Photo Credit: Sacha Chua || Planning is a good thing.
In any investment decisions, one must look at the long term. Don’t pay any attention to news that does not permanently change business conditions.
The thing that drew my attention here is the rather weak coronavirus. Stalin supposedly said, “A single death is a tragedy; a million deaths is a statistic.” My sympathies to the families of those who have died from the coronavirus. But to society as a whole, the coronavirus has done less damage than influenza does every year.
As such, I don’t pay attention to the coronavirus. Stocks are long-term assets, and if the coronavirus will have no impact on the economy past 2025, I don’t see why I need to pay attention to it.
The same applies to politics. Is there someone coming like Chavez or Maduro who will radically reshape business/industry? No? Well, don’t worry so much. Money votes for itself. Few genuinely want to slay the processes that make society well-off in aggregate, even if they are getting a lesser portion of the increase.
In healthy societies, there is a tendency to protect property rights. Property rights are an aspect of human rights, let the liberals note this. We can argue about the edges of the rights, but fundamentally property rights must be protected, or society falls apart.
Now, at present, I am not a bull on the stock markets, but it is not because of any event risk, but rather high valuations. We aren’t at the same valuations that we experienced at the top of the dot-com bubble, but we are in the range of valuations that only existed from 1998-2000. At present the S&P 500 is expecting gains of just 2.24%/year over the next ten years.
Even this is not the long term. Okay, bad returns for ten years, and after that, back to historic norms. Fine, that’s right. But how many will panic in the process of a crash, and not hang on for the long-term?
I think it is worth edging asset allocations toward caution as valuations are so high. We can’t predict when the disaster will happen, but when it does, there will be better opportunities to deploy free cash.
As such, lighten up on risk assets, and prepare for the next drop in the stock market.
Photo Credit: David Lofink || Most things in life have limits, the challenge is knowing where they are
I was at a conference a month ago, and I found myself disagreeing with a presenter who worked for a second tier ETF provider. The topic was something like “Ten trends in asset management for the next ten years.” The thought that ran through my mind was “Every existing trendy idea will continue. These ideas never run into resistance or capacity limits. If some is good, more is better. Typical linear thinking.”
Most permanent trends follow a logistic curve. Some people call it an S-curve. As a trend progresses, there are more people who see the trend, but fewer new people to hop onto the trend. It looks like exponential growth initially, but stops because as Alexander the Great said, “There are no more worlds left to conquer.”
Even then, not every trend goes as far as promoters would think, and sometimes trends reverse. Not everyone cares for a given investment idea, product or service. Some give it up after they have tried it.
These are reasons why I wrote the Problems with Constant Compound Interest series. No tree grows to the sky. Time and chance happen to all men. Thousand year floods happen every 50 years or so, and in clumps. We know a lot less than we think we do when it comes to quantitative finance. Without a doubt, the math is correct — trouble is, it applies to a world a lot more boring than this one.
I have said that the ES portion of ESG is a fad. Yet, it has seemingly been well-accepted, and has supposedly provided excess returns. Some of the historical returns may just be backtest bias. But the realized returns could stem from the voting machine aspect of the market. Those getting there first following ESG analyses pushed up prices. The weighing machine comes later, and if the cash flow yields are insufficient, the excess returns will vaporize.
In this environment, I see three very potent limits that affect the markets. The first one is negative interest rates. There is no good evidence that negative interest rates stimulate economic growth. Ask those in nations with negative interest rates how much it has helped their stock markets. Negative interest rates help the most creditworthy (who don’t borrow much), and governments (which are known for reducing the marginal productivity of capital).
It is more likely that negative rates lead people to save more because they won’t earn anything on their money — ergo, saving acts in an ancient mold — it’s just storage, as I said on my piece On Negative Interest Rates.
Negative interest rates are a good example of what happens you ignore limits — it doesn’t lead to prosperity. It inhibits capital formation.
Another limit is that stock prices have a harder time climbing as they draw closer to the boundary where they discount zero returns for the next ten years. That level for the S&P 500 is around 3840 at present. To match the all time low for future returns, that level would be 4250 at present.
Here’s another few limits to consider. We have a record amount of debt rated BBB. We also have a record amount of debt rated below BBB. Nonfinancial corporations have been the biggest borrowers as far as private entities go since the financial crisis. In 2008, nonfinancial corporations were one of the few areas of strength that the bond markets had.
One rule of thumb that bond managers use if they are unconstrained is that the area of the bond market that will have the worst returns is the one that has grown the most during the most recent bull part of the cycle. To the extent that it is possible, I think it is wise to upgrade corporate creditworthiness now… and that applies to bonds AND stocks.
Of course, the other place where the debt has grown is governments. The financial crisis led them to substitute public for private debt in an effort to stimulate their economies. The question that I wonder about, and still do not have a good answer for is what will happen in a fiat money world to overleveraged governments.
Everything depends on the policies that they pursue. Will the deflate — favoring the rich, or inflate, favoring the poor? No one knows for sure, though the odds should favor the rich over the poor. There is the unfounded bias that the Fed botched it in the Great Depression, but that is the bias of the poor versus the rich. The rich want to see the debt claims honored, and don’t care what happens to anyone else. The Fed did what the rich wanted in the Great Depression. Should you expect anything different now? I don’t.
As such, the limits of government stimulus are becoming evident. The economic recovery since the financial crisis is long and shallow. The rich benefit a lot, and wages hardly rise. Additional debt does not benefit the economy much at all. We should be skeptical of politicians who want to borrow more, which means all of them.
One of the greatest limits that exists is that of defined benefit pension plans vainly trying to outperform the rate that their risky assets are expected to earn. They are way above the level expected for the next ten years, which is less than 3%. Watch the crisis unfold over the next 15 years.
Finally, consider the continued speculation that shorts equity volatility. You would think that after the disaster that happened in 2018 that shorting volatility would have been abandoned, but no. The short volatility trade is back, bigger and badder than ever. Watch out for when it blows up.
Summary
Be ready for the market decline when it comes. It may begin with a blowout with equity volatility, but continue with a retreat from risky stocks that offer low prospective returns.
Photo Credit: Miles Nicholls || Actually, the bells get rung at the top, and quite frequently for the duration of the process. People hear it and they decide not to listen. Too many false alarms.
The stock market model is projecting a 3.06%/year return over the next ten years as of the close on 11/15/2019. That’s near where a 10-year mid-single-A rated bond would trade. That’s not offering a lot of compensation for putting your money at risk.
I’m planning on reducing my total risk level by 15% or so, moving my equity allocation from around 70% to 55%. That will be the lowest it has been in two decades. I’m not running to do this. I am still working out the details.
The Fundamentals of Equity Market Tops
You might recall an old piece of mine that I wrote for RealMoney back in January 2004 — The Fundamentals of Market Tops. In it, I gave a non-technical analysis approach to analyzing whether we might be near a market top. In 2004, I concluded that we were NOT near a market top. (This article also served as a partial template for the article at RealMoney in May 2005, which said that YES we were near a market top for Residential Real Estate. Two good calls.)
The article is longer than most, should not fit in the TL;DR bucket for most investors. I’m not going to reconstruct the article here, but just give some brief points that fit the frame of the article. Here I go:
Value investors have been sidelined. Growth is winning handily.
Valuation-sensitive investors are raising cash. Buffett sitting on $130 billion is quite statement. He’s not alone. More on that below.
Momentum is working.
There has been a decline in IPO quality.
Lots of money is getting attracted to private equity.
Corporate leverage is high, and covenants are weak.
Non-GAAP accounting gets more attention than it deserves.
Defined benefit plans are net sellers of stock, but not for the reasons I posit in my article — they are doing it to move to private equity and alternatives, and bonds as a part of liability-driven investing.
Cutting against my thesis:
More companies are committing to paying dividends, and growing them. I’m impressed with the degree that corporations are thinking through their use of free cash flow, even as they lever up.
Actual volatility isn’t that high.
The Fed is supportive.
On net, these conditions give some confirmation to what my quantitative model is saying… the market is near a top. Could it go higher still? You bet, with an emphasis on the word “bet.” The S&P 500 at 4500 would be where valuations were during the dot-com bubble.
The main idea as applied to the present is this: when you have “strong hands” (those with long time horizons and strong balance sheets) raising cash levels and those with “weak hands” (those with shorter time horizons and weaker balance sheets) staying highly invested in risk assets, it is a situation that is unstable. Those that have capability to “buy and hold” are sitting on their hands, whereas those who have to get returns or they will suffer (typically municipal defined benefit plans and older retail investor who didn’t save enough) are risking a great deal, and have little additional buying power.
This is unstable. This situation typically exists at market tops. Remember, it is what investors DO that is the consensus, not what they SAY.
With that, consider your risk positions, and if you think you should act, do so. If you are uncertain, you could ask an intelligent friend or do half.
Picture Credit: Brian Solis || What is true for a political leader is not the same as for an investor, unless you are an activist or a short seller who publishes
Understanding the consensus in investing is important. During the middle of when an investment idea is succeeding or failing, typically the consensus is correct. At the turning points, the consensus is typically wrong. That is why it is important to try to understand what the consensus is.
Often we listen to or read the news to learn the what current opinion is. In the quotation in the picture above, King was a major molder of the consensus on race relations in America. He knew the situation, and took action to try to change people’s minds, and thus move the consensus to a better place — closer to a colorblind society. We haven’t arrived on that yet; maybe in the generation of my children we will get there. We owe a debt of gratitude to King politically. (Religion was a different matter for King. If you want to read about that, there is an appendix at the bottom.)
Picture credit: tara hunt || Active managers must avoid being consensus thinkers, lest they be expensive indexers
But for investors, reading or listening to the news will not give you the consensus. It will give you opinions, and sometimes the agreeing chatter of opinions may give you the illusion that you know the consensus.
In an election, the consensus is whoever manages to win a majority of votes, whether of people, or their electoral representatives. This is can take place in a simple district, or in the more messy situation of who prime minister will be in a parliamentary system, or even the election of a US President.
But in the markets consensus does not stem from what is said, but rather where money is invested. This is once again the concept of Ben Graham’s voting machine. Thus to understand the consensus, we don’t read the news. Rather, we look at prices, and then try to do some sort of analysis, usually fundamental, to see whether the consensus is right or wrong.
Indexing is the ultimate statement of an investor saying he will just go with the consensus. That’s not a bad idea for many people. Active investing is a statement that you think the consensus is wrong, and that over a reasonable period of time, the consensus will be proven wrong, and you will make good money in the process. But part of that question is whether your investors will hang around long enough for you to be proven right. The other part is that you could be wrong — non-consensus does not mean right. (In my time, I have known more than my share of cranks who held extreme minority positions for a long period, and would rarely admit they were wrong. When they would admit failure, typically, they would blame someone else.)
Now let me give you two large present examples of how the “consensus” in the investment news is not the market consensus:
One frequent thing that I run into both on the web and radio is the argument from many advisors as to how pessimistic investors are today. The correct way to understand this is that because the market is high, many investors are skittish about future commitments. So what is the consensus here? The big investors of the world have and are investing money in the stock market such that prices are high — they discount a low expected future return.
The second example is people who kvetch about low interest rates and say they have nowhere to go but up. I’ve been hearing this off and on since 1987, when my boss said, “Interest rates will never go below 10%.” These arguments are a little dented today, because of the shell-shock stemming from negative interest rates in much of the developed world, but I still read commentators on the web and on the radio saying that interest rates must rise.
But what does the behavior of market participants tell you? It tells you that investors at present are yield-hungry, and that there has been money looking for a home than entities willing to borrow. No promises about the future, but the consensus has been that yields have been attractive to lenders, and that may continue for a while.
Now a hybrid regarding investment consensus and activists and short sellers who publish their opinions to the market in an effort to profit. In the long run, the cash flows will dictate the market movements, but in the short run their words, purchases/sales, and expected purchases/sales implied by their writing will drive prices in the short run.
Articles
Now, I’ve written a series of articles dealing with this topic over the years:
On Contrarianism — ” With markets, it doesn?t matter what people say.? What matters is what they rely upon.” I give several examples for how to possibly generate a correct contrarian (or, non-consensus) opinion.
My 9/11 Experience — A brief telling of what happened to me on 9/11/2001, but focusing on the very non-consensus investment decisions we made immediately after that.
The Ecology of Investment Strategies — ‘ Any investment strategy can be overused.? Part of the job of a portfolio manager is to ask the question ?To what degree am I in or out of the consensus? Where am I in the cycle for my strategy?? ‘ (I wish I had applied that to my deep value investing when the FOMC dropped rates to zero.)
Book Review: The Most Important Thing — Howard Marks as an investor is probably the best explainer of non-consensus investing, which he entitles “second level thinking.” I’m currently reading the book Non-Consensus Investing by Rupal Bhansali. This also seems to be a good book on the topic, and I will likely review it.
But then if you want to hear the same thing from someone who is out of favor right now it would be: Book Review: The Only Three Questions That Count by Ken Fisher. It’s his second question: ” What can you fathom that others find unfathomable?”
Summary
In general, talk is cheap. Money talks louder than human chattering when it comes to the markets. The consensus derives from the investment actions that market players make, not the words they utter.
Appendix (skip if you don’t want to read a brief critique of liberation theology)
Martin Luther King, Jr. was probably the most famous American example of a liberation theologian. Unlike many liberation theologians in Latin America, he was far more moderate in his goals — he sought the end of segregation, not a violent revolution.
Even the verse the liberation theologians so often cite, Jesus saying, “Think not that I have come to bring peace. I have not come to bring peace but a sword,” wasn’t talking about war. It meant that a division would be made between Christians and non-Christians, such that non-Christians would sometimes hate Christians, even if they were family members.
But King’s preaching nonetheless focused on ending a great evil in this life, rather than pointing people to repentance from sin, and faith in Jesus Christ, which would lead to eternal happiness in the life after death.
The Bible does not promise human happiness in this life to Christians, or anyone else for that matter. Christ said believers should not be surprised if they were persecuted, poor, and/or their own families might hate them. He said “I will never leave you nor forsake you.” He would bring comfort in the midst of sorrow.
As the BIble says, “What does it profit a man to gain the whole world, and lose his soul?” (This was my Bloomberg banner message for years.) The liberation theologian offers his hearer a poor deal. “Listen to me, overthrow the wicked government — God is behind you — He will support you in your goal.” Even if they succeed, and those who rebel rarely win, they might be happy for this life, but not eternally.
There are many verses in the Bible that discourage rebellion against the powers that be, but the overarching reason is that God sets rulers in place, even bad ones (see Romans 12). God says, “Vengeance is Mine, I will repay.” As such, it is not for us to take revenge against those who rule us. As it says in the Psalms many times, God will bring judgment on all bad rulers.
That’s my brief argument. I have a lot more to say, but the main thing is this: the Bible focuses on the eternal, not the temporal. It teaches that this short life of ours that ends in death is a test. Would you rather ignore God and enjoy life now, or deny present desires, and aim for heaven? God isn’t looking for perfection, but repentance and faith in Jesus Christ as Lord.
I know that I fail to always do what’s right, but I trust in Christ. Anyway, if you got this far, pray and consider it. Thanks.
Disclosure
If you enter Amazon through my site, and you buy anything, I get a small commission. This is my main source of blog revenue. I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)
Most people buying at Amazon do not enter via a referring website. Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites. Whether you buy at Amazon directly or enter via my site, your prices don?t change.
This should be a short post.? When I like a foreign market because it seems cheap (blood running in the streets), I sometimes buy a small cap ETF or closed-end fund rather than the cheaper large cap version.? Why?
They diversify a US-centric portfolio better.? There are several reasons for that:
a) the large companies of many countries are often concentrated in the industries that the nation specializes in, and are not diversified of themselves
b) the large companies are typically exporters, and the smaller companies are typically not exporters.?Another way to look at it is that you are getting exposure to the local economy with the small caps, versus the global economy for the large caps.
They are often cheaper than the large caps.
Institutional interest in the small caps is smaller.
They have more room to grow.
Less government meddling risk.? Typically not regarded as national treasures.
Now, the disadvantages are they are typically less liquid, and carry higher fees than the large cap funds.? There is an additional countervailing advantage that I think is overlooked in the quest for lower fees: portfolio composition is important.? If an ETF does the job better than another ETF, you should be willing to pay more for it.
At present I have two of these in my portfolios for clients: one for Russia and one for Brazil.? Overall portfolio composition is around 40% foreign stocks 40% US stocks, 15% ultrashort bonds, and 5% cash.? The US market is high, and I am leaning against that in countries where valuations are lower, and growth prospects are on average better.
Full disclosure: long BRF and RSXJ, together comprising about 4-5% of the weight of the portfolios for me and my broad equity clients.? (Our portfolios all have the same composition.)
I use [the phrase] during periods in the markets where normal relationships seem to hold no longer. It is usually a sign that something greater is happening that is ill-understood. ?In the financial crisis, what was not understood was that multiple areas of the financial economy were simultaneously overleveraged.
So what’s weird now?
Most major government running deficits, and racking up huge debts, adding to overall liability promises from entitlements.
Most central banks creating credit in a closed loop that benefits the governments, but few others directly.
Banks mostly in decent shape, but nonfinancial corporations borrowing too much.
Students and middle-to-lower classes borrowing too much (autos, credit cards)
Interest rates and goods and services price inflation stay low in the face of this.
Low volatility (until now)
Much speculative activity in cryptocurrencies (large percentage on a low base) and risk assets like stocks?(smaller percentage on a big base)
Low credit spreads
No one should be surprised by the current market action.? It wasn’t an “if,” but a “when.”? I’m not saying that this is going to spiral out of control, but everyone should understand that?The Little Market that Could?was a weird situation.? Markets are not supposed to go up so steadily, which means something weird was fueling the move.
Lack of volatility gives way to a surfeit of volatility eventually.? It’s like macroeconomic volatility “calmed” by loose monetary and fiscal policy.? It allows people to take too many bad chances, bid up assets, build up leverage, and then “BAM!” — possibility of debt deflation because there is not enough cash flow to service the incurred debts.
Now, we’re not back in 2007-9.? This is different, and likely to be more mild.? The banks are in decent shape.? The dominoes are NOT set up for a major disaster.? Risky asset prices are too high, yes.? There is significant speculation in areas?Where Money Goes to Die.? So long as the banking/debt complex is not threatened, the worst you get is something like the deflation of the dot-com bubble, and at present, I don’t see what it threatened by that aside from cryptocurrencies and the short volatility trade.? Growth stocks may get whacked — they certainly deserve it from a valuation standpoint, but that would merely be a normal bear market, not a cousin of the Great Depression, like 2007-9.
Could this be “the pause that refreshes?”? Yes, after enough pain is delivered to the weak hands that have been chasing the market in search of easy profits quickly.? The lure of free money brings out the worst in many.
You have to wonder when margin debt is high — short-term investors chasing the market, and Warren Buffett, Seth Klarman, and other valuation-sensitive investors with long horizons sitting on piles of cash.? That’s the grand asset-liability mismatch.? Long-term investors sitting on cash, and short-term investors fully invested if not leveraged… a recipe for trouble.? Have you considered these concepts:
Preservation of capital
Dry powder
Not finding opportunities
Momentum gives way to negative arbitrages.
Greater fool theory — “hey, who has slack capital to buy what I own if I need liquidity?”
Going back to where money goes to die, from the less mentioned portion on the short volatility trade:
Again, this is one where people are very used to selling every spike in volatility. ?It has been a winning strategy so far. ?Remember that when enough people do that, the system changes, and it means in a real crisis, volatility will go higher than ever before, and stay higher longer. ?The markets abhor free riders, and disasters tend to occur in such a way that the most dumb money gets gored.
Again, when the big volatility spike hits, remember, I warned you. ?Also, for those playing long on volatility and buying protection on credit default ? this has been a long credit cycle, and may go longer. ?Do you have enough wherewithal to survive a longer bull phase?
To all, I wish you well in investing. ?Just remember that new asset classes that have never been through a ?failure cycle? tend to produce the greatest amounts of panic when they finally fail. ?And, all asset classes eventually go through failure.
So as volatility has spiked, perhaps the free money has proven to be the bait of a mousetrap.? Do you have the flexibility to buy in at better levels?? Should you even touch it if it is like a knockout option?
There are no free lunches.? Get used to that idea.? If a trade looks riskless, beware, the risk may only be building up, and not be nonexistent.
Thus when markets are “weird” and too bullish or bearish, look for the reasons that may be unduly sustaining the situation.? Where is debt building up?? Are there unusual derivative positions building up?? What sort of parties are chasing prices?? Who is resisting the trend?
And, when markets are falling hard, remember that they go down double-speed.? If it’s a lot faster than that, the market is more likely to bounce.? (That might be the case now.)? Slower, and it might keep going.? Fast moves tend to mean-revert, slow moves tend to persist.? Real bear markets have duration and humiliate, making weak holders conclude that will never touch stocks again.
And once they have sold, the panic will end, and growth will begin again when everyone is scared.
That’s the perversity of markets.? They are far more volatile than the economy as a whole, and in the end don’t deliver any more than the economy as a whole, but sucker people into thinking the markets are magical money machines, until what is weird (too good) becomes weird (too bad).
Don’t let this situation be “too bad” for you.? If you are looking at the current situation, and think that you have too much in risk assets for the long-term, sell some down.? Preserving capital is not imprudent, even if the market bounces.
In that vein, my final point is this: size your position in risk assets to the level where you can live with it under bad conditions, and be happy with it under good conditions.? Then when markets get weird, you can smile and bear it.? The most important thing is to stay in the game, not giving in to panic or greed when things get “weird.”
It’s been a while since we last corresponded.??I hope you and your family are well.
Quick investment question. Given the sharp run-up in equities and stretched valuations, how are you positioning your portfolio?
This in a market that seemingly doesn’t?go down, where the risk of being cautious is missing out on big gains.
In my portfolio, I’m carrying extra cash and moving fairly aggressively into gold.?Also, on the fixed income side, I’ve been selling HY [DM: High Yield, aka “Junk”] bonds, shortening duration, and buying floating rate bank loans.
Please let me know your thoughts.
Regards
JJJ
Dear JJJ,
Good to hear from you.? It has been a long time.
Asset allocation is always a marriage between time horizon (when is the money needed for spending?) and expected returns, with some adjustment for risk.? I suspect that you are like me, and play for a longer horizon.
I’m at my lowest equity allocation in 17 years.? I am at 65% in equities.? If the market goes up another 4-5%, I am planning on peeling of 25% of that to go into high quality bonds.? Another 20% will go if the market rises 10% from here.? At present, the S&P 500 offers returns of just 3.4%/year for the next ten years unadjusted for inflation.? That’s at the 95th percentile, and reflects valuations of the dot-com bubble, should we rise that far.
The stocks that I do have are heading in three directions: safer, cyclical and foreign.? I’m at my highest level for foreign stocks, and the companies all have strong balance sheets.? A few are cyclicals, and may benefit if commodities rise.
The only thing that gives me pause regarding dropping my stock percentage is that a lot of “friends” are doing it.? That said, a lot of broad market and growth investors are making “new era” arguments.? That gives me more comfort about this.? Even if the FAANG stocks continue to do well, it does not mean that stocks as a whole will do well.? The overall productivity of risk assets is not rising.? People are looking through the rearview mirror, not the windshield, at asset returns.
I can endorse some gold, even though it does nothing.? Nothing would have been a good posture back in the dot-com bubble, or the financial crisis.? Commodities are undervalued at present.? I can also endorse long Treasuries, because I am not certain that inflation will run in this environment.? When economies are heavily indebted they tend not to inflate, except as a last resort.? (The wealthy want to protect their claims against the economy.? The Fed generally helps the wealthy.? Those on the FOMC are all wealthy.)
I also hold more cash than normal.? The three of them, gold, cash and long Treasury bonds form a good hedge together against most bad situations.
The banks are in good shape, so the coming troubles should not be as great as during the financial crisis, as long as nothing bizarre is going on in the repo markets.
That said, I would be careful about bank debt.? Be careful about the covenants on the bank debt; it is not as safe as it once was.? I don’t own any now.
Aside from that, I think you are on the right track.? The most important question is how much you have invested in risk assets.? Prudent investors should be heading lower as the market rises.? It is either not a new era, or, it is always a new era.? Build up your supply of safe assets.? That is the main idea.? Preserve capital for another day when risk assets offer better opportunities.
Thanks for writing.? If you ever make it to Charm City or Babylon, let me know, and we can have lunch together.
Credit: Roadsidepictures from The Little Engine That Could By Watty Piper Illustrated By George & Doris Hauman c. 1954
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I wish I could have found a picture of Woodstock with a sign that said “We’re #1!”? Snoopy trails behind carrying a football, grinning and thinking “In this corner of the backyard.”
That’s how I feel regarding all of the attention that has been paid to the S&P being up every month in 2017, and every month for the last 14 months.? These have never happened before.
There’s a first time for everything, but I feel that these records are more akin to the people who do work for the sports channels scaring up odd statistical facts about players, teams, games, etc.? “Hey Bob, did you know that the Smoggers haven’t converted a 4th and 2 situation against the Robbers since 1998?”
Let me explain.? A month is around 21 trading days.? There is some variation around that, but on average, years tend to have 252 trading days.? 252 divided by 12 is 21.? You would think in a year like 2017 that it must? have spent the most time where 21-day periods had positive returns, as it did over each month.
Since 1950, 2017 would have come in fourth on that measure, behind 1954, 1958 and 1995.? Thus in one sense it was an accident that 2017 had positive returns each month versus years that had more positive returns over every 21 day period.
How about streaks of days where the 21-day trialing total return never dropped below zero (since 1950)?? By that measure, 2017 would have tied for tenth place with 2003, and beaten by the years 1958-9, 1995, 1961, 1971, 1964, 1980, 1972, 1965, and 1963.? (Note: quite a reminder of how bullish the late 1950s, 1960s and early 1970s were.? Go-go indeed.)
Let’s look at one more — total return over the whole year.? Now 2017 ranks 23rd out of 68 years with a total return of 21.8%.? That’s really good, don’t get me wrong, but it won’t deserve a mention in a book like “It Was a Very Good Year.”? That’s more than double the normal return, which means you’ll have give returns back in the future. 😉
So, how do I characterize 2017?? I call it?The Little Market that Could.? Why?? Few drawdowns, low implied volatility, and skepticism that gave way to uncritical belief.? Just as we have lost touch with the idea that government deficits and debts matter, so we have lost touch with the idea that valuation matters.
When I talk to professionals (and some amateurs) about the valuation model that I use for the market, increasingly I get pushback, suggesting that we are in a new era, and that my model might have been good for an era prior to our present technological innovations.? I simply respond by saying “The buying power has to come from somewhere.? Our stock market does not do well when risk assets are valued at 40%+ of the share of assets, and there have been significant technological shifts over my analysis period beginning in 1945, many rivaling the internet.”? (Every era idolizes its changes.? It is always a “new era.”? It is never a “new era.”)
If you are asking me about the short-term, I think the direction is up, but I am edgy about that.? Forecast ten year returns are below 3.75%/year not adjusted for inflation.? Just a guess on my part, but I think all of the people who are making money off of low volatility are feeding the calm in the short-run, while building up a whiplash in the intermediate term.
Time will tell.? It usually does, given enough time.? In the intermediate-term, it is tough to tell signal from noise.? I am at my maximum cash for my equity strategy accounts — I think that is a prudent place to be amid the high valuations that we face today.? Remember, once the surprise comes, and companies scramble to find financing, it is too late to make adjustments for market risk.
Another quarter goes by, the market rises further, and the the 10-year forward return falls again.? Here are the last eight values:?6.10%, 6.74%, 6.30%, 6.01%, 5.02%, 4.79%, and 4.30%, 3.99%. ?At the end of September 2017, the figure would have been 4.49%, but the rally since the end of the quarter shaves future returns down to 3.99%.
At the end of June the figure was 4.58%.? Subtract 29 basis points for the total return, and add back 12 basis points for mean reversion, and that would leave us at 4.41%.? The result for September month-end was 4.49%, so the re-estimation of the model added 8 basis points to 10-year forward returns.
Let me explain the adjustment calculations.? In-between quarterly readings, price movements shave future returns the same as a ten-year zero coupon bond.? Thus, a +2.9% move in the total return shaves roughly 29 basis points off future returns. (Dividing by 10 is close enough for government work, but I use a geometric calculation.)
The mean-reversion calculation is a little more complex.? I use a 10-year horizon because that is the horizon the fits the data best.? It is also the one I used before I tested it.? Accidents happen.? Though I haven’t talked about it before, this model could be used to provide shorter-run estimates of the market as well — but the error bounds around the shorter estimates would be big enough to make the model useless. It is enough to remember that when a market is at high valuations that corrections can’t be predicted as to time of occurrence, but when the retreat happens, it will be calamitous, and not orderly.
Beyond 10-years, though, the model has no opinion.? It is as if it says, past mean returns will occur.? So, if we have an expectation of a 4.58% returns, we have one 4.58%/yr quarter drop of at the end of the quarter, and a 9.5% quarter added on at the end of the 10-year period. That changes the quarterly average return up by 4.92%/40, or 12.3 basis points.? That is the mean reversion effect.
Going Forward
Thus, expected inflation-unadjusted returns on the S&P 500 are roughly 3.99% over the next ten years.? That’s not a lot of compensation for risk versus investment-grade bonds.? We are at the 94th percentile of valuations.
Now could we go higher?? Sure, the momentum is with us, and the volatility trade reinforces the rise for now.? Bitcoin is an example that shows that there is too much excess cash sloshing around to push up the prices of assets generally, and especially those with no intrinsic value, like Bitcoin and other cryptocurrencies.
Beyond that, there are not a lot of glaring factors pushing speculation, leaving aside futile government efforts to stimulate an already over-leveraged economy.? It’s not as if consumer or producer behavior is perfectly clean, but the US Government is the most profligate actor of all.
And so I say, keep the rally hats on.? I will be looking to hedge around an S&P 500 level of 2900 at present.? I will be watching the FOMC, as they may try to invert the yield curve again, and crash things.? They never learn… far better to stop and wait than make things happen too fast.? But they are omnipotent fools.? Maybe Powell will show some non-economist intelligence and wait once the yield curve gets to a small positive slope.
Who can tell?? ?Well, let’s see how this grand experiment goes as Baby Boomers arrive at the stock market too late to save for retirement, but just in time to put in the top of the equity market.? Though I am waiting until S&P 2900 to hedge, I am still carrying 19% cash in my equity portfolios, so I am bearish here except in the short-run.
PS — think of it this way: it should not have gone this high, therefore it could go higher still…
Don’t look at the left side of the chart on an empty stomach
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This will be a short post.? At present the expected 10-year rate of total return on the S&P 500 is around 4.05%/year.? We’re at the 94th percentile now.? The ovals on the graph above are 68% and 95% confidence intervals on what the actual return might be.? Truly, they should be two vertical lines, but this makes it easier to see.? One standard deviation is roughly equal to two percent.
But, at the left hand side of the graph, things get decidedly non-normal.? After the model gets to 2.5% projected returns, presently around 3100 on the S&P 500, returns in the past have been messy.? Of course, those were the periods from 1998-2000 to 2008-2010.? But aside from one stray period starting in 1968, that is the only time we have gotten to valuations like this.
My last piece hinted at this, but I want to make this a little plainer.? For sound effects while reading this, you could get your children or grandchildren to murmur behind you “We know it can’t. We know it can’t.” while you consider whether the market can deliver total returns of 7%/year over the next 10 years.
There are few if any things that remain permanently valid insights of finance.? Anything, even good strategies, can be overdone.? Even stable companies can be overlevered, until they are no longer stable.
In this case, it is buying the dips, buying a value-weighted cross section of the market, and putting your asset allocation on autopilot.? Set it and forget it.? Add in companies always using spare capital to buy back shares, and maxing out debts to fit the liberal edge of your preferred rating profile.
These have been good ideas for the past, but are likely to bite in the future.? Value is undervalued, safety is undervalued, and the US is overvalued.? A happy quiet momentum has brought us here, and for the most part it has been calm, not wild.? Individually prudent actions that have paid off in the past are likely to prove imprudent within three years, particularly if the S&P 500 rises 10-15% more in the next year.
People have bought into the idea that market timing never matters.? I agree with the idea that it usually doesn’t matter, and that it is usually is a fool’s game to time the market.? That changes when the 10-year forward forecast of market returns gets low, say, around 3%/year.
Remember, the market goes down double-speed.? Just because the 10-year returns don’t lose much, doesn’t mean that there might not be better opportunities 3-5 years out, when the market might offer returns of 6%/year or higher.
Also, remember that my data set begins in 1945.? I wish I had the values for the 1920s, because I expect they would be even further to the left, off the current graph, and well below the bottom of it.
This isn’t the most nuts that things can be.? In fact, it is very peaceful and steady — the cumulative effect of many rational decisions based off of what would have worked best in the past, in the short-run.
As a result, I am looking 10 years into the future, and slowly scaling back my risks as a result.? If the market moves higher, that will pick up speed.
