5 Quotes From Financial Wizards To Help You Understand The Current Asset Bubble

Fed policy “makes no sense from a risk/reward perspective” and it will “end badly.” -Stan Druckenmiller

Druckenmiller went on to say, “every ounce of intuition in my body is that the potential costs have crossed the potential benefits in Fed policies.” I think what he is referring to here is that the tools available to the Fed are not precision tools. They are blunt instruments that are not very effective in their mission and their use comes with all sorts of side effects and consequences. I wrote a bit about this yesterday. We’re seeing the majority of the effects ZIRP and QE appear in stock and bond prices rather than in employment and wages. But so what?

“We are taking a greater chance of having another crash at a time when the world is less capable of bearing the cost.” -Raghuram Rajan

When you push up asset prices in an effort to stimulate the economy you also subject the economy and financial markets to the risk of asset bubbles – which, when they eventually pop (as they all do sooner or later), can undo all the work the policies or tools did in the first place. Anyone remember the financial crisis? We were well on our way to the Great Depression, part deux, as the Fed would have us believe. But have we reached “bubble” levels yet?

“Yellen’s comments suggest, and I agree, that we are in an asset bubble.” -Carl Icahn

Carl sure thinks so and evidently believes the Fed is doing it consciously. But how can we determine if we’re in a bubble?

Corporate bonds and junk bonds “have never been more over-valued in history.” -Jeff Gundlach

Oh, that’s how. Junk bonds valuations are sky high (not to mention other asset classes like stocks, farmland or office towers)…

“It is worrisome that covenant-lite lending has continued its meteoric revival and has even surpassed its 2007 highs.” -Richard Fisher

…and the riskiest sort of bonds are being issued at a record pace. Didn’t we learn our lesson after the financial crisis? That this sort of thing is not a fix at all but just exacerbates the problem? Will we ever learn?

Maybe somebody ought to teach the Fed Albert Einstein’s definition of insanity: ‘doing the same thing over and over again and expecting different results.’


I Shot Tim Ferriss

So last night I shot Tim Ferris… in my dream. It wasn’t a hostile thing at all, though.

He was hunting me and my family. We were all huddled up in the house and he was out there… somewhere… coming to get us. Suddenly, I saw him peek in the window upside down, like he was on the roof and hanging over the edge. Our eyes met and he must of noticed the .357 Magnum in my hand because he jumped off the roof to take cover in the nearby brush. But I was too quick. I shot him in the leg and he collapsed.

I ran over to shoot him again and realized, ‘wait, that’s Tim Ferris,’ and I went into rescue mode. I pulled my belt off and put a tourniquet on his bleeding leg. Then I woke up.

What the hell does it mean? No idea. It’s probably just an amalgamation of all the stuff I’ve been watching/listening to lately:

Storm Surfers – These guys were my heroes growing up as a grommet in SoCal. Their show is very cool – just wish there were more than 4 episodes. Tom Carroll putting a tourniquet on Ross Clarke-Jones was pretty funny.

Hell On Wheels – Just started watching this one so I can’t vouch yet but clearly the gunslinging made an impression on my subconscious.

Tim Ferris Podcast – SO GOOD. Go listen to every episode.


It’s A Put On

This morning over coffee my wife said to me, “I don’t think Kate Upton is very pretty at all. Are they even looking at her face?” And I thought (though I can’t wholeheartedly agree with her), it’s just like the music business: modern technology lets you take anyone and make them look and sound like a superstar. Hire a world-class photographer and take him to the most beautiful place on earth, let him shoot anyone – really anyone – and then give the shots to a photoshop expert and you’ll have your SI swimsuit cover.

Or have a world-class producer pick his favorite song from one of the top songwriters in the world, put him in a top-of-the-line studio where he can also hire the best musicians on the planet and you can literally take anyone – yes, anyone – put them on the mike and using ProTools or AutoTune you will have a hit record. Guaranteed. (If you don’t believe me listen to this.)

But where is the “real” in that? I miss “real” (with apologies to Bob Lefsetz for stealing his modus operandi.) There are an amazing number of talented and beautiful people out there that don’t get even a smidgeon of the notoriety that Kate Upton and Brittany Spears get. I heard a guy last night playing here in Bend down at the shopping plaza. He sounded awesome. Who cares?

Nobody – because we’ve been trained to eat up the “fake” and ignore the “real.” “Fake” is way more profitable for corporate America because it’s so easy. “Real” takes too much time and effort. 10,000 hours? Who’s got that kind of time?

In the Sixties, “real” was everywhere. Jimi Hendrix, Cream, The Stones, Bob Dylan, The Beatles. For Christ’s sake, The BEATLES! They were the ones who really capitalized (forgive the pun) on “real.” And now everyone wants the shortcut to being/finding/capitalizing on the next Beatles. The irony is that they’ll never find it so long as they do it the “fake” way.

And this is all happening in our financial world, too. We long for the days of real growth in the economy, jobs and wages but rather than do what it takes to make it “real” (like allowing institutions to fail and debt cycles to cycle) we insist on “faking” it. We (The Fed) do absolutely everything in our power, lower interest rates to zero, print trillions of new dollars, etc. in an effort to see “real” growth in the economy only to find that we only get “fake” signs of growth like soaring stock and bond markets while the things that really matter in the big picture, jobs and wages, continue to stagnate.

It’s ALL an “Eminence Front” but nobody’s talking about it because we’re much closer to the top of the cycle than we are to the bottom. Maybe at the completion of this cycle Brittany Spears will cover The Who’s classic. Wouldn’t that be an awesome contrary indicator?


How To Time The Market Like Warren Buffett

This is the first in a 3-part series on market timing – read part 2 here.

“The guy’s just not going to spend the cash to spend it. [He’s] the best market timer I ever saw.” -David Rolfe on Warren Buffett

Warren Buffett likes to counsel individual investors to buy-and-hold (specifically, buy an equity index fund and hold it forever). This is a perfect example of “do as I say, not as I do,” as Buffett has successfully timed the market for decades. And with Berkshire Hathaway reporting earnings last week it was revealed that Buffett is now carrying his largest cash position ever (in stark contrast to individual investors who now hold their smallest cash positions since the height of the internet bubble). Clearly, he’s timing once again and I’m sure a few of you are wondering just how he manages to do this so successfully.

A couple of days ago I wrote “Don’t Buy The Buy-And-Hold Line of BS” arguing that valuations matter and when stocks offer literally zero return over the coming decade it’s probably not a bad idea to own something else (like bonds). Well, this really gets at the heart of Buffett’s investment philosophy:

The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase…  Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable:  When bonds are calculated to be the more attractive investment, they should be bought. -Warren Buffett, 1992 Berkshire Hathaway Chairman’s Letter

In other words, ‘when stocks are better value buy them. When bonds are the better value buy them.’ Couldn’t be simpler; could it? But how does Buffett calculate “value?” In the quote above he references “discounted-flows-of-cash,” a very complicated valuation model that relies on many assumptions that can cause all sorts of problems. I think there’s actually a much easier way to look at it.

Back in 1999, when he decided to market-time the internet bubble (well done, sir), Buffett hinted at his process telling Fortune, “I think it’s very hard to come up with a persuasive case that equities will over the next 17 years perform anything like–anything like–they’ve performed in the past 17.” So what tool does he use to make a “persuasive case?” A couple years later, once again via Fortune, he revealed it: the ratio of total stock market capitalization-to-GNP (or GDP), calling it, “probably the best single measure of where valuations stand at any given moment.”

Okay, but HOW does he use it? Here’s my best guess:

John Hussman has done some work with this indicator and found that it is very closely correlated to future returns in the stock market. In other words, this indicator is very good a predicting future returns for stocks over the coming decade.

When Buffett said in 1999 that the next 17 years were very unlikely to look like the prior 17, he meant that the starting valuation in 1982 was so attractive (based on his favorite yardstick, market cap-to-GDP, which stood at 0.333) it virtually guaranteed wonderful returns over the coming decade. Conversely, the starting valuation in 1999 was so unattractive (based on the same yardstick reading of 1.536, or 4.5 times higher than the 1982 reading) it virtually guaranteed horrible returns.

So I believe Buffett very clearly understands the predictive ability of his favorite yardstick. And he uses it to time the market by comparing future stock returns to future bond returns, as he said in the quote from the 1992 letter above. Stay with me here.

I ran the numbers on Buffett’s yardstick and its predictive ability myself, using the data from FRED and Robert Shiller covering the years from 1950 to 2013, and found it to be negatively correlated (low values correlate with better 10-year returns and vice versa) by over 80%. I then created a forecasting model based on the data. This tells us what stock market future annualized returns should be over the coming decade based upon the current reading of the yardstick.

We can then take this number and simply compare it to the current yield on the 10-year Treasury note to see which offers the best return over the coming decade, just as Buffett prescribes. When stocks offer a better return, they should be bought. Conversely, when the 10-year treasury offers a better return it should be bought. Simple. As Buffett says, most of the time stocks are more attractive – but not always:

Screen Shot 2014-08-07 at 10.29.14 AM

So I went back and looked at what would have happened if someone had followed this model, only looking at it once a year at year-end, starting back in 1950. (I know this is cheating; our investor obviously didn’t have access to all of this then future data back in 1950. Still, it’s a fun exercise so get over yourself.)

They would have been fully invested in stocks from 1950 to 1981 at which point they would have switched into treasuries for only a year. They would have owned stocks again from that point until 1996 when bonds offered the greater prospective return. They would have stayed out of stocks for nearly the next decade (through the rise and fall of the internet bubble) and only sold their bonds in January 2003 when they would have bought stocks again. But they only owned stocks for two years before switching into bonds again in 2005. They didn’t buy stocks again until January 2009, after the heart of the financial crisis had already passed and stocks were once again attractively valued relative to bonds. Once again they sold their stocks and bought treasuries at the end of 2012 and still hold those treasuries today.

And how did she do? Even after missing the massive gains of the internet bubble and those we saw in stocks last year, this hypothetical Warren Buffett-wannabe-market-timer, was way ahead of the game. Her $1,000 grew to roughly $1.15 million today compared to $720k for the buy-and-hold investor and a mere $32k for the all-bonds guy. And all she did was buy stocks when they were more attractive; otherwise she bought bonds. Simple.

Screen Shot 2014-08-07 at 8.20.55 AM

Now this model is merely for educational purposes. It doesn’t factor in transaction costs or taxes (which could be huge) so it’s not in any way a recommendation for you to use with your investments. But it’s definitely something to consider when evaluating investment opportunities on a broad basis or deciding where to put new money to work.

I’ll soon put up a page on this site that regularly updates Buffett’s favorite yardstick and compares its prospective return to the yield on the 10-year treasury so we can keep tabs on it. Stay tuned.


Don’t Buy The Buy-And-Hold Line Of BS

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch

This quote has been making the rounds since the market’s 2% decline last Thursday. It’s a great quote; I’m a huge Peter Lynch fan. I’ve read each of his books at least twice and recommend them enthusiastically.

However, I think there’s an important point to be made here. Peter Lynch managed money professionally from 1977 to 1990 putting up an amazing track record: 29% average annual returns. No doubt this places him in a very elite class of the most skilled investors ever. But he also had a massive tailwind to work with as the stock market was very attractively valued during his entire career.

Below is a chart of the total stock market value relative to GDP (via Doug Short). I’ve circled the area that represents Lynch’s career in red:

Buffett Indicator Annotated

Over the past couple of decades there was maybe only a single month, at the very bottom of the financial crisis, during which stock market valuations neared the levels that Peter Lynch had to work with. And even then those levels, of about 60% market cap to GDP – that we considered cheap, during his career represented the month just before the 1987 crash!

Considering what investors have gone through since Lynch retired, the aftermath of the internet bubble, housing bubble and financial crisis, I think it would be very difficult to make the case that they lost far more money over the past couple of decades trying to sidestep these debacles than the money lost by those who didn’t sidestep them.

Screen Shot 2014-08-05 at 9.29.02 AM

When Treasury Bonds far outperform stocks over a 15 year period, I’d say sidestepping the madness of these markets has paid off fairly well. And considering the fact that stocks are now, once again overvalued to the point that an investor can expect roughly a 0% return over the coming decade, I’d say it will probably pay to sidestep it once again.


The “Honey Badger” Stock Market

The stock market is surging again to new highs and I’m asking myself, “who the hell is buying right now? Are investors insane?”

Let me explain. Fundamentals are deteriorating; technically, stocks remain in an uptrend but there are red flags (divergences) everywhere; greed is off the charts; and the macro/structural backdrop is no longer supportive of risk taking. Still investors just can’t seem to keep their “extreme greed” in check and the divide between price and reality is getting more massive every day.

It seems the only reason to buy stocks right now is because others are buying (the trend remains in place) which is fine. As always, this works until it doesn’t. Trend following is a valid investment process but don’t delude yourself into thinking there is any other reason to buy right now. And the longer this goes on, buying only because others are buying, the more painful the reckoning will be.

Wall Street insiders understand this all too well. That’s why they’re all lining up to sound the alarm. The Fed gets it, too. And they’re also openly expressing their worries. Still, investors clearly don’t give a s*** as they continue to pour money into the market.

Oh, you don’t buy the idea that Joe Retail is in the market? Then how to you explain the fact that only one point in the past 75 years has seen retail investors hold a larger allocation to the stock market? (Coincidentally, stocks have only been this overvalued once during that span, as well.) The fact is investors have never embraced risk to the degree that they are doing today, right now.

And they’re doing it by buying leveraged ETFs and Junk Bonds like there’s no tomorrow. Problem is there is a tomorrow. And when investors try to get out of these things they’re going to realize that they took on WAY more risk than they ever imagined when they first bought them.

The great irony is they are once again doing all of this at exactly the wrong time. Not only did the economy contract in Q1, more data coming out suggest the corporate profits bubble could finally be bursting. Not only did margins decline in the first three months of the year, all that cash on corporate balance sheets that the bulls keep talking about (and which Stephanie Pomboy reminds us resides at only a handful of firms, anyway) actually contracted, as well.

Aside form corporations, consumers are now telling us they are worried about they’re ability to keep up their spending going forward. And I think most of these folks are unaware that those HELOCs they took out during the real estate bubble are about to kick them in the ass.

To top it off the Fed is tightening! Yes, tapering = tightening. And if QE was bullish then the removal of QE is bearish. Period.

So call it a blowoff. Call it a Wile E. Coyote moment. Call it a divergence, a disconnect, a lapse of judgement. Call it whatever you want; I’ll call the “Honey Badger” market because this is one “crazy, nastyass” stock market. And I can’t believe I’m watching it happen all over again.

Investing, Markets, Weekly Reports

On The Stock/Bond Conundrum

Professional investors typically look at the stock market as playing Curly to the bond market’s Moe. (I don’t know who Larry is… Currencies? Commodities?) Behavioral finance teaches us that neither of them are very rational over the short run and can, at times, get pretty zany. But the bond market is typically a bit wiser than the stock market and at times it likes to slap the stock market around when it gets wise. Maybe it’s because the bond market has things like “vigilantes” (or used to) that keep it a bit more honest. Who really knows?

Right now traders can’t stop talking about the divergence between the two. Bonds are saying the economy looks punk (as the yield curve continues to flatten) and stocks are saying everything looks hunky dory (as they surge to new highs). So who’s right? Is Moe about to do the eye poke on Curly or will Curly get the block in along with the last laugh.

I’ll just say that I don’t know; I’m not an economist and I wouldn’t trust those guys to know either. But I do have at least a clue.

First quarter GDP would suggest that the bond market has it right but, as we all know, markets are forward-looking, discounting mechanisms. So the continued weakness in yields would suggest that bonds see the Q1 contraction as more then just a blip while stocks are saying, “it’s not so bad.

And we’ve recently heard from a couple of market watchers I do trust who have come down on the side of the bond market. Stephanie Pomboy gave a terrific interview to Barron’s over the weekend:

The No. 1 thing is that investors generally have underestimated the impact that QE [quantitative easing] has had on the economy and the degree to which it has supported growth. As a consequence, they have underestimated the cost the tapering [of monthly Treasury bond purchases by the Fed] would have, and that is starting to come into focus. People will realize that the economy really has not achieved any self-sustaining momentum and that it requires continued stimulus. I liken it to a car on a flat road that has no momentum. When you take your foot off the gas, the car just stops moving. That’s essentially what the Fed is doing…. I expect to see Treasury yields trading in a range from 2% to 3%, basically how it’s been for the past several years. You want to sell at 2% and buy at 3%. I wouldn’t be surprised to see rates fall below 2%, as investor perceptions about the economy meet with reality and they realize that the Fed still has a lot of work to do.

Is it just a coincidence that the Fed began to taper in January and the economy began to contract at the very same time? Maybe. But it’s worth making a note of especially due to the fact that each time QE has ended in the past it’s led to problems that have forced the Fed into a new round of QE. Different this time?

Jeff Gundlach, another whose work I greatly admire, seems to agree with Stephanie. A couple of weeks ago he predicted we would see “one of the biggest short covering scrambles of all time” in the bond market that would send the 10-year yield below 2% and perhaps even below the 1.5% level tagged back in 2012. The recent economic slowing would have to at least continue if not accelerate for something like this to occur.

To be sure, this is THE contrarian call right now. A recent poll of 72 economists found none of them see a contraction in our future. To me, this is the sort of consensus that Bob Dylan sang about:

“Half of the people can be part right all of the time
Some of the people can be all right part of the time
But all of the people can’t be all right all of the time” [emphasis mine]
I think Abraham Lincoln said that
“I’ll let you be in my dreams if I can be in yours”
I said that.

And I wouldn’t be surprised to see Curly get slapped upside the head yet again.