.

The S&P cap-weighted index (which was influenced by the high valuations of the S&P’s most expensive tech stocks) traded at 30.6 times earnings. The equal-weighted S&P index (which, as the name implies, weights each constituent stock equally, regardless of size) traded at 20.7 times.

Today, despite sky-high FANG valuations, the S&P market-cap weighted and equal-weighted indexes both trade at around 22 times earnings.

Thanks to the trillions of dollars printed by the Federal Reserve (and the popularity of passive investing, which we’ll discuss in a moment), investors are buying everything.

In a recent report, investment bank Morgan Stanley wrote:

We say this not as hyperbole, but based on a quantitative perspective… Dispersions in valuations and growth rates are among the lowest in the last 40 years; stocks are at their most idiosyncratic since 2001.

So, ask yourself… With stocks trading at some of the highest levels in history, is now the time to be adding more equity risk?

Or, as billionaire hedge fund manager Seth Klarman notes… “When securities prices are high, as they are today, the perception of risk is muted, but the risks to investors are quite elevated.”

Volatility – as measured by the Volatility Index (VIX) – remains below 10 (close to its lowest levels in history). For comparison, the VIX hit 89.53 in October 2008, as the market plunged.

We haven’t seen a 3% down day since the election. And if that holds through the end of the year, it will be the longest streak in history.

And this false sense of security comes just as the main driver of this bull market – the trillions of dollars global central banks printed after the GFC – is coming to an end.

Markets saw around $500 billion of accommodation in 2016. And “quantitative tightening” should suck about $1 trillion out of the markets in 2018… That’s a $1.5 trillion swing in two years. And it’s a major headwind for today’s already overvalued markets.

But that’s just one issue. Remember, we also have…

Slowing global growth, record-high debt, potential nuclear war with North Korea, a rising world power in China, and cyber terrorism (just to name a few of the potential pitfalls) …

Still, investors continue to put money to work without a care in the world.

And more and more of that money is being invested with ZERO consideration of market valuation – thanks to the rise of passive investing.

Through July 2017, exchange-traded funds (ETFs) took in a record $391 billion – surpassing 2016’s record inflow of $390 billion.

According to Bank of America, 37% of the S&P 500 stocks are now managed passively.

Investors in these passive index funds and ETFs pay super-low fees in return for an automated investment process. For example, any money invested in a passively-managed S&P 500 ETF is equally distributed (based on market cap weighting) across the 500 S&P companies… So, companies like Apple, Google, Facebook and Amazon get the biggest share of that money.

The result… as this dumb money rushes in, the biggest stocks get even bigger – despite their already ludicrous valuations.

And the biggest players in this field are amassing a tremendous amount of power.

Vanguard, which introduced the world’s first passive index fund for individuals in 1976, has $4.7 trillion in assets (around $3 trillion of that is passive).

BlackRock, the world’s largest asset manager and owner of the iShares ETF franchise, is approaching $6 trillion in assets. And only 28% of BlackRock’s assets are actively managed.

Passive funds owned by these two firms are taking in $3.5 billion a day.

Bank of America estimates Vanguard owns 6.8% of the S&P 500 (and stakes of more than 10% in over 80 S&P 500 stocks).

And as long as the money keeps flowing into passive funds, the bubble keeps expanding.

At a time of exceptional market risk, more and more money is being managed without any notion of risk.

But what happens when these uninformed and value-agnostic investors have to sell?

Humans are emotional creatures. And when we do finally see that 3% (or even larger) down day, investors will rush for the exits.

And the computers will pile on the selling (every model based on historically low volatility will completely break when volatility spikes).

But when the wave of selling comes, who will be there to buy?

As these passive funds dump the largest stocks in the world, we’ll see an air pocket… nobody will be there to hit the bid.

And when the drop comes, it will come faster than anyone expects.

So, while most investors are ignoring risk, I’d advise you to use this record-high stock market to your advantage…

Sell some expensive stocks to raise cash. Own some gold. And allocate capital to sectors of the market that haven’t been blown out of proportion thanks to the popularity of passive investing. That means looking at smaller stocks and stocks outside the US.

Even if stocks go up for another year, which they may, it’s simply not worth the risk to chase them higher… Because the downturn will be devastating.

And to continue learning how to safely grow your wealth, I encourage you to download our free Perfect Plan B Guide.


Peter Schiff Warns Of “Calm Before The Storm”

Authored by Peter Schiff via Euro Pacific Capital,

In light of the 30-year anniversary of the Black Monday Crash in 1987 (when the Dow lost more than 20% in "one day", we should be reminded that investor anxiety usually increases when markets get to extremes. If stock prices fall steeply, people fret about money lost, and if they move too high too fast, they worry about sudden reversals. As greed is supposed to be counterbalanced by fear, this relationship should not be surprising. But sometimes the formula breaks down and stocks become very expensive even while investors become increasingly complacent. History has shown that such periods of untethered optimism have often presaged major market corrections. Current data suggests that we are in such a period, and in the words of our current President, we may be "in the calm before the storm."

Many market analysts consider the Cyclically Adjusted Price to Earnings (CAPE) ratio to be the best measure of stock valuation. Also known as the “Shiller Ratio” (after Yale professor Robert Shiller), the number is derived by dividing the current price of a stock by its average inflation-adjusted earnings over the last 10 years. Since 1990, the CAPE ratio of the S&P 500 has averaged 25.6. The ratio got particularly bubbly, 44.2, during the 1999 crescendo of the “earnings don’t matter” dotcom era of the late 1990’s. But after the tech crash of 2000, the ratio was cut in half, drifting down to 21.3 by March of 2003. For the next five years, the CAPE hung around historic averages before collapsing to 13.3 in the market crash of 2008-2009. Since then, the ratio has moved steadily upward, returning to the upper 20s by 2015. But in July of this year, the CAPE breached 30 for the first time since March 2002. It has been there ever since (which is high when compared to most developed markets around the world). (data from Irrational Exuberance, Princeton University Press 2000, 2005, 2015, updated Robert J. Shiller)

But unlike earlier periods of stock market gains, the extraordinary run-up in CAPE over the past eight years has not been built on top of strong economic growth. The gains of 1996-1999 came when quarterly GDP growth averaged 4.6%, and the gains of 2003-2007 came when quarterly GDP averaged 2.96%. In contrast Between 2010 and 2017, GDP growth had averaged only 2.1% (data from Bureau of Economic Analysis). It is clear to some that the Fed has substituted itself for growth as the primary driver for stocks.

Investors typically measure market anxiety by looking at the VIX index, also known as “the fear index”. This data point, calculated by the Chicago Board Options Exchange, looks at the amount of put vs. call contracts to determine sentiment about how much the markets may fluctuate over the coming 30 days. A number greater than 30 indicates high anxiety while a number less than 20 suggests that investors see little reason to lose sleep.

Since 1990, the VIX has averaged 19.5 and has generally tended to move up and down with CAPE valuations. Spikes to the upside also tended to occur during periods of economic uncertainty like recessions. (The economic crisis of 2008 sent the VIX into orbit, hitting an all-time high of 59.9 in October 2008.) However, the Federal Reserve’s Quantitative Easing bond-buying program, which came online in March of 2009, may have short-circuited this fundamental relationship.

Before the crisis, there was still a strong belief that stock investing entailed real risk. The period of stock stagnation of the 1970s and 1980s was still well remembered, as were the crashes of 1987, 2000, and 2008. But the existence of the Greenspan/Bernanke/Yellen “Put” (the idea that the Fed would back stop market losses), came to ease many of the anxieties on Wall Street. Over the past few years, the Fed has consistently demonstrated that it is willing to use its new tool kit in extraordinary ways.

While many economists had expected the Fed to roll back its QE purchases as soon as the immediate economic crisis had passed, the program steamed at full speed through 2015, long past the point where the economy had apparently recovered. Time and again, the Fed cited fragile financial conditions as the reason it persisted, even while unemployment dropped and the stock market soared.

The Fed further showcased its maternal instinct in early 2016 when a surprise 8% drop in stocks in the first two weeks of January (the worst ever start of a calendar year on Wall Street) led it to abandon its carefully laid groundwork for multiple rate hikes in 2016. As investors seem to have interpreted this as the Fed leaving the safety net firmly in place, the VIX has dropped steadily from that time. In September of this year, the VIX fell below 10.

Untethered optimism can be seen most clearly by looking at the relationship between the VIX and the CAPE ratio. Over the past 27 years, this figure has averaged 1.43. But just this month, the ratio approached 3 for the first time on record, increasing 100% in just a year and a half. This means that the gap between how expensive stocks have become and how little this increase concerns investors has never been wider. But history has shown that bad things can happen after periods in which fear takes a back seat.

Past performance is not indicative of future results. Created by Euro Pacific Capital from data culled from econ.yale.edu & Bloomberg.

On September 1 of 2000, the S&P 500 hit 1520, very close to its (up to then) all-time peak. The 167% increase in prices over the prior five years should have raised alarm bells. It didn't. At that point, the VIX/CAPE ratio hit 1.97…a high number. In the two years after September 2000, the S&P 500 retreated 46%. Ouch.

Unfortunately, the lesson wasn’t well learned. The next time the VIX/CAPE hit a high watermark was in January 2007 when it reached 2.39. At that point, the S&P 500 had hit 1438 a 71% increase from February of 2003. As they had seven years earlier, the investing public was not overly concerned. In just over two years after the VIX/CAPE had peaked the S&P 500 declined 43%. Double Ouch.

For much of the next decade investors seemed to have been twice bitten and once shy. The VIX/CAPE stayed below 2 for most of that time. But after the election of 2016, the caution waned and the ratio breached 2. In the past few months, the metric has risen to record territory, hitting 2.57 in June, and 2.93 in October. These levels suggest that a record low percentage of investors are concerned by valuations that are as high as they have ever been outside of the four-year “dotcom” period.

Investors may be trying to convince themselves that the outcome will be different this time around. But the only thing that is likely to be different is the Fed's ability to limit the damage. In 2000-2002, the Fed was able to cut interest rates 500 basis points (from 6% to 1%) in order to counter the effects of the imploding tech stock bubble. Seven years later, it cut rates 500 basis points (from 5% to 0) in response to the deflating housing bubble. Stocks still fell anyway, but they probably would have fallen further if the Fed hadn't been able to deliver these massive stimuli. In hindsight, investors would have been wise to move some funds out of U.S. stocks when the CAPE/VIX ratio moved into record territory. While stocks fell following those peaks, gold rose nicely.

Past performance is not indicative of future results. Created by Euro Pacific Capital from data culled from Bloomberg.

Past performance is not indicative of future results. Created by Euro Pacific Capital from data culled from Bloomberg.

But interest rates are now at just 1.25%. If the stock market were again to drop in such a manner, the Fed has far less fire power to bring to bear. It could cut rates to zero and then re-launch another round of QE bond buying to flood the financial sector with liquidity. But that may not be nearly as effective as it was in 2008. Given that the big problem at that point was bad mortgage debt, the QE program’s purchase of mortgage bonds was a fairly effective solution (although we believe a misguided one). But propping up overvalued stocks, many of which have nothing to do with the financial sector, is a far more difficult challenge. The Fed may have to buy stocks on the open market, a tactic that has been used by the Bank of Japan.

It should be clear to anyone that since the 1990s the Fed has inflated three stock market bubbles. As each of the prior two popped, the Fed inflated larger ones to mitigate the damage. The tendency to cushion the downside and to then provide enough extra liquidity to send stock prices back to new highs seems to have emboldened investors to downplay the risks and focus on the potential gains. This has been particularly true given that the Fed’s low interest rate policies have caused traditionally conservative bond investors to seek higher returns in stocks. Without the Fed’s safety net, many of these investors perhaps would not be willing to walk this high wire.

But investors may be over-estimating the Fed's ability to blow up another bubble if the current one pops. Since this one is so large, the amount of stimulus required to inflate a larger one may produce the monetary equivalent of an overdose. It may be impossible to revive the markets without killing the dollar in the process. The currency crisis the Fed might unleash might prove more destructive to the economy than the repeat financial crisis it's hoping to avoid.

We believe the writing is clearly on the wall and all investors need do is read it. It’s not written in Sanskrit or Hieroglyphics, but about as plainly as the gods of finance can make it. Should the current mother-of-all bubbles pop, for investors and the Fed it won’t be third time’s the charm, but three strikes and you’re out.


Robert Shiller: 1987 Could Happen Again

By Robert Shiller, first published in the NYT

Oct. 19, 1987, was one of the worst days in stock market history. Thirty years later, it would be comforting to believe it couldn’t happen again.

Yet that’s true only in the narrowest sense: Regulatory and technological change has made an exact repeat of that terrible day impossible. We are still at risk, however, because fundamentally, that market crash was a mass stampede set off through viral contagion.

That kind of panic can certainly happen again.

I base this sobering conclusion on my own research. (I won a Nobel Memorial Prize in Economic Sciences in 2013, partly for my work on the market impact of social psychology.) I sent out thousands of questionnaires to investors within four days of the 1987 crash, motivated by the belief that we will never understand such events unless we ask people for the reasons for their actions, and for the thoughts and emotions associated with them.

From this perspective, I believe a rough analogy for that 1987 market collapse can be found in another event — the panic of Aug. 28, 2016, at Los Angeles International Airport, when people believed erroneously that they were in grave danger. False reports of gunfire at the airport — in an era in which shootings in large crowds had already occurred — set some people running for the exits. Once the panic began, others ran, too.

That is essentially what I found to have happened 30 years ago in the stock market. By late in the afternoon of Oct. 19, the momentous nature of that day was already clear: The stock market had fallen more than 20 percent. It was the biggest one-day drop, in percentage terms, in the annals of the modern American market.

I realized at once that this was a once-in-a lifetime research opportunity. So I worked late that night and the next, designing a questionnaire that would reveal investors’ true thinking.

Those were the days before widespread use of the internet, so I relied on paper and ink and old-fashioned snail mail. Within four days, I had mailed out 3,250 questionnaires to a broad range of individual and institutional investors. The response rate was 33 percent, and the survey provided a wealth of information.

My findings focused on psychological data and differed sharply from those of the official explanations embodied in the report of the Brady Commission — the task force set up by President Ronald Reagan and chaired by Nicholas F. Brady, who would go on to become Treasury secretary.

The commission pinned the crash on causes like the high merchandise trade deficit of that era, and on a tax proposal that might have made some corporate takeovers less likely.

The report went on to say that the “initial decline ignited mechanical, price-insensitive selling by a number of institutions employing portfolio insurance strategies and a small number of mutual fund groups reacting to redemptions.”

An avalanche of sell orders exhausted traders in New York. Credit Maria Bastone/Agence France-Presse

The panic in New York spread to the Sydney Stock Exchange in Australia. Credit Fairfax Media

Portfolio insurance, invented in the 1970s by Hayne Leland and Mark Rubinstein, two economists from the University of California, Berkeley, is a phrase we don’t hear much anymore, but it received a lot of the blame for Oct. 19, 1987.

Portfolio insurance was often described as a form of program trading: It would cause the automatic selling of stock futures when prices fell and, indirectly, set off the selling of stocks themselves. That would protect the seller but exacerbate the price decline.

A car for sale after its owner lost money in the 1929 stock market crash.

The Brady Commission found that portfolio insurance accounted for substantial selling on Oct. 19, but the commission could not know how much of this selling would have happened in a different form if portfolio insurance had never been invented.

In fact, portfolio insurance was just a repackaged version of the age-old practice of selling when the market started to fall. With hindsight, it’s clear that it was neither a breakthrough discovery nor the main cause of the decline.

Ultimately, I believe we need to focus on the people who adopted the technology and who really drove prices down, not on the computers.

Portfolio insurance had a major role in another sense, though: A narrative spread before Oct. 19 that it was dangerous, and fear of portfolio insurance may have been more important than the program trading itself.

On Oct. 12, for instance, The Wall Street Journal said portfolio insurance could start a “huge slide in stock prices that feeds on itself” and could “put the market into a tailspin.” And on Saturday, Oct. 17, two days before the crash, The New York Times said portfolio insurance could push “slides into scary falls.” Such stories may have inclined many investors to think that other investors would sell if the market started to head down, encouraging a cascade.

Newspapers grappled with the biggest one-day stock market decline, in percentage terms, in Wall Street’s modern history

In reality, my own survey showed, traditional stop-loss orders actually were reported to have been used by twice as many institutional investors as the more trendy portfolio insurance.

In that survey, I asked respondents to evaluate a list of news articles that appeared in the days before the market collapse, and to add articles that were on their minds on that day.

I asked how important these were to “you personally,” as opposed to “how others thought about them.” What is fascinating about their answers is what was missing from them: Nothing about market fundamentals stood out as a justification for widespread selling or for staying out of the market instead of buying on the dip. (Such purchases would have bolstered share prices.)

Furthermore, individual assessments of news articles bore little relation to whether people bought or sold stocks that day.

Instead, it appears that a powerful narrative of impending market decline was already embedded in many minds. Stock prices had dropped in the preceding week. And on the morning of Oct. 19, a graphic in The Wall Street Journal explicitly compared prices from 1922 through 1929 with those from 1980 through 1987.

A graphic in The Wall Street Journal on the morning of Oct. 19, 1987, compared current stock trends with those of the 1920s

The declines that had already occurred in October 1987 looked a lot like those that had occurred just before the October 1929 stock market crash. That graphic in the leading financial paper, along with an article that accompanied it, raised the thought that today, yes, this very day could be the beginning of the end for the stock market. It was one factor that contributed to a shift in mass psychology. As I’ve said in a previous column, markets move when other investors believe they know what other investors are thinking.

In short, my survey indicated that Oct. 19, 1987, was a climax of disturbing narratives. It became a day of fast reactions amid a mood of extreme crisis in which it seemed that no one knew what was going on and that you had to trust your own gut feelings.

The week of Oct. 19, 1987, people around the country kept a close eye on the market

Given the state of communications then, it is amazing how quickly the panic spread. As my respondents told me on their questionnaires, most people learned of the market plunge through direct word of mouth.

I first heard that the market was plummeting while lecturing to my morning class at Yale. A student in the back of the room was listening to a miniature transistor radio with an earphone, and interrupted me to tell us all about the market.

Right after class, I walked to my broker’s office at Merrill Lynch in downtown New Haven, to assess the mood there. My broker appeared harassed and busy, and had time enough only to say, “Don’t worry!”

He was right for long-term investors: The market began rising later that week, and in retrospect, stock charts show that buy-and-hold investors did splendidly if they stuck to their strategies. But that’s easy to say now.

Like the 2016 airport stampede, the 1987 stock market fall was a panic caused by fear and based on rumors, not on real danger. In 1987, a powerful feedback loop from human to human — not computer to computer — set the market spinning.

Such feedback loops have been well documented in birds, mice, cats and rhesus monkeys. And in 2007 the neuroscientists Andreas Olsson, Katherine I. Nearing and Elizabeth A. Phelps described the neural mechanisms at work when fear spreads from human to human.

The Chicago Stock Exchange was drawn into the market fall

We will have panics but not an exact repeat of Oct. 19, 1997. In one way, the situation has probably gotten worse: Technology has made viral rumor transmission much easier. But there are regulations in place that were intended to forestall another one-day market collapse of such severity.

In response to the 1987 crash and the Brady Commission report, the New York Stock Exchange instituted Rule 80B, a “circuit breaker” that, in its current amended form, shuts down trading for the day if the Standard & Poor’s 500-stock index falls 20 percent from the previous close. That 20 percent threshold is interesting: Regulators settled on a percentage decline just a trifle less than the one that occurred in 1987. That choice may have been an unintentional homage to the power of narratives in that episode.

But 20 percent would still be a big drop. Many people believe that stock prices are already very high — the Dow Jones industrial average crossed 23,000 this week — and if the right kinds of human interactions build in a crescendo, we could have another monumental one-day decline. One-day market drops are not the greatest danger, of course. The bear market that started during the financial crisis in 2007 was a far more consequential downturn, and it took months to wend its way toward a market bottom in March 2009.

That should not be understood as a prediction that the market will have another great fall, however. It is simply an acknowledgment that such events involve the human psyche on a mass scale. We should not be surprised if they occur or even if, for a protracted period, the market remains remarkably calm. We are at risk, but with luck, another perfect storm — like the one that struck on Oct. 19, 1987 — might not happen in the next 30 years.


Buffett’s Wrong – Why Market Valuations Are Not Justified By Low Interest Rates

As is his way, Billionaire investor Warren Buffett calmed an anxious nation earlier this month with his comments that:

"Valuations make sense with interest rates where they are."

And it seemed to work as stocks hit new record highs and Americans have never, ever been more sure that stocks will continue rising for the next 12 months

Why wouldn't they – Buffett knows all, right?

Wrong, says John Hussman

Via Hussman Funds.com

It’s such a comforting, even satisfying assumption; the idea that “lower interest rates justify higher valuations.” The idea is one of the most basic principles of finance. Indeed, investors could consider it a law of investing. Except for the fact that it’s an incomplete sentence. Unfortunately, the convenience of investing-by-slogan, rather than carefully thinking about finance and examining evidence, is currently leading investors into what is likely to be one of the worst disasters in the history of the U.S. stock market.

Here are the propositions that are actually true:

  • An investment security is nothing but a claim on some stream of expected future cash flows that will be delivered into the hands of investors over time.
  • Provided that the stream of expected future cash flows is held constant, discounting those future cash flows at a lower rate (which is the same as accepting a lower future rate of return), will result in a higher “justified” price today, and this impact can be quantified.

Below, we’ll also establish and demonstrate some additional propositions:

  • If interest rates are low because growth rates are also low, no valuation premium on stocks is “justified” by the low interest rates. Prospective returns are reduced without the need for any valuation premium at all.
  • Provided that a valuation ratio is based on a “sufficient statistic” for long-term cash flows, the logarithm of that valuation ratio will, in turn, act as a sufficient statistic for long-term investment returns.
  • Revenues and margin-adjusted earnings have historically been far more reliable “sufficient statistics” of future cash flows than year-to-year earnings, or even 10-year averages of earnings.
  • Currently depressed interest rates are indeed associated with unusually weak current and prospective U.S. growth rates, implying that elevated stock market valuations are not, in fact, “justified” by interest rates at all.
  • Margin-adjusted valuation ratios behave as sufficient statistics for likely future stock market returns, and adding information about interest rates improves neither the reliability of return projections, nor the current level of those projections.

By the end of this comment, all of these will be clear. The upshot of these propositions is this. At present, the most reliable measures of U.S. equity market valuation – the measures that are best-correlated with actual subsequent market returns in market cycles across history – are 2.75 times (175% above) their historical norms. Given that depressed interest rates are matched by commensurately low U.S. growth rates, little or none of this premium is actually “justified” by interest rates. Rather, the S&P 500 is likely to post negative total returns over the coming 10-12 year horizon, with a likely interim loss in excess of -60%.

Moreover, even if the growth rates of nominal GDP, S&P 500 revenues, and other fundamentals were to literally double to historically normal rates, yet Treasury bond yields could be held 2.5% below their historical median for another decade, the combination would only “justify” a valuation premium for the S&P 500 of about 2.5% x 10 years = 25% above its corresponding historical valuation norms. We’re already 175% above those norms. There's no way to make the arithmetic work without assuming an implausible and sustained surge to historically normal economic growth rates, a near-permanent suppression of interest rates despite a full resumption of normal economic growth, and the permanent maintenance of near-record profit margins via permanently depressed real wage growth, despite an unemployment rate that now stands at just 4.2%.

There’s little doubt that the general level of long-term interest rates should be markedly lower than historical norms. But that’s because prospects for long-term growth are also markedly lower than historical norms. Again, the problem is that this combination deserves no valuation premium at all. Expected future stock market returns would be commensurately lower even in the absence of a valuation premium. That’s just how the arithmetic works.

Today’s obscene market valuations are largely the result of a) ignoring the growth side of this relationship, and b) activist central bank policies that have repeatedly driven short-term interest rates to levels that create a mentality of yield-scarcity among investors; where they stop quantifying the effect of rates and simply decide that “there is no alternative” to blindly speculating in risky assets regardless of their valuations. That’s what created the mortgage bubble that ended in the global financial crisis, and it’s what has created the “everything” bubble today. With deep respect, my impression is that Warren Buffett’s statement reflects that same lack of quantification.

What follows is an exposition that includes both theory and evidence. I’ve drawn freely on some of my prior commentaries, so parts will look familiar to long-time readers. But this is important, particularly at present extremes, so I hope you’ll spend some time with it.

The nerve of this Hussman guy

Before we continue, let’s get my own stress-testing narrative in the half-cycle since 2009 right on the table, so my admitted stumble doesn’t quietly draw the focus away from objective data.

In late-October 2008, after the market had collapsed more than 40% in a decline we fully anticipated, I wrote a piece called Why Warren Buffett is Right, and Why Nobody Cares, observing that stocks had become undervalued and the S&P 500 was likely to enjoy strong returns over the decade ahead. Consider today's comment as a companion piece expressing the opposite view. That late-2008 shift to a constructive outlook, aligned with a material improvement in valuations, was similar to those I had made after every bear market in what is now more than three decades as a professional investor, following a discipline that had repeatedly navigated complete market cycles admirably.

In 2009, I brought a half-cycle’s worth of ignominy upon myself, by insisting on stress-testing our methods against Depression era data, in the face of job losses and banking strains that were wholly outside of the post-war data that then informed our methods of classifying expected market return/risk profiles. It was a reasonable fiduciary decision, but very badly timed. In the midst of that “two data sets” ambiguity, the decision truncated our late-2008 constructive shift, and we missed a rebound that both our pre-2009 and our current methods could have captured. Worse, based on the historical tendency for extreme “overvalued, overbought, overbullish” syndromes to be closely followed by abrupt market losses and deterioration in market internals, the resulting methods prioritized those syndromes ahead of market internals themselves.

Market internals are an important gauge of speculative pressures, because when investors are inclined to speculate, they tend to be indiscriminate about it. Our overreliance on “overvalued, overbought, overbullish” syndromes turned out to be our Achilles Heel in the recent half-cycle. Faced with the novelty of quantitative easing and zero interest rates, investors continued to speculate long after those extreme syndromes emerged. Those syndromes can still justify a rather neutral outlook, but amid the novelty of quantitative easing, the central lesson (and required adaptation) was this: in a zero interest rate environment, it is necessary to wait for explicit deterioration in market internals, indicating a shift in investor preferences toward risk-aversion, before adopting a hard-negative outlook.

At present, we observe extreme overvalued, overbought, overbullish conditions, interest rates are well off the zero bound, and market valuations, even given proper consideration of interest rates, are at the most offensive levels in history. Still, as I noted a few weeks ago, while I view hedges and safety nets as essential here, there’s no need to “fight” a continued advance, if it emerges, with even larger hedges or higher safety nets. With the S&P 500 far beyond twice the level at which I expect it will end this cycle, it will be fine if the initial few percent lower do nothing for us.

Understand that my error in the recent half-cycle traces to my insistence on stress-testing our methods in the face of undervaluation that our own measures clearly identified, and that I openly recognized (but where similar levels in the Depression were still followed by massive market losses). The resulting methods prioritized extreme “overvalued, overbought, overbullish” syndromes ahead of market internals, and amid the novelty of QE and zero-interest rates, led us to fight too hard against objectively extreme valuations and the persistent speculation of investors. It’s a mistake we’ve adapted to, and that we won’t make again. Understanding that narrative doesn’t require investors to overlook that the market was undervalued in 2009, but is wickedly overvalued today.

Recent years have encouraged the illusion that investors will never again feel anything but sheer euphoria. As one of the few observers who anticipated both the tech collapse and the global financial crisis, and who has adopted a constructive or leveraged outlook after every bear market decline in more than three decades, my sense is that this complete lack of imagination about the range of investor emotions is likely to have brutal consequences.

A final note before we get into the data. I’m a great admirer of Warren Buffett. Not because he’s a mysterious Oracle that can be treated as a black box, but because his views have historically lined up with reliable objective evidence on valuations. Buffett was right about rich valuations in 1972, and 2000. He was right about undervaluation in 1974, and 1982, and late-2008. But even humbled by the narrative that followed my stress-testing decision in 2009, I can say one thing with confidence. From the standpoint of a value-conscious, historically-informed, full-cycle investment discipline, it is utterly incorrect to maintain that “valuations make sense with interest rates where they are.”

Meanwhile, I’ve got no personal conflict with people who choose to be bullish here. My motive is to be of service to others, particularly over the complete market cycle. Most of what I’ve made in my lifetime has gone to philanthropic efforts, and the rest is invested in our value-conscious, historically-informed, full-cycle discipline. I’ll continue to follow our discipline on behalf of those who trust my work, whether others agree or not; adapting it where the evidence requires, and maintaining patience where patience is what’s needed most. Despite speculation that has gone beyond every historical precedent in the recent half-cycle, I know that my open concerns about valuations in prior bubbles, as well as the constructive outlooks I’ve adopted after previous bear market declines, have ultimately proved to be of service to others by the time the market cycle has been completed.

Valuation basics

Look across the room you’re in, and imagine there’s a $100 bill taped in the far upper corner, where the walls and ceiling meet. Imagine you’re handing over some amount of money today, in return for a claim on that $100 bill 12 years from now.

Drop your hand toward the floor. If you pay $13.72 today for that future $100 cash flow, you can expect an 18% annual return on your investment over the next 12 years.

Raise your hand a little higher. If you pay $25.67 today for that future $100 cash flow, you can expect a 12% annual return on your investment over the next 12 years

Raise your hand just above chest-level. If you pay $39.71 today, you can expect an 8% annual return. Move your hand to the top of your head. If you pay $70.14 today, you can expect a 3% annual return. Raise your hand above your head. If you pay $78.85 today, you can expect a 2% annual return.

Now imagine jumping up and touching the ceiling with your hand. If you pay $100 today for that future $100 cash flow, you’ll earn nothing on your investment over the next 12 years.

The chart below shows the relationship between the current price and the embedded future return for our simple 12-year security. Notice that I’ve put the price axis on log scale, which is why the relationship is linear rather than curved.

[Geek’s note: Technically, the relationship above is linear in log(1+r), but to a close approximation, that’s the same as being linear in r itself. You can see why the relationship is linear by observing that P = C/(1+r)^T and taking the log of both sides.]

Notice that the impact of a change in interest rates can be quantified. For example, moving from a 3% rate of return to a 2% rate of return for 12 years results in a price change from $70.14 to $78.85, a gain of about 12%. As a general rule of thumb, if we change the interest rate by X% for a period of T years, the impact on the present value of a given cash flow will be roughly X% times T. It’s not an exact rule, but it’s useful.

An additional feature of the relationship above is extremely important. Notice that once we are given the expected future cash flows and the current price, no additional information is required in order to calculate the expected future rate of return. In particular, while the general level of interest rates may be partly responsible for bringing the price to whatever level one observes, once the price is actually established, the expected future investment return can be directly estimated from the level of valuation. No additional “adjustment” for interest rates is needed. Stop and think about this before continuing.

Because present value involves exponents, we’ll generally discover that if we calculate a valuation ratio by dividing the price of the security by some reasonably representative fundamental that’s proportional to the future expected cash flows, there will be a roughly linear relationship between the log valuation ratio and actual subsequent long-term investment returns. Adding information about interest rates will emphatically not improve our estimates of future returns, because the valuation measure will already act as a “sufficient statistic” for those returns. We’ll examine this proposition in actual U.S. market data later in this comment.

Valuations and growth

Let’s imagine a slightly more complicated security. This one pays the holder one payment annually, starting at $10 a year from today. In addition, we’re going to assume that the cash payment grows at a constant rate over the coming 30 years. The chart below shows the present value of that stream of cash flows, depending on the rate of growth, as well as the long-term rate of return that the investor accepts on the investment.

Notice something very important here: if the long-term rate of return is lower, but the growth rate of cash flows is also lower, the “justified” price of the security does not change.

Put simply, if interest rates are low because growth rates are also low, no valuation premium is “justified.” The long-term rate of return on the security will be low anyway without any valuation premium at all. This observation has enormous implications for current U.S. stock market prospects. We’ll demonstrate those implications shortly, across a century of actual market data.

As a side note, we can also quantify the effect of a change in interest rates on the value of the securities above, though the process is slightly more complicated. Even though they’re 30-year securities, changing interest rates by 1% will change the value by much less than 30%, because many of the cash flows come in earlier years. If the interest rate change is permanent for the entire 30-year span, we can estimate the impact of the change using what’s called the “duration” of the security. Duration is essentially an “average” maturity that weights the number of years until each payment is received by the proportion of the total present value that's paid in each year. If the interest change isn’t permanent, the “justified” impact of the interest rate change on the security price will be smaller than its duration.

Earnings, revenues, and sufficient statistics

In much of my work, I use the phrase “sufficient statistic,” which is a concept drawn from probability theory. A sufficient statistic is basically a number that summarizes all relevant information, so providing additional data doesn’t change one’s expectation.

Consider the very long-term stream of cash flows that a security actually throws off to investors over decades and decades. I’ve regularly observed that while corporate earnings are necessary to generate deliverable cash to shareholders, comparing prices to earnings is actually quite a poor way to estimate future investment returns. The reason is simple. Stocks are not a claim to next year’s earnings, but to a very long-term stream of cash flows that will be delivered into the hands of investors over time. Most of the variation in earnings, particularly at the index level, is uninformative. Corporate earnings are more variable, historically, than stock prices themselves.

So year-to-year earnings are not very useful “sufficient statistics” for that very long-term stream of cash flows. Though “operating” earnings are less volatile, all earnings measures are pro-cyclical; expanding during economic expansions, and retreating during recessions. As a result, to quote the legendary value investor Benjamin Graham, “The purchasers view the good current earnings as equivalent to ‘earning power’ and assume that prosperity is equivalent to safety.”

Not surprisingly, the valuation measures having the strongest correlation with actual subsequent investment returns across history are smoother, and act as more representative “sufficient statistics” for the relevant long-term cash flows. In the valuation of broad equity market indices, and in the estimation of probable future returns from those indices, revenues are actually a better sufficient statistic than year-to-year earnings (whether trailing, forward, or cyclically-adjusted).

Don’t misunderstand – what ultimately drives the value of stocks is the stream of cash that is actually delivered into the hands of investors over time, and that requires earnings. It’s just that profit margins are so variable over the economic cycle, and so mean-reverting over time, that year-to-year earnings, however defined, are flawed measures of the long-term stream of cash flows that determine the value of the stock market at the index level.

The best way to see that revenues dominate earnings as “sufficient statistics” for valuation is to examine which valuation measures are most strongly correlated with actual subsequent 10-12 year S&P 500 total returns in market cycles across history. Invariably, measures that are based on revenues, or that adjust for variation in profit margins, have a much stronger relationship with actual subsequent market returns than unadjusted earnings-based measures. Our preferred measure is MarketCap/GVA, which I introduced in 2015, and we calculate as the ratio of nonfinancial market capitalization to corporate gross value-added (corporate revenues, excluding the double-counting of intermediate inputs) including estimated foreign revenues. As a reminder, we generally prefer a 12-year horizon because that’s where the “autocorrelation” of valuations reaches zero, meaning that prior overvaluation or undervaluation decays most reliably over that period.

With regard to “sufficient statistics,” remember two things.

  • First, revenues and margin-adjusted earnings have historically been far more reliable “sufficient statistics” of future cash flows than year-to-year earnings, or even 10-year averages of earnings.
  • Second, provided a valuation ratio is based on a sufficient statistic for future cash flows, the log of that valuation ratio will act as a sufficient statistic for actual subsequent returns. In particular, interest rates may very well affect the level of valuations that we observe, but once a given level of valuation is established, adding information about interest rates will not improve our projections of subsequent market returns.

A note on profit margins

It’s important to recognize that the unusual elevation of profit margins in recent years is largely a temporary artifact of the extraordinary slack in the labor market that emerged in the aftermath of the global financial crisis. Specifically, the elevation of profit margins in recent years has been a nearly precise reflection of declining labor compensation as a share of output prices. To illustrate this below, I’ve shown real unit labor costs (labor compensation per unit of output, divided by price per unit of output) in blue on an inverted left scale, with profit margins in red on the right scale. Real unit labor costs are de-trended, reflecting the fact that real wage growth has historically lagged productivity growth by about 0.4% annually.

What’s notable here is that the process of profit margin normalization is already underway. Though there will certainly be cyclical fluctuations, this process is likely to continue in an environment where the unemployment rate is now down to 4.2% and demographic constraints are likely to result in labor force growth averaging just 0.2% annually between now and 2024 (see below). Total employment will grow at the same rate only if the unemployment rate remains at current levels. That creates a dilemma for profit margins: if economic growth strengthens in a tightening labor market, labor costs are likely to comprise an increasing share of output value, suppressing profit margins. If economic growth weakens, productivity is likely to slow, raising unit labor costs by contracting the denominator.

Thus far, we’ve established a few propositions. First, provided that the stream of expected future cash flows is held constant, discounting those future cash flows at a lower rate (which is the same as accepting a lower future rate of return), will result in a higher “justified” price today. However, we’ve also observed that if discount rates are low because growth rates are also low, no valuation premium is “justified” at all.

As for “sufficient statistics,” we’ve observed that valuation measures that are relatively insensitive to variations in profit margins are better correlated with actual subsequent market returns than measures that are sensitive to year-to-year fluctuations in earnings (even when one uses operating earnings or smoothed 10-year earnings, as the Shiller CAPE does). It should also be clear from the examples above that as long as we base our valuation measures on “sufficient statistics” for long-term cash flows, we can expect a fairly linear relationship between log valuations and subsequent investment returns.

We have two remaining propositions to demonstrate. The first is that currently depressed interest rates are indeed associated with unusually weak current and prospective growth rates (which implies that low interest rates do not, in fact, “justify” elevated valuation multiples). The second is that margin-adjusted valuations act as sufficient statistics for likely future investment returns, so adding information about interest rates improves neither the reliability of return projections, nor the current level of those projections.

On the prospects for U.S. economic growth

Real U.S. GDP growth is driven by two engines: the growth rate of the labor force, plus the growth rate of output per worker (productivity). On the labor side, based on population growth and other demographic factors, the U.S Bureau of Labor Statistics (BLS) projects that the U.S. labor force – the number of people working or looking for work – will reach 163.8 million in 2024. As of September 2017, the U.S. labor force stood at 161.1 million. Accordingly, the growth rate of the U.S. labor force is projected to average just 0.2% annually over the coming 7 years.

To illustrate what’s going on, the chart below shows the 10-year growth rates of the U.S. working age population, the civilian labor force, and civilian employment since the 1960’s. It’s clear from this chart that the central tendency of the “labor force” contribution to U.S. GDP growth has been steadily declining, having peaked in the 1970s and early 1980s.

It’s also worth noting that periods of rapid and sustained economic growth invariably begin from points of steep unemployment, because that’s the point from which the economy can enjoy a great deal of growth in the “labor force” contribution to growth. We hear a lot of hope that corporate tax cuts will prompt the kind of growth the U.S. enjoyed following the tax reforms of the 1950’s and the 1980’s. What’s often lost in this conversation is that the principal engines of economic expansion were already loaded with fuel at those points, mainly in the form of rapid underlying labor force growth and slack labor market capacity. That is not at all true today.

On the productivity front, over the past decade, productivity growth has declined from a post-war average of 2% to a growth rate of just 1.2% annually, with growth of just 0.6% annually over the past 5 years. The gap between dismal productivity and the most productive economic environment in U.S. history is only about 2.5% annually.

Over the long-term, the growth of U.S. productivity is largely driven by the growth of U.S. domestic investment, particularly net of depreciation. As technology increases the speed of obsolescence, depreciation rates have progressively increased in recent decades, so a given amount of gross domestic investment does progressively less to expand the U.S. capital stock. The chart below shows the 10-year averages of U.S. domestic investment (net of depreciation) as a share of GDP, along with the growth rate of real output per labor hour.

It’s worth noting that rapid growth in U.S. domestic investment is also typically associated with rapid deterioration in the U.S. trade deficit (an implication of the savings-investment identity, as explained below). For that reason, we observe a very strong regularity across history: the quickest way to “improve” the U.S. trade balance is to torpedo gross domestic investment, and the quickest way to “worsen” the U.S. trade balance is to enjoy a boom in gross domestic investment. The chart below illustrates this regularity in post-war data.

From a cyclical perspective, the problem is that once the trade balance is already at a significant deficit, there is little remaining slack for rapid expansion in either gross domestic investment or, by extension, U.S. productivity growth.

Periods of rapid economic growth typically emerge from points of high unemployment – not when unemployment is already quite low. Likewise, periods of rapid economic growth typically emerge from points where the trade balance (exports – imports) is elevated as a share of GDP – not when it is already at a steep deficit.

Presently, the Federal Reserve estimates the central tendency of long-run real GDP growth to average just 1.85% annually. Understand that even a 1.85% average economic growth rate in the coming years already builds in some optimistic assumptions. See, even if U.S labor force growth grows at the projected rate of 0.2% annually, this growth will transfer to a similar rate of employment growth only if the unemployment rate remains constant at the current 4.2% level. Meanwhile, with labor productivity growing at only about 0.6% annually, well below the post-war average of 2%, the baseline expectation for U.S. GDP growth, given no change in the present trajectory, is actually just 0.2% + 0.6% = 0.8%. So a 1.85% growth trajectory for real GDP assumes that some combination of labor force growth and productivity growth will accelerate from the current baseline.

The upshot is this. Over the coming 7-10 years, the central tendency of U.S. GDP growth is likely to average less than 2%, a result that is largely baked-in-the-cake because of the underlying drivers already in place. On a cyclical horizon focused on the coming 4-year period, the diminished slack in core economic drivers is consistent with a material slowing of economic growth relative to its average in recent years. Given that real U.S. GDP growth has averaged just 2% annually over the past 5 years, and that the current starting positions of labor force growth, unemployment, and the trade balance suggest a deceleration even from that average, we shouldn’t be surprised if real U.S. GDP growth amounts to just a fraction of a percent annually over the coming 4-year period.

The chart below shows the 7-year average growth rate of real GDP, excluding the impact of fluctuations in the unemployment rate. I’ve chosen a 7-year lookback, specifically to exclude the impact of the global financial crisis from the latest data point. At a 4.2% unemployment rate, future economic growth is unlikely to benefit from a substantial further retreat in unemployment. Without that contribution, it should be clear that the underlying drivers of U.S. economic growth, even during the recent economic recovery, have never been weaker.

Notably, the growth rates of S&P 500 earnings and revenues have also slowed considerably in recent years, at a pace commensurate with economic growth itself. Indeed, in recent decades, these growth rates have plunged to less than half their historical rate. Given these facts, it’s worth repeating the following: If interest rates are low because growth rates are also low, no valuation premium on stocks is “justified” by the low interest rates. Prospective returns are reduced anyway, without the need for any valuation premium at all.

Valuations, sufficient statistics and interest rates

Our final proposition left to demonstrate is that (log) margin-adjusted valuations are sufficient statistics for likely future investment returns, and that adding information about interest rates improves neither the reliability of the associated return projections, nor the current level of those projections.

For decades, I’ve observed that the reliability of every earnings-based valuation ratio, as measured by its correlation with actual subsequent returns, is substantially improved if one adjusts that ratio for variation in its embedded profit margin. It’s easy to prove this to yourself.

1: Obtain data on your preferred price/earnings measure over several market cycles, and calculate the embedded profit margin (the denominator of your preferred P/E, divided by S&P 500 revenues). If you can’t get that margin data, you can proxy it with U.S. corporate profits divided by U.S. corporate gross value-added (or even divided by U.S. GDP if needed). Calculate the margin the same way you calculate the denominator of your P/E, so if you’re using 10-year average earnings, do the same with the margin data. Just for fun, get data on the long-term Treasury bond yield as well.


2: Now use ordinary least-squares or any other approach to obtain three estimators of actual subsequent S&P 500 10-12 year returns: one using the log valuation measure alone (I prefer the natural logarithm ln for reasons I can detail another time), one using the log valuation measure and the log profit margin, and one using the log valuation measure, the log profit margin, and the level of interest rates.

Here’s what you’ll discover. When you include information on the log profit margin, your estimator will suck it up like a sponge, dramatically increasing the accuracy of your fit, and most likely giving the log margin a very similar (negative) coefficient as your log valuation measure alone. Once you’ve included both the valuation and margin information, adding information on interest rates will do virtually nothing further for the accuracy of your fit.

The reason for this result is that even though you think you care about earnings, history actually cares about revenues, which serve as far better “sufficient statistics” of the very, very long-term cash flows provided by stocks. Observe that price/revenue = price/earnings x earnings/revenue. Taking the log of both sides, you’ll get log(price/revenue) = log(price/earnings) + log(embedded margin). Your predictor will celebrate the inclusion of that margin information, and give it nearly the same coefficient as the log(P/E), because what it actually wants is the log price/revenue ratio. You may not like that result at all, but that’s what you’ll find.

The chart below is based on my margin-adjusted variant of Robert Shiller’s cyclically-adjusted PE (CAPE). Specifically, the CAPE (calculated here as the ratio of the S&P 500 to the 10-year smoothing of inflation-adjusted earnings) is multiplied at each point in time by a factor equal to the 10-year smoothing of corporate after-tax profits to GDP, divided by the historical norm of 5.4%. The resulting measure is similar to the S&P 500 price/revenue multiple, the ratio of market capitalization to corporate gross value-added, and other measures that share a correlation near 90% or higher with actual subsequent 10-12 year S&P 500 total returns in market cycles across history.

As expected, the (log) margin-adjusted CAPE acts as a “sufficient statistic” for actual subsequent S&P 500 total returns, particularly on horizons of 10-12 years (which is the point where deviations from historically normal valuations most reliably damp out). Also as expected, adding additional information about interest rates (green) does virtually nothing to improve the reliability of the resulting projections; a result that can be understood from our earlier valuation examples. If anything, low interest rates actually worsen expected future market returns here. If extreme valuations were not enough, depressed interest rates suggest the likelihood of below-average economic growth as well.

A century of reliable valuation evidence indicates that the S&P 500 is likely to experience an outright loss, including dividends, over the coming 10-12 year horizon, and we presently estimate likely interim losses on the order of -60% or more. A rate of return of even 1% in cash is a much more desirable option than investors may imagine. Moreover, I have little doubt that we’ll observe a spike in prospective returns over the completion of the current cycle, as we’ve observed in every market cycle across history. These spikes are associated with material retreats in valuation. Historically, the best opportunities to embrace market exposure tend to emerge when material retreats in valuation are coupled with early improvements in market action.

It’s worth emphasizing again that while the general level of interest rates may be partly responsible for bringing the price to whatever level one observes, once the price is actually established, the expected long-term return can be directly estimated from the level of valuation. No additional “adjustment” for interest rates is needed. It’s fine to estimate the expected return from the level of valuation and then compare it to the level interest rates to decide whether it’s reasonable to take the risk. But it’s important to realize that once the price is established, the valuation level alone is sufficient to make that estimate. Investors may not like this fact, but it’s a basic implication of security pricing, properly understood.

The chart below shows this relationship in three dimensions. While it’s true that lower interest rates have generally been associated with higher market valuations (particularly during the inflation-deflation cycle from 1970 until the late-1990’s), those low interest rates did absolutely nothing to mitigate the dismal market returns that actually followed extreme market valuations. Interest rates can certainly contribute to the emergence of rich valuations. But once those valuations are set, so are the prospects for subsequent market returns.

It’s tempting to imagine that if interest rates remain low even 10-12 years from now, everything will work out somehow. Unfortunately, the fact is that interest rates at the end of any 10-12 year period are strongly correlated with the economic growth rate over that period itself. So whatever gains are not taken away by reversion of valuations would instead be taken away by weak interim growth.

In summary, current market valuations are consistent with negative expected returns for the S&P 500 over the coming 10-12 years, with a likely market loss of more than -60% in the interim. The proposition that “lower interest rates justify higher valuations” has become a rather dangerous slogan, and is a distressingly incomplete statement that ignores the other half of the sentence: “provided that the stream of expected cash flows is held constant.” Our refusal to accept the incomplete statement as a given is in no way a rejection of basic finance. To the contrary, it’s a reminder that investors need to quantify the effect of interest rates, to consider the fundamental drivers of growth, and to carefully examine the relationship between their preferred valuation measures and actual subsequent market returns.

What investors apparently want to believe is that low interest rates “justify” rich valuations, yet at the same time, those “justified” valuations will be associated with future returns similar to those that have historically been associated with valuation norms less than half of present levels. This mindset is wholly disconnected from any actual principle of finance. A full understanding of the extreme risks inherent in the current financial precipice calls on investors to recognize the following:

  • An investment security is nothing but a claim on some stream of expected future cash flows that will be delivered into the hands of investors over time.
  • Provided that the stream of expected future cash flows is held constant, discounting those future cash flows at a lower rate (which is the same as accepting a lower future rate of return), will result in a higher “justified” price today, and this impact can be quantified.
  • If interest rates are low because growth rates are also low, no valuation premium on stocks is “justified” by the low interest rates. Prospective returns are reduced without the need for any valuation premium at all.
  • Provided that a valuation ratio is based on a “sufficient statistic” for long-term cash flows, the logarithm of that valuation ratio will, in turn, act as a sufficient statistic for long-term investment returns.
  • Revenues and margin-adjusted earnings have historically been far more reliable “sufficient statistics” of future cash flows than year-to-year earnings, or even 10-year averages of earnings.
  • Currently depressed interest rates are indeed associated with unusually weak current and prospective U.S. growth rates, implying that elevated stock market valuations are not, in fact, “justified” by interest rates at all.

Valuation update

The following charts will provide a sense of where the U.S. equity market currently stands.

The first chart shows our margin-adjusted CAPE, which as noted above has a correlation of about -0.89 with actual subsequent market returns across U.S. market cycles since the 1920’s.

Based on the consensus of the most historically-reliable market valuation measures we identify, the U.S. equity market is now at the most offensive level of overvaluation in history, exceeding even the levels observed in 1929 and 2000. Because investors appear to have a speculative bit in their teeth, our very near-term outlook is rather neutral, allowing for both further speculation and abrupt market losses. Again, as I noted a few weeks ago, I view hedges and safety nets as essential here, but there’s no need to “fight” a continued advance, if it emerges, with even larger hedges or higher safety nets. With the S&P 500 likely to lose more than -60% by the completion of the current market cycle, it will be fine if the initial few percent lower do nothing for us.

Don’t confuse the extreme nature of our market loss projections with a requirement that they must be immediate. My expectation is that the initial market losses will be strikingly abrupt, in the sense that the first whack will emerge seemingly out of the blue. I also expect that the initial decline will immediately wipe out any residual gains the market may enjoy from current levels. Still, given the speculative bit that investors seem to have in their teeth here, an element of our patience here involves the willingness to tolerate any residual advance without raising safety nets further.

The chart below shows the median price/revenue ratio across all S&P 500 components (thanks to Russell Jackson, our resident math guru, for compiling this in data from FactSet and Standard & Poors). What’s notable here is that unlike the 2000 peak, when overvaluation was concentrated in the top two deciles of stocks (primarily representing large-cap tech stocks at the time), the current valuation extreme is uniform across every decile. Based on the historical relationship between the valuations of various deciles and their subsequent losses over the completion of prior market cycles, I expect nearly every decile of stocks to experience losses in the 50-70% range as this cycle completes, much like the losses that I projected at the 2000 and 2007 peaks (recall that the tech-heavy Nasdaq 100 lost -83% in the 2000-2002 rout), but with the losses extending to a much broader set of stocks in this instance.

To offer a longer historical perspective, and further insight into the difference between the 2000 peak and the present extreme, the chart below overlays the median price/revenue ratio along with the margin-adjusted CAPE. Notice that the extreme valuation of the S&P 500 Index in 2000 was not associated with anything close to the broad overvaluation among S&P 500 components that we currently observe. Indeed, at the 2000 peak, nearly half of all U.S. stocks were at valuations that we viewed as reasonable. This is certainly not the case at present.

With valuations at the most offensive extremes in history, careful investment analysis has been replaced with investing-by-slogan. The problem is that stocks still represent a claim on future cash flows, and over time, reality shows up as those cash flows are delivered. By the completion of the current cycle, I expect that the total return of the S&P 500 will have lagged Treasury bills all the way back to about October 1997, just as by the end of the 2007-2009 decline, the index had lagged Treasury bills all the way back to June 1995.

One of the challenges with securities, banks, and other objects of finance is that while they actually rest on a very long-term stream of future expected cash flows, investors focus mainly on returns, rather than the quality of those underlying factors. That feature allows enormous departures between what investors think is true and the underlying reality that will unfold over time. Those departures can exist and deteriorate for years before they inevitably become common knowledge. It’s exactly the feature that Ponzi schemes rely on, whether those schemes are sold by crooks or central bankers (and it’s sometimes hard to know the difference).

For a while, Bernie Madoff’s investors felt great about their impressive “returns.” For a while, investors in dot-com stocks felt the same. For a while, investors in mortgage bonds felt the same. But when investors focus on returns rather than the very long-term structure, stability, and even existence of the underlying cash flows, terrible things can happen. All that’s required to get the snowball rolling is the creeping recognition that there’s no “there” there.

In response to the delusion that low interest rates “justify” virtually any level of market valuation, regardless of the growth rate of the underlying cash flows, the speculation of recent years has created a situation where there is effectively no way out for investors in aggregate. Every security that is issued must be held by someone until it is retired. When one investor sells a share, it simply means that another investor buys it. The only question is who will hold the bag.

Market conditions are impermanent, and all of this will change over time. As has been the case in every market cycle, the strongest estimated market return/risk profiles we identify emerge when a material retreat in valuations is joined by an early improvement in market action. I have no doubt that we’ll observe similar opportunities over the completion of the current market cycle.


Bogle, Buffett, Shiller & Tobin – Valuations Are Expensive

Authored by Lance Roberts via RealInvestmentAdvice.com,

During my morning reading, I ran across a couple of very interesting articles that tied a common theme relating to the current risks in the financial markets.

Via Zerohedge:

88-year-old investing icon John “Jack” Bogle, founder of the Vanguard Group, said:

“The valuations of stocks are, by my standards, rather high, but my standards, however, are high.


When considering stock valuations, Bogle’s method differs from Wall Street’s. For his price-to-earnings multiple, Bogle uses the past 12 months of reported earnings by corporations, GAAP earnings, which include ‘all of the bad stuff,’ to get a multiple of about 25 or 26 times earnings.


‘Wall Street will have none of that. They look ahead to the earnings for the next 12 months and we don’t really know what they are so it’s a little gamble.’


He also noted that Wall Street analysts look at operating earnings, ‘earnings without all that bad stuff,’ and come up with a price-to-earnings multiple of something in the range of 17 or 18.


‘If you believe the way we look at it, much more realistically I think, the P/E is relatively high,’


‘I believe strongly that [investors] should be realizing valuations are fairly full, and if they are nervous they could easily sell off a portion of their stocks.'”

This, of course, from the father of “buy and hold” investing with whom millions of Americans have pumped roughly $4.7 Trillion into a whole smörgåsbord of indexed based ETF’s provided by Vanguard to meet investor appetites.

Think about that for a moment while you read the following snippet from Bloomberg:

“A buoyant and complacent stock market is worrying Richard H. Thaler, the University of Chicago professor who this week won the Nobel Prize in economics.


‘We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping. I admit to not understanding it.


I don’t know about you, but I’m nervous, and it seems like when investors are nervous, they’re prone to being spooked. Nothing seems to spook the market, and if the gains are based on tax-reform expectations, surely investors should have lost confidence that tax reform is going to happen.'”

These two points drive to the heart of the recent concerns I have expressed in both how companies continue to use accounting gimmickry to win the beat the estimate game” each quarter and the risk of disappointment surrounding tax reform legislation.

But since markets have continued to advance due to the ongoing flood of liquidity from global Central Banks, no one is really paying attention to such “silly” things. However, while market analysts continue to come up with a variety of rationalizations to justify high valuations, none of them hold up under real scrutiny. The problem is the Central Bank interventions boost asset prices in the short-term, in the long-term, there is an inherently negative impact on economic growth. As such, it leads to the repetitive cycle of monetary policy.

  1. Using monetary policy to drag forward future consumption leaves a larger void in the future that must be continually refilled.
  2. Monetary policy does not create self-sustaining economic growth and therefore requires ever larger amounts of monetary policy to maintain the same level of activity.
  3. The filling of the “gap” between fundamentals and reality leads to consumer contraction and ultimately a recession as economic activity recedes.
  4. Job losses rise, wealth effect diminishes and real wealth is destroyed. 
  5. Middle class shrinks further.
  6. Central banks act to provide more liquidity to offset recessionary drag and restart economic growth by dragging forward future consumption. 
  7. Wash, Rinse, Repeat.

If you don’t believe me, here is the evidence.

The stock market has returned more than 60% since 2007 peak, which is more than three times the growth in corporate sales growth and 30% more than GDP. The all-time highs in the stock market have been driven by the $4.5 trillion increase in the Fed’s balance sheet, hundreds of billions in stock buybacks, PE expansion, and ZIRP.

It is critical to remember the stock market is NOT the economy. The stock market should be reflective of underlying economic growth which drives actual revenue growth. Furthermore, GDP growth and stock returns are not highly correlated. In fact, some analysis suggests that they are negatively correlated and perhaps fairly strongly so (-0.40).

However, in the meantime, the promise of a continued bull market is very enticing as the “fear of missing out” overrides the “fear of loss.”

Valuations Are Expensive

This brings us back to Jack Bogle and the importance of valuations which are often dismissed in the short-term because there is not an immediate impact on price returns. Valuations, by their very nature, are HORRIBLE predictors of 12-month returns should not be used in any strategy that has such a focus. However, in the longer term, valuations are strong predictors of expected returns.

I have adjusted Bogle’s measure of valuations to a 24-month, versus 12-month, measure to smooth out the enormous spike in valuations due to the earnings collapse in 2008. The end valuation result is the same but peaks, and troughs, in valuations are more clearly shown.

At 26.81, Bogle is clearly correct that valuations have reached expensive levels. More importantly, outside of the peak in 1999, stocks are more highly valued today than at any other point in history. (The two points during bear market troughs are excluded as those valuations were due to earnings collapsing faster than prices due to recessionary conditions.)

Bogle’s view is also confirmed by other measures as well. The chart below shows Dr. Robert Shiller’s cyclically adjusted P/E ratio combined with Tobin’s Q-ratio. Again, valuations only appear cheap when compared to the peak in 2000. Outside of that exception, the financial markets are now more expensive than at any other single point in history.

I have also previously modified Shiller’s CAPE to make it more sensitive to current market dynamics.

“The need to smooth earnings volatility is necessary to get a better understanding of what the underlying trend of valuations actually is. For investor’s, periods of ‘valuation expansion’ are where the bulk of the gains in the financial markets have been made over the last 116 years. History shows, that during periods of ‘valuation compression’ returns are more muted and volatile.

Therefore, in order to compensate for the potential ‘duration mismatch’ of a faster moving market environment, I recalculated the CAPE ratio using a 5-year average as shown in the chart below.”

To get a better understanding of where valuations are currently relative to past history, we can look at the deviation between current valuation levels and the long-term average going back to 1900.

With a 63.62% deviation from the long-term mean, a reversion will be quite damaging to investors when it occurs. As you will notice, reversions have NEVER resulted in a “sideways” consolidation but rather much more serious, and sharp, declines. These rapid “maulings” of investors is why declines are aptly named “bear markets.” 

Lastly, even Warren Buffett’s favorite valuation measure is screaming valuation issues. The following measure is the price of the Wilshire 5000 market capitalization level divided by GDP. Again, as noted above, asset prices should be reflective of underlying economic growth rather than the “irrational exuberance” of investors.

Of course, it’s Buffett’s own axiom that best sums up all of the famous valuation measures noted above.

“Price is what you pay, valuation is what you get.” 

Maybe Not Today

Bogle, Buffett, Shiller, and Tobin are right about valuations.

Maybe not today.

Next month.

Or even next year.

But as Vitaliy Katsenelson just recently penned:

Our goal is to win a war, and to do that we may need to lose a few battles in the interim.


Yes, we want to make money, but it is even more important not to lose it. If the market continues to mount even higher, we will likely lag behind. The stocks we own will become fully valued, and we’ll sell them. If our cash balances continue to rise, then they will. We are not going to sacrifice our standards and thus let our portfolio be a byproduct of forced or irrational decisions.


We are willing to lose a few battles, but those losses will be necessary to win the war. Timing the market is an impossible endeavor. We don’t know anyone who has done it successfully on a consistent and repeated basis. In the short run, stock market movements are completely random – as random as you’re trying to guess the next card at the blackjack table.”

With that point, I clearly agree.


Nobel Laureate Richard Thaler: “We Seem To Be Living In The Riskiest Market Of Our Lives”

Robert Shiller isn’t the only Nobel Laureate who’s worried the US stock market is sleepwalking toward disaster.

In an interview with Bloomberg’s Jeanna Smialek, Thaler, who was awarded the Nobel Memorial Prize in Economic Sciences on Monday for his pioneering work in establishing that humans are “predictably irrational”, said that the stock market’s complacency in the face of the North Korean nuclear threat and political uncertainty at home is disconcerting.

“We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping,” Thaler said, speaking by phone on Bloomberg TV. “I admit to not understanding it.”

Adding his voice to a growing chorus of Wall Street analysts who suspect that the Trump administration’s tax reform ambitions will be dashed by a handful of intransigent senators, Thaler said any investors who’ve been paying attention should have “lost confidence” by now.

“I don’t know about you, but I’m nervous, and it seems like when investors are nervous, they’re prone to being spooked,” Thaler said, “Nothing seems to spook the market” and if the gains are based on tax-reform expectations, “surely investors should have lost confidence that that was going to happen.”

US stocks have continued to hit a string of records since President Donald Trump’s upset victory over Hillary Clinton in November while volatility has plunged, with realized vol reaching its lowest level on record in October.

As Bloomberg points out, Thaler, who has made a career of studying irrational and temptation-driven actions among economic actors claimed that the market’s complacency was fundamentally misguided.

Thaler’s comments echoed comments from Shiller, a professor at the Yale School of Management who won his economics Nobel in 2013, who warned during a July interview with CNBC, Shiller expressed concern that his Shiller CAPE ratio had crossed above 30, signaling that equity valuations were dangerously stretched. During the history of the stock market, stocks have only traded at richer valuations during one period – June 1997 to September 2001 – as the dotcom farce blew and burst. Historical data for the index is available going back to 1881.

Thaler also took a shot at President Donald Trump, mocking the president’s fondness for bluster and notorious aversion toward reading books.

“His ratio of certitude to knowledge is nearing record highs,” Thaler said on Bloomberg Radio with Tom Keene and David Gura. “We all need a lot of humility, and especially about the economy.”

He also added that the UK’s vote to leave the European Union was decision based on emotions, not rationality.

“I don’t think that the leave votes were based on any implicit spreadsheet running in people’s heads – it was just like, ‘I’m angry, and I’m voting no,’” he told Bloomberg TV’s Vonnie Quinn and Mark Barton. Of the Brexit process, he said: “It doesn’t seem to be headed in any productive direction.”

Thaler was perhaps one of the world’s best-known contemporary economists before receiving his award. His theory of "nudge" economics,  where humans are subtly guided toward beneficial behaviors without heavy-handed intervention, was the theme of a 2008 book that was well received around the world.


Weekend Reading: Bull Market In Complacency

Authored by Lance Roberts via RealInvestmentAdvice.com,

With the market recently breaking above 2500, there seems to be nothing to dampen the bullish exuberance. The recent run, which has largely been focused on areas in the market with the most sensitivity to tax cuts, has exploded over the last two weeks to record highs.

That explosion has also lead to a surge in the Market Greed/Fear Gauge which comprises different measures of market complacency and bullishness.

But the rush to chase performance can be clearly seen in the chart below of the S&P 600 index (small cap) which is now 4-standard deviations above the 6-month moving average.

Then there is the widely viewed CNN Fear/Greed Index.

Of course, not surprisingly, with investors as optimistic and bullish as they can be equity to money market ratios are at extremes.

And “Dumb Money” is continuing to pile into markets as “Smart Money” is willing to sell positions to them.

After 9-years of a bull market, and pushing a 270% gain from the lows, investors have now decided it is now time to get back into the market. But that is the nature of a bull market, and particularly one that has entered into the final stages of long-term cyclical advance, where the last of the “holdouts” are sucked back into the game.

As we enter into earnings season, we once again enter into the “beat the estimates game,” where analysts act surprised that companies “beat” lowered estimates. In the short-term, these “beat rates” will provide support for the bullish case, but in the long-term, it is valuations and actual revenue growth that matters.

I agree with Doug’s sentiment yesterday:

  •  Massive injections of liquidity from the world’s central bankers
  • Passive investing (quants and ETFs) are now dominating markets (at nearly 40%) at the margin
  • Machines and algorithms, as well as many individual investors, are behaving differently as they are now programmed and conditioned to buy the dips.
  • 17% of the listed shares outstanding have been retired in corporate stock repurchases since the Generational Low in March, 2009.
  • More than half of the listed companies on the exchanges have disappeared over the last eight years

“We have a Bull Market in Complacency.” – Doug Kass


Here’s your reading list to for the weekend.

Trump Tax Cuts…


Research / Interesting Reads

“In a bear market all stocks go down and in a bull market they go up.Jesse Livermore


Hussman Eyes The Market’s “Remarkable Moment Of Blissful Delusion”

"The present moment of blissful delusion is remarkable to witness. Take it in…" says John Hussman of Hussman Funds.

In the following few words and updated charts, Hussman exposes the farce even further…

The first chart below updates our variant of Robert Shiller’s cyclically-adjusted P/E (CAPE), where we’ve adjusted the measure to account for variation in the embedded profit margin; an adjustment that substantially improves the correlation of the resulting measure with actual subsequent market returns across history.

Few investors recognize that one of the reasons why valuation multiples were so rich in 2000 is that profit margins were actually below historical norms at the time. It's also worth noting that the benefit of normalizing the embedded profit margin comes not just from muting margins that are above historical norms, but also from normalizing margins in periods where they are below historical norms.

The next chart shows the margin-adjusted CAPE on an inverted log scale (left, blue line), along with the actual subsequent S&P 500 nominal average annual total return over the subsequent 12-year period (right, red line).

The next chart updates our best estimate of the likely 12-year prospective total return on a conventional portfolio mix invested 60% in the S&P 500 Index, 30% in Treasury bonds, and 10% in Treasury bills.

The current projection is the lowest in history, and I expect these weak passive investment returns, as they unfold, to trigger a rather broad crisis of pension underfunding in the years ahead.

To estimate the S&P 500 component here, we’re using another measure I’ve introduced over time: the ratio of nonfinancial market capitalization to corporate gross value-added (including estimated foreign revenues).

While we’re on the subject of corporate gross value-added (which essentially measures corporate revenues without double-counting intermediate inputs), I’ll add that another feature of Wall Street’s blissful delusion is the notion that “U.S. corporate taxes are the highest in the world.” It’s striking how disingenuous this claim is. The fact is that among all OECD countries, the U.S. is also the only country that does not levy any tax at all on corporate value-added in the production of goods and services.

Without getting deep into the relative merits and challenges of a value-added tax, suffice it to say that 1) the “incidence” of a value-added tax (whether it’s paid by consumers in the form of higher prices, or corporations in the form of lower profits) varies depending on the demand and supply characteristics of each sector, and 2) because a value-added tax tends to be “regressive” all by itself (hitting lower income individuals proportionally more since it functions much like a tax on sales), the appropriate way to introduce a value-added tax is to require additional features of the tax code such as low-income exclusions. Countries can also use policies such as tax credits for investment, R&D, job training, and other arrangements to strengthen incentives for productive investment and job creation.

The main point is this. The argument that U.S. taxes on corporate profits are somehow oppressive relative to other countries is an apples-to-oranges comparison. It wholly ignores that the U.S. levies no value-added tax on corporations at all, whereas the value-added tax is the principal revenue source for most other countries. The rhetoric on corporate taxes here is unfiltered effluvium.

The chart below presents a clearer picture of U.S. corporate profits taxation. Actual taxes paid by U.S. companies, as a share of pre-tax profits, have never been lower, outside of the depths of the global financial crisis.

As for the stock market, understand that total annual U.S. corporate taxes presently amount to only about 1.2% of current U.S. equity market capitalization, and even if a cut was to pass, it would be unlikely to endure for more than a few administrations. The potential effect of even a substantial percentage reduction in statutory rates for several years is quite small when the present value of the tax reduction is compared with existing equity market capitalization. The likely cumulative impact comes to just a few percent of stock market value.

Against that, consider that the most reliable market valuation measures we identify (as measured by their correlation with actual subsequent S&P 500 total returns in market cycles across history) are currently between 2.5 and 2.7 times their historical norms (that is, 150% to 170% above those norms).

Put simply, it seems misguided to imagine that “tax reform” will somehow make the most obscene speculative bubble in U.S. history something other than the most obscene speculative bubble in U.S. history. Corporations are already enjoying strikingly light tax burdens from a historical perspective, and investors are already paying extreme valuation multiples on elevated earnings.

We are observing an episode that will make future investors wince. Just like the two closest analogs, the 1929 high and the tech bubble, I expect that future investors will shake their heads in wonder at the stark raving madness of it all, and ask what Wall Street could possibly have been thinking. In any event, I've shared what I see as my truth, and I experience no need to change anyone's mind. I remain content to abide our value-conscious, historically-informed, full-cycle discipline, and to follow our path. Others are free to continue along their own.


How To Survive And Thrive In A “Zlatan Ibrahimovic” Market

Authored by Daniel Nevins via FFWiley.com,


REPORTER: “Who will win the World Cup playoff?”


ZLATAN: “Only God knows who will go through.”


REPORTER: “It’s hard to ask him.”


ZLATAN: “You’re talking to him.” 


REPORTER: “What did you get your wife for her birthday?”


ZLATAN: “Nothing. She already has Zlatan.” 


ZLATAN: “I can’t help but laugh at how perfect I am.”

In case you don’t pay attention to soccer, here are three things to know about Zlatan Ibrahimovic:

  1. He’s an excellent player.
  2. His ego, as you can see, is large.
  3. He doesn’t appear to have much in common with Yale University’s Robert Shiller.

I’ll start with the third point and the insightful Shiller, in particular. (I’ll get back to “Ibra” in just a moment.) Shiller wrote an article last week warning of the potential hazards of equity investment. As he often does, he shared a chart showing his cyclically-adjusted price-to-earnings (CAPE) ratio. He reminded us that the CAPE ratio is “somewhat effective at predicting real returns over a ten-year period.” But this particular article had little to do with ten-year forecasts. Here’s the conclusion (with my emphasis):

In short, the US stock market today looks a lot like it did at the peaks before most of the country’s 13 previous bear markets. This is not to say that a bear market is guaranteed: such episodes are difficult to anticipate, and the next one may still be a long way off…


But my analysis should serve as a warning against complacency. Investors who allow faulty impressions of history to lead them to assume too much stock-market risk today may be inviting considerable losses.

He likens today’s market to 1929, 2000, 2007 and other scary market peaks of the past, while pointing to characteristics he considers typical of market peaks. A high CAPE ratio stands at the top of his list, although he also mentions strong earnings and low volatility. Effectively, he says those three indicators should cause us to worry that a bear market could be right around the corner. And he makes useful observations about the CAPE ratio typically being high, earnings growth also somewhat high, and volatility low (although only slightly below average) just before bear markets begin.

With all due respect, though, I think Shiller’s pivot from long-term returns to a short-term outlook was incomplete. Sure, strong earnings and low volatility aren’t necessarily bullish – I get that – but I find it hard to call them bearish, either. My bigger objection, though, is with the CAPE ratio being part of a market-timing argument. (I applaud the “no guarantee” disclaimer, but still.) As a researcher and asset manager, I’ve never found valuation ratios useful for short-term horizons, nor have I found other researchers having much success using them as short-term indicators. From that experience, I would have recommended one more disclaimer for Shiller’s article – that valuation ratios stink for market timing. And I think my disclaimer is more than just a nitpick, for three reasons that I’ll explain with increasing “Ibra-ness.”

“A World Cup without me is nothing to watch, so it is not worthwhile to wait for the World Cup.”


—Ibrahimovic after Sweden failed to qualify for the 2014 World Cup finals

First, certain other indicators actually have helped foretell major market turning points. Nearly all of the past 13 bear markets, for example, were explained partly by some combination of sharply rising inflation, high interest rates, poor credit conditions or economic depression. I state that with conviction, but you can judge it yourself by reading our article “Riding the ‘Slide’: Is This What the Next Bear Market Looks Like.” Our research suggests that the most common bear-market conditions are mostly absent today. It uses Shiller’s data, by the way, although it covers bear-market conditions he didn’t consider in his article. Without being as bombastic as Ibra but being self-serving nonetheless, I recommend reading our research alongside Shiller’s for a more complete picture than either article offers on its own. (And while you’re at it, I highly recommend Eric Parnell’s latest for a third perspective.)

“I didn’t injure you on purpose and you know that. If you accuse me again I’ll break both your legs, and that time it will be on purpose.”


—Ibrahimovic responding to an accusation from Rafael van der Vaart

Second, the market’s current valuation is like Ibra’s ego – both are inflated. But if you’re Rafael van der Vaart or Pep Guardiola or Lucas Moura and hoping for Ibra to change, you’ll probably be disappointed. He’s not likely to become modest tomorrow just because he’s egotistical today, as if one state triggers the other. And the market won’t become a bear tomorrow just because it’s an expensive bull today. When Ibra’s skills finally erode, though, that’ll be a different story. That’ll be a change in the conditions that feed his ego, just as market forecasters should be concerned with the conditions that feed bulls and bears. In other words, market conditions (such as those mentioned in the preceding paragraph) seem more likely to predict the next bear than indicators calculated from market prices (such as the CAPE ratio).

“First I went left, he did too. Then I went right and he did too. Then I went left again and he went to buy a hot dog.”


—Ibrahimovic on how he dribbled around Liverpool defender Stephane Henchoz

Third, the market can be just as tricky as Ibra is with a ball at his feet, which is why you should choose your defenses carefully. In the big picture, your team (portfolio) should have an appropriate balance between attacking and defending elements. When you’re in the moment, though, I would suggest reading short-term outlooks with a degree of skepticism. If you’re prone to biting on feints and head fakes (overtrading), relying on the CAPE ratio for market timing might make it easier for your opponent to dribble around you. And where would that leave you? Apparently, you’d be found somewhere near the hot dog stand.


Like Robert Shiller, we would advise equity investors to have modest expectations for long-term returns (as we advised here). We also advocate diversifying across major asset classes to reduce the damage that could occur in a bear market. But having realistic expectations and diversifying won’t protect against the greatest risk many investors face – the risk of overtrading. Investors tend to sell risky assets at lower prices than they later repurchase them, suggesting that it’s important to build safeguards against overtrading. At a minimum, bullish and bearish indicators should be weighed carefully. By studying which indicators are most likely to predict bulls and bears, investors can build defenses against rash decisions. And that should be especially helpful today, as investors confront an unusually inflated and tricky mark… no, make that a Zlatan Ibrahimovic market.

Author’s note: Shiller’s article caught my attention because he wrote about 13 bear markets shortly after we, too, published an article about 13 bear markets. To identify bear markets, we used Shiller’s data, which he graciously includes on his website. But our 13 bears aren’t exactly the same as his 13 bears, because we defined them differently. If anyone would like to know the differences, just ask and I’ll discuss them in the comments when I have some free time. Also, I took the Ibrahimovic quotes from various websites, such as here, here and here.


Weekend Reading: Tax Cut Wish List

Authored by Lance Roberts via RealInvestmentAdvice.com,

On Wednesday, the President announced his plan to cut taxes for Americans, return jobs to America and return the country to economic prosperity.

It’s a tall order to fill, and the proposed tax reform is a “Christmas Wish List” that will have to checked twice to determine which parts are “naughty” and “nice.”

As I pointed out yesterday,

“The belief that tax cuts will eventually become revenue neutral due to expanded economic growth is a fallacy. As the CRFB noted:


‘Given today’s record-high levels of national debt, the country cannot afford a deficit-financed tax cut. Tax reform that adds to the debt is likely to slow, rather than improve, long-term economic growth.’


The problem with the claims that tax cuts reduce the deficit is that there is NO evidence to support the claim. The increases in deficit spending to supplant weaker economic growth has been apparent with larger deficits leading to further weakness in economic growth. In fact, ever since Reagan first lowered taxes in the ’80’s both GDP growth and the deficit have only headed in one direction – lower.’

That little green bump in the deficit was when President Clinton “borrowed” $2 trillion from Social Security to balance the budget, and since there were no cuts to spending, led a surplus that lasted about 20-minutes.

The problem is that the tax plan may not provide the benefits as hoped. While President Trump suggests the plan will return “trillions” of dollars locked up overseas to create jobs, the reality, according to Goldman Sachs, is likely closer to $250 billion that will primarily go to share buybacks, dividends, and executive compensation.  

Of course, such actions do not boost economic growth but are a boon to Wall Street and the 10% of the economy that invest in the market. 

But here is the key point with respect to tax cuts. History is replete with evidence that shows tax cuts DO NOT lead to a rapid growth in the economy. As shown below, the slope of economic growth has been trending lower since the “Reagan tax cuts” were implemented.

Lastly, tax cuts have relatively low economic multipliers particularly when they primarily only benefit those at the top of the income spectrum. With the average household heavily indebted, credit is being used to sustain the standard of living, there is likely to be little transfer of “tax savings” back into the economy.

It is a simple function of math. But the following chart shows why this has likely come to the inevitable conclusion, and why tax cuts and reforms are unlikely to spur higher rates of economic growth.”

As is always the case…“it’s the debt, stupid.” 

However, here are plenty of discussions both for and against the tax plan so you can decide for yourself.

Trump Tax Cut Plan


Research / Interesting Reads

A bull market is like sex. It feels best just before it ends.” – Warren Buffett


Weekend Reading: Yellen Takes Away The Punchbowl

Authored by Lance Roberts via RealInvestmentAdvice.com,

September 20th, 2017 will likely be a day that goes down in market history.

It will either be remembered as one of the greatest achievements in the history of monetary policy experiments, or the beginning of the next bear market or worse.

Given the Fed’s inability to spark either inflation or economic growth, as witnessed by their dismal forecasting record shown below, I would lean towards the latter.

The media is very interesting. Despite the fact there is clear evidence that unbridled Central Bank interventions supported the market on the way up, there is now a consensus that believes the “unwinding” will have “no effect” on the market.

This would seem to be naive given that, as shown below, the biggest injections of liquidity from the Fed have come near market bottoms. Without the proverbial “punch bowl,” where does the “support” come from to stem declines?

I tend to agree with BofA who recently warned” the paint may be drying but the wall is about to crumble.”

This point can be summarized simply as follows: there is $1 trillion in excess TSY supply coming down the line, and either yields will have to jump for the net issuance to be absorbed, or equities will have to plunge 30% for the incremental demand to appear.”

“An unwind of the Fed’s balance sheet also increases UST supply to the public. Ultimately, the Treasury needs to borrow from the public to pay back principal to the Fed resulting in an increase in marketable issuance. We estimate the Treasury’s borrowing needs will increase roughly by $1tn over the next five years due to the Fed roll offs. However, not all increases in UST supply are made equal. This will be the first time UST supply is projected to increase when EM reserve growth likely remains benign.


Our analysis suggests this would necessitate a significant rise in yields or a notable correction in equity markets to trigger the two largest remaining sources (pensions or mutual funds) to step up to meet the demand shortfall. Again, this is a slower moving trigger that tightens financial conditions either by necessitating higher yields or lower equities.”

Of course, as I have discussed previously, a surge in interest rates would lead to a massive recession in the economy. Therefore, while it is possible you could experience a short-term pop in rates, the end result will be a substantial decline in equities as money flees to the safety of bonds driving rates toward zero.

“From many perspectives, the real risk of the heavy equity exposure in portfolios is outweighed by the potential for further reward. The realization of ‘risk,’ when it occurs, will lead to a rapid unwinding of the markets pushing volatility higher and bond yields lower. This is why I continue to acquire bonds on rallies in the markets, which suppresses bond prices, to increase portfolio income and hedge against a future market dislocation.”

My best guess is the Fed has made a critical error. But just as a “turnover” early in the first-quarter of the game may not seem to be an issue, it can very well wind up being the single defining moment when the game was already lost. 

In the meantime, here is what I am reading this weekend.



Research / Interesting Reads

“If you are playing the rigged game of investing, the house always wins.” ? Robert Rolih