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I’m Hearing A Lot Of Smart People Use “The Four Most Dangerous Words In Investing” These Days

Let me begin this post by saying that the three sources I quote here are among the handful of voices on social media and the financial blogosphere I respect most. This is also why I’m especially concerned about this new trend.

What worries me is that I’m now hearing the “four most dangerous words in investing” from some of the smartest guys in the game. Each of the arguments I’m going to look at represent some version of “it’s different this time” in relation to overall stock market valuation.

I’ve made the case for months now that stocks are extremely overvalued. In fact, I believe there is a very good case to be made that while we may not have another full-fledged tech bubble on our hands, the broader stock market is just as overvalued today as it was fifteen years ago, at the peak of the internet bubble.

To counter or to justify this idea, some very smart people have gotten very creative. First, Alpha Architect recently ran a post on valuations determining that, “the stock market isn’t extremely overvalued.” It’s “normalish.”

However, and they do acknowledge this in the post, they are looking at today’s valuations in relation to the history of just the past 25 years. The problem with this is that the past 25 years represent the highest valuations in the history of the stock market so, obviously, today’s valuations will look much more reasonable when framed in that light.

In acknowledging the limitation of using just the past 25 years, however, the author of the post questions whether, “market conditions 100+ years ago may be different than they are today.” In other words, ‘it’s different this time’ so those historical measures are no longer be relevant. To their credit, they recognize, “this sounds a bit like the ‘new valuation paradigm’ thinking that prevailed during the dotcom boom when valuations went crazy.” Still, they are putting it out there for less circumspect investors to rely upon.

Similarly, my friend Jesse Livermore of Philosophical Economics recently posited in a terrific piece that there are very good reasons justifying the persistent high valuations of the past 25 years.

Should the market be expensive?  “Should” is not an appropriate word to use in markets.  What matters is that there are secular, sustainable forces behind the market’s expensiveness–to name a few: low real interest rates, a lack of alternative investment opportunities (TINA), aggressive policymaker support, and improved market efficiency yielding a reduced equity risk premium (difference between equity returns and fixed income returns).  Unlike in prior eras of history, the secret of “stocks for the long run” is now well known–thoroughly studied by academics all over the world, and seared into the brain of every investor that sets foot on Wall Street.  For this reason, absent extreme levels of cyclically-induced fear, investors simply aren’t going to foolishly sell equities at bargain prices when there’s nowhere else to go–as they did, for example, in the 1940s and 1950s, when they had limited history and limited studied knowledge on which to rely.

My problem with this line of thought is that it assumes that human beings have essentially begun to outgrow the behavioral biases that have ruled them throughout a history that encompasses much longer than just the past century. We have seen “low real interest rates” and “aggressive policymaker support” in the past. See Ray Dalio’s excellent letter on 1937 as an analog for today’s economy and markets. So this argument really hinges upon, “the secret of ‘stocks for the long run’ is now… seared into the brain of every investor…. For this reason… investors simply aren’t going to foolishly sell equities at bargain prices when there’s nowhere else to go.”

In other words, we have entered a new era where human beings have fully embraced “stocks for the long run” for the long run and without reservation so cycles will be muted and valuations remain elevated for the foreseeable future. Never mind the fact that the recent history of the financial crisis may contradict this idea. I think the burden of proof for this argument lies squarely with its author. I have my doubts. In fact, this sounds strangely similar to Irving Fisher’s famous line just days before the 1929 crash, “stock prices have reached what looks like a permanently high plateau.”

Finally, Alex Gurevich wrote a fascinating think piece over the weekend on the Fed, the economy and how they relate to stocks and bonds. While I truly appreciate following Alex’s thought process (as I do both of the previous authors’), it’s his case for owning stocks that strikes me as a clear rationalization of extreme valuations:

Singularitarians (such as Ray Kurzweil)  believe that we are on the brink of explosive self-acceleration led by computers designing better computers, which design better computers even faster, and rapidly surpassing every aspect of human intelligence. Singularitarian philosophy is migrating out of the province of science fiction writers into the  mainstream, and can no longer be ignored by long horizon investors… The idea of economic singularity allows me have a clear and consistent theory of unfolding events. I can be positive on stock market without being scared of valuations.

I don’t dispute the awesome idea of singularity. It seems inevitable and inevitably beneficial for society (though some very smart people would disagree). What I dispute is the idea that singularity should justify high valuations.

As I tweeted this morning, it reminds my of Warren Buffett and Charlie Munger on the awesome innovation of air conditioning and air travel. These things were miracle innovations that dramatically improved the lives of human beings but did they justify abandoning tried and true investment methods developed over long periods of history? In retrospect, the answer is obvious. Amazing innovation is truly inspiring but it shouldn’t inspire you to overpay for a simple stream of future cash flows that have been very easy to value accurately over very long periods of time.

Ultimately, only time will tell if it is, in fact, “different this time” or if history will rhyme once again and today will only represent another stanza in the poem it’s been writing for centuries. With all due respect to these three very wise market philosophers, my money is on the latter.

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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.

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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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I Have One Question For Warren Buffett At The Next Berkshire Meeting

I’ve been dying to ask this question of Mr. Buffett for the past few months. After reading his 50th annual letter to Berkshire Hathaway shareholders over the weekend I submitted it to Carol Loomis in hopes she would ask it at the upcoming shareholders meeting:

In November 1999 in Fortune magazine you wrote that you believed the coming decade couldn’t possibly witness returns in the stock market similar to those of the prior decade. That forecast proved very prescient as it preceded what is now called the “lost decade.” Considering the fact that stocks are just as highly valued today as they were then, in terms of your market cap-to-GNP valuation yardstick, do you feel the same about the coming decade for the stock market as you did then? If not, why?

Fingers crossed.

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“The Wisdom Of Insecurity” In The Stock Market

Over the past few years, the idea of “passive investing” has increasingly resonated with the general public. Money has rushed out of actively-managed mutual funds and into index funds at a rapid rate. Most recently, the passive investing ethos has grown so strong it now reminds me of some hard-core religions that take an unwaveringly literal interpretation of their founding texts.

In the case of passive investing, these founding texts are the “efficient-market hypothesis” (EMH) and “modern portfolio theory” (MPT). Created and developed by ingenious men with noble intentions, these theories put forth wonderful arguments for the wisdom of the crowd and the incredible value of diversification, among others.

Like most religious texts, however, the main problems arise in their interpretation and implementation. As Alan W. Watts explains in The Wisdom Of Insecurity, “the common error of ordinary religious practice is to mistake the symbol for reality, to look at the finger pointing the way and then to suck it for comfort rather than follow it.” Investors, too, must think critically about the effectiveness of these theories when it comes to practical application rather than take them literally on blind faith.

It pays to remember that blind faith in these sorts of mathematical models leads even nobel prize winners to disastrous results. As my friend Todd Harrison likes to say, “respect the price action but never defer to it.” Clearly, there is value in understanding and incorporating the ideals of these theories. There is also danger in simply deferring to them because the costs of their shortcomings can, at times, overwhelm the benefits of their wisdom. Like the Long-Term Capital boys learned, as soon as you really need to lean on them they vanish like a cheap magic trick.

Where these theories go wrong in their practical application is that they both assume there are only rational participants in the markets. While the crowd may be right most of the time, there are clearly times when the crowd is not rational (note the preponderance of manias throughout the history of finance). In fact, the proprietors of these models have acknowledged this Achilles’ heel themselves.

The most successful professional investors like Warren Buffett, Paul Tudor Jones, John Templeton, George Soros and Jim Rogers, know this well. Their methodologies are even built upon the idea that an intelligent investor can get ahead by taking advantage of those times the crowd becomes irrational, the antithesis of the EMH and MPT.

So saying you believe in passive investing is fine and, in fact, I’ll grant it’s better than most of the alternatives. It will work great most of the time. But know that, just like some fanatics deny evidence that disproves the idea that cavemen and dinosaurs coexisted, you are denying the overwhelming evidence that suggests its foundations are simply not to be relied upon during those rare times when market participants abandon rational thought for panic or euphoria.

Make no mistake, those selling this idea of passive investing are selling a very good product. I firmly believe it’s a large step above most of the alternatives out there, more so in the case of those selling it at a minimal cost. But I fear investors are also being sold a false sense of security today.

I believe investors passively buying equities today are doing so under one of two false assumptions. They either believe that future returns will look something like they have over the past 40 years or that because the market is totally efficient it’s currently priced to deliver risk-adjusted returns that are acceptable given the current low-yield environment.

The first assumption is something I have called the “single greatest mistake investors make” and it’s a trap even the Federal Reserve admits it regularly falls into. The second assumption runs into the problem of the evidence which suggests there is a very good likelihood returns from current prices will be sub-par, if not sub-zero over the next decade.

And the reason returns are likely to be poor going forward is investors have pushed prices to levels that nearly guarantee it. In my view, passive investors have irrationally relied upon the idea that the market is rational, and therefore attractively priced, in pouring money into equity index funds, sending equity values to heights never before seen (on median valuations) virtually guaranteeing themselves they’ll be disappointed.

Just because the future of the stock market is bleak doesn’t mean investors should ignore these facts or have them withheld from them. Ignorance may be bliss but it is not a valid investment methodology. Those with a religious sort of belief in passive investing and its main tenets need not abandon it to acknowledge its limitations. In fact, a little insecurity would go a long way for the growing hoard of passive investors in today’s market.

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Here’s Why Investors Are Now Facing Another “Lost Decade” In The Stock Market

In my last piece, I wrote that stock market valuations are currently at the same level they were when Warren Buffett, in November 1999, wrote his famous op-ed for Fortune magazine explaining that investors would inevitably be disappointed by returns over the coming decade. The stock market actually declined 30% over the following 10 years. “Disappointed” was actually an understatement as investors were downright despondent (which set up a wonderful opportunity to be greedy).

In fact, when looking at median valuations in today’s market, stocks are even more overvalued than they were at the peak of the internet bubble, some 3 or 4 months after Buffett’s piece was published. Considering valuations are roughly equivalent, or even worse than back then, what are the odds that we see another “lost decade”?

This is actually fairly easy to answer. The valuation indicator we looked at in the last post, total stock market capitalization in relation to Gross National Product, has actually been 83% negatively correlated to future 10-year returns dating back to 1950 (high valuations mean low forward returns and vice versa). Based on this correlation, this measurement of valuations, Buffett’s favorite, currently forecasts an annual return over the coming decade of about -0.88%. Yes, that’s losing almost 1% per year over the next decade – the very definition of a lost decade, even if it’s not quite as bad as the 1999-2009 period.

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Now there certainly is a possibility that stocks do significantly better than that dour forecast but it’s not very likely, at least not from a historically-informed perspective. (I should note here that other measures that are very highly correlated to future returns essentially agree with this one, as well.) This is why some of the most respected firms in the world, like GMO and Bridgewater, are informing clients of this very same fact.

And if I were forced to take the over/under on a 0% forecast over the next decade I would take the “under” for one simple but significant reason. The decade following Buffett’s op-ed saw stocks decline 30% but the Fed recently published research suggesting the decline from today’s level could be even greater than that simply due to demographics. Their study implied a decline of closer to 40% was very possible, if not probable.

The thesis suggests that equity valuations will be under pressure until 2025 as baby boomers age and reduce exposure to risk assets. Intuitively, this makes sense. During their peak earning years, the baby boomers poured money into the stock market driving the greatest equity bubble in history. As they now enter their later years the demand for equities, or lack their of, from this generation could have the opposite effect.

A chart from Ned Davis, in his terrific book “Being Right Or Making Money,” shows that this is not just theory. The chart below plots equities alongside births in the United States shifted forward 46 years (to the beginning of peak earning age). Clearly, over the long-term, equities benefit or suffer based simply on the general demand from the relative size of a given generation. Demand, as evidenced by births, has been waning since 2005. Another plunge in births begins right about now and looks to bottom sometime after 2020 before picking up again in 2025.

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At best, equity returns over the coming decade will simply reflect earnings growth, assuming valuations can remain elevated. Historically, this has averaged about 3.8% over time. At worst, valuations will revert to an undervalued state and stocks will decline about 40% or more, as the Fed study suggests. Either way, the odds for another “lost decade” in the stock market are far higher than most people currently believe.

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