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Playing Defense In The Stock Market Right Now Doesn’t Make You An Idiot

I’ve taken some flak recently for my persistently bearish views of the stock market over the past year. Rightfully so. I’ve been dead wrong. And with a record level of bulls it should come as no surprise that they’d like gloat.

But I’d like to make a few things clear. First, I’m not a perma-bear. Far from it. I was rip-snorting bullish on stocks back in early 2009 when it was very painful and lonesome to be such. And when the broader stock market presents investors with another good buying opportunity I won’t hesitate to get bullish again.

Second, just because I “worry top down” that doesn’t prevent me from successfully investing “bottom up.” I was very bullish on Apple a couple of years ago when it was also painful and lonesome to be such. I also turned very bullish on Herbalife earlier this year. Even if these trades were fully hedged they would have crushed the S&P. My worries are also one reason I’ve been bullish long bonds, another trade that has crushed the stock market.

I really find it funny that stocks are the only asset class where if you don’t own them – and today that means owning the index – when they go up you’re an idiot. What about those who didn’t own gold in the 2000’s? Or those who didn’t short financials in 2008? Or those who haven’t owned long bonds over the past few years? Why aren’t you an idiot for missing these trades?

Right now there’s a zeitgeist. It’s a mantra among investors that if you don’t own stocks 100% of the time you’re a loser. To me this is asinine. There have been plenty of times throughout history where owning stocks was a loser’s game and today has all of the makings of another one. And the zeitgeist, itself, is compelling anecdotal evidence of that!

One of the best rules anybody can learn about investing is to do nothing, absolutely nothing, unless there is something to do… I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up… I wait for a situation that is like the proverbial “shooting fish in a barrel.” -Jim Rogers in Market Wizards

I look for compelling risk/reward setups. That’s my personal style and it works for me. As I see it, the current risk/reward equation for owning an equity index fund is all risk and no reward. And some very smart people agree with the idea.

Ultimately, I still believe it’s time to play defense:

Marks became bearish on “riskier debt markets” way back in 2004. Just because he was three or four years early does that make him an idiot? Of course not. Did playing defense cost him performance during those years? Yes. But was it worth it? Absolutely. Playing defense was critical to surviving the financial crisis.

Knowing when it’s time to play defense versus offense is critical to staying power in this game. I’ve been through a number of cycles now in my career. I’m not going to simply decide one day to ignore the risks I see just because they haven’t materialized over the past 12 months. I don’t need to own an S&P 500 index fund to make money when there are plenty of other far more compelling ways to do so.

And the single reason I continue to share my bearish views on stocks is that I truly care about trying to help long-term investors avoid another painful lesson. In fact, that’s exactly what I’ve been doing here for nearly a decade now.

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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.

fredgraph

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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Why The Smart Money Is Beginning To Worry About The Downside

A month or so ago, I was struck by Ray Dalio’s comments at Davos. He seemed fairly concerned and the major media outlets didn’t really pick it up.

“It’s the end of the supercycle. It’s the end of the great debt cycle.” -Ray Dalio

What does this mean? I think the simplest explanation is that over the past several decades we’ve gone from a nation of savers who paid cash for things including homes and cars to a nation of spenders who use debt like mortgages, car loans and credit cards to pay for things.

And it’s not just on the consumer level. It’s also happened at the corporate level.

“Corporate debt was $3.5 trillion– in 2007, arguably a period and– many would describe as bubbly. It’s 7 trillion now. So it’s gone from 3.5 trillion to 7 trillion. As you know, most of that mix has been in more highly leveraged stuff, Covenant-Lite loans– high yield, that’s where the majority of the rise has been. And if you look at corporations have been using it for, it’s all financial engineering.” -Stan Druckenmiller

Government debt has also grown to multiples of GDP around the world. But it can’t keep growing forever.

“In the past 20 to 30 years, credit has grown to such an extreme globally that debt levels and the ability to service that debt are at risk, relative to the private investment world. Why doesn’t the debt supercycle keep expanding? Because there are limits.” -Bill Gross

The debt boom over the past few decades has been a big economic stimulant. It reminds me of the steroids era in baseball. You take a great player, put him on the juice and he becomes a record-breaking home run machine.

But what happens when he comes off the juice? Have you seen a picture of Mark McGuire or Sammy Sosa lately? They are shadows of their former selves. Now that rates are zero and everyone has borrowed as much as they possibly can debt is no longer the super-stimulant it once was.

“The process of lowering interest rates causing higher levels of debt, debt service and spending, I think is coming to an end.” – Ray Dalio

The steroid era is over. So what are the implications for the economy and the markets?

“The implications are much lower growth, less inflation, lower interest rates, and less profit growth.” -Bill Gross

These are all symptoms that we’ve already witnessed since the financial crisis, right? Slower economic growth has been partially masked by rising asset prices and the wealth effect. Slower profit growth has been masked by the “financial engineering” Druck mentioned above. But that doesn’t change the fact that we are now facing a post-steroid era for the economy.

“We brought consumption forward and issued one giant credit card for the past 30 years. Now the bill is coming due. Investors need to get used to low returns, and low growth, inflation, and interest rates for a long time.” -Bill Gross

What’s probably most troublesome about the whole situation is that now that rates are zero or negative, debt levels have reached their maximum capacity and asset prices are already inflated (and spreads flattened), central banks no longer have the ability to ameliorate an economic slowdown by easing monetary policy.

“Central banks have largely lost their power to ease… We now have a situation in which we have largely no spreads and so as a result the transmission mechanism of monetary policy will be less effective. This is a big thing… So I worry on the downside ’cause the downside will come.” -Ray Dalio

With corporate debt levels twice what they were before the financial crisis, the covenants on much of that debt weaker than ever before and liquidity in the bond market disappearing, the next downturn could present a unique challenge for the Fed. And their traditional tool to address these sorts of challenges is now essentially impotent. No wonder Dalio is worried.

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Don’t Kid Yourself: Stocks Are Just As Overvalued Today As They Were In 2000

As the Nasdaq approaches its 2000 highs people are talking about the similarities and the differences between the market then and now. Most seem to be focusing on the differences, on how much more attractively-priced stocks are today than they were then. From Barron’s:

“What was propelling the Nasdaq in the year 2000 was a dream. What’s driving the Nasdaq today is reality,” says Gavin Baker, who runs the Nasdaq-focused Fidelity OTC Portfolio fund (FOCPX). “The current valuation is very well supported by earnings and cash flows and if those earnings and cash flows continue growing, the Nasdaq should continue going up.”

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The article continues by predicting the index not only surpasses the 5,000 mark but surges as far as 7,000 in “coming years.” This is certainly possible but using the table above to make the case that the Nasdaq, or stocks generally, are cheaper today than they were then is just faulty.

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The internet bubble was characterized by incredible euphoria and unbelievable valuations in just one group of companies. What investors fail to recall is that at the same time there were incredible values to be had in other sectors. The “old economy,” “bricks and mortar” companies had been left for dead as investors believed the internet revolution would put them out of business.

We don’t have a sector today that is nearly as overvalued at the tech/internet sector was in 2000 but we also don’t have any sector that is significantly undervalued:

In fact, virtually every sector is historically overvalued. This is why active managers and value investors are pulling their hair out right now:

Rather than prove that stocks are cheaper today, that first chart above from Barron’s merely demonstrates why the stock market appeared to be more expensive back then even if it wasn’t. Because the indexes are market cap weighted, that relatively small number of incredibly overpriced companies in 2000 skewed the overall valuation of the market much higher than was true for the majority of stocks in the market and obscured the segments of the market that were actually cheap.

If we look at median valuations of the market then and now we see a completely different story. The median number, rather than the aggregate number, is a much better indicator of the valuation of the average stock in the market because it eliminates the bias of market cap weighting toward only the biggest companies. Whether you look at price-to-earnings or price-to-cash flow, the average stock in the market has never been more highly valued than it is today:

Screen Shot 2015-02-24 at 1.12.15 PMScreen Shot 2015-02-24 at 1.12.32 PMCharts via Wells Capital

So don’t kid yourself. Stocks aren’t any cheaper today than they were at the height of the internet bubble. What’s truly “different this time” is that, rather than seeing incredible overvaluation confined to just one segment of the market, it is far more pervasive than it was back then. In my view, this also makes it far more insidious.

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Why Today’s Ultra-Low Interest Rates Are Actually Bearish For Stocks

There are plenty of pundits out there arguing that today’s record-high valuations in the stock market are validated by ultra-low interest rates (see Fed Model). The problem with this idea is it really only tells us how we got here. What investors should really care about is where we’re going and ultra-low interest rates are not at all bullish for future returns in the stock market.

In some respects, the idea that low rates should mean higher equity valuations makes perfect sense. If the 10-year treasury bond only pays 1.7% and the dividend yield on the S&P 500 is closer to 1.9% why wouldn’t I be more inclined to buy stocks? Good question! And this is probably why investors bid stocks up to astronomical valuations in the first place.

The major problem with this line of thinking is that it is backward-looking and it is no justification for valuations to remain high going forward. I’ll let Cliff Asness explain:

It is true that all-else-equal a falling discount rate raises the current price. All is not equal, though. If when inflation declines, future nominal cash flow from equities also falls, this can offset the effect of lower discount rates.

In fact, over time corporate earnings growth tracks very closely to the rate of inflation. This is why so many people like to say stocks are a good inflation hedge because they can typically raise prices to combat rising costs in an inflationary environment. But if that’s true then they also make a very poor deflation hedge as their earnings also must also fall when the rate of inflation does. And right now the bond market is pricing in the lowest levels of inflation since the financial crisis:

fredgraphChart via FRED

This would suggest that earnings growth going forward should also be very weak. In fact, we are already seeing this reflected in companies’ fourth quarter earnings reports and in the forward guidance they are now giving. Goldman Sachs reports that guidance is now the worst ever recorded. Forward earnings estimates are beginning to reflect this as they have been falling for almost as long as long-term interest rates have been:

Screen Shot 2015-02-02 at 1.02.58 PMChart via Humble Student

From this perspective, it’s very hard to make the case that low-interest rates are a valid reason to be bullish on equities. It may be true that low rates encourage increasing risk taking when investors compare alternatives to the “risk-free rate” of the 10-year treasury bond. This is where the Fed’s interest rate lever and quantitative easing have obviously been successful. But at some point, plunging interest rates like we have seen over the past year, are a sign that earnings growth could be rapidly slowing if not turning negative, a development not at all supportive of risk assets.

Historically, this may be represented by the fact that low interest rates have led to the worst forward returns for stocks. The chart below separates the market into five distinct buckets ranked by the level of interest rates. Bucket 1 reflects the lowest month-end 10-year treasury rates on record during the 1965-2001 period. It’s clear that the 10 year periods leading up to those low-rate environments were fantastic for stocks. The subsequent 10 years were not nearly so kind, as investors suffered losses after adjusting for inflation.

Screen Shot 2015-02-02 at 11.36.14 AMChart via Fight The Fed Model

There is also recent evidence in other countries that the idea of low interest rates supporting stock prices is faulty. Just take a look at Switzerland. This Swiss 10-year bond yield is now negative. Based on the idea that low rates justify higher valuations, one could make the case that an infinite price-to-earnings multiple for stocks would not be unreasonable in comparison. But what did the Swiss stock market do while their long bond yield recently plunged? It also plunged!

tumblr_nialaheKOR1smq3o4o1_1280Chart via JLFMI

The point is investors like to use low rates as justification for higher equity valuations. At some point, however, really low rates go from being benign to malignant for risk assets. No doubt low rates have supported risk assets in our markets for the past five years or longer. But the rapid decline over the past few months is now being reflected in company earnings. And investors may soon begin to question whether it still makes sense to pay record-high valuations in light of this.

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