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The Beard Has Spoken

I’ve written plenty about the markets over the past six months since I started growing the correction beard. But I regularly get questions related to one post or the other that I’ve already answered somewhere else. So I thought I’d try to write a more comprehensive view aggregating much of what I’ve written over that time so it’s all in one place. The underlined words and phrases below link to articles for further reading.

The stock market has done very well over the past six years. In fact, there are only a few other times in history where it’s seen a 200% rise in such short a time. This has led many to believe that investing in the stock market is an easy game when they should really be on guard against just this sort of hubris.

This may be the single greatest mistake investors make – extrapolating recent performance out into the future, especially after the sort of historic run we have seen lately. Momentum can be a powerful force and even an effective trading strategy on its own but in this case long-term investors are likely to be sorely disappointed. Stocks are just as overvalued today as they were in 2000. Why, then, should, investors expect a vastly different result?

You may counter this idea by saying, ‘forecasts like that aren’t usually worth much,’ but, in my humble opinion, everything is a forecast. Buying stocks today is making a forecast that they will generate an adequate return over the coming decade. If that’s what you’re doing, I challenge you to show me why your forecast is more valuable than mine. I’m sincerely curious. And please know that in making this forecast, I’m not trying to scare you. I’m trying to help you.

Like some very smart people I know, you may also try to justify the extreme overvaluation in the stock market right now by pointing to ultra-low interest rates. Rather than justifying high valuations, though, low-interest rates confirm the idea that equity returns will also be ultra-low going forward.

Because stock market valuations have remained so high for so long, it’s very tempting to believe “it’s different this time.” It’s not. The simple reason that valuations have been so high for so long is that over the past 25 years there has been unprecedented demand for equities from the baby boom generation. But this is coming to an end very quickly. Ultimately, this may prove to be one of the worst times in history to own equities.

Just for a minute, look at the markets like Warren Buffett does. 10-year treasury bonds currently offer a better prospective return over the coming decade than equities do (based on the most reliable models), a fairly rare occurrence. In the past, if you just sold stocks and bought bonds during these times you missed most of the major equity bear markets of the past half century (and did especially well last year).

I acknowledge, however, that the trend is still up for the major stock market indexes. So maybe you would prefer to stay involved until the trend changes. That’s absolutely valid so long as you have a plan. As we learned in the late 1990’s, an expensive market can get even more expensive though I believe we are unlikely to see another such blowoff this time around.

Why is that? Because bond market risk appetites have already signaled a shift in investor sentiment that began last summer and stocks are historically very highly correlated. All sorts of demand sources for equities also seem to be drying up. In fact, it looks as if everything but the stock market has already peaked. This is probably why the smart money has begun to worry about the downside.

So I encourage you to have this conversation with your advisor. Take some time to understand the risks in relation to the potential rewards from being involved in equities right now and what that means to you. There’s wisdom in insecurity. And be aware of what this relationship ultimately costs you. In this new era of ultra-low returns it’s more important than ever to avoid the “new wolves of Wall Street.”

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Investing, Markets, Posts

This Simple Indicator Explains Persistently High Equity Valuations… For Now

In my last piece, I openly worried about a few very smart investment minds who have recently attempted to rationalize or justify the persistently high equity valuations we have seen over the past 25 years. I don’t believe that, “it’s different this time.” The modern economy doesn’t have any new magical component that makes a standard stream of cash flows any more valuable than they were 50 or 100 years ago. Nor have investors become generally more intelligent.

I think there’s a very simple explanation for the high stock market valuations since 1990: demographics. From 1981-2000, the baby boom generation came into their peak earning and investing years. Is it just coincidence that during that very same time we witnessed the largest stock market valuation bubble in history? No. In fact, there is a statistically significant correlation between demographic shifts like this and stock market valuations.

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A few years ago a pair of research advisors to the Federal Reserve Bank of San Francisco demonstrated this link. They found that demographics (specifically, the ratio between retirement age workers to peak earning and investing age ones) is responsible for 61% of the changes in the price-to-earnings ratio of the stock market over time. Additionally, they found that when their model’s forecast p/e was off by a significant amount the real p/e consistently reverted to their forecast p/e.

el2011-26-1All this means is that there is a very strong relationship between the size of the generation that is currently in its peak earnings and investing years and the valuation of the stock market. Over the past 25 years we have seen the single largest generation in our nation’s history, the baby boomers, push stock market valuations higher than they have ever been. It’s not magic; it’s simple supply and demand (mainly demand).

According to this theory, for valuations to remain elevated the stock market needs the generations that follow the baby boomers to maintain the same population growth that the baby boom represented. We already know that this just isn’t going to happen. The generation following the baby boomers, Generation X, represents a significant deceleration in population growth. For this reason, this model forecasts a contraction of the price-to-earnings ratio over the next decade, from about 18 last year to roughly 8 in 2025.

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In a piece from last December, I assumed an earnings growth rate of 3.8% over the coming decade, the historical average according to Robert Shiller, in forecasting 2025 earnings for the S&P 500 of 156.76. Apply an 8.23 p/e (forecast by the model) and you get a price level for the index of 1,290.

However, Cliff Asness has shown that earnings are very highly correlated with the level of inflation. With 10-year TIPS now implying inflation of less than 2% we can make a new earnings forecast using that as our assumed level of earnings growth. In this case, we arrive at a 2025 earnings number of 131.75. Applying an 8.23 multiple we get a price level for the index of 1,084. This would represent a decline of about 50% over the coming decade, a truly horrific prospect.

Ned Davis Research has also studied this relationship and come to a similar conclusion. The chart below comes from Davis’ terrific book, “Being Right or Making Money.”

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Of course, there are many factors that influence stock prices and valuations over time and demographics is just one of them. But it’s the only one I’ve found that convincingly explains the persistently high valuations we have seen since the 1990’s. And it doesn’t support the idea that high valuations are here to stay, as some may believe. In fact, it suggests just the opposite.

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I’m Hearing A Lot Of Smart People Use “The Four Most Dangerous Words In Investing” These Days

Let me begin this post by saying that the three sources I quote here are among the handful of voices on social media and the financial blogosphere I respect most. This is also why I’m especially concerned about this new trend.

What worries me is that I’m now hearing the “four most dangerous words in investing” from some of the smartest guys in the game. Each of the arguments I’m going to look at represent some version of “it’s different this time” in relation to overall stock market valuation.

I’ve made the case for months now that stocks are extremely overvalued. In fact, I believe there is a very good case to be made that while we may not have another full-fledged tech bubble on our hands, the broader stock market is just as overvalued today as it was fifteen years ago, at the peak of the internet bubble.

To counter or to justify this idea, some very smart people have gotten very creative. First, Alpha Architect recently ran a post on valuations determining that, “the stock market isn’t extremely overvalued.” It’s “normalish.”

However, and they do acknowledge this in the post, they are looking at today’s valuations in relation to the history of just the past 25 years. The problem with this is that the past 25 years represent the highest valuations in the history of the stock market so, obviously, today’s valuations will look much more reasonable when framed in that light.

In acknowledging the limitation of using just the past 25 years, however, the author of the post questions whether, “market conditions 100+ years ago may be different than they are today.” In other words, ‘it’s different this time’ so those historical measures are no longer be relevant. To their credit, they recognize, “this sounds a bit like the ‘new valuation paradigm’ thinking that prevailed during the dotcom boom when valuations went crazy.” Still, they are putting it out there for less circumspect investors to rely upon.

Similarly, my friend Jesse Livermore of Philosophical Economics recently posited in a terrific piece that there are very good reasons justifying the persistent high valuations of the past 25 years.

Should the market be expensive?  “Should” is not an appropriate word to use in markets.  What matters is that there are secular, sustainable forces behind the market’s expensiveness–to name a few: low real interest rates, a lack of alternative investment opportunities (TINA), aggressive policymaker support, and improved market efficiency yielding a reduced equity risk premium (difference between equity returns and fixed income returns).  Unlike in prior eras of history, the secret of “stocks for the long run” is now well known–thoroughly studied by academics all over the world, and seared into the brain of every investor that sets foot on Wall Street.  For this reason, absent extreme levels of cyclically-induced fear, investors simply aren’t going to foolishly sell equities at bargain prices when there’s nowhere else to go–as they did, for example, in the 1940s and 1950s, when they had limited history and limited studied knowledge on which to rely.

My problem with this line of thought is that it assumes that human beings have essentially begun to outgrow the behavioral biases that have ruled them throughout a history that encompasses much longer than just the past century. We have seen “low real interest rates” and “aggressive policymaker support” in the past. See Ray Dalio’s excellent letter on 1937 as an analog for today’s economy and markets. So this argument really hinges upon, “the secret of ‘stocks for the long run’ is now… seared into the brain of every investor…. For this reason… investors simply aren’t going to foolishly sell equities at bargain prices when there’s nowhere else to go.”

In other words, we have entered a new era where human beings have fully embraced “stocks for the long run” for the long run and without reservation so cycles will be muted and valuations remain elevated for the foreseeable future. Never mind the fact that the recent history of the financial crisis may contradict this idea. I think the burden of proof for this argument lies squarely with its author. I have my doubts. In fact, this sounds strangely similar to Irving Fisher’s famous line just days before the 1929 crash, “stock prices have reached what looks like a permanently high plateau.”

Finally, Alex Gurevich wrote a fascinating think piece over the weekend on the Fed, the economy and how they relate to stocks and bonds. While I truly appreciate following Alex’s thought process (as I do both of the previous authors’), it’s his case for owning stocks that strikes me as a clear rationalization of extreme valuations:

Singularitarians (such as Ray Kurzweil)  believe that we are on the brink of explosive self-acceleration led by computers designing better computers, which design better computers even faster, and rapidly surpassing every aspect of human intelligence. Singularitarian philosophy is migrating out of the province of science fiction writers into the  mainstream, and can no longer be ignored by long horizon investors… The idea of economic singularity allows me have a clear and consistent theory of unfolding events. I can be positive on stock market without being scared of valuations.

I don’t dispute the awesome idea of singularity. It seems inevitable and inevitably beneficial for society (though some very smart people would disagree). What I dispute is the idea that singularity should justify high valuations.

As I tweeted this morning, it reminds my of Warren Buffett and Charlie Munger on the awesome innovation of air conditioning and air travel. These things were miracle innovations that dramatically improved the lives of human beings but did they justify abandoning tried and true investment methods developed over long periods of history? In retrospect, the answer is obvious. Amazing innovation is truly inspiring but it shouldn’t inspire you to overpay for a simple stream of future cash flows that have been very easy to value accurately over very long periods of time.

Ultimately, only time will tell if it is, in fact, “different this time” or if history will rhyme once again and today will only represent another stanza in the poem it’s been writing for centuries. With all due respect to these three very wise market philosophers, my money is on the latter.

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Why The Buyback Binge Is Not As Bullish As You May Think

As Bloomberg recently reported, stock buybacks are now running at over $40 billion per month. With margin accounts already maxed out and households along with the largest sovereign wealth funds already “all in,” buybacks now represent the single greatest source of demand for equities.

On the surface, this should give investors great comfort. Stock buybacks may be the most effective way for companies lacking growth opportunities to enhance shareholder value. Look a little deeper, however, and this fact should give investors pause. Why? Because companies may be the worst market timers there are. They routinely set buyback records at major market peaks and buy only a tiny fraction of that amount at major bottoms.Screen Shot 2015-03-17 at 12.46.35 PMChart via Factset

How can that be? Shouldn’t the companies be in the best position to most accurately estimate their own intrinsic value and future prospects and thus most effectively buy low and sell high? Yes BUT companies are far more capable of buying back stock when cash is plentiful – when money is easy to borrow and profits are high.

The time when money is easy to borrow and profits are high, however, usually coincides with high equity prices. When money is hard to borrow and profits squeezed like during a recession, stock prices are usually much lower but companies are not in a position to take advantage. Buybacks, then, are very highly correlated with corporate profits and bond market risk appetites.

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Right now companies are spending fully 95% of their profits on buybacks and dividends. As I recently wrote, profit margins peaked over a year ago. And aggregate corporate profits are expected to decline over the next two quarters for the first time since the great recession. It’s hard to imagine companies being able to maintain near-record buyback levels amid this pressure in profits.

But they can still borrow money to buyback shares, right? Well, borrowing power is also tied to profits and investors’ willingness to buy their debt. I have also written recently that bond market risk appetites peaked last summer and have diverged from equities ever since. Should this trend continue, it would not be supportive of continued buybacks.

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All in all then, just like margin traders, households and the largest pension funds on the planet, the greatest source of demand for equities right now may also be maxed out.

A version of this post first appeared on The Felder Report PREMIUM

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Posts

Don’t Be Seduced By The Siren Song Of The Stock Market

I recently wrote that, “the single greatest mistake investors make is to extrapolate recent history out into the future.” As an example of how dangerous this natural tendency is, I shared a bit of Warren Buffett’s warning from late 1999 in which he wrote that the amazing returns from the stock market during that period had led to investor expectations rising far too high. He forecast that the coming decade would not be nearly as rewarding as investors were hoping it would be. Clearly, the “lost decade” that followed vindicated this idea.

Recently, the Wall Street Journal ran a story about investor expectations once again becoming “delusional.” And with the 200% gain in the stock market over the past six years we probably shouldn’t be surprised. When stocks return 20%+ per year for a few years investors become accustomed to it. It’s only natural to extrapolate recent history into the future even if it is also extraordinarily dangerous to your financial health.

Earlier this month, Nautilus Research shared on twitter the chart below which shows exactly how dangerous this natural tendency really can be:

This is only the fourth time in history the stock market has risen 200% over a six year period.  Exactly six years ago, when I wrote that the market presented investors with an ‘opportunity of a lifetime,’ I was rip snorting bullish but still never dreamed the following six years would be so rewarding.

And while it may be difficult to base anything on only 3 previous occurrences, returns after each of these amazing runs were lackluster at best. History has not been kind to investors acting on their natural tendency to extrapolate.

In fact, only the 1955 occurrence shows a positive subsequent return on a 2, 3 or 5-year time frame. The one thing that sets this occurrence apart, however, is that valuations back then, based on Warren Buffett’s favorite metric (total market capitalization-to-gross national product), were about half what they are today.

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As I wrote previously, today’s stock market is priced just as high as it was in November 1999 when Buffett wrote his warning in Fortune. For this reason, the April 1999 occurrence in the Nautilus study is probably much more relevant to our current situation than the 1955 one. And there is good reason to believe that this market is even more insidious than the one that peaked 15 years ago this month.

The stock market today is calling to investors just as the sirens of Greek mythology called to sailors drawing them into their rocky shores only to be shipwrecked. Extrapolating the fantastic recent returns into the future despite all the evidence against it is succumbing to the stock market’s perfidious seduction. And history suggests that’s almost a sure way to shipwreck.

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