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.

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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.


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.


Are Stocks On The Verge Of Another Incredible 1999-Style Surge?

Over the past few months the “blow off” camp has gotten fairly crowded. First, Jeremy Grantham said that we are very nearly in bubble in the stock market currently. However, he believes that bubbles don’t just fizzle out. They usually end in an epic move that runs faster and farther than anyone could ever imagine. Specifically, he’s looking for valuations to come fairly close to what we saw back in 1999.


Then, a few months later, David Tepper said that because this year rhymes (of course, history never repeats) with 1998 we could see a 1999-style surge in the stock market in 2015. Today, like in the late 90’s, money is being made too easy resulting in yet another asset bubble, he says. He is also looking for valuations that reach levels close to what we saw back in 1999 (according to him, today’s p/e is a mere 16 compared to 1999’s 40 but there are much better ways to measure valuations, in my humble opinion).

Recently, Richard Russell wrote a piece in which he revealed that he believes we are are only now entering the third phase of this bull market. He reminds us that gains in the third phase are usually equal to those of both phases one and two. Stocks have roughly tripled since the 2009 low (700 to 2100) so his expectation is about 3,500 on the S&P 500, almost 70% higher than its current level.

Just this week, Jim Rogers hopped aboard the “blow off” bus by saying he believes the stock market is probably due for some sort of decline but if stocks decline to any significant degree, the Fed will turn the printing presses back on and like never before sending stocks to ridiculous heights.

So we now have at least four respected pundits predicting an amazing “blow off” run for stocks. Know that I respect each of these individuals greatly and in their own right. Rogers is a hero of mine and I have as much admiration for Grantham’s work as for anyone in the industry.

Having said that, I strongly believe that the more popular a prediction becomes the less likely it is to come to pass. And this “blow off” thesis is getting fairly popular now. More importantly I’d like to try to examine what factors would have to align for this thesis to work.

First, the credit markets, which I have been watching very closely, would have to rebound. The high-yield market has been showing signs of weakness since mid-summer last year. This makes sense as that area of the bond market has about a 14% exposure to companies directly affected by the oil crash. Leveraged loans, however, only have a 4% exposure and have been just as weak as high-yield so we can’t just write off the waning risk appetites there to the energy sector. I believe both would have to improve significantly for stocks to have any chance of a “blow off.”

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Second, the global markets would have to avoid any significant fallout from the crashes in oil and in some emerging market currencies. There is a chance, though I have no idea how to put any probability on it, that there could be significant ramifications from the sharp moves we have seen recently in these areas.

Third, because sentiment and valuations go hand-in-hand, investors would have to become even more bullish than they are today. This would mean allocating an even greater percentage of household assets to equities, a statistic that is already fairly stretched and looks to possibly be peaking. It would also mean they would have to take on even more margin debt which, in relation to GDP (or inflation-adjusted, take your pick) is already far higher than what we saw at the peak of the internet bubble.

ALANMARGINDEBTChart from CrossCurrents via CNBC

Fourth, baby boomers would have to, at the very least, maintain their current equity exposure. If this retiring generation decides at some point that they have too much exposure to equities it could create an incredible headwind for the markets. In fact, the San Francisco Fed recently suggested the S&P 500 could finish as low as 1,290 a decade from now, 40% lower than its current level.

Finally, market participants must to continue to have full faith in powers of the Fed to manage not only the stock and bond markets but the economy and the dollar, as well. This is not a given. I believe that the Fed is not as powerful as the markets currently give them credit for being. If stocks began to fall in response to some dislocation in the currency or commodity markets the Fed may be hard-pressed to create a fix. Investors should have learned this lesson in 2008 when the markets essentially ignored every effort on the part of the Fed to reign in the financial crisis.

Ultimately, a number of things have to align nearly perfectly for the stock market to see another 1999-style surge. I do, however, envision one major possible driver of an equity blow-off. Should investors, both foreign and domestic, decide that Europe, Japan and emerging markets are not the best place for their money and that the US is the right place, we could see a continued surge in the dollar and increasing demand for our investment assets.


But what might make them move so dramatically out of those markets? I think the most likely reason would be a dislocation in one or more of them. In that case, which asset class here would most likely benefit? Risk assets, like stocks and high-yield? Or risk-free treasury bonds? I believe investors looking for a safe haven would most likely pick the latter. This is one reason I wrote a couple of months ago that treasury bonds could be about to blast off. They have already risen 10% since then but in this scenario that could be only just the beginning.

As I wrote earlier, I have tremendous respect for these guys who are looking for a “blow off” in stocks. They could very well be proven right, yet again as they have many times during their careers. All in all, however, I think there are a lot of things that need to go exactly right for a “blow off” in stocks to materialize. What’s more likely, in my mind, is that we see a “blow off” in the bond market, something almost nobody expects right now.


The Most Bearish Bear You’ll Find Anywhere: The FED

In a new economic letter recently released by the Federal Reserve Bank of San Francisco (h/t @dvolatility), a pair of researchers forecast a price-to-earnings ratio for the S&P 500 of a mere 8 in the year 2025 (due to retiring baby boomers’ waning risk appetites). This compares to 17 at the end of last year.

Let’s take this prediction out to its fullest conclusion. Assuming 3.8% earnings growth over the next decade (the long-term historical average according to Robert Shiller) we would achieve an earnings number of 156.76 for the S&P 500 in the year 2025.

Applying the 8.23 multiple to those earnings we get a price level of 1290 for the S&P 500. Yesterday the index closed at 2090. Ultimately, this research concludes then that stocks could very well witness a decline of 800 points over the coming decade, or about 40%, as baby boomers retire and shift their portfolios to a more conservative stance.

Have you heard a more dire prediction from ANYONE?