“The issue is no longer whether the current market resembles those preceding the 1929, 1969-70, 1973-74, and 1987 crashes. The issue is only – are conditions like October or 1929, or more like April? Like October of 1987, or more like July? If the latter, then over the short-term, arrogant imprudence will continue to be mistaken for enlightened genius, while studied restraint will be mistaken for stubborn foolishness. We can’t rule out further short-term gains, but those gains will turn bitter.”
February 2000 (S&P 1425)
“On Wall Street, urgent stupidity has one terminal symptom, and it is the belief that money is free. Investors have turned the market into the carnival, where everybody ‘knows’ that the new rides are the good rides, where the carnival barkers seem to hand out free money just for showing up. Unfortunately, this business is not that kind – it has always been true that in every pyramid, in every easy-money sure-thing, the first ones to get out are the only ones to get out.”
March 2000 (S&P 1400)
“We’ve seen a continuous movement from trough to peak, and investors appear all too willing to label it a New Economy. At current valuations, even optimistic assumptions lead to the conclusion that a long-term buy-and-hold approach will underperform Treasury bills during the next decade and perhaps beyond (using today as a starting point). Of course, stocks may offer excellent returns beginning from some future trough, but from current levels, investors are unlikely to enjoy much reward for the risk they are accepting. That’s a long-term statement. Unfortunately, long-term thinking means little to investors here… Bullish sentiment remains high. Our view is that the massive bubble in tech stocks is only beginning to burst. One of the hard lessons that investors will learn in the coming quarters is that technology stocks are actually cyclicals.”
John P. Hussman, Ph.D., Hussman Investment Research & Insight, August 2000 (S&P 1480)
We are in very familiar – if frustrating – terrain here. While valuations are not as extreme as they were in 2000, the level of investor confidence in “free money” is nearly identical, as is my conviction that this belief in free money will end in tears. Even on the optimistic assumption of 6.3% nominal economic growth for the indefinite future, we estimate a probable 10-year nominal total return on the S&P 500 averaging just 3.6% annually (seeInvestment, Speculation, Valuation and Tinker Bellfor a set of historically accurate models that share that conclusion). Above, I’ve chosen quotations spanning several months in 2000 to emphasize the drawn-out nature of the 2000 peak – the seeming “resilience” of the market above the 1400 level certainly did not prevent the market from losing half of its value over the following 2-year period, wiping out the entire total return of the S&P 500 – in excess of Treasury bill returns – all the way back to May 1996.
Early 2003 provided a good opportunity to shift to a constructive view for a while. We gradually found ourselves back in a defensive stretch (seeCritical Pointin November 2007), which was followed by a market decline of more than 50%, which erased the entire preceding bull market gain in the S&P 500 index, and wiped out the entire total return of the index – in excess of Treasury bill returns – all the way back to June 1995.
At the 2009 low, our estimates of prospective 10-year S&P 500 total returns moved above 10% annually, but in that case – unlike 2003, and unlike what I expect in future market cycles – the extreme nature of economic conditions forced us to contemplate Depression-era outcomes and stress-test our approach against that data. My regret in hindsight is not that I insisted on ensuring that our approach could navigate out-of-sample Depression-era data – that was fiduciary duty, plain and simple. Rather, my regret is that over time, even I had been lulled into the idea that Depression-era data was too outdated to worry about, so we had to address that need in the thick of things. It's important to recognize that the need for stress-testing was not in response to any significant difficulty with our approach, which had navigated the crisis well.
Preparing for uncertainty is different than preparing for risk. Risk involves possible events within a reasonably known range of outcomes (like the possibility of rolling a number greater than 5 on a six-sided die). Uncertainty involves possible events where the range of outcomes is not known (like the possibility of rolling a number greater than 5 when you don’t even know how many sides the die has). It would have taken only a few days to “back-fit” some model to Depression-era data, but we don’t believe in back-fitting because it typically doesn’t work out-of-sample (that is, in data that the model has not “seen” before). It’s a much more challenging problem to develop methods that can navigate extreme data that is outside the bounds that the model is based upon – and without letting the approach “see” that data.Ensemble methodsturned out to be well-suited to the problem of uncertainty.
While we don’t require an improvement in prospective returns to 10% annually in order to justify a constructive outlook (we certainly did not observe those levels in 2003), I continue to expect that the best opportunity to shift to a constructive or aggressive investment stance will emerge at the point when a move to less extreme valuations is followed by an early improvement in market action. That’s what encouraged a constructive outlook in 2003, and what we might have embraced in 2009 had stress-testing concerns not dominated.
In any event, to disregard our present concerns because of our “miss” in the recent cycle is like disregarding a Great White shark because the swimmer who accurately warned about the last two predators fell short in the recent lap – due to the time required to secure shark repellant.
As in 2000, and as in 2007, it is not necessarily the case that stocks will decline immediately. Still, the percentage of bearish investment advisors reported byInvestors Intelligencehas declined to just 18.6%, from 18.8% the week earlier. The last times that bearish sentiment was below 20%, at a 4-year market high and a Shiller P/E above 18 (S&P 500 divided by the 10-year average of inflation-adjusted earnings – the present multiple is 23) were for two weeks in May 2007 with the S&P 500 about 1525, two weeks in August 1987, and 3 weeks of a 5-week span in December 1972 and January 1973, which was immediately followed by a 50% market plunge. Still, a handful of observations in March-May 1972 preceded the late-1972 peak and were followed by a modest further advance, and that lag is enough to discourage any near-term conclusions in the present instance. To complete the record, the instance before that was in February 1966, which was promptly followed by a bear market decline over the following year.
When you realize that the 2000-2002 decline wiped out 6 years of S&P 500 total returns in excess of T-bills, and that the 2007-2009 decline wiped out 14 years of excess returns, it may be clear why I am unsympathetic to the idea that we should abandon our discipline in response to a mature - though seemingly endless - market advance today. It’s been said that the best time to invest with a good investor is when he is having his own bear market. The difficulty today is the same one I described approaching the 2000 top – “over the short term, arrogant imprudence will continue to be mistaken for enlightened genius, while studied restraint will be mistaken for stubborn foolishness.”
The present environment is characterized by unusuallyovervalued, overbought, overbullish conditions, with rising 10-year Treasury bond yields, heavy insider selling, valuations on “forward earnings” appearing reasonable only because profit margins are more than 70% above historical norms (fully explainedby the negative sum of government and personal savings as a share of GDP), with the S&P 500 at a 4-year market high, in a mature market advance, with lagging employment indicators still positive but more than half of all OECD countries already in GDP contraction, Europe in recession, Britain on the cusp, and the EU imposing massive losses on depositors in order to protect lenders in an unstable banking system where Cyprus is the iceberg’s tip. Investors have assumed a direct link between money creation and stock market performance, where provoking yield-seeking and discomfort among conservative investors is the only transmission mechanism of anearly-insolventFed. Investors have assumed that stocks can be properly valued on the basis of a single year of earnings reflecting the benefit of massive fiscal deficits, depressed household saving, and extraordinary monetary distortion – when the more relevant long-term stream of earnings will enjoy far less benefit. Historically, extreme overvalued, overbought, overbullish, rising-yield syndromes have outweighed both trend-following and monetary factors, on average. For defensiveness to be inappropriate even in this environment, investors must rely on the present instance to be a radical outlier.
“Every bull and bear market needs a ‘hook.’ The hook in a bear market is whatever the bear serves to keep investors and traders thinking that everything is going to be all right. There is always a hook.”
Richard Russell, Dow Theory Letters, November 2000 (S&P 1400)
One of the striking things about the late-1990’s bubble was that even investment professionals who should have known better were swept into New Economy thinking. To some extent, the same dynamic is true today – even among some investors whom I greatly admire.
For example, back in 1999, Warren Buffett correctly warned “In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%… Maybe you’d like to argue a different case. Fair enough. But give me your assumptions. The Tinker Bell approach – clap if you believe – just won’t cut it.”
Yet today, with corporate profits near 11% of GDP – a level that isclearly explainedby massive federal deficits and depressed personal savings – not a peep.
The “hook” today is the dramatically elevated, deficit-induced level of profit margins. While the complete faith of investors in the Federal Reserve may prove to be the hook for ordinary investors, it’s not enough to draw in more careful observers. The real hook, in my view, is the absence of a bubble in any individual sector, and instead a bubble in profit margins across the entire corporate sector. That is the hook that serves to keep investors and traders thinking that everything is going to be all right.
Even the revered bond investor Howard Marks, who appears correctly concerned about the depressed risk premiums in high-yield debt, seems to give a pass to stocks. He does observe that “appreciation at a rate in excess of the cash flow accelerates into the present some appreciation that otherwise might have happened in the future.” But then, even Marks gets snagged by the “hook” – basing his view of stock valuations on “projected earnings for the year ahead,” and the corresponding “earnings yield” compared with the yield on bonds (seeInvestment, Speculation, Valuation, and Tinker Bellfor an extensive historical perspective on this metric, compared with far more reliable models).
Again, it is the absence of an obvious bubble in any individual sector, and instead a bubble in profit margins across the entire corporate sector, that is likely to be the “hook” that drags investors deep into eventual bear market losses.
A few additional notes – Warren Buffett once noted “when people forget that corporate profits are unlikely to grow faster than 6% per year, they tend to get into trouble.” Marks comments “I doubt he intended anything special about 6%, but rather a reminder than when assets appreciate faster than the rate at which their value grows, it isn’t just a windfall, but also a warning sign.”
I would suggest that Buffett does indeed intend something special about 6%, as the entire post-war history of S&P 500 earnings is nicely contained – with brief and rare exception – within a trend channel growing at a rate of just 6% annually from peak-to-peak across economic cycles. As I noted last week, our own estimate of 3.6% annual total returns for the S&P 500 over the coming decade reflects the assumption that nominal GDP, revenues, and cyclically-adjusted earnings will grow at an annual rate of 6.3% over that period. This may or may not be optimistic in the present instance, but that growth assumption is certainly not pessimistic. The more important issue here is that profit margins are demonstrably an artifact of historic federal deficits and depressed household savings. A hundred million individual transactions may have produced this result, but in equilibrium, the deficit of one sector must be the surplus of another.
A final point – I was intrigued by Marks’ comment that “many institutions have allocations to equities that are well below the average of the last fifty years, and no one’s rushing to move them up.”
Strictly speaking, Marks' observation is correct, but to see what's actually happening here, it’s important to think in terms of equilibrium. Why do investors seem to be “underweighted” in equities relative to debt (especially compared with the allocations over the past fifty years)? Very simply, because there is so much more debt to be held, andsomeone has to hold it. The chart below shows the expansion of both equity and debt outstanding since 1950.
Notably, the market value of U.S. equities relative to GDP – though not as elevated as at the 2000 bubble top – is not depressed by any means. On the contrary, since the 1940’s, the ratio of equity market value to GDP has demonstrated a 90% correlation with subsequent 10-year total returns on the S&P 500 (seeInvestment, Speculation, Valuation, and Tinker Bell), and the present level is associated with projected annual total returns on the S&P 500 of just over 3% annually.
Make no mistake – every share of stock, every bond certificate, every dollar of monetary base that has been created is being held by someone, and will continue to be held by someone until each of those securities is retired.
UBS noted last week that “The Federal Reserve and global central banks are now the dominant holders of Treasuries; if they decide to sell, the money will not directly flow into equities.” I would actually go one step further. If central banks decide to sell, the public will hold more Treasuries, and the public will hold less monetary base. The change in the relative supply of Treasury securities and base money (currency and bank reserves) may cause a change in interest rates that makes stocks more or less desirable, but in the end, investors in aggregate will not hold a single share of stock more, or a single share of stock less, than the outstanding quantity of stock that has been issued by companies.
What global central banks have done is to take Treasuries out of public ownership, replacing those Treasuries with zero-interest base money (which someone has to hold until it is retired). But because it is uncomfortable to hold zero-interest money, each successive “someone” has felt the need to reach for alternatives. That continual process of hot potato has driven the prices of speculative assets higher, and the equilibrium of that process has created a world where the prospective return on stocks (at least on a 5-7 year horizon) is also zero – or less.
While it is impossible for the economy as a whole to “rotate” out of bonds and into stocks – since both must be held in exactly the amount that has been issued – global central banks have already forced a “rotation” by the public out of Treasury bonds and into far more zero-interest money than they would ever voluntarily hold. The consequence is near-zero prospective returns on virtually every asset class, looking out over a 5-7 year horizon, though some with dramatically greater exposure to interim losses than others.
On the subject of quantitative easing, I have no expectation that the Fed will suspend QE in the foreseeable future, though I do believe that the requisite40 weeks of zutzare now behind us. Still, as we parsed the Fed’s statement on Wednesday, we couldn’t help noticing that the Fed replaced “until such improvement is achieved ” with “until the outlook for the labor market has improved substantially.” There was also a subtle easing of promises, deleting “will continue” and inserting “decided to continue,” and dropping the phrase “will, as always.”
As I’ve noted before, quantitative easing has invariably operated along the following sequence: 1) the stock market declines significantly from its peak of about 6 months earlier; 2) quantitative easing is initiated; 3) the market recovers its prior loss over a period of about 40 weeks. Notably, since 2007, there has been a negative correlation of -76% between the 6-month drawdown in the S&P 500 and the 40-week growth rate of the monetary base (with a 10-week lag - the deeper the market loss, the greater the monetary response), and a positive correlation of 54% between the 40-week growth rate of the monetary base and the subsequent recovery of the market, resulting in a negative correlation of -34% between the 6-month drawdown in the S&P 500 and the advance in the S&P 500 itself over the following 40 weeks. Quantitative easing is not rocket fuel. At best, it is a bungee cord.
As economist David Rosenberg has noted, if recent decades have taught investors anything, it is that every time the Federal Reserve drives interest rates to negative levels after inflation, it creates a bubble that subsequently bursts. As part of this painful learning experience, investors have become at least somewhat practiced in identifying bubbles within individual sectors – technology, housing, and debt, for example. The problem, in my view, is that the present bubble is systemic – with short-term interest rates at zero, the prospective returns of nearly every asset class, looking out over a 5-7 year horizon, is also close to zero. Equity investors, in particular, don’t see it because part of this bubble is captured in profit margins rather than in prices (unless one uses cyclically-adjusted earnings, which make the overvaluation more evident). But the result is the same – stock prices are dramatically elevated on the basis of the long-term stream of cash flows that investors can actually expect to receive over time. It may make investors feel better that current profit margins are elevated enough to make price/earnings ratios seem “reasonable.” But then, that’s the hook.
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