bear beard

Am I Bearish Or Are You Just WAY Too Bullish?

Yesterday I found myself reading GMO’s latest quarterly letter and thinking, ‘wow, I’m fairly bearish but Jeremy Grantham just sounds like a grumpy old man!’ Until I came upon this passage:

…you may think that I am particularly pessimistic. It is not true: It is all of you who are optimistic! Not only does our species have a strong predisposition to be optimistic (or bullish) – it is probably a useful survival characteristic – but we are particularly good at listening to agreeable data and avoiding unpleasant data that does not jibe with our beliefs or philosophies. Facts, whether backed by 97% of scientists as is the case with man-made climate change, or 99.9% as is the case with evolution, do not count for nearly as much as we used to believe. For that matter, we do a terrible job of planning for the long term, particularly in postponing gratification, and we are wickedly bad at dealing with the implications of compound math. All of this makes it easy for us to forget about the previously painful market busts; facilitates our pushing stocks and markets on occasion to levels that make no mathematical sense; and allows us, regrettably, to ignore the logic of finite resources and a deteriorating climate until the consequences are pushed up our short-term noses.

It immediately made me think of one of my favorite songs from The Who:

The shares crash, hopes are dashed.
People forget,
Forget they’re hiding,
Behind an Eminence Front,
Eminence Front – it’s a put on.

We are only a few years removed from one of the worst financial crashes in our history and investors have already put it out of their minds. Most importantly they have forgotten perhaps the greatest lesson of that time: overpay for a security and you are essentially taking much greater risk with the prospect of much reduced reward.

Right now, stocks as a whole present very little in the way of potential reward. According to Grantham’s firm, investors should probably expect to lose money over the coming seven years in real terms (after inflation). Other measures (explained below), very highly correlated to future 10-year returns for stocks, suggest investors are likely to earn very little or no compensation at all over the coming decade for the risk they are assuming in owning stocks.

In trying to quantify that risk, Grantham’s firm suggests that investors are now risking about a 40% drawdown in order to earn less than the risk-free rate of return. I have also demonstrated recently that margin debt in relation to GDP has been highly correlated to future 3-year returns in stocks for some time now. The message we can glean from record high margin debt levels is that a 60% decline over the next three years is a real possibility. Know that I’m not predicting this outcome; I’m just sharing what the statistics say is a likely outcome based on this one measure.

Screen Shot 2015-07-29 at 10.04.43 AMThis horrible risk/reward equation is simply a function of extremely high valuations. As Warren Buffett likes to say, “the price you pay determines your rate of return.” Pay a high price and get a low return and vice versa. Additionally, if you can manage to buy something cheap enough to build in a “margin of safety,” your downside is limited. However, when you pay a high price you leave yourself open to a large potential downside.

Speaking of Buffett, his valuation yardstick (Market Cap-to-GNP) shows stocks are currently valued just as high as they were back in November 1999, just a few months shy of the very top of the dotcom bubble. Investors should look at this chart and remember what the risk/reward equation back then meant for the coming decade. For those that don’t remember, it meant a couple of massive drawdowns on your way to earning very close to no return at all. (Specifically, this measure now forecasts a -1% return per year over the coming decade.)

fredgraph-2Instead, investors today choose to hide behind an “eminence front.” They ignore these facts simply because they are unpleasant to think about. Despite the horrible risk/reward prospects of owning equities today, they have now put nearly as much money to work in the market as they did back in 1999. (This measure is even more highly correlated to future 10-year returns. It now forecasts about a 2.5% return per year over the coming decade.)

fredgraphIt’s truly an astounding phenomenon that investors, after experiencing the very painful consequences of buying high – not just once but twice over the past 15 years, can once again be so enamored with paying such high prices yet again. Amazingly, they are as eager as ever to take on incredible risk with very little possibility of reward. It proves that “rational expectations” are merely the imaginings of academics and have no place in real world money management. It also validates Grantham’s view that it’s not him who is pessimistic; it’s investors who are too optimistic.


Shanghai As A Leading Indicator For The S&P 500

“The Shanghai Composite is an excellent leading indicator for the S&P 500.” –Jeff Gundlach

The Shanghai Composite is rallying nicely today for what feels like the first time in what’s been a horrific period for the index. Since its peak less than a month ago it has lost nearly a third of its value. This amounts to roughly $4 trillion in losses, greater than the value of the entire German stock market. This should be of great concern to US investors because there are many similarities and connections between our equity markets and theirs.

First, it’s plain to see that global equity markets’ long-term cycles harmonize. They don’t always move together over the short-term but the major trends are broadly correlated. Most importantly, major tops and bottoms seem occur simultaneously. If the Chinese stock market just witnessed a major market peak, it may suggest our market could also be in the process of peaking.

This close correlation is due to a multitude of factors but it’s probably fair to simplify by saying that as companies and economies have become more and more globalized they have also become more and more synchronized.

One key component of this rising globalization has been rise of the Chinese consumer. GM is a great example. In June, GM sold just about as many cars in China as they did in the US. Apple has also benefitted greatly from the success of the iPhone with the Chinese consumer which has recently become responsible for a huge portion of the company’s growth.

Considering that 80% of Chinese urban households have been affected by the crash in the stock market, it’s hard to imagine there won’t be repercussions for companies whose success is dependent upon them. In fact, recent reports show that GM’s China sales are falling for the first time in years even as they cut prices a whopping 20%.

All in all, the Chinese consumer has represented one of the greatest hopes for global growth until the stock market crash. Time will tell just how much it affects companies like GM and Apple and the broader global economy.

It’s also important to understand that the stock market bubble in China was intentionally manufactured by the People’s Bank of China in an effort to support its flagging economy which is suffering a real estate bust amid the burden of a massive private debt load. A failure to rescue the economy by inflating consumer wealth could trigger a daisy chain of economic troubles for the country. This is why the People’s bank is so obviously desperate to support the stock market right now.

In some ways, the Chinese example parallels our own. We also suffered a real estate bust which the Fed responded to by explicitly targeting the asset markets in hopes of creating a wealth effect. And it has worked beautifully.

Ultimately, the greatest consequence of a stock market crash in China could be the simple realization that even a completely autonomous, communist government is not omnipotent when it comes to the markets. It’s not capable of defying market forces and human nature. It’s simply not possible to have a boom without a bust.

The one major difference between the Federal Reserve and the People’s Bank of China is that the Fed is out of ammo. We are very near or have already reached the end of the credit super cycle. If the economy slows again, lowering interest rates to spur more private debt can’t save us this time.

The Fed’s other tools, like quantitative easing, are mainly effective at boosting the wealth effect through rising risk assets only to the degree that investors believe they are effective. And if the Chinese example begins to disabuse investors of this faith in the Fed we may soon discover that there’s not much else holding risk assets up at this point.

For more detail on the Chinese stock market bubble read this.


A Tale Of Two Mondays

For those that don’t know, back in late September I vowed not to shave until the S&P 500 saw it’s first 10% correction in years.

Since then I’ve been tracking “the beard indicator.” During this tight trading range over the past few months sentiment has been swinging from bullish to bearish in a matter of minutes it seems. One day, I get loads of folks telling me I’m never shaving again. The next they tell me to get my razor ready.

Last Monday, stocks gapped up and folks were rather bullish:

Today they gap down and they’re not feeling so bullish anymore:

Is there any better contrary signal out there right now? I think I may have to figure out how to quantify this thing. I could probably build an ETF around it and make a fortune right now.


Everything You Need To Know About The Chinese Stock Market Bubble

This post first appeared on The Felder Report Premium on June 20, 2015.

I’ve mentioned the Chinese stock market mania here briefly in recent weeks. I’ve now compiled a fair amount of data along with some interesting anecdotes that show just how crazy it’s gotten so I thought I’d spend this week’s market comment laying it all out for you.

The first thing I like to focus on is valuations. If the dot-com bubble is the gold standard, then China is a bona fide financial bubble. According to Bloomberg:

Valuations in China are now higher than those in the U.S. at the height of the dot-com bubble just about any way you slice them. The average Chinese technology stock has a price-to-earnings ratio 41 percent above that of U.S. peers in 2000, while the median valuation is twice as expensive and the market capitalization-weighted average is 12 percent higher, according to data compiled by Bloomberg.

Another way to look at it is to compare current valuations around the world:

I’ve made the case that US stocks are more overvalued than they appear due to the fact that the median stock is now more highly valued than ever. There’s now a very similar but far more dramatic situation going on in China. Again, from Bloomberg:

The problem with the Shanghai Composite is that 94 percent of Chinese stocks trade at higher valuations than the index, a consequence of its heavy weighting toward low-priced banks. Use average or median multiples instead and a different picture emerges: Chinese shares are almost twice as expensive as they were when the Shanghai Composite peaked in October 2007 and more than three times pricier than any of the world’s top 10 markets.

So if US stocks are expensive on a median basis, Chinese stocks are incredibly so. What’s pushed valuations so far is euphoria like we may have never seen here at home. More than any developed stock market in the world, China’s is driven mainly by individual investors rather than institutions. This means that it’s probably more influenced by what Keynes termed “animal spirits” than most. And boy are there signs of those “animal spirits” in China today.

The number of new trading accounts being opened is simply stunning. I don’t know if I’ve ever seen a more dramaticly parabolic rise in anything.

And they’re not just buying stocks with cash. They’re using an incredible amount of debt, aka margin financing, to leverage their purchases right now.

What I find so stunning is that there are really no margin regulations on individual trading accounts. Yes, the brokerage firms all implement their own sort of margin limits mainly to cover their own asses but the regulators essentially allow for infinite leverage. In other words, it’s 1929 in China right now. The regulators are now considering implementing a 4-to-1 ceiling. To put this in perspective, the SEC allows for 2-to-1 leverage for US investors. Still it’s pretty plain to see what exactly is driving prices higher right now:

Though they make up the majority, it’s now gone far beyond individual investors. The Wall Street Journal reports that some manufacturing companies in China have completely shut down their main operations and put their cash to work in the stock market. Fully 97% of the growth in manufacturers profits now comes from this source of “income.” It’s hard to fathom just how insane this is: Manufacturers realizing they can make more money trading each others’ stocks than actually running their manufacturing businesses.

It’s also the growing popularity of index funds pushing prices to astronomical levels. A great example of this was the recent trading in Hanergy and Goldin Financial. Here were a pair of stocks that everyone knew were extremely overvalued. But they grew to a size that required index funds to add them to their portfolios. Now consider those valuation statistics above. 94% of Chinese stocks are valued more highly than the index. How many of these have also grown to a size that requires them to be purchased by index funds? I guess we probably won’t find out until the dust settles.

And if you think all these new traders and index funds, which are clearly at the mercy of some pretty hot money, are long-term investors, think again.

These guys make our dot-com era day traders look like Warren Buffett. The Chinese stock market just set a record for the shortest average holding period in history, just one week.

For some context here’s what happened to Taiwanese stocks after they witnessed the sort of frenetic turnover now driving the Chinese stock market. They fell about 80% over the course of just 8 months or so:


“So how did we get here?” you may ask. I’ll let the FT explain:

There is one sense, though, in which euphoria in mainland Chinese equities is unusual. Far from being an unintended consequence of policy, the authorities are egging investors on with articles in the state-run press seeking to justify extreme valuations. The People’s Bank of China has been busy cutting interest rates.

And they have not yet cracked down on the incredible leverage being used by individual investors. The powers that be in China have carefully cultivated this incredible bubble. The reason they have done so is that, after the huge boom they have created over the past 20 years or so, they are now facing a potentially huge bust, especially in real estate (sound familiar?).

John Hempton recently wrote a blog post about his personal experiences with the incredible over-investment in China that is now coming home to roost. It sounds like Potemkin Villages on steroids over there.

And companies have been continuing to lever up even in the face of a deteriorating economy.

…until very recently.

So the equity bubble is a desperate attempt to avoid or at least ameliorate the damage of the economic bust the country now faces. The FT reports:

Why, you might ask, would those charming officials in Beijing wish to encourage a bubble? A consequence of the investment boom is that many state-owned enterprises are lossmaking, while state-owned banks have lent excessively to these companies and to local governments. The authorities are urging them to lend more despite the fact that they will never be repaid in full. The obvious way to de-risk this dangerous game of extend and pretend is to recapitalise the state-owned corporate sector. Bubble valuations will make this easier and cheaper.

Will it work? That is the $64,000 question. Still, I think it’s fairly easy to answer. Every other bubble in history has ended the same way. It’s popped. For the Chinese authorities to think they can avoid these consequences is probably fairly naive. Still, their grip on power over the country may depend on it so I don’t expect they stop short of doing whatever it takes to keep the game going. Having said that, once sentiment turns against the markets, it’s probably impossible for anyone to stop it.

Hanergy may actually provide a decent example for what that looks like. Once the game was up, it ended in a flash – literally less than a second.

Amazingly, the person who may have take greatest advantage of the situation was the company’s Chairman, Li Hejun, who shorted a boatload of his own company’s stock just prior to plunge.

Li is not alone. Reuters reports that Chinese corporate insiders are selling at a record pace.

In May company insiders – senior executives or their relatives – sold a combined 1.68 billion shares, a tripling from April, and much more than in each of the previous months of this year, according to data compiled by Reuters… A similar trend was captured by an index compiled by Shenwan Hongyuan Securities that tracks major shareholders’ trading activities. The index surged over the past month, to a record high, meaning major shareholders are reducing holdings at unprecedented levels.

It looks like all those individual investors, manufacturers-turned-day-traders, and index funds are going to left holding the bag. Last week the market lost 12.5%. A few weeks ago I suggested the ETF below had potentially seen blowoff-type volume. Now I’m even more convinced. And I wouldn’t be surprised to see a Taiwanese-style bust over the next 6 months or so. sc-6On a broader level, if this is the end of the Chinese equity bubble it has major ramifications for every other market and economy around the globe. For this reason, I expect more market participants to start paying very close attention.

We’ll just have to stay tuned and see how it all unfolds.

Disclosure: I own put options on ASHR.


Investors Are Bullish On The Stock Market But Should They Be?

A week ago I put out a call to the bulls. I was looking for someone to demonstrate why stocks are likely to outperform the risk-free rate over a number of years (3,7 and 10 were the examples I gave). I’ve gotten a few responses since but they mostly feel like half-hearted attempts to explain why investors are still bullish rather than why they should be bullish.

Here’s a good example:

First off, I am in complete agreement with the observation (and your comments) that current valuations on US stocks are so high that rates of return over the next 7 to 10 years are likely to be very low to negative.
However, valuations have never been (as far as I can tell) a market timing mechanism.  The broad history of the US stock market is that prices advance until a recession is imminent.   Even after the declines in 1962 (Cuban Missile Crisis) and 1987 (Portfolio Insurance Debacle) the market went on to new highs before the next recession. 
My supposition for why this occurs is encapsulated in the chart below.  So long as the economy is expanding and as a result carrying consumer confidence higher, then investors (whether it is rational or not) will continue to pay higher valuations for equities. 


Until there is a recession, investors are comfortable bidding stock prices higher.  

Here’s another one:

Okay, I’m not REALLY a bull, but this is the best I could figure for a bull case for equities…

Executive Summary: Hyperinflationary Monetary Supernova (Fed buys all US Government debt and forgives it all).


  1. After a 20% dip in equities, the Fed panics and launches into QE4. Equities begin an aggressive rally.
  2. After some time, the Fed notices that equities have again stalled and the yield on the ten year note isn’t falling quickly enough for their tastes (perhaps spooked by all the money printing). So they buy Treasuries even more aggressively. Equities rally some more.
  3. But the bond market isn’t falling for it, and to keep Treasury rates low, the Fed ends up having to buy all of the Treasury market that is available to buy. Equities are going ballistic by now.
  4. Having defined inflation out of existence, and seeing no economic growth (even as interest rates continue to rise), the Fed decides that even more radical steps are necessary to protect the economy. After much internal deliberation, the Fed announces that it is forgiving all of the Treasury debt that it owns, and furthermore, it will continue to purchase new issuance from the Treasury department. The hyperinflationary monetary supernova sends equities soaring.

And another:

For the record I’m not a “bull” and don’t seek to make a bullish case for equities. I was intrigued by the challenge and allowed myself a few minutes to ponder.

At the risk of sounding philosophical, I am going to give you a philosophically-sounding answer. Think of an 8-yr-old boy asking his mom if Santa Clause is real. (He has some newfound doubts because he’s heard some naysayers at school talking.) Is Santa celebrated every year? Yes. What’s Santa’s track record? A perfect 8 for 8: a gift under the tree every year of the boy’s life.

It doesn’t matter what the boy should know, the truth; what matters is what he’s told to believe. As long as the common knowledge holds he can reasonably extrapolate forward. However, the moment he ceases to believe and tells his parents as much, his odds of receiving another gift from Santa drop dramatically. There doesn’t have to be a sound reason to support the bull case at this juncture. It is what it is until it isn’t.

These are all fascinating things to think about but none of them demonstrate why stocks are likely to outperform the risk-free rate over any number of years in the future. Still, I’ll tackle each one briefly here.

First, it’s true that bear markets usually coincide with recessions so it may be true that we are unlikely to see stocks decline meaningfully while the economy remains fairly strong. Still, this argument only argues against a coming bear market rather than making a positive case for equities. How likely is the economy to avoid recession over the next 3, 7 or 10 years? I have no idea. But this forecast is critical to the case being made here.

Additionally, it seems like the past couple of recessions may have been triggered by major asset price declines as much as anything rather than the reverse. If this is true, then waiting for a recession to tell you when to get out of stocks is likely to be a losing proposition.

As for the hyper-inflationary case, this is sort of a spin on the familiar “this time is different” argument for owning stocks. While it may be an interesting exercise to think about these sort of possibilities, we really have no reason to believe that the Fed is likely to pursue policies that would create and sustain hyper-inflation. In fact, history shows the Fed would do everything in its power to avoid hyperinflation.

Finally, in regard to the Santa Claus analogy, this sort of reminds me of Pascal’s Wager. From Wikipedia:

Pascal’s Wager is an argument in apologetic philosophy devised by the seventeenth-century French philosopher, mathematician and physicist Blaise Pascal (1623–62). It posits that humans all bet with their lives either that God exists or not. Given the possibility that God actually does exist and assuming an infinite gain or loss associated with belief or unbelief in said God (as represented by an eternity in heaven or hell), a rational person should live as though God exists and seek to believe in God. If God does not actually exist, such a person will have only a finite loss (some pleasures, luxury, etc.).

Applying this idea to investors, bulls may posit that ‘given the possibility that an omnipotent Fed does exist and assuming an infinite gain or loss associated with belief or unbelief in said Fed, a rational person should live as though an omnipotent Fed exists. If it does not actually exist, such a person will have only a finite loss.’ This may be the ultimate “this time is different” argument. The Fed has never been, nor will it ever be omnipotent. Still, I think this begins to explain how some investors view the market these days.

But the analogy also brings up another point which is a critical insight into current market psychology: So long as we collectively believe the Fed is omnipotent then we will continue to receive the benefits of their magnanimous policies. As soon as we begin to doubt the Fed’s powers, the confidence game is up and we can no longer expect those gifts under the tree at the open of trading every day.

I think this is very close to what’s going on in the minds of many investors today. While I find the Santa Claus argument lacking in terms of making a convincing case for stocks outperforming the risk-free rate, I think it does a fantastic job of explaining why investors feel they should be bullish right now.

I received a few other responses but nothing that met my simple criteria. The lack of convincing arguments is either due to the fact that there just isn’t a compelling case to be made or I have just cultivated the sort of audience that doesn’t believe in Santa Claus. Either way, I still think it’s very difficult to justify owning risk assets once they have become priced so high as to virtually guarantee they underperform riskless ones. If you disagree and have a convincing case for me, I’m all ears.