One Year To Nowhere

[OriZ 3,157]

Dec 5, 2014 - S&P500 = 2075

Dec 4, 2015 - S&P500 = 2091

Dec 5, 2014 - NYSE Composite = 10,970.

Dec 4, 2015 - NYSE Composite = 10,408.

Every time throughout history investors have said "this time it is different", or it's the "new economy". We heard that in 1929 and in the 70's and in 2000 and 2007 and in other instances. That never turned out well for them. So you are right, accepting that a decade and a half of overvaluation would become the norm after centuries where it was not would be a huge mistake.

As far as interest rates go - Investors may wish to believe that low interest rates somehow may limit their losses. But the fact is that for instance Japanese stocks plunged by 62% in 2000-2003 and 61% in 2007-2009 despite interest rates that never exceeded half of one percent. There are certainly structural differences between Japan and the U.S., but those differences do not extend to eliminating the iron laws of investing - that every security is a claim on some stream of expected future cash flows, and the higher the price one pays for those cash flows, the weaker the long term rate of return. Outside of the disinflationary period of 1980-98, the historical correlation between interest rates and equity valuations has actually been zero. Suppressed interest rates can certainly encourage yield-seeking speculation, and drive equities and other securities to extreme valuations that offer similarly dismal prospects for future returns. But when investors turn risk-averse, as they did in 2000-2002 and 2007-2009, those dismal prospects are realized, and even persistent and aggressive Fed easing has not prevented U.S. equities from collapsing.

Now what happens if interest rates remain so low in the future that investors maintain stocks at extremely high valuation levels, with no tendency toward mean-reversion at all. Well what one has to remember is that there is a 90% correlation between interest rates at any given date (for example the 10-year Treasury bond yield) and nominal economic growth over the preceding decade. So if you’re assuming that interest rates will be low a decade from now, you’re also effectively assuming that nominal economic growth will be dismal. Assuming that interest rates will be strikingly low in the future is essentially equivalent to assuming nominal growth will be strikingly low. Because those two effects tend to offset each other, the relationship between valuations and subsequent 10-12 year returns has typically been unaffected.

The reason I do not believe that the market has much further to go despite the fact that technically overvaluation could eclipse that of 2000, is market internals. When investors are inclined to speculate, they tend to be indiscriminate about it, so strongly speculative markets demonstrate a clear uniformity across a broad range of individual stocks, industries, sectors, and risk sensitive securities, including debt of varying creditworthiness. In contrast, as risk aversion sets in, the first evidence appears as divergence in these market internals. So while overvaluation reflects compressed risk premiums and is reliably associated with poor long term returns, over shorter horizons, investor risk preferences determine whether speculation will continue or collapge, and the condition of market internals acts as the hinge that distinguishes those two outcomes.

Valuations have been obscene for some time. Historically, the thing that has differentiated an overvalued market that remains elevated or continues higher, and an overvalued market that plunges, is the preference of investors toward risk, which is best inferred from the uniformity or divergence of market internals. Those measures have been unfavorable since the third quarter of 2014, which has opened the door to more frequent air-pockets and vertical losses. As with the 2000 and 2007 top formations, market peaks are often a process, and while recoveries on weak internals tend to be followed by fresh losses, the process can extend for months.

The overall economic and financial landscape, then, is one where obscene valuations imply zero or negative S&P 500 total returns for more than a decade, an outcome that is largely baked in the cake regardless of shorter term economic or speculative factors. Presently, market internals remain unfavorable as well. Coming off of recent overvalued, overbought, overbullish extremes, this has historically opened a clear vulnerability of the market to air-pockets, free-falls and crashes.

Part of my work is also technical analysis. There are some who may not believe in it just as there are some who may wish to believe that neither valuations nor market internals matter anymore. My experience has taught my otherwise and technical analysis has helped navigate through the rough waters of this market in the last decade+. Technicals right now are also in horrible condition, so I don't see what's going to push this market higher, but I cannot completely exclude it either at this point.

In the absence of improved market internals or a change in the technical picture, my impression is that the economy is increasingly likely to roll into a recession at the same time the equity market rolls into a rather severe bear market decline. If the Fed raises rates in that environment, the FOMC will likely be blamed for losses that are actually already inevitable as a result of the Fed’s much earlier recklessness. If the Fed fails to raise rates in that environment, after having conditioned investors to expect a rate hike, it will likely be taken as a vote of no-confidence in the economy, and the FOMC will likely be blamed for losses that are actually already inevitable as a result of its much earlier recklessness. Even provided a change in market internals or technicals, ultimately, the only way to avoid near-term losses is to make the prospect of longer-term losses that much worse.

Think of it this way. If the market crashsed by 50% tomorrow morning, assuming no further economic deterioration, the ratio would still only be about 20% lower(cap/gdp) than at ANY previous top except for 2000 and 2007, and 30% higher than the ratio around previous important bottoms.

I want to add/clarify something to this. When I write 30% higher than the ratio I meant simply - if it would bottom with a CAP/GDP ratio of 60%, that is 30%more than it used to at 30%.

However, neat math trick here, ultimately, we are talking about twice the level of valuation the market bottomed with during the 20th century. So double, 100% higher. Which would of course require an additional 50% drop FROM those very levels, to make a total decline of 75% from the top. Do I believe it will happen? Well, right now it is not probable, but mean reversion alone as I have already written, and not any sort of undervaluation would require a 40-55% drop.

As far as Div Yield...

Over centuries of data, the div yield was in a range of roughly 3% to 8.5% historically. At the 1929 top right before black tuesday it was over 3%. It briefly spiked to 14% as the market dropped but went right back into the range, during the 60s it was between 3-4% and at the 1982 bottom it was just over 6%. Before Black Monday(1987) it briefly slipped uner 3% and then spiked to 3.5% due to the drop. But then something happened.

In the 90's bubble investors became to fixated on capital gains(and are to this day) that dividend yields did not matter anymore. They were not what's important because hey, there's a pot of gold in capital gains. So it fell and fell to 1% in the year 2000. The 2000-2002 decline brought it close to 2%, still lower than other historical tops(remember, those normally came at roughly 3%).

The 2007-9 decline brought the yield closer to 3%, but still beneath it. The last few years have caused the dividend yield to retreat back to 2.03% today. So even by this measure, the market is beyond overvalued.

A ranking of the most overvalued extremes in U.S. history, on the basis of several valuation measures(the most reliable over more than a century of data), in order of severity, includes: 2000, 2015, 1929, 2007, 1937, 1907, 1968, and 1972. While the 1969-70 bear market took the S&P 500 down by only 1/3 of its value, each of the other instances was followed by market losses of 50% or more. So considering the fact that 2015 is the second highest valuation extreme on record, such an outcome is not some worst case scenario, but a rather run of the mill expectation.

Just as crucial to remember is, the 2000 market peak was dominated by large cap stocks and the technology sector. The recent Fed induced speculative bubble actually brought the valuation of the median stock beyond the 2000 extreme, marking the most offensive point of overvaluation in history for the broad market. A 50% market loss would not even bring the most historically reliable valuation measures materially below their long-term averages.

And this is all out of here:

http://www.visajourney.com/forums/topic/472315-us-stock-markets-continue-to-reach-record-highs-thanks-obama/page-21

Lets continue this interesting conversation respectfully and see what happens. We are living in interesting times for sure.

Edited December 8, 2015 by Penguin_ie

[Jacque67 7,328]

Off topic again-sorry! What's up with the whale this time? Sorry, I forget her name. Do you keep her in a pool?

[OriZ 3,157]

Haha no, this is from the last time my wife and I went to seaworld. However I do have many other pics of me with whale sharks, sea turtles, manta rays, hammerhead sharks, dolphins, penguins and others from my scuba diving trips. Gosh I wish I could have her in my own lil pool but I don't believe that's legal

[Jacque67 7,328]

Haha no, this is from the last time my wife and I went to seaworld. However I do have many other pics of me with whale sharks, sea turtles, manta rays, hammerhead sharks, dolphins, penguins and others from my scuba diving trips. Gosh I wish I could have her in my own lil pool but I don't believe that's legal

I thought you had connections-lol.

Hey, you should definitely go to the Galápagos Islands if you haven't already.

[OriZ 3,157]

Funny you mention that, I was actually supposed to in 2008, had everything booked - but then I ended up staying in the US with the one who became my wife She had to have neck surgery and I cancelled my trip.

We're waiting for an opportunity to go together, but I've been to other cool places meanwhile.

Edited December 7, 2015 by OriZ

[Jacque67 7,328]

Funny you mention that, I was actually supposed to in 2008, had everything booked - but then I ended up staying in the US with the one who became my wife She had to have neck surgery and I cancelled my trip.

We're waiting for an opportunity to go together, but I've been to other cool places meanwhile.

Have you been to Jelly Fish Lake in Palau? That's pretty amazing.

[X Factor 1,112]

There are lots of negative divergences in market internals. I am waiting until January after the usually bullish December season to reenter.The interesting thing about the market is it usually fakes people out and then it crushes them.

[crazyworld 54]

OriZ - You got a lot of knowledge there!

I invested a lot of money in the renewable energy market when it started and lots most of it in the recession. Took what I had left and invested in FORD when it was under $2.00 a share. Sold it a couple of years later and made everything back I had lost. Took my money and ran. lol

What I learned,

If you want to make money in the market, you need to work the market. You need to spend a lot of time and do a lot of homework and not expect to make millions in a day or two.

When the market takes a big hit, then invest in only company's that have been around for a long time and have a sell target price with in expectations of what the company was doing before the hit.

If you do not want to spend all your after work time and weekends doing the research, then invest in a established fund with a retirement year so the fund get reallocated to more conservative funds by somebody who does it as a living as the time grows near.

Only buy and hold companies that pay good dividends.

Just my 2 cents worth

[OriZ 3,157]

Have you been to Jelly Fish Lake in Palau? That's pretty amazing.

I have not. Palau(and micronesia and other polynesian islands) and Fiji are places I still want to go to.

But I did get to do Cocos island, utila, roatan, red sea and mediterranean of course, maldives and a few others.

[OriZ 3,157]

Oh, forgot to mention the Blue hole in Belize.

[OriZ 3,157]

OriZ - You got a lot of knowledge there!

I invested a lot of money in the renewable energy market when it started and lots most of it in the recession. Took what I had left and invested in FORD when it was under $2.00 a share. Sold it a couple of years later and made everything back I had lost. Took my money and ran. lol

What I learned,

If you want to make money in the market, you need to work the market. You need to spend a lot of time and do a lot of homework and not expect to make millions in a day or two.

When the market takes a big hit, then invest in only company's that have been around for a long time and have a sell target price with in expectations of what the company was doing before the hit.

If you do not want to spend all your after work time and weekends doing the research, then invest in a established fund with a retirement year so the fund get reallocated to more conservative funds by somebody who does it as a living as the time grows near.

Only buy and hold companies that pay good dividends.

Just my 2 cents worth

I'm not much of an investor, I'm a trader - and even though I analyze the market from a technical perspective, I know the valuation side of it just as well.

The way the system I've developed and trade on a day to day basis with works actually has nothing to do with trying to "predict" movements. It's actually all about risk management and uses several indicators like momentum indicators and moving averages to give me entry points and take profit/stop loss points. It's brilliance if you ask me is its simplicity and it's worked very very well for me so far.

But it never hurts to know more than that and that's why I do the rest of the work I do. For one - it's exciting. For two, it's always good to know exactly where you are in a cycle and three, I do trade using that for longer term trades from time to time as well(such as the trend short I am in now).

As far as buying and holding companies that pay good dividends - that's one of the problems today like I wrote earlier - most companies don't pay good dividends anymore. Whereas investors would not pay, on average, for a company with under 3.5% dividend yield in the past and usually only thought it was worth investing(i.e. market bottom) at an average 8% dividend yield(and 14% during the great depression), in the past couple decades they will buy companies that pay an average dividend of 1-3%. That's very low and it's because investors have become greedy and want the capital gains. Needless to say that's not sustainable.

Edited December 8, 2015 by OriZ

[Penguin_ie 5,993]

**** part of the Op removed for TOS violation- "Make comments in a Post either direct or implied toward another member that are purposely designed to upset, antagonize, make fun of, belittle, harass, insult, or otherwise instigate an argument that takes away from the personal enjoyment of the Service by other users.". Stick to discussing news, not eachother. *****

[Jacque67 7,328]

Oh, forgot to mention the Blue hole in Belize.

Had to google that-looks amazing. Yeah, the Maldives are cool, but for diving micro-Polynesia is a must awa Okinawa and the Galápagos Islands .. You should change your avatar on a regular basis!

[OriZ 3,157]

There are lots of negative divergences in market internals. I am waiting until January after the usually bullish December season to reenter.The interesting thing about the market is it usually fakes people out and then it crushes them.

Yes new highs would be AWESOME in the way of getting even more people hyped up about a market on the verge of a major heart attack.

[GandD 5,966]

Isn't a downturn always inevitable? How can you be wrong really? You've missed a few markers already as I recall but I don't really want to dig back into it that deeply. The gas price prediction went pretty well I suppose. It's just to vague IMO. If it doesn't turn, you can always say it's still looming. If it does, you were right. Is there anything you're willing to say with certainty as a direct measurable? And preferably without a million word response. The market's complicated for sure. But you're so certain there's a major event coming. When's the cut off point for this prediction? A year? Two? 6 months?