Pushing Luck

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The latest data from the NYSE shows equity margin debt at a new all-time high. Relative to GDP, the current 2.6% level was eclipsed only once – at the March 2000 market peak. In the context of the most extreme bullish sentiment in decades, and reliable valuation metrics about double their historical norms prior to the late-1990’s bubble (price/revenue, market cap/GDP, Tobin’s Q, properly normalized price/forward operating earnings, price to cyclically-adjusted earnings), we view present market conditions as dangerously speculative.

Before it’s too late, I should note – as I also did at the 2007 market peak just before the market collapsed – that unadjusted forward operating P/E ratios and the Fed Model are both quite unreliable indications of value or prospective returns (seeLong-Term Evidence on the Fed Model and Forward Operating P/E Ratios).

Even the shallow 3% retreat from the market’s all-time highs may be enough to prompt a reflexive “buy-the-dip” response in the context of extreme bullish sentiment here, as the S&P 500 bounced off of a widely monitored and steeply ascending trendline last week that connects several short-term market lows over the past year. Regardless, the potential for short-term gains is overwhelmed by the risk of deep cyclical and secular losses. We presently estimate prospective 10-year S&P 500 nominal total returns averaging just 2.7% annually, with negative expected total returns on every horizon shorter than 7 years.

Could the stock market’s valuation really be double its historical norm? Yes, this is presently the case for numerous historically reliable measures, including price/revenue, market cap/GDP, Tobin’s Q, and a variety of properly normalized earnings-based measures.

[Geek’s Note: Think of the market’s overvaluation this way. Suppose that a security achieves a 10% long-term return when it is priced at “fair value,” and that the security is expected to trade at fair value X a decade from today. In order to achieve a 10% return over the coming decade (ignore dividends for a second), the security must be priced at X/(1.10)^10 = 0.386X today. Now suppose that the security is actually priced to achieve annual returns of just 2.7% over the coming decade. In that case, the price would be X/(1.027)^10 = 0.766X today. Of course 0.766/0.386 is 1.98, so at a 2.7% 10-year expected return, the price is 98% above the level at which the security would achieve a 10% rate of return.

Alternatively, if one argues that a 5% annual rate of return would be perfectly acceptable for the next decade, it follows that the price should be X/(1.05)^10 = 0.614X. In that case, the security is only 25% overvalued at 0.766X. Indeed, if one argues that a 2.7% annual rate of return is perfectly acceptable, it follows that the security is appropriately priced at 0.766X. To say that we view stocks as strenuously overvalued is to assert that a 2.7% annual return for the S&P 500 over the next decade is unacceptable relative to the probable risks, even given currently depressed interest rates. But that’s how stocks are priced here.

One can show that similar calculations apply in the presence of cash payouts. For example, begin with an arbitrary payout growing at 6% over time. Suppose that for a decade the expected total return k = 2.7%, with k = 10% thereafter. Under those assumptions, the security will be priced 82% above the level at which it would achieve a consistent 10% rate of return].

There are certain points in history where the projections of S&P 500 total returns have differed somewhat depending on which fundamental measure one uses. At present, a wide range of valuation methods that are actually historically reliable show very little variation. Uniformly, and across fundamentals that have reliably correlated with actual subsequent market returns, we project likely S&P 500 total returns in the range of 1-3% annually over the coming decade. Given a 2% dividend yield, this implies that we fully expect the S&P 500 to be no higher a decade from today than it is at present.

These are, of course, the same methods that led us to correctly anticipate a decade of negative total returns in 2000, and significant market weakness in 2007. In contrast, note that these same methods were quite favorable toward equities in 2009 (our stress-testing concerns were not driven by valuations). A passive, equally balanced portfolio of stocks, bonds, and cash can be expected to return about 2% annually over the coming decade. If this seems to be an untenable long-term rate of return, understand that the security prices underlying those expected returns are equally untenable. Also, remember that historical evidence is sufficient to distinguish between competing valuation approaches.

None of this ensures that stocks will decline rather than advance over the near term, but any expectation of adequate longer-term returns in equities from present valuation levels taxes the historical evidence. What accelerates our concerns is the extreme level of speculation in the present market environment. For example, the chart below shows NYSE margin debt both in dollar terms and relative to nominal GDP. We use GDP here because margin debt to GDP has a much higher correlation with actual subsequent market returns than say, margin debt / market capitalization (which destroys information by muting the indicator exactly at points when prices are extremely elevated or depressed). That said, the main usefulness of this measure isn’t for any fixed correlation with subsequent returns – numerous valuation measures do much better – but for its extremes. This is particularly true when margin debt advances rapidly over a span of several quarters relative to prices, GDP and other measures.

Points of rampant speculation on margin strongly overlap points of extreme bullish sentiment and extreme valuation. For that reason, and also because numerous valuation measures have a more direct relationship with subsequent market returns, margin debt is best used as a confirming indicator of cyclical market extremes.

Prior spikes in margin debt / GDP in June 1968, December 1972, August 1987, March 2000, and October 2007 were followed by a bear market losses of at least one-third of market value shortly thereafter. A couple of peaks like 1978 and 1984 occurred at quite reasonable valuation levels, and were uneventful. The April 1964 spike is interesting in that it was uneventful over the near term, but the S&P 500 was lower even a decade later. My impression is that this result owes far more to the general overvaluation of the market in the mid-1960’s than it does to the elevated level of margin debt at the time.

Of course the peaks are only observable after the fact. But it’s easy enough to define a spike as a significant advance from the prior low. The spikes that accompany extreme bullishness and rich valuation are most notable. Examine points in history where margin debt / GDP was more than 70% above its 5-year low, the 2-week average of advisory bulls exceeded 53% with bears less than 27%, and the price/peak earnings ratio was greater than 18 (price/peak earnings is the S&P 500 divided by the highest level of index earnings achieved to date – I created that measure a couple of decades ago and use it here because the Shiller P/E is presently spurned out of dislike for its implications). There are only five instances, all at or in the final few months preceding the market peaks of 1972, 1987, 2000, and 2007 (and of course today).

With the caveat that pre-1990’s data does not normalize as well, the chart below shows the more recent relationship between margin debt/GDP and S&P 500 returns over the subsequent 30-month period (most historical spikes in margin debt/GDP have been followed by subsequent bear market troughs within that time-frame). Note that returns (red) are inverted, so higher points imply more negative outcomes. Of course, the red line ends 30 months ago.

Needless to say, there are endless arguments as to why this time is different, just as there were at each of those other peaks. The present, uncompleted half-cycle is being used to argue that historical full-cycle relationships no longer hold. It’s certainly true that quantitative easing has allowed the market to ignore even extreme variants of overvalued, overbought, overbullish conditions that have historically been resolved much more quickly. Similarly extreme conditions emerged in February and May of 2013 without consequence, and lesser variants have appeared sporadically for 2-3 years. There’s no question that the suspension of historical regularities in this uncompleted half-cycle has destroyed my credibility with those who don’t take historical evidence seriously in the first place – despite losing half of their assets in 2000-2002 and 2007-2009, and I expect will shortly do so again. Speculators have been luckier than they may realize, and are now pushing their luck.

Still, nearly all of the current disputes about valuations, profit margins and so forth can be settled by an evaluation of the historical evidence. The unsettled arguments are the ones that require the present to depart from history against a century of evidence. There are two main beliefs here: that profit margins will remain elevated dramatically above norms that have been revisited in every cycle, including the two most recent ones; and that strenuously overvalued, overbought, overbullish conditions can be sustained indefinitely. These beliefs areidentical to those in 2007that we thought were settled by the 55% market plunge that followed. Investors have become speculators, and now rely on both, in the face of the same conditions that have repeatedly emerged at the most memorable market peaks in history.

As I’ve frequently observed, such extremely overvalued, overbought, overbullish conditions often feature “unpleasant skew” – a tendency toward small, persistent market advances followed by very steep and abrupt declines that wipe out weeks or months of prior gains in one swoop. In the options market, recent prices have reflected the greatest amount of implied “skew” on record (measured using the difference in prices between significantly “out of the money” put options versus equally distant call options).

The problem is always that historical outcomes are easy to observe in hindsight, but the outcome of the present instance is still unseen – even if the underlying conditions are the same. As we saw in 2000 and again in 2007, until unseen risks becomeobservable reality in hindsight (and by then, it’s too late), all of these concerns are quickly dismissed and ignored by investors. Quantitative easing has distorted not only financial markets, but financial memory. The awakening is not likely to be gentle.

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