One Year To Nowhere

[OriZ 3,157]

6 minutes ago, X Factor said:

Yep won't end well. But I will ride this bull until it ends. 

I see it going to 2,500-2,600 on the SPX by mid year and possibly topping there(and ultimately getting cut by more than half). But yeah, I don't decide for it, but the havoc is going to be epic.

Edited February 23, 2017 by OriZ

[OriZ 3,157]

"The issue is no longer whether the currnet market resembles those preceding the 1929, 1969-70, 1973-74, and 1987 crashes. The issue is only - are conditions like October of 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... Let's not be shy: regardless of short-term action, we ultimately expect the S&P 500 to fall by more than half, and the Nasdaq by two-thirds. Don't scoff without reviewing history first."

- John P. Hussman, Ph.D., Hussman Econometrics, February 9, 2000

 

"On Wall Street, urgent stupidity has one terminal symptom, and it is the belief that money is free. Investors have turned the market into a carnival, where everybody 'knows' that the new rides are the good rides, and the old rides just don't work. 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... Over time, price/revenue ratios come back in line. Currently, that would require an 83% plunge in tech stocks (recall the 1969-70 tech massacre). The plunge may be muted to about 65% given several years of revenue growth. If you understand values and market history, you know we're not joking."

- John P. Hussman, Ph.D., Hussman Econometrics, March 7, 2000

 

On Wednesday, the consensus of the most reliable equity market valuation measures we identify (those most tightly correlated with actual subsequent S&P 500 total returns in market cycles across history) advanced within 5% of the extreme registered in March 2000. Recall that following that peak, the S&P 500 did indeed lose half of its value, the Nasdaq Composite lost 80% of its value, and the tech-heavy Nasdaq 100 Index lost an oddly precise 83% of its value. With historically reliable valuation measures beyond those of 1929 and lesser peaks, capitalization-weighted measures are essentially tied with the most offensive levels in history. Meanwhile, the valuation of the median component of the S&P 500 is already far beyond the median valuations observed at the peaks of 2000, 2007 and prior market cycles, while our estimate for 10-12 year returns on a conventional 60/30/10 mix of stocks, bonds, and T-bills fell to a record low last week, making this the most broadly overvalued instant in market history.

 

There is a quick, knee-jerk response floating around these days, which asserts that “stocks are still cheap relative to interest rates.” This argument is quite popular with investors who haven’t spent much time getting their hands dirty with historical data, satisfied to repeat verbal arguments they’ve heard elsewhere as a substitute for analysis. It’s even an argument we recently heard, almost inexplicably, from one investor we’ve regularly agreed with at market extremes over several decades (more on that below). In 2007, as the market was peaking just before the global financial crisis, precisely the same misguided assertions prompted me to write Long-Term Evidence on the Fed Model and Forward Operating P/E Ratios. See also How Much Do Interest Rates Affect the Fair Value of Stocks? from May of that year. Let’s address this argument once again, in additional detail.

 

Valuations and interest rates

There’s no question that interest rates are relevant to the fair valuation of stocks. After all, a security is nothing but a claim to some future stream of cash flows that will be delivered into the hands of investors over time. The higher the price an investor pays for a given stream of future cash flows, the lower the long-term return the investor can expect to earn as those cash flows are received. Conversely, the lower the long-term return an investor can tolerate, the higher the price they will agree to pay for that stream of future cash flows. If interest rates are low, it’s not unreasonable to expect that investors would accept a lower expected future return on stocks. If rates are high, it’s not unreasonable to expect that investors would demand a higher expected future return on stocks.

 

The problem is that investors often misinterpret the form of this relationship, and become confused about when interest rate information is needed and when it is not. Specifically, given a set of expected future cash flows and the current price of the security, one does not need any information about interest rates at all to estimate the long-term return on that security. The price of the security and the cash flows are sufficient statistics to calculate that expected return. For example, if a security that promises to deliver a $100 cash flow in 10 years is priced at $82 today, we immediately know that the expected 10-year return is (100/82)^(1/10)-1 = 2%. Having estimated that 2% return, we can now compare it with competing returns on bonds, to judge whether we think it’s adequate, but no knowledge of interest rates is required to “adjust” the arithmetic.

 

There are three objects of interest here: the current price, the future stream of expected cash flows, and the long-term rate of return that converts one to the other. Given any two of these, one can estimate the third. For example, given a set of expected future cash flows and some “justified” return of the investor’s choosing, one can use those two pieces of information to calculate the price that will deliver that desired expected return. If I want a $100 future payment to give me a 5% future return over 10 years, I should be willing to pay no more than $100/(1.05)^10 = $61.39.

 

So when you want to convert a set of expected cash flows into an acceptable price today, interest rates may very well affect the “justified” rate of return you choose. But if you already know the current price, and the expected cash flows, you don’t need any information about prevailing interest rates in order to estimate the expected rate of return. One does not have to “factor in” the level of interest rates when observable valuations are used to estimate prospective long-term market returns, because interest rates are irrelevant to that calculation. The only thing that interest rates do at that point is to allow a comparison of the expected return that’s already baked in the cake with alternative returns available in the bond market.

 

The Fed Model is an artifact of just 16 years of history

There’s an additional problem. While it’s compelling to believe that the expected return on stocks and bonds should have a one-to-one relationship, history doesn’t bear that out at all. Indeed, over the past century, the correlation between bond and stock yields has historically gone in the entirely wrong direction except during the inflation-disinflation cycle from about 1970 to 1998. What investors may not realize is that the correlation between interest rates and earnings yields (as well as dividend yields) has been negative since 1998. Investors across history have not been consistent at all in treating stocks and bonds as closely competing substitutes.

 

As I noted during the bubbles that ended in 2000 and 2007, the problem with the Fed Model (which compares the S&P 500 forward operating earnings yield with the 10-year Treasury yield) is that this presumed one-to-one relationship between stock and bond yields is wholly an artifact of the disinflationary period from 1982 to 1998. The stock market advance from 1982 to 1998 represented one of the steepest movements from deep secular undervaluation to extreme secular overvaluation in stock market history. Concurrently, bond yields declined as inflation retreated from high levels of the 1970’s. What the Fed Model does is to overlay those two outcomes and treat them as if stocks were “fairly valued” the entire time.

 

The chart below shows the S&P 500 forward operating earnings yield alongside the 10-year Treasury bond yield. The inset of the chart is the chart that appeared in Alan Greenspan’s 1997 Humphrey Hawkins testimony, and is the entire basis upon which the Fed Model rests. The same segment of history is highlighted in the yellow block. Notice that this is the only segment of history in which the presumed one-to-one relationship actually held.

 

 

Descriptive versus predictive

The Fed Model is not a fair-value relationship, but an artifact of a specific disinflationary segment of market history. It is descriptive of yield behavior during that limited period, but it has a very poor predictive record with regard to actual subsequent market returns.

When investors assert that stocks are “fairly valued relative to interest rates,” they are essentially invoking the Fed Model. What they seem to have in mind is that regardless of absolute valuation levels, stocks can be expected to achieve acceptably high returns as long as the S&P 500 forward operating earnings yield is higher than the 10-year Treasury yield.

 

No, no. That’s not how any of this works, and we have a century of evidence to show it. The deep undervaluation of stocks in 1982 was followed by glorious subsequent returns. The steep overvaluation of stocks in 1998 was followed by one crash, then another, which left S&P 500 total returns negative for more than a decade. I fully expect that current valuations, which are within a breath of 2000 extremes on the most historically reliable measures, will again result in zero or negative returns over the coming 10-12 years. Let’s dig into some data to detail the basis for those expectations.

First, a quick note on historically reliable valuation measures. The value of any security is based on the long-term stream of cash flows that it can be expected to deliver over decades and decades. While corporate earnings are certainly required to generate future cash flows, current earnings (or even forward earnings) are very poor “sufficient statistics” for that stream of cash flows. That’s true not only because of fluctuations in profit margins over the economic cycle, but also due to very long-term competitive forces that exert themselves over multiple economic cycles. From the standpoint of historical reliability, valuation measures that dampen or mute the impact of fluctuating profit margins dramatically outperform measures based on current earnings. Indeed, even the Shiller CAPE, which uses a 10-year average of inflation-adjusted earnings, provides substantially better results when one also adjusts for the embedded profit margin (the denominator of the CAPE / S&P 500 revenues). For a brief primer on the importance of implied profit margins in evaluating market valuations, see Two Point Three Sigmas Above the Norm and Margins, Multiples, and the Iron Law of Valuation.

 

The chart below shows the ratio of nonfinancial market capitalization to corporate gross value-added, including estimated foreign revenues. I created this measure, MarketCap/GVA, as an apples-to-apples alternative to market capitalization/GDP that matches the object in the numerator with the object in the denominator, and also takes foreign revenues into account. We find this measure to be better correlated with actual subsequent S&P 500 total returns than any other measure we’ve studied in market cycles across history, including price/earnings, price/forward earnings, price/book, price/dividends, enterprise value/EBITDA, the Fed Model, Tobin’s Q, market cap/GDP, the NIPA profits cyclically-adjusted P/E (CAPE), and the Shiller CAPE.

MarketCap/GVA is shown below on an inverted log scale (blue line, left scale), along with the actual subsequent 12-year total return of the S&P 500 (red line, right scale). From current valuations, which now rival the most extreme levels in U.S. history, we estimate likely S&P 500 nominal total returns averaging less than 1% annually over the coming 12-year horizon. As a side note, we tend to prefer a 12-year horizon because that is the point where the autocorrelation profile of valuations drops to zero, and is therefore the horizon over which mean reversion is most reliable (see Valuations Not Only Mean-Revert, They Mean-Invert).

 

 

I’m often asked why we don’t “adjust” MarketCap/GVA for the level of interest rates. The answer, as detailed at the beginning of this comment, is that given both the price of a security, and the expected stream of future expected cash flows (or a sufficient statistic for those cash flows), one does not need any information at all about interest rates in order to estimate the expected long-term return on that security. Each point in the chart below shows the actual 12-year subsequent total return of the S&P 500 index, along with two fitted values, one using MarketCap/GVA alone, and the other including the 10-year Treasury bond yield as an additional explanatory variable. That additional variable adds absolutely no incremental explanatory power. Both fitted values have a 93% correlation with actual subsequent 12-year S&P 500 total returns.

We’re now in a position to say something very precise about current valuations and interest rates. Given the present level of interest rates, investors who are willing to accept likely prospective nominal total returns on the S&P 500 of less than 1% over the coming 12-year period are entirely welcome to judge stocks as “fairly valued relative to interest rates.” But understand that this is precisely what that phrase implies here.

 

Moreover, as one can see from the foregoing charts, there’s not a single market cycle in history, neither in the period before the 1970’s (when interest rates regularly hovered near current levels), nor in recent decades, that has failed to raise prospective 10-12 year S&P 500 total returns to the 8-10% range or beyond over the completion of that cycle. So even if investors are willing to accept 10-12 year total returns of next to nothing, they should also be fully prepared for an interim market loss on the order of 50-60%, because that is the decline that would now be required to restore those 8-10% return expectations, without even breaking below historical valuation norms.

 

It’s important for investors to recognize how extreme market valuations have become. The chart below shows the valuation measures we find best correlated with actual subsequent S&P 500 total returns, shown as percentage deviations from their historical norms, along the premium of the 10-year Treasury to its own historical norm. While yields on U.S. Treasury bonds were regularly below current levels prior to the 1960’s, the yield on a 10-year constant maturity Treasury bond has averaged about 5.3% since 1940. At current interest rates, a 5.3% coupon bond would currently trade about 20% above its historical norm. If you’re willing to adjust your expected return on stocks downward on an equivalent basis over the coming decade, I have no objection to pricing that kind of premium into stocks, relative to their historical norms. But a premium of that magnitude comes nowhere close to justifying valuations that pushed beyond 160% above those norms last week.

 

 

Recall that the 2000 market peak was dominated by breathtaking overvaluation among a subset of very large capitalization stocks, while the broader market was less extreme, particularly among smaller capitalization issues. That didn’t prevent the S&P 500 Index from losing half of its value, or the Nasdaq 100 Index from losing 83% of its value, but it did create the basis for a long period of relative outperformance by small cap stocks. By contrast, we presently observe, by far, the most extreme median valuations in history. The chart below shows the median valuation of S&P 500 components, which is now well beyond levels observed at the 2000 and 2007 market peaks.

 

 

From a stock pricing perspective, it’s also important to understand that if investors expect interest rates to remain depressed forever, they should also be pricing in low nominal economic growth forever. The fact is that variations in those two factors have historically canceled out, which is another reason why the relationship between reliable valuation measures and actual subsequent S&P 500 total returns are largely unaffected by those variations. The chart below plots the 10-year Treasury yield versus the nominal growth of nonfinancial gross value-added (essentially U.S. corporate revenues) over the preceding decade, in data since the 1940’s. Whatever assumption one makes for nominal growth in corporate fundamentals over the coming decade, one should make the same assumption about future interest rates, and vice versa.

 

 

So understand that there is no historical basis to expect that a rebound in nominal growth will occur without also observing substantially higher interest rates. Rather, the level of interest rates a decade from now will be strongly determined by the nominal economic growth we observe between now and then.

 

A note on earnings dynamics

Investors often ask why we don’t place more weight on forward operating P/E ratios. Presently, the S&P 500 P/E on the basis of next year’s estimated operating earnings is about 18. That’s high, but certainly not far beyond double historical norms, which is what we observe from better-performing valuation measures. One has to remember that “forward earnings” came into common use during the tech bubble, as an “alternative” valuation measure to actual 12-month trailing earnings (which include “bad stuff” like actual losses that are regularly classified as “extraordinary”). By the 1990’s, investors had become used to the fact that a normal P/E on trailing earnings was about 14-15, and have kept that figure in their heads as a “normal” P/E, even though forward operating earnings typically run an average of nearly 35% above trailing earnings, while current estimates are about 50% higher than trailing figures.

 

The fact is that prior to the late-1990’s bubble, the median forward operating P/E for the S&P 500 in imputed data since 1940 is actually less than 11 (which agrees with estimates by Cliff Assness at AQR). But using the correct median is easy to address. The reason we still would not rely on forward P/E ratios, as noted above, is that stocks are not a claim on next year’s earnings, but a stream of payments that will be delivered over decades. Earnings-based measures, unadjusted for their embedded profit margins, are quite poor “sufficient statistics” for those long-term cash flows.

It’s easy to demonstrate that these measures have substantially weaker correlations with actual subsequent market returns than a variety of more robust measures we’ve presented over time, such as MarketCap/GVA. Because profit margins are systematically elevated at cyclical economic peaks, raw earnings-based measures invariably reassure investors that extreme stock market levels are really not as dangerous as they seem. As Ben Graham warned decades ago, “The purchasers view the good current earnings as equivalent to ‘earning power’ and assume that prosperity is equivalent to safety.”

 

To illustrate this recurring phenomenon, the chart below presents the S&P 500 forward operating P/E as a ratio to MarketCap/GVA (blue line). The interpretation here is that when the blue line is very low, as it is today, market valuations appear much more attractive on a P/E basis than on measures that are less vulnerable to profit margin fluctuations. Conversely, when the blue line is high, it indicates that market valuations appear more expensive on a P/E basis than on other measures. The red line shows the actual subsequent 4-year annual growth of S&P 500 operating earnings. Notice that when stocks look “cheap” on forward earnings, relative to other measures, operating earnings growth tends to collapse over the subsequent 4-year period.

 

 

At present, corporations have benefited because wages and salaries as a share of GDP are near record lows, while nonfinancial corporate debt is at a record high ratio to revenues (about double the historical norm, even after netting out cash). This leaves margins vulnerable to any normalization in either the wage share or interest rates. Finally, while there’s a lot of enthusiasm over the potential for tax cuts to boost after-tax earnings, the fact is that the effective U.S. corporate tax rate (what corporations actually pay as a fraction of pre-tax profits) is already near the lowest level in history outside of recessionary periods, and earnings would benefit rather little even from quite a sharp reduction in tax rates. With reduced labor force slack, upward interest rate pressure, and little room for further reduction in effective taxes, we expect that this is as good as it gets. Indeed, the data suggest that investors should not be at all surprised to see S&P 500 operating earnings lower in 4 years than they are today.

 

Mapping current valuations to subsequent expected returns

To understand why good valuation measures are so reliable in projecting 10-12 year market returns, a little bit of arithmetic is useful, which I detailed formally in Rarefied Air: Valuations and Subsequent Market Returns. The essential idea is that the return investors obtain from stocks over a given holding period is a function of initial valuations, terminal valuations at the end of the period, and the growth rate of fundamentals in the interim. Given the relationships I’ve outlined above, think carefully about how this works. Rapid growth in fundamentals over a given decade is systematically associated with higher interest rates at the end of that decade. Moreover, because rapid growth also often reflects transient cyclical expansion or contraction in profit margins, investors tend to split the difference except in their most reckless moments (like today). Specifically, following periods of rapid growth and expanding profit margins, they tend to be more conservative with the multiples they assign to stocks, and following periods of weak growth and contracting profit margins, they tend to be more generous. Interest rate movements reinforce these effects. The combined outcome is that periods of rapid growth in fundamentals tend to be associated with lower terminal valuations at the end of a given decade, while periods of dismal growth in fundamentals tend to be associated with richer terminal valuations.

 

In short, total returns are driven by initial valuations, terminal valuations, and the growth rate of fundamentals in the interim. As detailed above, unexpected fluctuations in growth and terminal valuations over a 10-12 year holding period tend to systematically cancel each other out. As a result, it turns out that initial valuations alone are reliable in projecting S&P 500 total returns over that horizon.

 

As for real returns, equity market valuations provide very little information about future inflation, so while they certainly do well in projecting real investment returns, there’s no particular advantage to the additional inflation adjustments. For reasons detailed above, we’ve found it best to estimate nominal total returns directly, and then subtract a well-formed estimate of inflation that relies on a broader information set. Still, see the final chart of my November 30, 2015 comment for a scatterplot of the robust relationship between MarketCap/GVA and subsequent real S&P 500 total returns.

 

On a related note, investors who feel compelled to use interest rate information to adjust the implications of reliable valuation measures should do so as I outlined at the beginning of this comment. First, use the valuation measures to estimate prospective 10-12 year total returns, then subtract the observed level of interest rates of that maturity (or a blended average that approximates it). The result is the amount by which the S&P 500 can be expected to outperform or underperform Treasury securities over the chosen horizon. The approximate projection for S&P 500 annual total returns on a 12 year horizon is 0.10 - 0.13 x ln(MC/GVA). The chart below shows this “excess return” estimate (blue) versus the actual performance of the S&P 500 versus Treasury bonds over the following 12-year period (red). It will come as no surprise that at present valuations, we expect the S&P 500 total return to underperform Treasury yields by about -2% annually over the coming 12-year horizon. The correlation between projected and actual returns here is 93%, which strikingly exceeds the reliability of any variant of the Fed Model we’ve tested over time.

 

 

Who are you, and what have you done with Warren Buffett?

Back in 2001, Warren Buffett gave an interview with Carol Loomis in Fortune Magazine, and made the following observations:

“I was no good then at forecasting the near-term movements of stock prices, and I’m no good now. I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two.

 

“But I think it is very easy to see what is likely to happen over the long term. Ben Graham told us why: ‘Though the stock market functions as a voting machine in the short run, it acts as a weighing machine in the long run.’ Fear and greed play important roles when votes are being cast, but they don’t register on the scale.

 

“A stock is a financial instrument that has a claim on future distributions made by a given business, whether they are paid out as dividends or to repurchase stock or to settle up after sale or liquidation. These payments are in effect ‘coupons.’ The set of owners getting them will change as shareholders come and go. But the financial outcome for the business’ owners as a whole will be determined by the size and timing of these coupons. Estimating those particulars is what investment analysis is all about.

 

“On a macro basis, the quantification doesn’t have to be complicated at all. Below is a chart, starting almost 80 years ago and really quite fundamental in what it says. The chart shows the market value of all publicly traded securities as a percentage of the country’s business; that is, as a percentage of GNP. The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment. And as you can see, nearly two years ago the ratio rose to an unprecedented level. That should have been a very strong warning signal.”

Warren Buffett on the Stock Market, Fortune Magazine, December 10, 2001

 

I’ve always shared Buffett’s respect for Ben Graham and value-conscious investing. Indeed, and at market extremes, we’ve almost always been in agreement about valuations. That was certainly true during the tech bubble. After the 2000-2002 collapse, we shifted to a constructive outlook on stocks, not because stocks had become deeply undervalued, but because the sufficiently large retreat in valuations during prior years was joined, in early-2003, by early improvement in our measures of market action.

 

By late-2006, our market outlook had become quite negative, and I wrote two pieces on Buffett, largely defending continued adherence to a value-focused investment discipline. One piece, When Value Mavens Lag, observed that the performance of value-conscious investors has typically been least impressive just before the market itself has fallen into a long period of dull and often negative returns. See, value investing relies on a certain amount of mean reversion, and at points where the market is at speculative extremes, the most overvalued stocks - precisely those that are not included in a value investor’s portfolio - have yet to experience that mean reversion. As a consequence, value portfolios will typically have already lagged large-cap glamour stocks for some period of time at the point that a speculative market reaches its peak. The pattern then tends to reverse during periods of market weakness.

 

The following week, I wrote Why Warren Buffett Plays Bridge, which includes one of my favorite passages from Ben Graham on the long-term importance of informed discipline, rather than the constant attempt to win every hand. I wrote:

“Aside from an affection for cheeseburgers and cherry Coke, one of the personal facts commonly known about Warren Buffett is his love of bridge, which he periodically plays online with Bill Gates.

 

“Why bridge? Though Graham wasn't talking about Buffett at the time, he offers a clue: ‘I recall to those of you who are bridge players the emphasis that bridge experts place on playing a hand right rather than on playing it successfully. Because, as you know, if you play it right you are going to make money and if you play it wrong you lose money - in the long run. There is a beautiful little story about the man who was the weaker bridge player of the husband-and-wife team. It seems he bid a grand slam, and at the end he said very triumphantly to his wife ‘I saw you making faces at me all the time, but you notice I not only bid this grand slam but I made it. What can you say about that?' And his wife replied very dourly, ‘If you had played it right you would have lost it.'

 

“It seems to me (and it has certainly been my experience) that it takes an enormous amount of restraint to focus on playing every investment hand ‘right,’ according to an established discipline, allowing the law of averages to work in your favor, rather than trying to win every hand. I would guess that this is exactly what appeals to Warren Buffett's temperament. Over the long-term, good investing requires it.”

 

By May 2007, my views had become much the same as they are today, and I wrote, “we can't have any assurance that the market will roll over into a bear market next week, next month, next quarter or even next year. But we can have reasonable confidence that markets will continue to cycle between great optimism and great despair. With stocks at over 18 times top-of-channel earnings on record profit margins, with the major indices at multi-year highs, with short-term trends easily through the upper Bollinger bands at the monthly, weekly and daily frequencies, with 54.3% of advisors bullish and only 19.6% bearish according to the latest Investors Intelligence figures, and with 10-year Treasury yields higher than they were 6 months ago, it should be reasonably easy to determine which extreme the market more closely resembles at present.”

 

In the quarters that followed, the stock market would collapse. By late-October 2008, the S&P 500 was down more than 40% from its peak. If you’ve studied the charts earlier in this comment, you can see the substantial improvement in valuations at the time. Buffett’s outlook turned positive, and so did ours. Given the improvement in market valuations, I wrote Why Warren Buffett is Right (and Why Nobody Cares), observing:

“The best way to begin this comment is to reiterate that U.S. stocks are now undervalued. I realize how unusual that might sound, given my persistent assertions during the past decade that stocks were strenuously overvalued (with a brief exception in 2003). Still, it is important to understand that a price decline of over 40% (and even more in some indices) completely changes the game. Last week, we also observed early indications of an improvement in the quality of market action, and an easing of the upward pressure on risk premiums.”

 

Which brings us to the present. Last week, Warren Buffett himself made the jaw-dropping suggestion that the market was “cheap relative to interest rates.” Now, if you understand a century of market history, and Buffett’s own investment decisions over time, the most obvious conclusion is that Warren has been abducted and replaced by either an imposter or a highly sophisticated yet folksy robot.

My friend Jesse Felder has a simpler explanation, which is that Buffett strongly prefers not to disrupt the markets to the downside. In a piece titled Why Warren Buffett is So Reluctant to Call Stocks a ‘Bubble’ Jesse mentions the 2001 Fortune article and writes, “What you need to know about Mr. Buffett, though, is that he was eager to share this warning signal with investors only well after stocks had peaked. In fact, the Nasdaq Composite had already crashed by more than 70% before the words above were published. It’s true that he did make an earlier warning in Fortune but both articles were the products of the enterprising (or kindhearted - I’ll let you choose) reporter Carol Loomis who learned of Buffett’s private worries about the stock market and convinced him to make them public.”

 

Two years ago, as the broad market was about 10% below current levels, Alice Schroeder, who authored a book on Buffett titled The Snowball, also observed, “in private he has been more negative, at least with me, about the economy, money-printing, employment, than he is in public.”

Buffett has always expressed an admiration for the U.S. economy, and for long-term investment in the equity market. Knowing that every share of stock outstanding has to be held by someone at every point in time, he undoubtedly recognizes that there is no way for investors, in aggregate, to avoid market risk. My impression is that he has decided that he’s not going to be the guy who busts their bubble. To the extent that Buffett is now in the commendable process of divesting his holdings for the benefit of charity, one might even view his reluctance to rock this boat to be protective of that legacy - provided that investors aren’t encouraged by his words to take investment positions they can’t tolerate holding over the completion of this market cycle and for a very, very, long time thereafter.

 

For our part, we’ve always given more weight to a century of observable evidence than to anyone’s verbal arguments, even those who we hold in high esteem. Still, as long as investors are comfortable with expected S&P 500 10-12 year total returns of less than 1% annually, with likely interim losses on the order of 50-60%, investors are free to label this situation as “fairly valued” or with any other phrase they wish.

 

https://www.hussmanfunds.com/wmc/wmc170306.htm

Edited March 6, 2017 by OriZ

[X Factor 1,112]

Waiting for signal to go short. None yet.

[OriZ 3,157]

5 minutes ago, X Factor said:

Waiting for signal to go short. None yet.

No none over here either. But I thought this week's commentary by Hussman was exceptional. There is not a shred of doubt where this is going, but for now, my system is still long.

[OriZ 3,157]

Another wall with huge writing on it...

 

Pension Crisis Too Big for Markets to Ignore

 

https://www.bloomberg.com/view/articles/2017-03-24/pension-crisis-too-big-for-markets-to-ignore

[OriZ 3,157]

Great job by Hussman this week:

 

Let’s begin by distinguishing the short-run from the full-cycle and the long-run. While we presently observe wicked valuations from a historical perspective, the fact is that valuations often have very little effect on short-term market behavior. The primary factor that drives market fluctuations over short horizons is the preference or aversion of investors toward risk, and the best measure of that is the uniformity or divergence of market internals across a broad range of individual stocks, industries, sectors and security types (when investors are inclined to speculate, they tend to be indiscriminate about it).

 

While the classification methods we’ve found most reliable in complete market cycles across history remain negative, we follow a broad range of measures, and a few of the less-reliable but still-useful measures are mixed. As a result, our immediate view is currently a bit more neutral than negative. Our overall outlook is defensive either way, so that may seem like a distinction without a difference, but it's mainly a statement about the magnitude of our near-term concerns. Currently, we’d look for more uniform deterioration in market internals before pounding the table about an immediate market collapse.

 

From a full-cycle perspective, my expectation remains that the S&P 500 is likely to lose between 40-60% of its value over the completion of the current cycle (a market cycle combines a bull market and a bear market, and a full cycle is appropriately measured peak-to-peak or trough-to-trough). On a longer-term perspective, we presently estimate 12-year S&P 500 nominal total returns averaging just 0.6% annually. Indeed, as noted below, unless one believes that the entire structure of the U.S. financial markets has changed since as recently as 2012, investors should allow for the market to lose at least one-third of its value over the completion of the current cycle, with the S&P 500 underperforming even the depressed yields on Treasury bonds over the coming decade.

 

To get a sense of why these expectations are so pointed, I’ll begin with a familiar chart, which shows the ratio of nonfinancial market capitalization to corporate gross value-added (including estimated foreign revenues). I originated this measure to create a true apples-to-apples metric that also takes foreign revenues into account. Perhaps not surprisingly, we find this measure better correlated with actual subsequent market returns than any other measure we’ve studied, including forward operating P/Es, the Shiller CAPE, price/cash flow, price/dividend, Tobin’s Q, the Fed Model, and market capitalization/GDP, among others. On a 12-year horizon (the point where the autocorrelation profile of valuations typically hits zero, and the most reliable horizon over which mean-reversion can be expected), MarketCap/GVA has a correlation of -0.93 with actual subsequent S&P 500 total returns (negative because higher valuations imply lower subsequent returns).

 

The chart below presents MarketCap/GVA on an inverted log scale (blue line, left), along with the actual subsequent 12-year nominal annual total return of the S&P 500 Index (red line, right scale).

 

 

I occasionally receive questions asking why our valuation measures are supposedly “not working.” Wait. Hold on and look carefully at the chart above. It should be rather obvious that valuations have continued to “work” even in recent complete market cycles, and throughout the recent series of bubbles and crashes, correctly identifying stocks as wickedly overvalued in 2000, today, and to a lesser extent, 2007, while identifying stocks as undervalued in 2009, and reasonably valued at the 2002 low. Even the “overshoot” of actual returns from expected returns in the past few years is something that regularly occurs at valuation extremes, particularly when the completion of an extreme cycle occurs a bit sooner or later than usual. Note, for example, the 1988 overshoot of actual market returns for the 12-year horizon that ended with the 2000 peak. The reverse tendency is often seen at major lows. Note, for example, the 1997 undershoot of actual market returns for the 12-year horizon that ended with the 2009 low.

 

I’m going to say this yet again: our challenges in the recent half-cycle had nothing to do with valuation measures, but was instead the result of my own insistence in 2009 on stress-testing our methods of classifying market return/risk profiles against Depression-era data. The inadvertent result of that decision was to create an Achilles Heel in the face of zero interest rate policy and extreme yield-seeking speculation. That took us much of the recent half-cycle to fully address. See Portfolio Strategy and the Iron Laws for further discussion.

What investors imagine to be a “different” market is merely a market near the mature end of an as-yet uncorrected episode of reckless speculation, just as it was in 2000. If you’re an investor and you want to do yourself a favor, do this: distinguish my own inadvertent stumble in the recent half-cycle, which I’ve regularly, openly and exhaustively discussed, from objective evidence on valuations. What you see at present is not valuations “failing to work.” We already know valuations don’t govern short-run market outcomes - that’s why market action and related measures are useful over shorter segments of the market cycle. What you see is a speculative bubble that is doing its best to draw you in like Sirens singing to Ulysses, across a graveyard of ship hulls smashed against the rocks.

 

The chart below presents MarketCap/GVA on a regular scale in post-war data. What investors should note is that no market cycle in history, including the most recent ones, has failed to take valuations down to half of today's level (or below) over the completion of the cycle. So whatever change investors think has occurred to make valuations useless had better be something permanent that’s occurred in the past few years. And even if investors do believe that the level of valuations has shifted forever higher (meaning that the level of normal stock market returns has also shifted forever lower), they are encouraged to recognize that there are no permanent plateaus in the chart. Instead, one observes repeated extremes and troughs.

 

The current level of MarketCap/GVA is above 2.0. Investors who refuse to allow for a retreat even to a level of 1.35 over the completion of this cycle (which would be a market loss of one-third) had better be able to explain what has permanently changed since 2012, because we saw 1.35 even well into the current speculative run. Zero interest rates, by the way, are not adequate to dismiss valuations here. Changing the level of interest rates alters the laws of finance no more than changing the value of x alters the laws of arithmetic. You don’t suddenly decide that math itself is no longer useful. The maximum “justified” effect of interest rates on valuations is quantifiable (see The Value of Dry Powder). The fact is that current valuations would not be “justified” even the Fed brought rates back down to zero and held them there for decades.

 

 

The chart below broadens the picture to the measures we’ve found most tightly correlated with actual subsequent S&P 500 total returns in market cycles across history. These measures are presently well beyond double their historical norms, ranging from 125% to 160% over those norms.

 

 

It’s not unheard-of for a peaceful Zen teacher to give a student a little whack over the head with a bamboo stick in order to wake them up, as an act of compassion. So I’m going to be blunt. Stop arguing that the market has permanently changed over the last several decades when you’re really trying to argue that the market has permanently changed over the past 5 years. Don’t get me wrong. It’s essential to ask questions, obtain data, and test every possibility. What’s offensive is Wall Street’s endless reliance on verbal argument in place of evidence, and the eagerness of investors to buy into verbal fictions to the point where they second-guess actual data.

 

If you can’t demonstrate your arguments with evidence, you’re fooling yourself. You’re mistaking the delay of consequences with the absence of consequences. You see the advancing half of a mature speculative episode and you’re looking for any excuse at all to escape into a fantasy world where stock prices never go down. Worse, you may even be using a stumble I’ve already admitted and addressed in the first half of this cycle as an excuse to make your own in the second half.

 

Again, on the question of near-term outcomes, we’ll take our evidence as it arrives, particularly from market internals. In any event, however, I expect any near-term market returns to be quickly wiped out quite early into the completion of this cycle. Investors who ignore valuations are going to get hurt.

 

Valuation Breakevens

In prior comments, I’ve demonstrated that the relationship between valuation measures such as MarketCap/GVA and subsequent S&P 500 total returns is not affected by the level of interest rates. That’s not to say that interest rates don’t affect valuations - though the historical evidence is far more mixed on that question than investors seem to assume. Rather, the point is for any given level of valuations, we can estimate prospective market returns without appealing further to interest rates. That’s because, given any set of expected future cash flows along with the current market price, one already has all the information required to estimate the future return on the asset. Of course, that estimated rate of return can then be compared with the prevailing level of interest rates to evaluate the relative merits of the two choices (See The Most Broadly Overvalued Moment in Market History for more on this point).

 

Lower interest rates may encourage investors to accept higher valuations (which imply correspondingly low future stock returns), but as a historical matter, investors don’t reliably behave this way. In fact, prospective stock returns and interest rates have actually been negatively correlated through most of the past century, outside of the inflation-deflation cycle from the early 1970’s until about 1998. In fact, the correlation between the two has been negative even over the past 20 years.

 

Still, the following is an approach I constructed to use information on stock valuations and interest rates in a systematic way, by estimating the break-even level of valuation that would have to exist at given points in the future, in order for stocks to outperform or underperform bonds over various horizons. The chart below shows these breakeven estimates for several market extremes across history: June 1949, December 1968, October 1974, August 1982, March 2000, March 2009, and April 2017.

 

Each line begins at the prevailing market valuation at each date (so the starting point gives a quick indication of how rich or cheap the market was relative to historical norms at each date). As one moves into the future, the lines show the valuation level below which stocks would lag bonds, and above which stocks would outperform bonds, over each horizon. Below, those horizons extend from 1 to 30 years. Everywhere below the breakeven profile, the return on stocks purchased at today's levels would be expected to lag what you could expect from bonds over the same horizon.

 

Put simply, low breakeven profiles are better for stocks, since their returns over any given horizon (measured from today to various future dates) would only be expected to lag bonds at points where future valuations fall below the breakeven line. A breakeven profile that begins at a low level (regardless of its slope) also means that investors are bargaining for a strong overall return in stocks either way. Conversely, a breakeven profile that begins at a high level means that investors are bargaining for a poor overall return in stocks either way. A breakeven profile that slopes downward means that bonds have little long-run advantage, so beating them becomes progressively easier over time. A breakeven profile that slopes upward means that interest rates are so attractive that market valuations must rise over time in order for stocks to keep pace. Today's high, downward sloping breakeven line is essentially the worst of both worlds for both asset classes. The high level means that prospective stock returns are weak, while the downward slope means that prospective bond returns aren't very attractive either. This menu will change over the full course of the market cycle.

 

For example, in June 1949, MarketCap/GVA stood at 0.64, a level we associate with expected 12-year returns of more than 15% annually. The dividend yield on the S&P 500 stood at 7.4% at a time when Treasury bond yields were just 2.4%. That’s why the breakeven line plunges so steeply. Given those relative prospective returns, stock valuation multiples could have declined progressively, yet stocks would still have been expected to outperform bonds (indeed, the S&P 500 averaged total returns of close to 19% annually in the 12 years following the June 1949 low).

 

 

By contrast, in March 2000 (green line), MarketCap/GVA reached 2.29, a level that we associate with 12-year expected S&P 500 total returns of zero. At the same time, the dividend yield on the S&P 500 was just 1%, while Treasury bond yields were at 6.2%. The combination produced a situation where even very high future valuations could be expected to result in stocks underperforming bonds over the same horizon. Indeed, today, even 17 years later, and even after one of the most offensive speculative episodes in history, the total return of the S&P 500 has averaged only 4.5% annually since that 2000 peak, easily lagging bonds over this horizon, with violent interim losses of 50% and 55% respectively, and another likely on the way.

 

Notice the orange breakeven corresponding to the March 2009 low. The ratio of MarketCap/GVA dropped to about 0.8, a level that we associate with 12-year prospective annual returns about 12% annually (as I observed in real time - recall that our challenges in the half cycle that followed were due to my insistence on stress testing our methods against Depression era data, not to any change in the reliability of our valuation methods). Meanwhile the S&P 500 dividend yield was at 3.6%, while Treasury yields were at 2.9%. As a result, the breakeven line slopes down, implying that only progressively lower valuations would cause stocks to underperform bonds in subsequent years.

 

The December 1968 valuation peak (purple) was associated with a MarketCap/GVA ratio of 1.5, which we associate with expected S&P 500 12-year total returns of about 5%. At the time, however, Treasury bond yields were above 6%, requiring elevated valuations to be sustained for quite some time in order for stocks to outperform bonds. As it happened, the S&P 500 enjoyed average annual total returns of 6% over the following 12-year period, falling slightly short of the return on bonds over the same horizon.

The October 1974 low, less than 6 years later (light blue) was associated with a MarketCap/GVA ratio of just 0.5, resulting from intervening growth in fundamentals coupled with a 50% market loss. We associate that valuation level with expected S&P 500 12-year total returns of 17.9%. At the time, Treasury bond yields stood just over 8%. As it happened, the total return of the S&P 500 averaged 17.0% over the following 12-year period, even though valuations would establish a deeper secular low in 1982.

 

The August 1982 secular low (red) was a bit unusual, because the breakeven line slopes higher. At that secular low, the ratio of MarketCap/GVA fell to just 0.4, a level that we associate with expected S&P 500 12-year returns averaging over 19% annually. The actual 12-year total return came in at 17.2%, with the tech bubble extending that return to 20% annually over the nearly 18-year span ending with the March 2000 market peak (hold that thought until the next paragraph). The S&P 500 dividend yield rose above 6.6% at the 1982 low, but note that the breakeven line still slopes up, meaning that valuations still needed to rise over time in order for stocks to outperform bonds. The reason for this is that the yield on Treasury bonds in August 1982 was more than 13%.

 

Based on the estimated 1982 breakeven line, stocks would not outperform bonds over the following 30 years unless valuations moved above their historical norms by August 2012. In hindsight, we know that the tech bubble didn't last. In fact, MarketCap/GVA stood slightly below 1.0 by August 2012, and as a result, the S&P 500 actually slightly underperformed bonds as measured from the August 1982 low, with an annual total return averaging 11.9%. That's a useful reminder that the glorious market returns one measures at the peak of a bubble aren't actually retained over the completion of the cycle. Think carefully about that. The gains of recent years are just as unlikely to be retained. This is a very, very bad time to finally become "convinced" about the merits of passive investing.

 

The dark blue line shows the current breakeven profile as of last week. MarketCap/GVA recently pushed above 2.0, driving our 12-year estimate of S&P 500 total returns to just 0.6% annually. The dividend yield of the S&P 500 is now just 2.0%, but with the 10-year Treasury bill yield at just 2.2%, investors face a dismal menu of expected returns regardless of their choice. Indeed, in order for expected S&P 500 total returns to outperform even the lowly return on Treasury bonds in the years ahead, investors now require market valuations to remain above historical norms for the next 22 years. The good news is that this menu is likely to improve substantially over the completion of the current market cycle. The problem is that current valuation extremes present a hostile combination of weak prospective return and steep risk.

 

Even a retreat in MarketCap/GVA from the current level of 2.0 to a still-elevated level of 1.35 over the next decade will likely result in S&P 500 total returns below the 2.3% available on Treasury bonds. To see why, assume that real economic growth averages 2% in the coming decade (see Stalling Engines to see why this is quite a likely expectation), while inflation averages 2% annually. Couple 4% annual growth in corporate gross value added (matching the growth rate of GVA over the past two decades, and close to the growth rate of earnings over the same period) with a 2% dividend yield and a modest reduction in the valuation multiple, and you get S&P 500 annual returns of roughly: (1.04)*(1.35/2.0)^(1/10)+.02-1 = 2% annually, with the S&P 500 Index itself no higher 10 years from now than it is today.

 

https://www.hussmanfunds.com/wmc/wmc170424.htm

[OriZ 3,157]

“History repeats - the argument for abandoning prevailing valuation methods regularly emerges late in a bull market, and typically survives until about the second down-leg (or sufficiently hard first leg) of a bear. Such arguments have included the ‘investment company’ and ‘stock scarcity’ arguments in the late 20's, the ‘technology’ and ‘conglomerate’ arguments in the late 60's, the nifty-fifty ‘good stocks always go up’ argument in the early 70's, the ‘globalization’ and ‘leveraged buyout’ arguments in 1987 (and curiously, again today), and the ‘tech revolution’ and ‘knowledge-based economy’ arguments in the late 1990's. Speculative investors regularly create ‘new era’ arguments and valuation metrics to justify their speculation.”

- John P. Hussman, Ph.D., New Economy or Unfinished Cycle?, June 18, 2007. The S&P 500 would peak just 2% higher in October of that year, followed by a collapse of more than -55%.

 

“Old ways of valuing stocks are outdated. A technological revolution has created opportunities for continued low inflation, expanding profits and rising productivity. Thanks to these factors, the United States may be able to enjoy an extended period of expanding stock prices. Jumping out now would leave you poorer than you might become if you have some faith.”

- Los Angeles Times, May 11, 1999. While it’s tempting to counter that the S&P 500 would rise by more than 12% to its peak 10 months later, it’s easily forgotten that the entire gain was wiped out in the 3 weeks that followed, moving on to a 50% loss for the S&P 500 and an 83% loss for the tech-heavy Nasdaq 100..

 

“Stock prices returned to record levels yesterday, building on the rally that began in late trading on Wednesday... ‘It’s all real buying’ [said the head of index futures at Shearson Lehman Brothers], ‘The excitement here is unbelievable. It’s steaming.’ The continuing surge in American stock prices has produced a spate of theories. [The] chief economist of Kemper Financial Services Inc. in Chicago argued in a report that, contrary to common opinion, American equities may not be significantly overpriced. For one thing, [he] said, ‘The market may be discounting a far-larger rise in future corporate earnings than most investors realize is possible, [and foreign investment] may be altering the traditional valuation parameters used to determine share-price multiples.’ He added, ‘It is quite possible that we have entered a new era for share price evaluation.’”

- The New York Times, August 21, 1987 (the S&P advanced by less than 1% over the next 3 sessions, and then crashed)

 

“The failure of the general market to decline during the past year despite its obvious vulnerability, as well as the emergence of new investment characteristics, has caused investors to believe that the U.S. has entered a new investment era to which the old guidelines no longer apply. Many have now come to believe that market risk is no longer a realistic consideration, while the risk of being underinvested or in cash and missing opportunities exceeds any other.”

- Barron’s Magazine, February 3, 1969. The bear market that had already quietly started in late-1968 would take stocks down by more than one-third over the next 18 months, and the S&P 500 Index would stand below its 1968 peak even 14 years later.

 

“The 'new-era' doctrine - that 'good' stocks (or 'blue chips') were sound investments regardless of how high the price paid for them -- was at bottom only a means for rationalizing under the title of 'investment' the well-nigh universal capitulation to the gambling fever.”

- Benjamin Graham & David Dodd, Security Analysis, 1934, following the 1929-1932 collapse

 

“The recent collapse is the climax, but not the end, of an exceptionally long, extensive and violent period of inflation in security prices and national, even world-wide, speculative fever. This is the longest period of practically uninterrupted rise in security prices in our history... The psychological illusion upon which it is based, though not essentially new, has been stronger and more widespread than has ever been the case in this country in the past. This illusion is summed up in the phrase ‘the new era.’ The phrase itself is not new. Every period of speculation rediscovers it.”

- Business Week, November 1929. The market collapse would ultimately exceed -80%.

 

This time is not different

Mark Twain once said “History doesn’t repeat itself, but it does rhyme.” Unfortunately, the failure of history to precisely replicate itself, in every detail, is at the heart of the failure of humanity to learn from it. Each separate instance has its own wrinkles, and within those wrinkles is wrapped the delusion that “this time” is cut from wholly different cloth.

In the financial markets, the unique features of “this time” entice investors away from systematic analysis and durable relationships. It eventually becomes enough simply to refer to buzz-words - “investment companies,” “technology,” “globalization,” “conglomerates,” “dot-com,” “leveraged buy-outs,” “quantitative easing” - as a substitute for data and clear-sighted analysis. If doctors behaved like investors do, every time a new strain of virus emerged, they would declare a “new era,” immediately disregarding every known principle of the immune system until everybody was dead.

 

This is emphatically not to say that new changes in the economic or financial environment should be disregarded. The argument is exactly the opposite. When faced with these changes, our obligation as careful investors is to obtain data and quantify, as well as possible, how they reasonably impact the objects we care about, such as long-term cash flows, valuations, and prospective returns. We can’t just take some buzz-word and bandy verbal arguments about, without any analysis at all.

We should never abandon our central principles just because we see a squirrel outside the window. If we think the squirrel is important, we have to obtain data and carefully study and quantify how squirrels actually affect the things we care about. We don’t just say, “Ooh, the squirrel has created a new era, so we’re going to ignore everything that history has taught us.”

 

So if we care about how interest rates might impact valuations, we shouldn’t just switch our brains off and talk about low interest rates. We should quantify their effect (see, for example, The Most Broadly Overvalued Moment in Market History). If we think changes in economic policy might affect economic growth, we shouldn’t just toss around figures that pop out of our imagination. We should estimate the potential range of outcomes, given the conditions that systematically determine GDP growth (see Economic Fancies and Basic Arithmetic). If we think the international activity of U.S. corporations has changed traditional valuation relationships, we should explicitly quantify that impact (see The New Era is an Old Story). If we wonder why valuations and subsequent market returns are systematically related even though interest rates aren’t constant, we should work out the arithmetic and examine the historical relationships (see Rarefied Air: Valuations and Subsequent Market Returns). If we wonder whether valuation measures should be corrected for the level of profit margins embedded in those measures, we should collect the data and evaluate the question (see Margins, Multiples, and the Iron Law of Valuation). And if we think that we could be living in a new era of permanently high profit margins, we might want to quantify the evidence before adopting that view (see below).

 

Every episode in history has its own wrinkles. But investors should not use some “new era” argument to dismiss the central principles of investing, as a substitute for carefully quantifying the impact of those wrinkles. Unfortunately, because investors get caught up in concepts, they come to a point in every speculative episode where they ignore the central principles of investing altogether. The allure of those wrinkles is what leads investors to forget the lessons of history, and repeat its tragedies again and again.

This time is not different, because this time is always different.

 

Throwing in the towel

When a boxer is taking a beating, to avoid further punishment, a towel is sometimes thrown from the corner as a token of defeat. Yet even after the towel is thrown, a judicious referee has the right to toss the towel back into the corner and allow the fight to continue.

 

For decades, Jeremy Grantham, a value investor whom I respect tremendously, has championed the idea, recognized by legendary value investors like Ben Graham, that current profits are a poor measure of long-term cash flows, and that it is essential to adjust earnings-based valuation measures for the position of profit margins relative to their norms. In Grantham’s words, “Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism.”

 

He learned this lesson early on, during the collapse that followed the go-go years of the late-1960’s. Grantham once described his epiphany: “I got wiped out personally in 1968, which was the last really crazy, silly stock market before the Internet era... I became a great reader of history books. I was shocked and horrified to discover that I had just learned a lesson that was freely available all the way back to the South Sea Bubble.”

 

In recent weeks, Grantham has essentially thrown in the towel, suggesting “this time is decently different”:

“Stock prices are held up by abnormal profit margins, which in turn are produced mainly by lower real rates, the benefits of which are not competed away because of increased monopoly power... In conclusion, there are two important things to carry in your mind: First, the market now and in the past acts as if it believes the current higher levels of profitability are permanent; and second, a regular bear market of 15% to 20% can always occur for any one of many reasons. What I am interested in here is quite different: a more or less permanent move back to, or at least close to, the pre-1997 trends of profitability, interest rates, and pricing. And for that it seems likely that we will have a longer wait than any value manager would like (including me).”

 

I’ve received a flurry of requests for my views on Grantham’s shift.

My simple response is to very respectfully toss Grantham’s towel back into the corner.

Here’s why.

 

First, Grantham argues that much of the benefit to margins is driven by lower real interest rates. The problem here is two-fold. One is that the relationship between real interest rates and corporate profit margins is extremely tenuous in market cycles across history. Second, the fact is that debt of U.S. corporations as a ratio to revenues is more than double its historical median, leaving total interest costs, relative to corporate revenues, no lower than the post-war norm.

 

With regard to real interest rates, there’s always a question of how one adjusts for inflation, which can involve trailing rates or inflation rates implied by inflation-protected securities. Because inflation has such a strong serial correlation over time, the distinction matters less than one might think, but it typically helps to use a 2-year trailing rate rather than just the past 12 months. The chart below shows the historical relationship between corporate profit margins and real Treasury yields on that basis. Real interest rates are shown in blue on an inverted (left) scale, with profit margins shown in red on the right scale.

 

About the only segment worth mentioning is a short span during the rapid disinflation of the early 1980's. Both Treasury yields and wage inflation fell slower than general prices, so real interest rates, real wage rates, and the U.S. dollar all shot higher (leading to the 1985 Plaza Accord). Aside from that, there’s not much to see here, with no systematic fluctuation between real interest rates and profit margins across economic cycles.

 

 

I would argue that what’s really going on with profit margins is quite different than what Grantham suggests. As usual, my views reflect the data. 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. Since unit labor costs and the GDP deflator are indexed differently, the left scale values are meaningful on a relative basis, but shouldn't be interpreted as actual fractions.

 

 

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 4.4% and demographic constraints are likely to result in labor force growth averaging just 0.3% annually between now and 2024. 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. [As a side-note, this analysis links up with the Kalecki profits equation because a depressed wage share is typically associated with weak household savings and high government transfer payments].

 

It’s tempting to imagine that offshoring labor would allow a sustained below-trend retreat in real unit labor costs. But while foreign labor can be cheaper, the corresponding productivity is also often lower, so the impact on unit labor costs is more nuanced than one might think.

 

So again, with great respect, my response is to encourage Grantham to pick up his towel and lace up his gloves. Even if profit margins have moved forever higher, they are unlikely to have moved to the point where recent highs are the new average. Given that valuations fluctuate around norms that reflect those average margins, valuations are now so obscenely elevated that even an outcome that fluctuates modestly about some new, higher average would easily take the S&P 500 35-40% lower over the completion of the current market cycle.

 

Let’s also be careful to distinguish the level of valuations from the mapping between valuations and subsequent returns. As evidenced below, there’s utterly no evidence that the link between historically reliable valuation measures and actual subsequent market returns has deteriorated in any way during recent cycles. So even if one wishes to assume that future valuation norms will be higher than “old” historical norms, it follows that one should also assume that future market returns will be lower than “old” historical norms. It has taken the third financial bubble in 17 years to bring the total return of the S&P 500 to 4.7% annually since the 2000 peak. Don’t imagine that future returns will be much better from current valuations, even if future valuations maintain current levels forever. Indeed, my actual expectation is that the completion of the current market cycle will wipe out the entire total return of the S&P 500 since 2000.

 

Back to the Iron Laws

If we are careful about history, evidence, and market analysis, we repeatedly find that the central principles of investing are captured by a few iron laws. Two of them are particularly important in our discipline.

The first of these is what I call the Iron Law of Valuation: Long-term market returns are driven primarily by valuations. Every valuation ratio is just shorthand for a careful discounted cash-flow approach, so the denominator of any valuation ratio had better be a “sufficient statistic” for the likely stream of cash flows that will be delivered to investors over decades. For market-based measures, revenues are substantially more reliable than current earnings or next year’s estimated earnings.

 

A second principle is what I call the Iron Law of Speculation: While valuations determine long-term and full-cycle market outcomes, investor preferences toward speculation, as evidenced by uniformity of market action across a broad range of internals, can allow the market to continue higher over shorter segments of the cycle, despite extreme overvaluation. At rich valuations, one had better monitor those internals explicitly, because deterioration opens the way to collapse.

 

As usual, it’s worth briefly recalling not only the success of our discipline in previous complete market cycles, but also the elephant that I let into the room in 2009. Whatever criticism one might direct toward my shortcomings in the half-cycle since 2009, the fact is this. Our challenges arose from my 2009 insistence on stress-testing our methods against Depression-era data, which inadvertently created a specific vulnerability that should be distinguished from our current outlook. Prior to 2009, overvalued, overbought, overbullish conditions were associated with average market returns below risk-free T-bill returns regardless of whether market internals were favorable or not. But the novelty of the Federal Reserve’s deranged monetary policy response encouraged yield-seeking speculation by investors well after historically reliable “overvalued, overbought, overbullish” conditions appeared. In a zero interest rate environment, one had to wait for explicit deterioration in market internals to signal a weakening of investors’ willingness to speculate, before adopting a hard-negative outlook.

 

Put simply, the methods that emerged from that stress-testing exercise inadequately accounted for the effect of zero interest rate policies on speculation, and that’s why our adaptations have focused primarily on imposing additional requirements related to market internals. In contrast, valuation relationships have remained completely intact in recent cycles, correctly identifying stocks as undervalued in 2009, but wickedly overvalued today. Our current defensiveness is fully consistent with the Iron Laws. With interest rates well off the zero bound and market internals already showing internal dispersion, now is not a time to become complacent, and certainly not a time to throw in the towel.

 

Hoping for greater fools

We’ll finish with a review of where the most reliable valuation measures stand, showing their relationship with actual subsequent market returns across history, and over recent market cycles. As I’ve observed before, whatever one proposes as being “different” this time had better be something that suddenly changed in the past 5 years and will persist forever. Undoubtedly, Wall Street will think of something, because as Hegel wrote, “We learn from history that we do not learn from history.”

 

The first chart updates the ratio of nonfinancial market capitalization to corporate gross value-added (including estimated foreign revenues), which we find better correlated with actual subsequent S&P 500 total returns than any other measure we’ve studied over time. Note in particular that no market cycle in history (even recent ones) has failed to take this measure to half of its current level by the completion of the cycle. But if one wishes to rule that possibility out, notice that even the level of 1.35 was observed as recently as 2012, and is about the highest level ever observed in post-war data prior to 1998. A retreat merely to that level over the completion of the current market cycle would involve a loss of one-third of the value of the S&P 500.

 

 

We certainly don’t require a breathtaking market loss in order to adopt a constructive or aggressive market outlook, particularly at the point that a material retreat in valuations is joined by early improvement in market action. Yet investors seem to rule out any material retreat at all. In effect, investors are arguing not only that elevated valuations are justified; they are also quietly assuming that market cycles have been abolished. This is a much larger mistake.

The chart below shows MarketCap/GVA on an inverted log scale (left), along with actual subsequent S&P 500 nominal average annual total returns over the following 12-year horizon. Note that the current estimate of near-zero total returns also includes dividends, meaning that we fully expect the S&P 500 Index itself to be lower 12 years from now than it is today.

 

 

I can’t emphasize enough that the mapping between reliable valuation measures and subsequent market returns is a calculation that does not require adjustment for the level of interest rates. Rather, one uses interest rates for comparative purposes after the expected return calculation is made (see The Most Broadly Overvalued Moment In Market History to understand this distinction). While investors seem to look at low interest rates as if they are a good thing, what low interest rates really do here is to lock passive investors in conventional portfolios into a situation where they have no way to avoid dismal outcomes in the coming 10-12 years. Unlike even 2000, when 6.2% Treasury bond yields provided a conventional alternative to obscenely overvalued stocks, yields on all conventional assets are uniformly depressed here. We presently estimate that the total return of a passive, conventional portfolio mix of 60% stocks, 30% bonds, and 10% cash will hardly exceed 1% annually over the coming 12-year horizon.

 

 

My expectation is that prospects for long-term investors can be improved only to the extent they can tolerate the possibility of missing returns in the short-term in order to retain the ability to invest at lower valuations and higher prospective returns over the full course of the market cycle.

 

Since investors have been encouraged to use the distance of valuations from their March 2000 bubble peak as a benchmark for prospective returns, it’s worth noting that on the basis of measures that have been most strongly correlated with actual subsequent market returns in market cycles across history, current valuation levels don’t put the “you are here” sign in 1996, or 1997, or even 1998, but rather in late-December 1999. The ebullience of the tech rampage at the time gave the market a level of momentum that it does not have at present, and the price/revenue multiple of the median S&P 500 component is already 50% beyond the 2000 extreme. Still, if one wishes to use the 2000 peak as a valuation bell to ring, it’s worth recognizing how close valuations are to that peak already. Investors should again recall that once the 2000 peak was in, it took just three weeks for the market to plunge more than 11%, bringing valuations below those December 1999 levels. Investors hoping to sell to greater fools had better be able to call a top rather precisely.

 

With weak estimated 10-12 year returns expected for conventional portfolios, investors should not exclude alternative assets, tactical strategies, hedged equity, or at least a good amount of dry powder from consideration. For more comments on alternative investment strategies, see When Speculators Prosper Through Ignorance. As Grantham mentioned, we do see investors engaging in put-writing strategies as a way to generate "income." In the illusion that stocks cannot decline steeply, these strategies have become so aggressive that implied option volatilities were recently driven to levels seen in just 1% of history. That's not a crash warning by itself, but depressed volatility did appear in combination with divergent market internals and overvalued, overbought, overbullish conditions approaching the 1987 and 2007 peaks. In my view, shorting cheap put options in a high-risk environment like this one is like writing cheap auto insurance at the Demolition Derby. In the short-run, these strategies crush the volatility index (VIX), but if (and I expect when) a steep market loss turns those short puts into in-the-money obligations to take stock off of other investors' hands at a fixed price, they are likely to contribute to an acceleration of selling pressure, just as portfolio insurance did in 1987.

 

We'd be inclined toward exactly the opposite strategy. Given low option premiums, along with extreme valuations, interest rates above the zero-bound, and market internals showing continued dispersion, patient investors who can tolerate the potential risk of a slow and annoying drip of option decay over a shorter segment of the market cycle could also see asymmetrically large returns from tail-risk hedges as the market cycle is completed. That kind of position always has to be limited to a small percentage of assets, and should be limited mainly to conditions that join unfavorable valuations and internal dispersion. In the face of marginal new highs, it's also a reasonable concession to be slow about raising strike prices, since the main object of interest is the 50-60% gap from current valuations to historical norms. As a side note, yes, we did see "Hindenburg" on Thursday, so last week's high was sloppy internally, but we can't rule-out further short-term upside..

 

While about 80% of the market gain since the 2009 low occurred by the end of 2014, a sequence of novelties since then (particularly Brexit and the U.S. election) have worked to extend this high-level top-formation. Still, I continue to view this as a period of top-formation. Unlike Irving Fisher in September 1929, I have no expectation that the market has reached a “permanently high plateau.”

 

https://www.hussmanfunds.com/wmc/wmc170508.htm

[OriZ 3,157]

"Historically, when trend uniformity has been positive, stocks have generally ignored overvaluation, no matter how extreme. When the market loses that uniformity, valuations often matter suddenly and with a vengeance. This is a lesson best learned before a crash rather than after one."

- John P. Hussman, Ph.D., October 3, 2000

 

"One of the best indications of the speculative willingness of investors is the 'uniformity' of positive market action across a broad range of internals. Probably the most important aspect of last week's decline was the decisive negative shift in these measures. Since early October of last year, I have at least generally been able to say in these weekly comments that “market action is favorable on the basis of price trends and other market internals.” Now, it also happens that once the market reaches overvalued, overbought and overbullish conditions, stocks have historically lagged Treasury bills, on average, even when those internals have been positive (a fact which kept us hedged). Still, the favorable market internals did tell us that investors were still willing to speculate, however abruptly that willingness might end. Evidently, it just ended, and the reversal is broad-based."

- John P. Hussman, Ph.D., July 30, 2007

 

When one examines market cycles across history, including the most extreme speculative bubbles, one typically finds segments where valuations were clearly elevated relative to historical norms, and yet the stock market continued to advance. Still, one also finds that the market dropped like a rock over the completion of the market cycle. Likewise, one finds that virtually every point of significant overvaluation was systematically followed by below-average total market returns over a 10-12 year horizon.

 

It’s precisely the failure of valuations to matter over shorter segments of the market cycle that regularly convinces investors that valuations don’t matter at all. This delusion is strikingly ingrained into investor behavior, and is almost inescapably revived during every speculative episode. As Graham and Dodd wrote in Security Analysis (1934), referring to the final advance that led to the 1929 market peak, the reason investors shifted their attention away from historically-reliable measures of valuation was “first, that the records of the past were proving an undependable guide to investment; and, second, that the rewards offered by the future had become irresistibly alluring.” The consequence of the delusion that “old valuation measures no longer apply” was predictably wicked, as it was after the 1969, 1972, 2000 and 2007 extremes. What’s distressing is that this delusion is actively encouraged by investment professionals who ought to know better.

 

Valuations seem unreliable during speculative episodes because investors neglect a critical distinction. While long-term and full-cycle market outcomes are tightly determined by market valuations, the effect of valuations on outcomes over shorter segments of the market cycle depends on the psychological preference of investors toward speculation or risk aversion. When investors are inclined to speculate, they tend to be indiscriminate about it, and for that reason, we’ve found that the most reliable measure of investor psychology is the uniformity or divergence of market action across a wide range of individual stocks, industries, sectors, and security types, including debt securities of varying creditworthiness.

 

Our own measures of market action extract a signal from the behavior of thousands of securities, and are not captured by simple indicators like 200-day moving averages or advance-decline lines. Still, as a rule-of-thumb, divergence in the behavior of a broad range of individual stocks from the behavior of the major indices tends to be a warning sign, as do widening credit spreads, or lack of uniformity in the behavior of various market sectors.

 

Put simply, when valuation measures are steeply elevated but investors remain inclined to speculate, as evidenced by very broad uniformity of market action and the absence of internal divergences, rich valuations often have little effect on market outcomes. However, in an environment of extreme valuations, even fairly subtle deterioration in the uniformity of market internals should be taken as a signal of increasing risk-aversion among investors, and the market becomes vulnerable to steep and abrupt losses.

 

Uniformity of market internals matters

My hope is that, before the current speculative episode predictably unwinds in another catastrophe, investors will learn something from my own successes and challenges over more than 30 years as a professional investor. With regard to successes, my anticipation of the 2000-2002 and 2007-2009 market collapses was based on the combination of rich valuations and deteriorating market internals, which I discussed at the time. Conversely, my adoption of a constructive or leveraged investment stance after every bear market decline in the past three decades typically reflected the combination of a material retreat in valuations coupled with an early improvement in our measures of market action (though my early measures were rather crude).

 

Since valuation is something I’ve never overlooked, the periodic challenges I’ve encountered in the past three decades have invariably centered on measures of market action. During the advance to the 2000 bubble peak, I became defensive too early. Still, I adapted not by abandoning valuations, but by increasing my research efforts. That research led to the recognition that uniformity across market internals could make even the most obscene levels of overvaluation temporarily irrelevant. Respecting that distinction, without disregarding overvaluation, allowed us to come out ahead over the complete market cycle, as the 2000-2002 decline wiped out the entire total return of the S&P 500, in excess of Treasury bills, all the way back to May 1996.

 

Likewise, nearly all of our challenges during the advancing half-cycle since 2009 can be traced to my 2009 decision to stress-test our market return/risk classification methods against Depression-era data, which inadvertently led us to overemphasize “overvalued, overbought, overbullish” syndromes that had reliably warned of market losses in prior market cycles across history. The very reliability of these syndromes in prior market cycles made them a complication in the period since 2009. If quantitative easing and zero-interest rate policy made anything legitimately “different” about this half-cycle, it was to disrupt that historical reliability, and to encourage investors to continue speculating even after those extreme syndromes emerged.

 

Most of our difficulty in the advancing half-cycle since 2009 would have been avoided by the key adaptation that we made in 2014: in the presence of zero-interest rate conditions, even the most extreme “overvalued, overbought, overbullish” syndromes were not enough. One had to wait for market internals to deteriorate explicitly before adopting a hard-negative market outlook (see Being Wrong in an Interesting Way for the full narrative).

 

The supports have already eroded

If one is talking about a complete market cycle, or 10-12 year investment prospects, valuations matter unconditionally. But if one is talking about a segment of the market cycle, valuations matter to the extent that they are aligned with the prevailing psychology of investors toward speculation or risk-aversion. Those preferences are best inferred from the uniformity or divergence of market internals. The result is that an undervalued market can continue to collapse until market internals demonstrate early improvement and positive divergences. Likewise, an overvalued market can continue to advance until market internals demonstrate early deterioration and negative divergences.

 

Those shifts of internal market action don’t always have immediate consequences, and they have to be constantly monitored as the evidence changes. Still, a shift in market internals does immediately change the return/risk profile of the market; that is, the probability distribution that describes likely subsequent returns. An overvalued market with uniformly favorable market action has a dramatically different return/risk profile than an overvalued market with deteriorating market action.

 

At present, we continue to identify one of the most hostile market environments we’ve observed in a century of historical data, not only because obscene valuations and extreme “overvalued, overbought, overbullish” syndromes are in place, but also because our measures of market internals remain in a deteriorating condition. That may change, in which case we will shift to a more neutral outlook. Indeed, if improvement in market internals is joined by a material retreat in valuations, we would expect to shift to a constructive or aggressive outlook (even if valuation measures were still well-above historical norms).

 

Presently, speculators seem not to recognize how strongly the odds are stacked against them, and how steep and abrupt market losses could become. We are not inclined to “fight” further speculation by raising our safety nets on every advance, and again, our outlook would become far more neutral if market internals were to improve. Still, given the deterioration we observe in market internals here, Wall Street’s habit of dismissing and second-guessing every historically reliable valuation measure is likely to be rewarded by steep losses, as it has following every speculative extreme in history.

 

Remember the key lesson

Over the weekend, my friend Jonathan Tepper sent me a note suggesting that it might be interesting to discuss the extreme position of the S&P 500 relative to its upper Bollinger bands (two standard deviations above a 20-period moving average) at monthly, weekly, and daily resolutions. Several variants I’ve constructed to identify “overvalued, overbought, overbullish” syndromes include the use of Bollinger bands. Those who fully understand the key lesson of our 2014 adaptations will also know why Jonathan’s question made me cringe.

 

See, prior to the advancing half-cycle that began in 2009, those “overvalued, overbought, overbullish” syndromes were regularly followed by air pockets, panics and crashes in stock prices. But in this cycle, there’s a whole block of those signals, literally for years, that were followed by further market advances, as the Federal Reserve’s deranged zero-interest rate policy encouraged continued yield-seeking speculation. One had to wait for internals to deteriorate explicitly before taking hard-defensive action in response to those signals. That single restriction (among the adaptations we introduced in 2014) is sufficient to wipe out the entire block of incorrect warnings. But the real-time challenges we experienced as a result of responding to those warnings prior to mid-2014 were ruthless to my previously lauded reputation (hence the cringe).

 

It may take the completion of the current market cycle for investors to recognize that we’ve already adapted. Though the gain in the S&P 500 since 2014 is likely to be wiped out rather easily, the challenge for hedged equity strategies in the interim has been the extended duration of this top formation, coupled with a feverish shift of investors toward indexing, which has benefited the capitalization-weighted indices relative to a wide range of historically effective stock-selection approaches. As I noted approaching the 2007 peak, value-tilted portfolios often lag just before extended periods of weak or negative performance for the major indices. Conversely, the best time to establish a constructive or leveraged market outlook is when a material retreat in valuations is joined by an early improvement in market action. That’s the point that observers who consider me a “permabear” may become deeply confused, but again, I’ve done the same after every bear market decline in over 30 years of investing. My inadvertent branding is an artifact of my 2009 stress-testing decision (which truncated our late-2008 constructive shift), and it will understandably take a greater portion of the market cycle to shed that.

 

Meanwhile, Jonathan is right - the S&P 500 is currently at extremely overvalued, overbought, overbullish levels. In the chart below, I’ve coupled one of our “Bollinger band” variants, limited to periods featuring explicit deterioration in our measures of market internals. Without that limitation, there would be a thick red block of false signals covering much of the recent half-cycle. That additional limitation also filters out a few useful warnings that preceded corrections in excess of -10% in 1998 and 1999, but it retains most of the signals in prior market cycles because “overvalued, overbought, overbullish” syndromes typically overlapped a shift toward risk-aversion by investors and a deterioration in our measures of market internals. To the extent that the Federal Reserve’s policies of quantitative easing and zero interest rates disrupted that overlap in the recent half-cycle, “this time” was legitimately “different.” But don’t fall prey to the delusion that this difference can't be accounted for in a systematic way.

 

 

Remember the key lesson. At the personal risk of sounding like a broken record, I also recognize the far greater risk that investors face by ignoring valuations, or assuming something has “gone wrong” with historically reliable measures. The upshot is that the psychological preference of investors toward speculation (which we infer from the behavior of market internals) can temporarily defer the consequences of extreme valuations. Respect that distinction without abandoning valuations altogether, and recognize that at least for now, the combination of obscene overvaluation, extreme overvalued, overbought, overbullish conditions, and divergent market internals creates a terribly hostile return/risk profile for investors. That profile will change as market conditions do. The extent that investors are sensitive to those changes will likely determine the extent that they weather the completion of the current cycle, and benefit from future ones.

 

You are here

Finally, we should distinguish ignoring valuation measures from systematic research to improve them. Much of my work over the past three decades has been along those lines. For example, our effort to carefully account for the impact of foreign revenues, and to create an apples-to-apples measure of general equity valuation led us to introduce MarketCap/GVA, which is better correlated with actual subsequent 10-12 year market returns than any of scores of measures we’ve studied.

 

The problem is that we often see investors dismissing various measures of valuation, or proposing alternative measures, without any examination of the logic or historical validity of those measures whatsoever. Every valuation measure should be judged by a) whether it can be reasonably interpreted as a relationship between the current price and the very long-term stream of cash flows that stocks can be expected to deliver over the long-term, and b) the link between that valuation measure and actual subsequent total market returns, ideally over a period of 10-12 years (which is the horizon at which the autocorrelation profile of most valuation measures hits zero).

 

I’ve previously demonstrated that the correlation of the Shiller cyclically-adjusted P/E (CAPE) with subsequent market returns is substantially strengthened by considering its embedded profit margin (the denominator of the CAPE divided by S&P 500 revenues). Indeed, adjusting for that embedded profit margin boosts the correlation with subsequent 10-12 year returns to nearly 90%. I mention this because investors seem to be playing a game of “you are here”: comparing the current unadjusted CAPE of 28 with the 2000 record high of over 43, inferring that the S&P 500 could rise by over 50% before matching that 2000 extreme. The problem is that in 2000, the CAPE was elevated because the embedded profit margin was just 5.1%, compared with a historical norm of 5.4%. In contrast, current CAPE embeds a profit margin of 7.4%, which results in a lower multiple that is only valid if we require recent record profit margins to be sustained permanently. On the basis of normalized profit margins (which improves the relationship of the CAPE with actual subsequent market returns), the margin-adjusted CAPE was 41 at the 2000 bubble peak, and is above 38 today.

 

We observe the same thing for other historically-reliable measures such as MarketCap/GVA and the S&P 500 price/revenue ratio. Among the valuation measures having the strongest correlation with actual subsequent market returns, current levels are actually within 10% of the March 2000 extreme. There’s no question that investors have become nearly frantic in their verbal arguments about the permanence of elevated profit margins (which is something that Benjamin Graham observed at other market peaks, and warned against decades ago). We’re certainly open to systematic evidence supporting those arguments in a significant span of post-war data, ideally partitioning margins into the components that drive them. For my own analysis on this subject, see This Time is not Different, Because This Time is Always Different. Meanwhile, our best response to Wall Street’s evidence-free assertions about profit margins is to quote W. Edwards Deming: “Without data, you’re just another person with an opinion.”

 

Again, if our measures of market internals were to improve, we would allow for the possibility that reliable measures of market valuations could surpass their 2000 extreme, and we would not place a “cap” on how high stock prices could move. As I observed approaching the 2007 peak, "As long as investors perceive valuations to be acceptable, there is no compelling reason why the actual facts should get in their way over the short-term. That allows for the possibility that the current speculative blowoff will continue further. The implications for long-term returns remain daunting, but over the short-term, perception is reality."

 

The effect a shift back to uniformly favorable market internals would be to move us to a more neutral outlook, though we would maintain our expectation of dismal full-cycle and long-term outcomes. An early improvement in market action following a material retreat in valuations would provide latitude for a constructive or aggressive outlook. Presently however, the market environment features a combination of obscene overvaluation, extreme “overvalued, overbought, overbullish” syndromes, and deteriorating market internals. The first two features of that combination create poor long-term and full-cycle prospects for the market. The last feature of that combination is what currently opens a potential abyss. Our outlook will shift as conditions change.

 

https://www.hussmanfunds.com/wmc/wmc170529.htm

[OriZ 3,157]

On 2/22/2017 at 11:29 PM, OriZ said:

I see it going to 2,500-2,600 on the SPX by mid year and possibly topping there(and ultimately getting cut by more than half). But yeah, I don't decide for it, but the havoc is going to be epic.

Looks like we're getting close. 

[OriZ 3,157]

In recent decades, two of the financial concepts that have become most vulnerable to squishy thinking are the notions of “fair value” and “bubbles.” Ironically, but also necessarily, the misuse of these concepts becomes most prevalent exactly during periods of extreme overvaluation that investors identify, in hindsight, as bubbles.

 

One of the reasons why valuations are poorly understood, and their importance is wholly underestimated, is that overvaluation alone is not enough to drive prices lower over shorter segments of the market cycle. For that reason, it’s essential to monitor the speculative inclinations of investors through the uniformity and divergence of market internals. The inclination of investors toward speculation or risk-aversion, as measured by the quality of market internals, is the hinge between an overvalued market that continues higher and an overvalued market that collapses. This is a lesson that was dramatically reinforced in recent years, as deranged Federal Reserve policies encouraged yield-seeking speculation even in the face of warning signs that were reliable in other market cycles across history. In the face of zero interest rates, one had to wait for market internals to deteriorate explicitly before adopting a negative market outlook (we made our own adaptations in 2014 in that regard).

 

Unfortunately, investors seem to have concluded that central bank easing is omnipotent, despite the fact that the Fed eased persistently and aggressively, to no effect, through the entire course of the 2000-2002 and 2007-2009 market collapses. It’s almost impossible for convey how badly investors are likely to regret dismissing valuations and ignoring market internals by the time the current speculative market cycle is completed. This movie has been re-made many times, always with the same ending.

The most egregious misuse of “fair value” in recent decades was during the speculative episode that ended in 2000, as Wall Street abandoned historically-informed valuation approaches, and embraced methods that directly conflicted not only with the basics of asset pricing, but with all economic experience.

 

For example, near the peak, James Glassman and Kevin Hassett published a book titled Dow 36,000, which not only treated earnings as dividends, but used a static infinite-horizon model that falls apart with the slightest change in assumptions. As I wrote at the time, their model “assumes that stocks should earn no risk premium, imagines that all earnings are paid out to shareholders with no reinvestment in new capital, and assumes that earnings will grow at 5% annually nonetheless. Of course, there is no plausible, historical, or economic basis for this. But hey, we’re trying to sell a book here. They assume stocks should be priced to offer a 6% long term rate of return, giving a resulting model: Price = Earnings / (0.06 - 0.05), which gives the result that the fair price/earnings ratio of the market = 100. Wow. Now let’s suppose that interest rates go to 7%. Using Glassman and Hassett’s assumptions, we then get Price = Earnings / (0.07 - 0.05), or P/E = 50. In other words, interest rates rise by 1% and stock prices drop by half. No risk. Yeah.”

Even at the March 2000 extreme, Wall Street largely denied the possibility that the stock market could, in fact, be experiencing a bubble. While observers often quote Alan Greenspan’s December 1996 lip-service to the possibility of “irrational exuberance” (which was merely a question and not an assertion), the fact is that his views remained quite floppy on the subject years later, when the bubble was full-blown:

 

“Bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best. While bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy. This all leads to the conclusion that monetary policy is best primarily focused on stability of the general level of prices of goods and services as the most credible means to achieve sustainable economic growth.”

Still, a few observers recognized the reality of the situation. On March 30, 2000, Nobel Laureate Franco Modigliani published an op-ed in the New York Times, observing:

“I can show, really precisely, that there are two warranted prices for a share. The one I prefer is based on such fundamentals as earnings and growth rates, but the bubble is rational in a certain sense. The expectation of growth produces the growth, which confirms the expectation; people will buy it because it went up. But once you are convinced that it is not growing anymore, nobody wants to hold a stock because it is overvalued. Everybody wants to get out and it collapses, beyond the fundamentals.”

 

A few weeks later, I detailed how bubbles can emerge when investors focus on year-to-year returns and not discounted cash flows. Suppose that investors come to expect some annual rate of return k, say 10% annually, and even though the actual stream of cash flows cannot be expected to provide that return, suppose that investors bid prices up at a sufficient pace to produce that rate of investment returns anyway. The result is that prices gradually detach from fundamental values. I wrote:

“Mathematically speaking, the defining characteristics of a bubble are 1) price movements satisfy a ‘differential equation,’ in this case, Price = (1+k) x Last Price - cash flow, but 2) the long-term return k expected by investors does not equate price with the present value of future cash flows. In other words, the price contains a ‘bubble component,’ and the present value of that component is not zero. That’s what Modigliani means when he says ‘I can show, really precisely, that there are two warranted prices for a share.’ One is the price based on discounted fundamentals, but as he notes, ‘the bubble is rational in a certain sense. The expectation of growth produces the growth, which confirms the expectation.’ The only question is how long it takes for the gap between price and fundamentals to become intolerably wide. As we’ve seen, it can take a long time. But once the bubble psychology breaks, that gap can close with sickeningly great speed.”

 

Over the following 18 months, the S&P 500 would lose half of its value, and the tech-heavy Nasdaq 100 would lose 83% of its value, both in line with the projections I published at the March 2000 high. Though the broad uniformity or divergence of market internals (the best measure we’ve found of risk-seeking or risk-aversion among investors) greatly impacts market returns over shorter segments of the market cycle, valuations are extremely informative about long-term returns on a 10-12 year horizon, and potential downside risk over the completion of any given market cycle.

By 2007, yield-seeking speculation had driven stocks to a second bubble peak. A few weeks before that market extreme, which would be followed by a 55% plunge in the S&P 500, I reminded investors: 

“Remember, valuation often has little impact on short-term returns (though the impact can be quite violent once internal market action deteriorates, indicating that investors are becoming averse to risk). Still, valuations have an enormous impact on long-term returns, particularly at the horizon of 7 years and beyond. The recent market advance should do nothing to undermine the confidence that investors have in historically reliable, theoretically sound, carefully constructed measures of market valuation.

“Indeed, there is no evidence that historically reliable valuation measures have lost their validity. Though the stock market has maintained relatively high multiples since the late 1990's, those multiples have thus far been associated with poor extended returns. Specifically, based on the most recent, reasonably long-term period available, the S&P 500 has (predictably) lagged Treasury bills for not just seven years, but now more than eight-and-a-half years. Investors will place themselves in quite a bit of danger if they believe that the ‘echo bubble’ from the 2002 lows is some sort of new era for market valuations.”

 

Because Wall Street continued to encourage speculation based on the idea that stocks were “cheap relative to interest rates,” I added:

“I've done my best to warn loudly, I've put the data out there, and have analyzed this thing to pieces. The Fed Model has no theoretical validity as a discounting model, is a statistical artifact, would never have been materially negative except in 1987 and the late 1990's (even in 1929 or 1972), yet views the generational 1982 lows as about ‘fairly valued,’ is garbage in data prior to 1980, and vastly underperforms proper discounted cash flow models and normalized P/E ratios. If investors still wish to follow the Fed Model, my conscience is clear, and my hands are clean.”

 

Fair Value and Bubbles: 2017 Edition

One of the reasons the concept of “fair value” is so misused is that it depends on what one means by “fair.” Consider a $100 bill that will be received 10 years from today. One definition of the word “fair” is “historically normal.” During the post-war period, 10-year Treasury bonds have had a median yield-to-maturity of 5.2%. On that notion of “fair”, the value of the $100 future payment would be $100/1.052^10 = $60.23. An investor paying that price would then expect a historically-normal 5.2% rate of return over the coming decade.

However, the current 10-year Treasury yield is just 2.2%, so one could reasonably argue that the future payment should be priced to deliver only a 2.2% return over the next decade, in which case the appropriate price would be $100/1.022^10 = $80.44. An investor paying that price would then expect a 2.2% rate of return over the coming decade. Assuming the risk is identical to Treasury bonds, this outcome would be fair “relative to similar alternatives.”

 

Either definition of “fair value” is acceptable, but it’s essential for investors to be explicit about which definition they are using. In particular, it would be ridiculously squishy thinking for investors to assert that fair value is $80.44, and at the same time, to expect the long-term return on that 10-year investment to average a “historically normal” level of 5.2% annually. No. If you’re paying $80.44, you should expect a 2.2% 10-year return. Alternatively, if you want to achieve historically normal returns, you should expect your future returns to be disappointing if you pay anything greater than $60.23.

 

The chart below presents our best estimate of S&P 500 fair value across history, where we have defined “fair” as the level of the S&P 500 that would be consistent with historically-normal long-term returns averaging 10% annually. These calculations (estimated based on our measures of U.S. nonfinancial corporate gross value-added, including estimated foreign revenues) provide a consistent benchmark across history.

 

It’s quite reasonable to assert that stocks should be priced to achieve long-term returns lower than a historically-normal 10%, given the current position of interest rates, and the chart that follows will address that issue. Meanwhile, however, it’s important to recognize that no market cycle in history, including the most recent ones, and including cycles that featured similarly low interest rates, has failed to bring prospective S&P 500 12-year expected total returns into the 8-10% range by the completion of the cycle. For that reason, one should hesitate to entirely dismiss a return toward “historically normal” valuations for the S&P 500.

 

 

Two features of the above chart are notable. First, the chart implies that from the standpoint of historically-normal expected returns, the S&P 500 has been persistently overvalued for over two decades, with the notable exception of the 2009 market low. This is what has made attention to market internals so essential; because the uniformity or divergence of market internals is the hinge that distinguishes overvalued markets that continue higher from those that drop like a rock.

One might argue that “true” fair values are actually higher than our estimates, but that proposition is testable: if stocks have not been overvalued during this period, we should have observed long-term S&P 500 total returns near 10% annually during this period, as a rule. Instead, we find that even using the current extreme as an endpoint, the only points in recent decades that have been rewarded with 10% annual S&P 500 total returns are the horizons that originate at the 1990 low, the 1994 low, the 2002 low, and the 2008-2009 lows (precisely where we would have expected such returns to originate).

 

That’s also why the S&P 500 has averaged total returns of just 4.7% annually over the past 17 years, despite an advance to the second most offensive valuation extreme in history. Without yet another bubble 17 years from now, the coming 17 years are likely to feature even lower average S&P 500 total returns (we’d presently estimate about 3% annually on that horizon).

Consistent with the estimates above, the total return of the S&P 500 has indeed averaged less than 10% for the bulk of the period since 1992. Of course, the steepest shortfalls in market returns from a historically-normal 10% originate from the 2000 and 2007 peaks. Because market cycles have always reasonably approached historically-normal values by their completion (even when interest rates have been quite low), I fully expect that S&P 500 total returns, as measured from the 2000 and 2007 peaks, are likely to fall to the 0-2% range by the completion of the current market cycle

 

A second feature of our estimates is that if these fair values are accurate, we should be able to demonstrate that stocks produced long-term returns below 10% annually whenever the S&P 500 was above the fair value estimate, and enjoyed long-term returns greater than 10% annually whenever the S&P 500 was below the fair value estimate. The chart below, computed using the two lines in the preceding chart, confirms this intuition. The blue line (left scale) shows the log ratio of the S&P 500 fair value estimate to the actual S&P 500 Index. The higher the blue line, the cheaper the S&P 500 was relative to estimated fair value. The red line (right scale) shows the actual subsequent S&P 500 annual nominal total return over the following 12 years.

 

 

Presently, the S&P 500 stands at an extreme that is nearly 140% above the level that we would associate with historically-normal 10% long-term expected returns. Clearly, investors view some portion of this valuation premium as “justified” based on the low competing level of interest rates. The problem is that while investors give lip service to the idea that lower interest rates “justify” higher valuations, they appear to ignore that valuations are now so extreme that S&P 500 total returns can be expected to average roughly zero over the coming 12-year period.

 

Put simply, investors should expect no total return at all from the S&P 500 for quite a long period ahead. Moreover, based on valuations that have been observed over the completion of every market cycle in history (including cycles prior to 1960, when interest rates were similarly low), investors should also expect interim losses on the order of 50-60% over the completion of this market cycle.

 

The characteristic feature of a bubble is that the long-term return implied by discounted cash flows becomes detached from the higher, temporarily self-reinforcing return that is imagined by investors. As a result, the bubble component accounts for an increasingly large proportion of the total price, and becomes progressively vulnerable to collapse. It is in this precise sense that the current speculative episode can be characterized as a bubble, just as I (and Modigliani) characterized the bubble that ended in 2000.

 

Bubbles and crash hazards

In his book “Why Stock Markets Crash,” Didier Sornette formalizes a dynamic model of bubbles and crashes. It’s important, though, to recognize first that Sornette’s model doesn’t reflect valuation considerations, and second, that it doesn’t capture measures of investor risk-seeking or risk-aversion. Our central and hard-won lesson of the advancing half-cycle since 2009 was that the Federal Reserve’s zero interest rate policies were able to encourage continued yield-seeking speculation long after even the most extreme overvalued, overbought, overbullish syndromes emerged. In the face of zero interest rates, one had to wait for explicit deterioration in the uniformity of market internals (reflecting a subtle shift from risk-seeking to risk-aversion among investors) before adopting a hard-negative market outlook. So our present views remain driven by valuations and market action, not by the analysis below.

 

As we approached early-2014, the dynamics of market prices were very well-described by the “log periodic” structure described by Sornette. The problem was that this period also featured aggressive quantitative easing and zero interest rates, while market internals continued to feature broad, uniform strength across a wide range of stocks, industries, sectors and security-types. The adaptations we imposed in 2014 would have substantially softened our defenses during that period. Currently, given obscene valuations and divergent market internals, Sornette’s approach is interesting and probably more relevant. Still, an improvement in the uniformity of market internals would soften our negative outlook even here.

 

Sornette describes bubbles and crashes in terms of probabilities (emphasis mine):

“Our key assumption is that a crash may be caused by local self-reinforcing imitation between traders. This self-reinforcing process leads to the blossoming of a bubble. The interplay between the progressive strengthening of imitation and the ubiquity of noise requires a probabilistic description: a crash is not a certain outcome of the bubble but can be characterized by its hazard rate, that is, the probability per unit of time that the crash will happen in the next instant, provided it has not happened yet.

“Since the crash is not a certain deterministic outcome of the bubble, it remains rational for investors to remain in the market provided they are compensated by a higher rate of growth of the bubble for taking the risk of a crash, because there is a finite probability of ‘landing smoothly,’ that is, of attaining the end of the bubble without crash.”

As Modigliani observed in 2000, the bubble is “rational” in a certain sense, provided that investors are inclined to self-reinforcing behavior. The problem is that as the bubble proceeds, the crash hazard rate begins to increase at an exponential rate. Sornette continues:

 

“This line of reasoning provides us with the following important result: the market return from today to tomorrow is proportional to the crash hazard rate. In essence, investors must be compensated by a higher return in order to be induced to hold an asset that might crash. As the price variation speeds up, the no-arbitrage conditions, together with rational expectations, then imply that there must be an underlying risk, not yet revealed in the price dynamics, which justifies this apparent free ride and free lunch. The fundamental logic here is that the no-arbitrage condition, together with rational expectations, automatically implies a dramatic increase of a risk looming ahead each time the price appreciates significantly, such as in a speculative frenzy or in a bubble. This is the conclusion that rational traders will reach.”

 

It’s difficult to tightly estimate a Sornette bubble that extends as long as the recent one has, without softening the shape parameters and accelerating the estimated rate of price appreciation. Still, here we are, so the following chart presents our best fit to the current episode. This isn’t a prediction by any means; our measures of valuation and market action are already unfavorable, so we would certainly not speculate on a continuation of the recent advance. What’s clear, however, is that any further speculative blowoff would be associated with an exponentially increasing crash hazard rate; to compensate, as Sornette suggests, for the apparent free-lunch.

 

 

If we’re willing to sacrifice the longer-cycle fit in order to capture more of the local dynamics, we can nicely illustrate the “log periodic” feature that often characterizes bubbles. As I noted in 2004, speculative bubbles are typically marked by “increasingly immediate impulses to buy the dip.” This creates price fluctuations that have an accelerating pitch of urgency to them. This tendency has been very evident in recent months, as corrections have become increasingly shallow. Again, we don’t consider these to be predictive, and our most reliable measures already feature a hostile combination of extreme valuations and unfavorable market internals. Purely from a price-based perspective, however, the log-periodic bubble that best fits recent fluctuations has its singularity in mid-August. The point of this chart is not to forecast a price trajectory, but rather to illustrate the increasingly frequent and shallow character of market retreats, which is a more general feature of speculative blowoffs in market cycles across history.

 

 

So while our own discipline already takes a hostile view toward market risk, as the combined result of offensively elevated market valuations and divergent market internals on our measures, the near-term behavior of both market internals and general market fluctuations is worth monitoring. As I observed in real-time at the 2007 market peak, pre-crash markets often take on features of a “phase transition” that includes increasing volatility at short intervals:

“I've noted over the years that substantial market declines are often preceded by a combination of internal dispersion, where the market simultaneously registers a relatively large number of new highs and new lows among individual stocks, and a leadership reversal, where the statistics shift from a majority of new highs to a majority of new lows within a small number of trading sessions.

 

“This is much like what happens when a substance goes through a ‘phase transition,’ for example, from a gas to a liquid or vice versa. Portions of the material begin to act distinctly, as if the particles are choosing between the two phases, and as the transition approaches its ‘critical point,’ you start to observe larger clusters as one phase takes precedence and the particles that have ‘made a choice’ affect their neighbors. You also observe fast oscillations between order and disorder in the remaining particles. So a phase transition features internal dispersion followed by leadership reversal. My impression is that this analogy also extends to the market's tendency to experience increasing volatility at 5-10 minute intervals prior to major declines.”

 

Presently, my sense is that investors should pay particular attention to leadership and divergences across groups of stocks, including the broad behavior of new highs and new lows among individual stocks. Any tendency toward increasing short-horizon volatility, particularly an accelerating frequency of progressively shallow corrections, would also be worth monitoring. These considerations don’t imply any need for short-term forecasts, trading, or other actions, but can be instructive about the behavior of speculators, and the potential for abrupt increases in risk-aversion.

 

https://www.hussmanfunds.com/wmc/wmc170612.htm

[OriZ 3,157]

Janet Yellen, Federal Reserve Chair, recently stated;

“Will I say there will never, ever be another financial crisis? No, probably that would be going too far. But I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will.” 

That is a pretty bold statement to make considering that every one of her predecessors failed to predict the negative consequences of their actions.

Will there will be another “Financial Crisis” in our lifetimes?  

Yes, it is virtually guaranteed.

The previous “crisis” wasn’t about just “an asset gone bad,” but rather the systemic shock caused by a “freeze” in the credit markets when Lehman Brothers filed for bankruptcy. Counterparties evaporated, banks froze lending and the credit market ceased to function.

Credit, not the stock market, is the “lifeblood” of the economy.

Of course, it is all good now because the Federal Reserve says so with Ms. Yellen placing a great amount of faith in the Federal Reserve’s own carefully constructing, and recently released results, of “bank stress tests.” Interestingly, EVERY bank passed with flying colors. In other words, the Millennial generation has now passed the baton of “Everybody Gets A Trophy” to the banking sector.

“Test results released by the Federal Reserve show that the 34 institutions under scrutiny have enough capital to make it through the two scenarios regulators posed — one akin to the financial crisis and another entailing a shallower downturn.

Under the scenarios, the banks tested ‘would experience substantial losses.’ However, in total, the institutions ‘could continue lending to businesses and households, thanks to the capital built up by the sector following the financial crisis.’

In the most severe scenario, bank losses are projected to be $493 billion. In the less severe, the losses were put at $322 billion.”

This passage of the “test” by every bank, of course, is based on several faulty assumptions including:

• FASB Rule 157 is still repealed allowing banks to mythically mark bad assets to “face value” which makes balance sheets stronger than they appear. So, how do you know what “toxic assets” still exist?
• There is roughly $2 Trillion of excess reserves supporting banks which will evaporate IF the Fed actually commences with shrinking their bloated balance sheet. 
• The worst case scenario only accounted for a “doubling” of the unemployment rate, or 8.6% from current levels, despite the fact we have an exceptionally low labor force participation rate and a surge to more than 10% is quite likely in the next recession. 
• With more leverage in the system than at any point any previous history, and banks inextricably linked to the financial markets, just how sensitive are the tests to another “worst case scenario?”

What was NOT included in the test was another “Financial Crisis” scenario which SHOULD be the baseline of the stress tests to begin with. Unemployment rates of 15% or more, asset price declines of 50% and default rates of 20% or greater on outstanding debt should be the baseline by which you stress test financial systems against another systemic shock.

The Federal Reserve is once again engaging in very faulty thinking by believing the system will operate normally during a more severe economic scenario. It isn’t just the losses projected on the banking sector in terms of defaulting loans that are the problem, but also the collapse in the asset markets when defaults ramp sharply as recessionary pressures build. Most assuredly, lenders will immediately shut off access to capital leading to another “freeze” in the credit system. (Not to mention the sharp losses in market capitalization due to share price declines.)

Here is why Janet Yellen is wrong in believing another “Financial Crisis” can’t occur.

Catalyst 1: Delinquency & Defaults

We are already seeing the early warning signs with delinquency rates rising and commercial lending on the decline in both consumer and commercial and industrial loans.

Of course, as I noted above, once delinquency and default rates begin to rise, the first thing banks tend to do is to stop lending. Naturally, as banks shut off capital to businesses, private investment begins to slow which reduces employment and leads to slower economic growth.

Of course, this also includes the credit problems of the collapse in Commercial Real Estate which is grossly leveraged at a time when prices have begun to stagnate with an oversupply of inventory sitting on the ground.

Catalyst 2: Leverage & Robots

It isn’t just bank loans which will catalyze the coming financial crisis. It is also, be the massive surge in debt and leverage over the last eight years including student loans, credit cards, corporate debt and margin loans. As I discussed recently in the “Illusion Of Liquidity:”

“The illusion of liquidity has a dangerous side effect. The process of the previous two debt-deleveraging cycles led to rather sharp market reversions as margin calls, and the subsequent unwinding of margin debt fueled a liquidation cycle in financial assets. The resultant loss of the ‘wealth effect’ weighed on consumption pushing the economy into recession which then impacted corporate and household debt leading to defaults, write-offs, and bankruptcies.”

“With the push lower in interest rates, the assumed ‘riskiness’ of piling on leverage was removed. However, while the cost of sustaining higher debt levels is lower, the consequences of excess leverage in the system remains the same.”

You will notice in the chart above, that even relatively small deleveraging processes had significant negative impacts on the economy and the financial markets. With total system leverage spiking to levels never before witnessed in history, it is quite likely the next event that leads to a reversion in debt will be just as damaging to the financial and economic systems.

Of course, when you combine leverage into investor crowding into “passive indexing,” the risk of a “disorderly unwinding of portfolios” due to the lack of market liquidity becomes an issue. As Mark Carney, head of the BOE, recently opined:

“Market adjustments to date have occurred without significant stress. However, the risk of a sharp and disorderly reversal remains given the compressed credit and liquidity risk premia. As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets.’”

At some point, that reversion process will take hold. It is then investor “psychology” will collide with “margin debt” and ETF liquidity. As I noted in my podcast with Peak Prosperity:

“It will be the equivalent of striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.”

When the “robot trading algorithms”  begin to reverse, it will NOT BE a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures as the exit will become very narrow.

Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause catastrophic spreads between the current bid and ask pricing for ETF’s. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments.

Catalyst 3: Pensions

Lastly, and a point clearly missed by Ms. Yellen in her quest to dismiss financial crisis risks, is the $3 Trillion “Pension Crisis” that is just one sharp downturn away from imploding. The cresting of the “baby boom” generation now puts these massively underfunded pensions at risk of a “run on assets” during the next downturn which could send the entire system into chaos. Of course, this problem can be directly traced to the malfeasance of pension fund managers, and pension boards, which used excessively high return rates to lower costs of contributions.

“Pension computations are performed by actuaries using assumptions regarding current and future demographics, life expectancy, investment returns, levels of contributions or taxation, and payouts to beneficiaries, among other variables. The biggest problem, following two major bear markets and sub-par annualized returns since the turn of the century, is the expected investment return rate.

Using faulty assumptions is the lynch-pin to the inability to meet future obligations. By over-estimating returns, it has artificially inflated future pension values and reduced the required contribution amounts by individuals and governments paying into the pension system.

It is the same problem for the average American who plans on getting 6-8% return a year on their 401k plan, so why save money. Which explains why 8-out-of-10 American’s are woefully underfunded for retirement.”

The chart below demonstrates the problem pensions face today. The chart shows a $1000 investment into the S&P 500 TOTAL return from 1995 to present. There is a substantial difference between a dollar-weighted outcome in markets versus just looking at a market-capitalization weighted index return. I have then projected for using variable rates of market returns with cycling bull and bear markets, out to 2060 along with projections of 8%, 7%, 6%, 5% and 4% average rates of return from 1995 out to 2060. 

See the problem here. The average rate of return growth is far above what markets are expected to return over a long period of time. But this has not deterred pension funds from clinging on to exceptionally high return rates. According to a recent report from the Hoover Institution:

“Despite the introduction of new accounting standards, the vast majority of state and local governments continue to understate their pension costs and liabilities by relying on investment return assumptions of 7-8 percent per year. This report applies market valuation to pension liabilities for 649 state and local pension funds. Considering only already-earned benefits and treating those liabilities as the guaranteed government debt that they are, I find that as of FY 2015 accrued unfunded liabilities of U.S. state and local pension systems are at least $3.846 trillion, or 2.8 times more than the value reflected in government disclosures. Furthermore, while total government employer contributions to pension systems were $111 billion in 2015, or 4.9 percent of state and local government own revenue, the true annual cost of keeping pension liabilities from rising would be approximately $289 billion or 12.7 percent of revenue. Applying the principles of financial economics reveals that states have large hidden unfunded liabilities and continue to run substantial hidden deficits by means of their pension systems.””

If the numbers above are right, the unfunded obligations of approximately $4-$5 trillion, depending on the estimates, would have to be set aside today such that the principal and interest would cover the program’s shortfall between tax revenues and payouts over the next 75 years.

That ain’t gonna happen.

As Axel Merk recently penned:

“So while the banks may not need a bailout, I’m not so sure about pension funds or individual investors. Yet, ‘needing a bailout’ and actually getting one are different stories.”

Axel is right. When the next major bear market comes growling, the “financial crisis” won’t be secluded to just sub-prime auto loans, student loans, and commercial real estate. The real crisis comes when there is a “run on pensions” when the “fear” prevails that benefits will be lost entirely.

As George Will recently wrote:

“The problems of state and local pensions are cumulatively huge. The problems of Social Security and Medicare are each huge, but in 2016 neither candidate addressed them, and today’s White House chief of staff vows that the administration will not ‘meddle’ with either program. Demography, however, is destiny for entitlements, so arithmetic will do the meddling.”

Ms. Yellen is wrong about the next financial crisis. The only question is the timing and magnitude of its occurrence?

 

 

 

My answer is soon...very soon. As I have said before it will be before the end of this decade.

[OriZ 3,157]

I don't agree with everything he says there, but, good read nontheless, and includes many of the same points I follow.

 

As markets have reached my upper market risk price zone (see also: Playing with Fire & The Final Wave) I wanted to share some larger structural observations with readers. Note the backdrop of volatility at record lows, markets seemingly rising every day and people being bullish as dips no longer exist. All this fits in with a larger macro script I’ve been commenting on for quite some time and from my perspective we are setting ourselves up for massive pain, one that will now only get worse after all the artificial intervention we have witnessed in the past several years.

 

In walking you through some considerations I’ve drawn from the macro sections of some of our recent Daily Briefs:

We have entered the prime sell zone we’ve been talking about for a long time now. The price expansion came on the heels of yet another central banker who again turned dovish (Janet Yellen July 12). Why? Because the macro reality I have been harping about continues to gnaw on the central bank narrative: They can’t normalize rates, the entire financial construct would collapse on its own weight. Debt levels are unsustainable and low rates keep the illusion of sustainability alive. The question always was how sensitive the spending and investment universe would react to any changes in rates.

 

What we’ve witnessed over the past 1 1/2 years has been a bounce in earnings, one that in aggregate, benefited greatly from a bounce in energy earnings, but one that also continued to draw from ever more free liquidity that is permeating the financial system along with tech monopolies expanding their power/monopoly positions.

In my view none of it is sustainable, the question has always been how this would unfold in terms of a final wave or topping move as I have termed it previously.

In recent weeks again we saw disappointing data on the macro front and I want to reiterate what I regard as an important fact in all this: Bears continue to be correct in their macro assessment. All the growth promised simply has not materialized. Again. And hence Janet Yellen was 50/50 and non committal in her July 12/13 testimony to Congress.

The Fed is done raising rates again. Maybe we’ll get one more for giggles in December during what appears to be her last meeting. Donald Trump looks to replace her and he’ll replace her with someone that will do his bidding although he left the door open yesterday. Never before has a president used market levels as a benchmark of his presidential performance in such a way. But he does. Every time markets make new highs he tweets about it. It makes sense for him to use the market as a benchmark as he’s now polling worse after 6 months in office than any president in the past 70 years.

 

His base continues to support him although it is unclear as to why from a policy perspective. From an entertainment perspective perhaps. From a ideological perspective perhaps. From a policy perspective? Name me one policy that’s on the agenda or under discussion that will help address wealth inequality or further wage growth. I can’t think of any. Not that any would have been on the plate during a Clinton presidency either. But that has been my larger point: Nothing is structurally changing and the problems keep being pushed under the rug. Politicians keep getting to play the game consequence free as central bankers keep pushing markets higher. And so we have a lot of drama in the news but precious little substance.

Hence I suspect the president is taking credit for a liquidity cycle he has precious little to do with. But I mention it all because he will have a strong incentive to appoint someone who will do his bidding for when markets drop. And they will drop.

 

This week I again added macro charts that highlight the coming wall in the earnings narrative that has helped support equities. Here’s the picture that presents itself:

Loan growth continues to slow. Delinquencies continue to rise. People have piled into higher car loan balances while used car prices are plummeting. Consumer debt is at all time highs and retail sales growth has been falling. Yet rent prices, the largest cost line item for most people, continue to rise unabated. Construction spending growth has been sinking. These are all facts.

 

An economy dependent on debt expansion to keep the elusion of organic growth alive can’t sustain growth in the long term without it. And so the price sensitivity of consumers would be greatly challenged with raising rates. Productivity growth is not there and neither is the real wage growth needed to offset these challenges. And hence the Fed is done raising rates again.

As I was reading the comments coming from the various FOMC members recently (and there were plenty) the immediate impression I got was: They know. They know and they are following all the issues we’ve been talking about here. Productivity growth is not there. Debt levels are too high and valuations are stretched and are posing risks.

Key comments:

“the increase in prices of risky assets in most asset markets over the past six months points to a notable uptick in risk appetites, although this shift has not yet led to a pickup in the pace of borrowing or a sizable rise in leverage at financial institutions.

Measures of earnings strength, such as the return on assets, continue to approach pre-crisis levels at most banks, although with interest rates being so low, the return on assets might be expected to have declined relative to their pre-crisis levels–and that fact is also a cause for concern.

the corporate business sector appears to be notably leveraged, with the current aggregate corporate-sector leverage standing near 20-year highs.

elevated leverage leaves the corporate sector vulnerable to other shocks, such as earnings shocks.

In the household sector, new borrowing is driven mostly by borrowers with higher credit scores, and the amount of debt that borrowers have relative to their incomes is falling, suggesting that the debt is more manageable. That said, two pockets in the household sector deserve scrutiny. Auto loan balances and delinquency rates are high for borrowers with lower credit scores, meaning that the riskiest borrowers are borrowing more and not paying it back as often. Of note, delinquencies on recently issued auto loans have also increased, indicating that underwriting standards in the auto loan industry may be deteriorating. Student loan balances keep rising, and delinquency rates on those loans are near historical highs. These strains within the household sector leave such borrowers vulnerable to adverse shocks and probably weigh on their spending. At first glance, one is tempted to say that the potential for this distress to adversely affect the financial system seems moderate, because both subprime auto loan and student loan borrowers account for a small share of other debt categories. But, on second thought, one should remember that pre-crisis subprime mortgage loans were dismissed as a stability risk because they accounted for only about 13 percent of household mortgages, and not take excessive confidence.

Let me conclude my assessment of current financial stability conditions with a discussion of asset valuation pressures. Prices of risky assets have increased in most major asset markets in recent months even as risk-free rates also rose. In equity markets, price-to-earnings ratios now stand in the top quintiles of their historical distributions, while corporate bond spreads are near their post-crisis lows.

The general rise in valuation pressures may be partly explained by a generally brighter economic outlook, but there are signs that risk appetite increased as well. For example, estimates of equity and bond risk premiums are at the lower end of their historical distributions, and, relative to some non-price-based measures of uncertainty, the implied volatility index VIX is particularly subdued. So far, the evidently high risk appetite has not lead to increased leverage across the financial system, but close monitoring is warranted.

We have a better capitalized and more liquid banking system, less run-prone money markets, and more robust resolution mechanisms for large financial institutions. However, it would be foolish to think we have eliminated all risks. For example, we still have limited insight into parts of the shadow banking system, and–as already mentioned–uncertainty remains about the final configuration of short-term funding markets in the wake of money funds reform.

The U.S. financial system is inherently dynamic, with a range of institutions competing to offer a changing mix of financial products. New financial technologies promise great benefits but will no doubt carry novel risks. As a result, we monitor these vulnerabilities, and we are vigilant with respect to economic and financial developments across markets and institutions within the United States and around the world. And we know that complacency must be avoided.”

 

The Fed’s William’s says this:

“The stock market seems to be running pretty much on fumes,” San Francisco Federal Reserve Bank President John Williams said in an interview carried on Sydney’s ABC News affiliate and available on the internet on Tuesday. “It’s something that clearly is a risk to the U.S. economy, some correction there — it’s something we have to be prepared for to respond to if it does happen.”
with measures of market volatility near historic lows, “I am somewhat concerned about the complacency in the market,” he said.

They know. And the very notion of a market correction is a risk factor to their outlook. That’s how intertwined everything has become and hence they continuously aim to prevent one from occurring.

Yet even Janet Yellen was referring to “rich valuations”. While she declares the world to be safe from another financial crisis in our lifetime (huh?) she too is aware of where we are and the risks of unwinding policies that were intended for banks to go back to the very same ways that contributed so much to the crisis in 2007:

“Yellen said it would “not be a good thing” if reforms of the financial services industry since the crisis were unwound, and urged those who had helped manage the fallout at the time to be vocal in preventing such a dilution.”

And policy risks exists.

Take healthcare. I know of no policy detail that suggests this latest “healthcare” bill, if you can call it that, would do anything to improve health or care. It’s a tax distribution bill that benefits insurance agencies and the top 1% at the explicit expense of the poor and vulnerable and is cutting Medicare. Check with the CBO or the AMA.

This again goes to the financial viability of the bottom 50% who have no way of ever catching up and are a recession away from being completely financially defunct:

“Half of this country cannot cope with another recession.

These people don’t have savings to tide them through another blight in the job market. They don’t have backup streams of income. They don’t even know what a recession might mean for their investments, with the result that they have not made any preparations.

They don’t have an updated resume either — a minor point, except that it says something about preparedness.

Such are the alarming findings of a new survey, reminding us once again that for half of us America is a “rich country” in name only.

Some 49% say they are living paycheck to paycheck, and 61% admit they lack the savings to cover six months of expenses.”

Come on. So from a structural perspective I have to take all this as another validation point that none of the structural issues are getting addressed, if anything, wealth inequality is set to expand even further at the first sign of trouble.

And what is it we are seeing? Where’s the growth?

So no, from my perspective the seeds of the next crisis have been planted and no current policy proposals will help address any of them. If anything, tax cuts, if they ever come through in whatever form, will only help exacerbate the structural issues and, if anything, may provide additional and temporary liquidity into a financial system that is already drowning in artificial liquidity.

Keep in mind that almost 50% of Americans don’t own any stocks. In essence one could argue that every headline of new market highs is celebrating an increase in wealth inequality on some level as the poor and middle class are simply not benefitting from these gains. Actually they get hurt by the ancillary effects. Housing prices hit record highs and many people simply can’t afford them hence the amount of renters keeps rising.

But you see headlines of record household wealth. True in aggregate, but of course it does not account for wealth distribution. Again half the country doesn’t own stocks and the wealthiest own the most shares. And of course much of this wealth is not in liquid assets. Housing prices are near record highs. We all know what happens when the wind blows the other direction. Household wealth figures can be quite deceiving.

The fact is we have been witnessing years of failed promises of growth and hence we get treated to this constant show of forecast failure:

So who benefits from tax cut proposals? The top 1% of course and it highlights the priorities of the system: It benefits those that is serves and NONE of this helps with the structural issues or wealth inequality or anything that voters supposedly concern themselves about.

Even Warren Buffet was very clear on this recently in reference to the healthcare plan:

“Warren Buffett thinks the Republican health care bill has an alternative purpose: to help the already-wealthy make even more money.

“I filed this on April 15. And if the Republican — well, if the bill that passed the House with 217 votes had been in effect this year, I would have saved — I can give you the exact figure. I would have saved $679,999, or over 17% of my tax bill,” Buffett said.

The Senate bill repeals a number of Affordable Care Act taxes that primarily affect wealthier Americans. An analysis from the Tax Policy Center found that almost half the benefits from those tax cuts would go to the top 1% of households, with an average tax bill decrease of $37,240 under the proposed legislation.

“There’s nothing ambiguous about that,” Buffett said. “I will be given a 17% tax cut. And the people it’s directed at are couples with $250,000 or more of income. You could entitle this, you know, Relief for the Rich Act or something . . . I have got friends where it would have saved them as much as — it gets into the $10-million-and-up figure.“

There you have it, make no mistake about what’s going on here. And I think most people get it and hence even a FOX News poll, FOX being extremely supportive of the president, shows disastrous polling results for the health care bill proposed by Republicans:

So none of this has to do with populism, a broad based agenda to help people, or healthcare, or any structural improvements. And know that is the same agenda for the proposed estate tax elimination: Make the wealthy wealthier.

And it’s working:

“The number of ultra-high net worth (UHNW) individuals, or those with $30 million (£23.58 million) in assets or more, grew by 3.5% to 226,450, according to a new report by Wealth-X. Their combined wealth increased by 1.5% to $27 trillion (£21.22 trillion), although the average net worth of each person fell for the first time since 2013. UHNW individuals make up only 0.003% of the global adult population.”

All of this is accelerating the speed of the wealth inequality train which, from an ultimate macro perspective, is bearish as it continues to hollow out society at large:

“Global debt levels have climbed $500 billion in the past year to a record $217 trillion, a new study shows, just as major central banks prepare to end years of super-cheap credit policies.

Years of cheap central bank cash has delivered a sugar rush to world equity markets, pushing them to successive record highs. But another side effect has been explosive credit growth as households, companies and governments rushed to take advantage of rock-bottom borrowing costs.

Global debt, as a result, now amounts to 327 percent of the world’s annual economic output, the Institute of International Finance (IIF) said in a report late on Tuesday.”

These are strange times we operate in and from my perspective the ongoing central bank interventions continue to distort everything. Yet even BAML is seeing the end game here and it’s a matter of when and how as the ever expanding wealth inequality is an obvious problem in the world:

I don’t know when markets will wake up to this realization as well, but as we saw sudden liquidity surprises such as the recent bank buyback announcements still hold sway over these markets.

Yet, it’s all rather marginal isn’t it? For months I’ve been pointing out the select participation and markets keep running from sector rotation to sector rotation. To me this is a warning sign of things to come.

Everything I see data wise seems so strenuously put together to mask the structural rot underneath. And, to be fair, they, meaning those that perpetrate the illusion, have been extremely successful in masking everything and we see it every single day in the stock market.

After all they keep pressing the buy button:

 

There has been zero accountability for all the meddling, distortions and artificial interference in what is supposed to be free markets. There are no free markets in the sense that asset classes, currencies or interest rates are not floating freely in a global market of buyers and sellers. Interest rates are largely pegged, currencies are constantly played with and moved by central bankers, and of course many stocks and ETFs are bought by central banks directly. We all know that.

My issue has always been: What is the ultimate result? Well, the result is that the world is more in debt than ever, wealth inequality is at its worst in many decades and growth has been absent. With no change in sight.

Yes global intervention can keep things on the up and up but it takes ever more to do it.

And so now we have this occasional talk about central banks tightening and taking away the sugar. I’m not buying it.

 

The ECB already is on record they are not even discussing taking away stimulus, there is no timetable, the BOJ will not stop either (they said) and the Fed recently made it clear they have no idea what to do when. It’s all talk at best. Indeed both Draghi and Janet Yellen are on the record that they would increase stimulus at the first sign of trouble. They can’t let markets operate freely  which suggests organic price discovery is much lower.

Hence in context it is interesting that the FOMC pointed out the issues in loan growth and subprime exhaustion.

Yes the absolute levels are still ok, but it’s the growth trend that informs us about something not being right. Without loan growth and with increasing delinquencies you don’t have a growth story. Full stop:

 

 

The auto industry is slowing and consumers that are buying cars now will have their resale values hammered. Recently Volvo announced that by 2019 ALL their new cars will be either electric or partially electric. There’s clearly a shift coming.

Subprime is already a challenge. Student loans? Don’t get me started. Student loan debt is so high it is locking out an entire generation from becoming homeowners.

How about retirements for the baby boomers leaving the job market if they can?

 

Read the details and weep.

There is ZERO evidence that markets or the economy can handle higher yields, yet I see people propagating exactly this notion. Stay long, buy every dip.

But if they were to actually remove the sugar?

Impact unknown, but Jamie Dimon rang the warning bell recently:

JPMorgan Chase & Co. Chairman Jamie Dimon said the unwinding of central bank bond-buying programs is an unprecedented challenge that may be more disruptive than people think.

“We’ve never have had QE like this before, we’ve never had unwinding like this before,” Dimon said at a conference in Paris Tuesday. “Obviously that should say something to you about the risk that might mean, because we’ve never lived with it before.”

So I’m waving the white flag. Not for us or our outlook, but I’m waving it for central bankers for the time they will have to admit defeat. The very defeat that is already programmed into what they are doing. Take Mario Draghi who basically claimed victory but then conceded he “MUST” continue with stimulus. The unprecedented distortion in global capital markets continues unabated and is reflected in not only in the unnatural volatility compression, but the ever apparent totality of the positions that central banks are acquiring to keep things calm.

As much as you are likely tired hearing about it I am tired of talking about it, but how can we ignore it? Tiny Switzerland is now the 8th largest holder of US stocks via its central bank the SNB. Madness. Buyers with no consequences or consideration for value keep buying US stocks with no end in sight. Don’t anyone tell me it has no impact on valuations and the supply/demand curve. Of course it does and hence the distortions. More passive buyers who don’t know what they actually own, more central bank buyers who face no consequences when stocks go down, and fund managers who need to create alpha.

And yet margins are decreasing:

 

 

 

 

We all have an appointment with reality but nobody is acknowledging it it seems. Instead we got buybacks in lieu of financial soundness in many cases.

Take GE. GE has a pension deficit of over $31B!! Yet:

“At $31 billion, GE’s pension shortfall is the biggest among S&P 500 companies and 50 percent greater than any other corporation in the U.S. It’s a deficit that has swelled in recent years as Immelt spent more than $45 billion on share buybacks to win over Wall Street and pacify activists like Nelson Peltz.”

Guess what? You either default or you have to take on debt or reprioritize spending to meet these obligations, that limits the business prospects, it’s a major structural weakness.

“Yet in the last two years, GE spent little more than $2 billion on total pension contributions, which hasn’t been nearly enough to keep the overall shortfall from widening. (The company also curtailed capital investments.) At the end of last year, its pension had $94 billion in obligations but only $63 billion in assets — a funding ratio of 67 percent.

“GE has the tension between financialization and innovation,” said William Lazonick, a professor of economics at the University of Massachusetts Lowell. “People at the top are living in fear of hedge fund activists and worry about their share price rather than what is going on with the company.”

So low rates hurt and keep in mind all these pension funds need 7.5% in annual return to even have a chance at surviving. The demographic picture is not changing any time soon.

“And the longer its pension remains underfunded, the costlier it becomes. The Pension Benefit Guaranty Corp., a government agency that acts as a backstop when plans fail, has more than tripled its rates for companies with funding deficits, and they’re set to rise even more in the next two years.

Because interest rates are still relatively low, it’s possible for GE to borrow money it needs to cover its shortfall. Verizon Communications Inc. and FedEx Corp. sold bonds this year to do just that. But according to Cowen, GE may be constrained in how much more debt it can take on because it’s already on the hook for about $130 billion. Debt in the industrial units is lower, though, at about $20.5 billion.

If GE is able to fully fund its pension with debt, there’s no guarantee it won’t fall behind again. Investing in safe, low-yielding bonds might not be enough for GE to earn the 7.5 percent return that it expects for its pension assets each year and pay for the debt that it incurs. Taking on more risk could leave its pension vulnerable to another market downturn.

“This would be quite a risky strategy,” Mitchell said. “Any unpleasant investment surprises would leave the pension even worse-funded than now.”

So you see the structural issues I keep harping about are deep and they are real and they remain completely unaddressed and central banks keep them at the low, but they are also exacerbating the issues.

I have no idea how any of this can or will play out, but I keep coming back to the same conclusion: Our financial system and markets are in no way reflective of the structural reality underneath.

Fool’s Gold.

So people keep buying stocks, central banks are buying stocks, pension funds are buying stocks, ETFs are buying stocks and round and round we go.

But what are people buying here?

 

As it turns out the investment universe keeps shrinking and is increasingly becoming one dimensional in the hands of ever fewer active investors. The larger pool is simply getting smaller. There are more ETFs than stocks, ever larger funds & central banks holding an increasing amount of shares and individual investors owning less individual stocks but different forms of derivatives via ETFs, 401Ks, etc.

 

The global financial system of stock markets is becoming a self-fulfilling ecosystem where no sellers exist and ever more money gets allocated into fewer and fewer available asset options to buy. To be frank I don’t fully understand the long term implications and I’m not sure anybody does. My gut tells me that this is an accident waiting to happen as more and more investors actually don’t really understand what they own.

 

Consider: There are nearly 6,000 indexes today but just 3,599 stocks in the Wilshire 5000 total market index, down from 7562 in 1998. Much of it due to M&A and hence the big became even bigger and, in some cases, clearly stifled competition by getting rid of rivals or potential rivals in the marketplace.

The other big trend is the move toward passive investing:

And the landscape keeps changing:

“ETFs currently account for nearly a quarter of U.S. stock-market trading volume versus 76% for individual stocks. Three years ago, ETFs accounted for 20%. Meanwhile, the percentage of equity-fund assets has jumped in the wake of the U.S. financial crisis, rising to 37% in 2017 from 19% in 2009, according to Bank of America.”

“Investors have increasingly shifted to passive investments: Clients have been net buyers of over $160 billion in ETFs versus net sellers of over $200 billion in single stocks since 2009,” said Subramanian, citing Bank of America Merrill Lynch’s equity client flow data.

At the forefront of this charge has been Vanguard, whose share of the S&P 500 market capitalization doubled from 2010 to 6.8% today, Subramanian said. The number of S&P 500 stocks in which Vanguard holds more than a 5% stake totaled 491 recently, versus 116 in 2010.

The end result:

“The number of S&P 500 stocks in which Vanguard holds more than a 5% stake totaled 491 recently, versus 116 in 2010”:

So Vanguard alone holds over 5% of the float in virtually all the SPX stocks. And they’re not selling, they just keep allocating, especially through their passive index funds. Self-fulfilling? Why do we climb the mountain? Because it is there. Why do we buy stocks? Because they are there and we have to allocate funds.

Long everything and still pension funds are hopelessly underfunded, the middle class shrinking with insufficient retirement money to rely on:

“Baby boomers, or those born between 1946 and 1964, expect they’ll need $658,000 in their defined contribution plans by the time they retire, but the average in those employer-sponsored plans is $263,000, according to a survey of 900 investors by financial services firm Legg Mason. Older boomers, who are 65 to 74, have an average of $300,000. Their asset allocation for all of their investments are also conservative, according to QS Investors, an investment management firm Legg Mason acquired in 2014, with 30% in cash, 24% in equities, 22% in fixed income, 4% in non-traditional assets, 8% in investment real estate, 2% in gold and other precious metals and 8% in other investments.

“They have less than half the assets they hope to have in retirement,” said James Norman, president of QS Investors. “That’s a pretty big miss.”

Swell. So what will it take to get everything funded and people to have adequate security in their retirements? Nobody knows. But the train needs to keep on chugging otherwise it will get even worse. Again it seems a self fulfilling prophecy.

And yet by definition the variety of shareholders is shrinking. And to me this raises questions of liquidity and risk. After all:

“The actual shares available, or ‘true float’ — float shares, less shares held by passive funds — for S&P 500 stocks, may be grossly overestimated,” 

And yet there seems no end in sight:

“For a glimpse of what a market increasingly driven by ETFs looks like, Subramanian pointed to Japan.

“In Japan, nearly 70% of the assets under management of Japan-focused equity funds is passive — granted, the BoJ has been buying ETFs — and their markets are still functioning,” she said.

But it has come at a price. The number of active funds outperforming Japan’s Tokyo Stock Price Index has fallen to 34% between 2014 to 2016 from 46% between 2002 to 2013.”

2 key messages here: This will continue and likely expand. And times will get even more complex for active managers. The implications for us as traders can also not be underestimated.

Between passive ETF flows, central banks buying, buybacks, algos, etc it remains a very challenging environment as the rules of just 2 years ago, never mind 10 years ago, no longer seem to apply.

My biggest complaint of all this has been that volatility has been compressed, valuations have gotten ever more expensive and indices no longer correct and the dips are getting shallower and shallower. Every breakdown is bought. Because it has to.

 

To be fair earnings growth continues to be decent for the moment (mostly driven by a YoY bounce in energy), but again, we see everything heading for an unavoidable wall. Consumers continue to be tapped out by ever higher debt burdens, car loans are now close to running for 6 years on ever higher balances, wage growth again disappointed and the entire forward multiple universe seems premised on none of this mattering and recessions having been eliminated. Given the passive and unconcerned nature of markets operating in a reduced liquidity environment I maintain we are opening ourselves up to an eventual negative shock of epic proportion.

 

But fair enough, so far nothing has mattered and in no bubble anything matters until there is a trigger, hence critics like myself get often dismissed as naysayers or perma-bears.

From my perspective we are in the final move up paving the way for a larger top in 2017 setting us up for a recessionary move into 2018/2019 with potential far reaching consequences if central banks lose control. And it’s the timing of the latter part that is unknowable. Plenty of fund managers think we’re setting up for a downturn later in 2018.

 

But it’s coming whether we want to believe it or not. And a large swath of the American population is utterly unprepared for it. They already don’t have the resources to pay for a basic cash emergency. They are in record debt, and many have lost all hope in the American Dream. George Carlin famously quipped: That’s why they call it the American dream, because you have to be asleep to believe it.

 

And it is precisely because of this structural ‘left behind’ feeling millions of Americans have experienced that Donald Trump is in power. He wasn’t elected because he brings expertise, wisdom, or any particular competence to the job. Indeed his daily twitter outbursts tend to suggest precisely opposite. While many may have believed his campaign promises, for many more it was clear that, if nothing else, a Donald Trump presidency would be a giant middle finger in the face of the very establishment that has so underserved them.

If it’s entertainment you want, you got it. But the business model of both parties continues to be to sell hope and fear at the same time, but not to deliver on any substantive level.

Here’s the cumulative running Treasury P&L from June 2016 versus June 2017:

The short answer: Nothing has structurally changed except more debt and spending. But central banks have enabled politicians to keep selling the same goods. Unemployment is low, stock markets are high and all appears calm and sanguine.

But be aware: Things always look the best near tops, bears look like idiots and Wall Street never tells you to sell:

 

 

 

So by all means, keep thinking that all the glitter in the headlines is gold. It’s not. It’s fool’s gold.

 

https://northmantrader.com/2017/07/26/fools-gold/

[X Factor 1,112]

With markets near all time highs keep trading shorter time frames nwith downside hedges.    

[OriZ 3,157]

6 hours ago, X Factor said:

With markets near all time highs keep trading shorter time frames nwith downside hedges.    

This market is so boring nowadays, I've gone to crypto to find some excitement. Still use my daily system for intra day and swing options trading, but it's kinda meh. Money is good just boring. Need to spice things up a bit.

[OriZ 3,157]

This is excellent:

 

There’s an apocryphal story that in 1787, during the journey of Empress Catherine II to Crimea, Prince Grigory Potemkin, the governor of the region, erected fabricated villages along the Dnieper River, which would be disassembled after she passed by, and rebuilt again downstream overnight.

 

When one examines the collapses of the tech bubble and the housing bubble, it’s evident that one of the central elements of those collapses was the gradual recognition by investors that the overvalued pieces of paper they were holding were actually little Potemkin Villages; temporarily glorious and impressive on the surface, but backed by much less than investors had imagined was there. What sort of “catalyst” is needed for a Potemkin Village or a Ponzi scheme to disappoint? Only the gradual or sudden discovery of the reality behind it: the recognition that there is no “there” there.

 

Investors presently appear to be taking past investment returns and economic growth at face value, without considering their underlying drivers at all. My impression is that while the U.S. may very well encounter credit strains or other economic dislocations in the coming years, nothing is actually required for yet another equity market collapse except the gradual recognition by investors of a reality that already exists. Strip away the effects of short-term cyclical factors that have now been largely exhausted, and it becomes clear that the financial markets have again become a Potemkin Village.

 

I’ve previously detailed the argument that if interest rates are low because growth is also low, no increase in market valuation is “justified” at all by the lower interest rates, and yet future returns on stocks will be commensurately lower anyway (see the Geek’s Note in Valuations, Sufficient Statistics, and Breathtaking Risks to understand this from the standpoint of discounted cash flows). In that situation, elevating market valuations results in a reduction of prospective stock market returns by a far greater amount than interest rates have been reduced.

 

Market returns don’t just emerge from nowhere. They are driven by the sum of three factors: growth in fundamentals, income from cash distributions, and changes in valuations (the ratio of prices to fundamentals). Since 1960, for example, the S&P 500 has enjoyed an average rate of return of about 10% annually, which derives from three main components: growth in earnings (and the overall economy) averaging about 6.3% annually, dividend income averaging about 3.0% annually, and a gradual increase in price/earnings multiples that has contributed about 0.7% annually to total returns. One can also make a similar attribution using other fundamentals. For example, the 10% annual total return of the S&P 500 since 1960 also derives from growth in S&P 500 revenues averaging 5.7% annually since the 2000 peak, dividend income averaging about 3.0% annually, and a much steeper increase in the S&P 500 price/revenue ratio contributing 1.3% annually (taking the current price/revenue multiple to the same level observed at the 2000 market peak).

 

Consider these drivers today. Combining depressed growth prospects with an S&P 500 dividend yield of just 2.0%, the likelihood is that over the coming 10-12 years, even a run-of-the-mill reversion of valuations will wipe out the entire contribution of growth and dividend income, resulting in zero or negative total returns in the S&P 500 Index on that horizon, with an estimated interim market loss on the order of -60%.

 

Here are the facts: over the past several decades, due to a combination of demographic factors and persistently slowing productivity growth, the core drivers of real U.S. GDP growth have declined toward just 1% annually, with a likely decline below that level in the coming 10-12 years. Indeed, in the absence of any recession, U.S. nonfarm productivity growth has averaged just 0.8% annually since 2010 and 0.6% over the past 5 years, while the U.S. Bureau of Labor Statistics estimates labor force growth of just 0.3% annually in the coming years (which would be matched by similar growth in employment only if the unemployment rate does not rise from the current level of 4.3%). Add 0.6% to 0.3%, and the baseline expectation for real GDP growth is just 0.9%. Nominal growth is likely to be similarly weak.

 

While S&P 500 earnings growth has slightly outpaced revenue growth over the past two decades because of rising profit margins, recent record profit margins have now stagnated and have begun to retreat, resulting in the likelihood that earnings growth will match (at best) or even lag, overall economic growth in the years ahead. At the same time, the valuation measures we find most reliably correlated with actual subsequent S&P 500 total returns now average between 150-170% above historical norms that they have approached or breached by the completion of every market cycle in history. For a review of the historical reliability of these measures and popular alternatives, see the table in Exhaustion Gaps and the Fear of Missing Out.

 

 

What if inflation bursts durably higher? Wouldn’t one expect higher future nominal returns over the long-term? The answer is yes, but the present valuation premium would still not be justified. Rather, as we observed in the mid-1970’s, the likely first response of the market would be for valuation multiples to surrender their premium, and possibly move to a substantial discount, after which higher long-term returns would emerge. So inflation or no inflation, I don’t expect that any plausible economic outcome will prevent a wholesale market collapse over the completion of the current cycle.

 

Keep in mind that even if the most reliable valuation measures we identify were to move from 170% above their historical norms to still 35% above those norms, the move would imply a -50% market loss (as we observed in both the 2000-2002 and 2007-2009 cycle completions). The longer-term effect of that normalization would be to subtract about -6.7% from 10-year S&P 500 total returns, and about -5.6% from 12-year total returns (subtracting -9.5% and -7.9%, respectively, if valuations were actually to visit their historical norms 10-12 years from now, even if they never move below those historical norms again). Add in about 2% of dividend income, and a few percent in nominal growth, and the market would still be struggling to claw out 10-12 year total returns of zero.

 

Behind the Potemkin Village

It’s tempting to imagine that the market returns of recent years, in the face of already extreme valuations, are somehow evidence that valuations no longer matter, and that underlying drivers are no longer necessary. But investment returns can be broken down into components. The reason that investors don’t recognize the dismal condition of core economic drivers, or the drivers of long-term investment returns, is that they remain dazzled by shorter-term cyclical factors, including the effects of their own speculation.

 

Make no mistake: the main contributors to the illusion of permanent prosperity have been decidedly cyclical factors. These include 1) a decline in the U.S. unemployment rate from 10.0% in 2009 to a low of 4.3% in July of this year; 2) an expansion in equity market valuations from levels easily below their historical norms in 2009 to levels that, on the most reliable measures we identify, now stand 150-170% above their historical norms, and are rivaled only by the final extremes of the 2000 bubble peak; and 3) a widening of profit margins, driven by weak growth in labor costs in the face of high unemployment after the global financial crisis, and which is already reversing in the face of much lower unemployment today.

 

Let’s take a look at the data, and the barren fields behind this Potemkin Village may be more apparent. Recall that real U.S. GDP growth is driven by two factors: growth in the number of employed workers, plus growth in output per worker (productivity). Of course, growth in the number of employed workers itself has two drivers: the underlying growth rate of the labor force (largely determined by population growth and demographic factors), and cyclical changes in the fraction of the labor force that is actually employed (the remaining fraction is measured by the unemployment rate).

 

The first chart is one I presented last week. To illustrate the underlying drivers of economic growth, 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 4.4% unemployment rate, future economic growth is unlikely to benefit from 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.

 

 

The chart below shows the trajectory of nominal growth from the standpoint of nonfinancial corporate revenues, including estimated foreign revenues. The fundamental drivers of U.S. corporate revenues have declined progressively in recent decades and have never been weaker. This fact may not be evident to investors, but as it becomes clear, it will contribute to a psychology of “growth despair” that will ultimately form the basis for the next bear market low. I’ve previously discussed economic policies that could improve long-term outcomes over a period of decades, but for the completion of the present market cycle, there is no fix. Extraordinarily negative outcomes are baked in the cake.

 

 

Again, when interest rates are low because growth is also low, no valuation premium is “justified” at all. In the present environment, investors are inviting disastrous losses by paying the highest S&P 500 price/revenue ratio in history (outside of the single week of the 2000 market high) and the highest median price/revenue ratio in history across S&P 500 component stocks (more than 50% beyond the 2000 peak, because extreme valuations in that episode were focused on much narrower subset of stocks than at present). Glorious past returns and record valuations are a Potemkin Village with a barren field behind it.

 

From an earnings standpoint, growth in earnings requires some combination of growth in revenues and expansion in profit margins. Presently, profit margins are near the highest levels in history, but have begun to contract, reflecting a gradual increase in labor costs relative to productivity growth. There will undoubtedly be fluctuations in these components from quarter to quarter, but at a 4.4% unemployment rate, the absence of labor cost pressures should not be assumed to persist, as if unemployment was still above 10%.

 

 

The bottom line is that we presently observe some of the most offensive equity market valuations in history, coupled with deterioration in the underlying drivers of long-term growth. The chart below shows the most historically reliable valuation measure we identify (nonfinancial market capitalization to corporate gross value-added, including estimated foreign revenues) on an inverted log scale, along with the actual subsequent S&P 500 average annual nominal total return over the following 12-year period (red line, right scale). Even if we were to assume historically normal future economic growth rates, we would still anticipate zero total returns for the S&P 500 over the coming 12-years, with a likely interim loss on the order of -60%. Frankly, my concern is that a zero total return over the coming 12-years may be optimistic, because even if both interest rates and growth rates remain several percent historical norms, a zero total return would require investors to maintain a valuation premium that is actually unwarranted.

 

 

Let’s be clear. It has taken the third financial bubble in 17 years to bring the total return of the S&P 500 since the 2000 peak to just 4.8% annually, all of which we expect to be wiped out over the completion of the current market cycle. Even if investors are lucky, and valuations reach yet another bubble extreme 10-12 years from today, the annual total return of the S&P 500 between now and then is likely to be even lower than the 4.8% return since 2000, because the underlying economic drivers have deteriorated further. In my view, it’s substantially more probable that investors 10-12 years from now will find the S&P 500 Index at a lower level than it is today, with the average portfolio struggling to get back to zero from deeply negative interim losses.

 

A note on unemployment and inflation

From the standpoint of unemployment and general price inflation, it’s useful to emphasize once again that the so-called “tradeoff” between the two is a wholesale misinterpretation of both economic theory and historical data. There is no such tradeoff. Recall that the title of the famous 1958 paper by A.W. Phillips was “The relation between unemployment and the rate of change of money wage rates in the United Kingdom, 1861-1957.” Recall also that during most of that period, the United Kingdom was on the gold standard, and the rate of general price inflation was very well-behaved. Finally, recall that Phillips explicitly excludedperiods from his analysis that included what he described as large “cost of living adjustments” in the general price level.

 

Given those observations, I’ve regularly argued over the years that the true “Phillips Curve” that A.W. Phillips originally identified is actually a scarcity relationship between unemployment and real wages, not general prices. Put simply, when labor is scarce, the price of labor rises relative to the prices of other things, and when labor is plentiful, its price falls relative to the prices of other things.

 

From my perspective, the main reason to normalize the Federal Reserve’s balance sheet is not because low unemployment creates inflation risk. Rather, the main reason for normalization is to limit further distortion and ultimate economic fallout from yet another round of Fed-encouraged yield-seeking speculation (even broader than the preceding episode, which ended in the worst economic crisis since the Great Depression). Given the weak fundamental drivers of long-term economic growth, it’s quite reasonable for interest rates to be lower now than in the past (though there is no reason, given that interest rates and growth prospects are both depressed, that stocks deserve a valuation premium as a result). But even allowing for weak expected economic growth, the Fed’s balance sheet is still double the size that would actually be required to sustain short-term interest rates of just 2% (without the need to pay interest on reserves). The Fed has done nothing but to maintain a pool of low-interest hot potatoes that has now encouraged one of the three most extreme episodes of financial speculation in U.S. history.

 

As for unemployment and inflation, the charts below show the relationship between the two from the standpoint of joint correlation. The first chart below shows the correlation between unemployment and the rate of CPI inflation. You’ll notice that unemployment does notreliably produce opposite movements in general price inflation at all. Indeed, the correlation between the two is uniformly positive: higher unemployment is associated with higher inflation. The relationship is also a lagging relationship, where high unemployment tends to follow periods of high inflation, and low unemployment tends to follow periods of low inflation. In my view, this relationship doesn’t reflect cause-and-effect, but rather the lagging behavior of unemployment in the business cycle. The general tendency here is that periods of elevated inflation are often followed by recessions, and recessions are often followed by lower inflation. Since unemployment is one of the most lagging economic series available, the result is that high unemployment appears to follow elevated inflation with a substantial lag (typically peaking more than two years later), and low unemployment appears to follow low inflation with a substantial lag.

 

 

You certainly won’t get much benefit from trying to predict inflation using the unemployment rate. Better leading indicators of inflation include year-over-year nominal GDP growth, and the year-over-year percentage change in gold prices, both which lead inflation by about 52 weeks. Short-term interest rates have a fairly coincident relationship with inflation, and once short-term yields are taken into account, long-term interest rates come in with a negative sign, since yield curve inversion also often precedes inflation. In any event, the notion of an “inflation-unemployment tradeoff” rests on a misunderstanding of Phillips’ work, and a disregard for historical evidence.

 

By contrast, here’s the basis for what I view as the “true” Phillips Curve. The relationship between real wage inflation and unemployment is negative at all leads and lags (which creates a downward sloping relationship when the two are plotted together). Here too, unemployment is a somewhat lagging economic variable, but the main feature of the chart below is the consistently negative correlation, which means that high unemployment is associated with low real wage inflation, and low unemployment is associated with high real wage inflation. There’s your scarcity relationship. At a 4.4% unemployment rate currently, it’s this feature that has recently been putting gradual pressure on corporate profit margins. Despite quarter-to-quarter variability, the likelihood is that the period of persistently rising margins is behind us, and a period of gradually normalizing margins is ahead of us. Even if margins remain permanently high, weak structural growth drivers and extreme valuations are likely to be problematic for stocks in the years ahead. Downward pressure on profit margins would simply amplify these risks.

 

 

As for the stock market, when one strips away the impact of short-term cyclical drivers such as falling unemployment, widening profit margins, and expanding valuations, the underlying drivers of future economic growth and future investment returns are rather dismal. Investors now rely on unemployment to remain depressed, profit margins to remain at record levels, and valuations to be sustained at historic elevations, simply for U.S. real GDP to average 1-2% annually in the coming years, and for stocks to achieve low single-digit total returns. More likely, any normalization at all in these cyclical factors is likely to produce near-zero growth in U.S. GDP and corporate earnings in the coming years, with steep market losses over the completion of the current cycle, gradually recovering to an overall total return of zero for the S&P 500 over the coming 12-year horizon.

 

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