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.

Investing, Markets

The Calm Before The Storm

It seems like volatility always dies down in the summertime as traders retreat to the Hamptons and focus more on sunscreen than stock screens. And you’re not supposed to short a dull market but…

When volatility gets as low as it has recently I take it as a sign of dangerous complacency, especially with the growing potential risks to stocks right now. Bianco research recently noted that over the past 25 years there has only been one other period where volatility has been as low as it is today: July 2007. This marked the beginning of a volatility pick up that ultimately peaked manifold higher during the height of the financial crisis.

Normally, low volatility is no reason in and of itself to become worried about stocks. In fact, low volatility is typically bullish. However, when complacency reaches an extreme like this it does suggest that investors are usually in for some sort of ‘surprise’ that sends volatility higher. And there’s a very good argument to be made that prolonged periods of low volatility actually create more extreme, pent-up volatility.

It works like this: A stock market that goes months and months without anything more than mild pullbacks lulls investors into a sense of security or confidence that stocks just don’t go down anymore. They extrapolate the recent benign price action far out into the future; they start believing things like the “great moderation” line of bullshit. This causes them to become overconfident and over-commit to stocks. When a pullback greater than just a few percent finally happens these investors are surprised by the ‘extreme volatility’ (which is really just normal volatility that has been dormant) and they reduce the undue exposure they put on when they believed volatility was dead. Add this to the normal selling that occurs during and you get a greater than average sell off. Multiply all of these effects (to account for record low vol) from the beginning and that’s how you get a crash like we saw subsequent to the record low vol mid-2007.

Now there were all sorts of other issues that compounded to create the worst financial panic in a few generations and that’s not about to happen again. But history does look like it could be rhyming in some ways right now.

Any major dude will tell you” about not just the record low vol but also that record high margin debt has finally and ominously begun to reverse. A few months ago Jeff Gundlach warned that we could expect a double digit decline once this happened. And @jlyonsfundmgmt shared a great chart the other day showing the correlation between margin debt and the peaks of the past few bubbles.

I know: Correlation ≠ causation. Still, it makes a great deal of sense to me that margin debt is greatly responsible for blowing up an equity bubble in the first place and when it peaks it’s a good sign that the bubble has run out of fuel.

And we’ve seen some canaries croaking in this coal mine over the past couple of months. Biotech stocks, MoMos and the Russell 2000 have all taken it on the chin lately even while the major indexes have hovered near their all-time highs.

As for the latter, @ukarlewitz noted late last week in his excellent “Weekly Market Summary” that, “RUT [Russell 2000] recently ended a streak of more than 360 days above its 200-dma, its longest ever. Every prior instance when a long streak in RUT ended has led to SPX also breaking its 200-dma in the weeks ahead.” That level lies >5% below its current number but there’s a good chance stocks could fall at least twice that much. Again @ukarlewitz:

At more than 5 years, the current bull market (defined as a gain uninterrupted by a drawdown of more than 20% on a closing basis) is both longer and more powerful (on an inflation-adjusted basis) than either the one from 1982-87 or 2002-07. It is, in fact, longer than every bull market in the past century except the ones ending in 1929 and 2000. In other words, this exceptionally long advance without a 10% correction is occurring at the point where virtually every bull market has already ended.

No. This doesn’t mean stocks are about to fall 20%+. But with record low vol over this span how many investors are prepared for such a scenario?

There are also divergences galore. Toddo, calls our attention to the weakness in the banks along with the small caps in contrast to the majors. Maybe more important is what the smart money is doing. We haven’t seen a divergence this large between “emotional buying” and rational buying since… you guessed it. Yep, 2007.

Another noteworthy divergence/canary can be seen in junk bonds. Risk appetites there have also begun to reverse and this is typically a prelude to equity risk appetites reversing as well. So what to junk bond investors see that equity investors don’t?

Maybe it’s that the latest episode of “reaching for yield” is about to come home to roost.

Maybe it’s the weakness in retail. TJX, HD, WFM, BBY, PETM and others have all disappointed investors over the past couple of weeks and we all know consumers make up 70% of the economy.

Maybe it’s the bursting of the bubble in profit margins.

Maybe it’s the bursting of the housing bubble in China.

Or maybe it’s just the fact that this cycle has run its course and is about to swing the other direction. Who knows?

In any case, I’d argue that the record low vol shows investors aren’t looking ahead as much as looking behind and reminiscing at how good things have been over the past five years or so. They’re expecting more of the same even though it’s mathematically impossible. But people love to believe things even when they know they’re not true. And you know what? According to the Fed, this is the very definition of a bubble.

It might not be your father’s bubble but just because we haven’t matched the p/e’s achieved during the internet bubble doesn’t mean that we aren’t ridiculously overvalued today. And it’s increasingly likely this is just the calm before the storm.

Screen Shot 2014-04-25 at 7.50.35 AM

How The Corporate Profits Bubble Is Deceiving Even The Smartest Of Investors

The other day I wrote about the various possible ways to define a bubble. Jeremy Grantham, one of the financial minds I admire most, defines a stock market bubble as a 2-standard deviation valuation event, that is, when stock valuations exceed their historical average by an amount that occurs less than 5% of the time.

This is exactly what happened during the internet bubble. In fact, valuations at that time far exceeded 2-standard deviations above their historical average. The chart below shows just how extended they became – that massive surge on the right hand side of the chart represents the dotcom bubble (and the prior occurrence is the 1929 bubble):

Screen Shot 2014-04-25 at 8.11.24 AM

Data via Robert Shiller

Currently stock valuations are above average but nowhere near as expensive relative to their profits as they were back then.

But what if the profits side of this equation was inflated so that this valuation measure was being depressed? In fact, it looks like that is exactly what’s happening right now. The chart below depicts corporate profits as a percent of GDP:

Screen Shot 2014-04-25 at 7.50.35 AM

Data via FRED

If we are to use Grantham’s 2-standard deviation definition for a bubble then clearly we currently have a bubble in corporate profits to a degree that hasn’t been seen at any other point during the past 67 years (the data range provided by FRED).

Now some might argue that, “it’s different this time,” and profit margins won’t revert back to average but I find that hard to swallow. I believe Grantham would probably agree as does another brilliant financial mind:

[blockquote2]In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. In addition, there’s a public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems—and in my view a major reslicing of the pie just isn’t going to happen. -Warren Buffett[/blockquote2]

Unless our capitalist system has radically changed somehow then Mr. Buffett is right and profit margins will tend to revert back to their historical average of 6.5% over time. And if this is true then current valuation methods that incorporate inflated earnings as a denominator are simply unreliable.

Maybe this is why Mr. Buffett’s favorite valuation measure doesn’t incorporate earnings; it measures total equity market capitalization to GDP. When we look at this yardstick we can see that current stock valuations don’t look nearly as reasonable as they do relative to earings. In fact, they exceed 2-standard deviations above their historical average, suggesting that, according to Mr. Grantham’s definition, stocks are, indeed, currently in a bubble:


Chart via Doug Short

I believe that the reason Mr. Buffett puts so much stock into this measure is due to its practical use: it is one of the best predictors of future returns. The chart below is the inverse of the chart above overlayed with subsequent equity market returns. Right now this indicator suggests that future returns from stocks will be less than zero and it’s got a damn good track record to back it up:


Chart via John Hussman

Ultimately, stocks have only been this unattractive in the past less than 5% of the time (only during the dotcom bubble, really). Just because P/Es look reasonable doesn’t mean stocks are attractive. The “E” could very well turn out to be nothing more than a mirage.


To The Bubble Deniers

Yesterday David Einhorn made news by writing, “we are witnessing our second tech bubble in 15 years.” Almost immediately folks started attacking the idea on the grounds that, ‘individual investors haven’t bought into it yet,’ and ‘if everyone is talking about a bubble, it can’t be a bubble.’

What I find fascinating is none of these folks actually tackle the evidence Einhorn puts forward: obscene valuations, short sellers throwing in the towel and the popularity of money-losing IPOs. They merely throw up these two red herrings.

Ultimately, I think that the argument centers around the definition of the word, “bubble.” Jeremy Grantham defines a bubble as valuations that are two standard deviations above their long-term average. He also looks for anecdotal signs of euphoria and based on these measures he doesn’t currently see a bubble in the broader stock market. This would seemingly validate Einhorn’s critics.

But Einhorn didn’t say there is a bubble in the broader stock market; he said there is a “tech bubble.” And Grantham is also looking at the valuation of market-cap weighted indexes which tell us little or nothing about individual sectors like tech or even the broader market as evidenced by small cap stocks.

What I find even more disturbing this time than the original dotcom bubble is, while it may not show in the market-cap weighted measures, the overvaluation is far more pervasive today. Back in 1999-2000 there were, in fact, great bargains to be had in the “brick and mortar” companies investors shunned in favor of the high flying tech names. I was able to buy stocks like Washington Mutual at 5x earnings and Abercrombie & Fitch at 8x. Both stocks performed very, very well during the tech bust.

Today, almost everything is priced for perfection. This is clearly evidenced by two indicators. First, valuations among individual stocks have rarely been so tightly correlated. Second, the median stock is now more highly valued on a price/revenue basis than at any other time in history. Essentially, this means that almost everything is overpriced and to a degree never before seen. If we can agree that 2000 was a bubble, it’s very hard to deny that stocks, now being even more pervasively overvalued, are not currently experiencing one. And at the very least there is a bubble in small cap stocks.

In terms of the tech sector, we’ve only seen one other time in history where the percentage of money-losing IPOs was as high as it is currently. Can you guess when that was? Can you also tell me how to value a company with no earnings? Again, if we can agree that was a bubble, how is this NOT one?


Personally, however, I like to combine as many types of useful analysis as possible, fundamental, technical, sentiment, etc. to reach a holistic conclusion. In contrast to Grantham, Didier Sornette, another bubble expert, defines a “bubble” based on a technical pattern. He looks for what he calls a “log periodic bubble” that is essentially a price pattern that nearly every bubble in every asset class experiences. John Hussman explains:

[blockquote2]A log periodic pattern is essentially one where troughs occur at increasingly frequent and increasingly shallow intervals. As Sornette has demonstrated across numerous bubbles over history in a broad variety of asset classes, adjacent troughs (say T1, T2, T3, etc) are often related to the crash date (the “finite-time singularity” Tc) by a constant ratio: (Tc-T1)/(Tc-T2) = (Tc-T2)/(Tc-T3) and so forth, with the result that successive troughs come closer and closer in time until the final blowoff occurs.[/blockquote2]

It’s probably easier to just look at the chart pattern. Here Hussman overlays the “log-periodic” bubble model over the S&P 500 Index over the past few years. Technically, the current stock market pattern fits very closely with Sornette’s bubble model:


Finally, sentiment has rarely been this euphoric. Investors Intelligence reports the highest bull/bear ratio since 1987. Rydex traders have never been so heavily invested in bullish funds relative to bearish ones. And margin debt is setting new records every month, a testament to investors unwavering belief in higher prices. I have yet to see any real evidence that retail investors haven’t yet joined the party. All of these indicators suggest just the opposite.

Fundamentals, technicals and sentiment, then, all agree that stocks are currently experiencing many, many signs of a bubble: record (or near) valuations, bubblish price patterns and euphoric devotion to the asset class. I’m certainly not qualified to be the arbiter when it comes to the official definition of a bubble. Guys like Grantham and Sornette are much smarter than I am. But does it really matter if the broader stock market meets everyone’s individual definition or not when a wide variety of indicators like these across a variety of disciplines are all screaming, “BUBBLE”?

To me, if it looks like duck and sounds like duck I’m not going to call it a dove because I hope stocks are headed higher and I’m afraid of missing out. And I’m also pretty sure that just because other people are calling it a duck doesn’t mean it’s not a duck.

Related: What Does Reduce Risk Mean To You?

Investing, Posts

The Creative Destruction of Wall Street

I was taking a look at the different robo-advisors today and I’m just amazed at how fast technology is revolutionizing the investment industry. It’s a f***ing awesome thing to witness. I’m not specifically recommending any one of these companies but WealthFront now charges just 0.25% per year to do what most advisers charge at least 4 times as much for. Betterment charges just 0.15%. And WiseBanyan is FREE – yes, FREE. The robo-advisor price war is officially getting bloody.

It’s still very early in the game but what we are witnessing is nothing less than the creative destruction of Wall Street via Silicon Valley and it’s about time. WealthFront is the largest and fastest growing of the group and has nearly cracked $1 billion under management mainly because it’s become so popular with the tech community. As it expands outside of those early adopters into the general population it’s growth will only accelerate. The big Wall Street firms, Merrill Lynch, Morgan Stanley, etc. along with most independent investment advisers must be s****ing themselves watching this unfold. I don’t think there’s ever been a threat of this magnitude to their businesses.

I finally got around to watching The Wolf of Wall Street last night and, as a Wall Street insider, I have to say it really resonated with my personal experience (what I witnessed, not what I did, LOL). I spent just under a year at Bear Stearns before I migrated to the hedge fund world but I can tell you that that early scene movie, when Jordan Belfort first lands on Wall Street, absolutely nails it. The Matthew McConaughey character is spot on: “Fuck the clients…. The name of the game: move the money from your client’s pocket into your pocket.”

Robo-advisors now have the power to change the game entirely. Jack Bogle has been fighting this battle for decades and has surely made massive inroads in the world of investment products. In just the past ten years we’ve seen the explosion of ETFs that give investors access to every kind of index and sector at the lowest possible price. The price war between Vanguard and Schwab has now pushed the annual cost of owning the entire US stock market to just 0.04%. That’s insanely cheap!

Still, the gatekeepers, the brokers and advisers of the world, were the one thing separating the general public from these fantastic, low-cost products. They don’t make any money selling them so their clients just haven’t heard about them. It’s taken Silicon Valley stepping in to shake up the services side of the business so that Joe Retail investor can actually access these super-low-cost products. And it’s so cool to see it finally happening. Granted, there are some serious drawbacks (read this and this) but for 90% of investors robo-advisors are simply heaven sent. Do yourself a favor and look into them.

Investing, Posts

Less Than Zero

That’s the return investors should now expect from the stock market over the next decade… according to Warren Buffett’s favorite valuation measure: total stock market capitalization relative to GDP.

wmc140407cChart via John Hussman

The chart above shows the correlation between this valuation measure (blue line) and subsequent 10-year year returns (red line) and it’s pretty damn tight. I think the only possible argument one can make against “less than zero” returns over the next decade is something along the lines of, ‘companies are much more profitable now than they have ever been. For this reason, investors will be willing to pay higher valuations in the future so this correlation will break down.’ In other words, ‘its different this time.’ To those of us who have been around the block these are the four most dangerous words in the investment game. (See my thoughts on profit margins here.)

If investors are guaranteed to achieve nothing over the next ten years why would anyone in their right mind put money into the stock market right now? Or even keep a significant chunk invested right now? I keep asking myself this question because it just doesn’t make any sense to me.

I think there are two reasons. First, individual investors are deathly afraid to miss out on future profits EVEN if they understand that those profits are almost sure to be given back (and maybe they get off on the roller coaster ride). They just can’t stand to see their friends make money, even temporarily, and leave them behind. Second, professional investors are deathly afraid of underperforming because it may mean they get fired – even if they absolutely believe that the risk of owning stocks far outweighs the potential reward. They would rather lose money along with everyone else than forgo profits on their own.

It’s just very, very hard to put rational analysis above our natural “herding” instincts. In fact, for most people it’s nearly impossible which is why markets will never be efficient and we will always have booms and busts.

There’s only one reason I can think of for investors to keep money invested right now and to keep putting new money to work in stocks: you’ve got a time frame longer than 10 years AND you don’t have the time or wherewithal to pay attention to even the most basic investment merits of stocks as an asset class. In this case, dollar cost average into an index fund and put more into it every single month, without fail. Over 10, 20, 30 years you should do very well – the longer your time frame, the better.

Those who have a time frame less than 10 years or who can understand and pay attention to the investment merits of stocks as an asset class, however, have no excuse. There’s just no good reason to have undue exposure to stocks right now that I can think of.

Ultimately, the stock market right now is flying as high as Robert Downey, Jr.’s character in the movie that shares a title with this blog post. And now that the Fed is taking away its heroin (QE) it’s inevitably going to go through some painful withdrawals. And even if it doesn’t, you’d do better to put your money under the mattress.