So the bears keep saying we are in overvalued territory and we will see a huge correction soon. On the other hand, we got guys like Dan Loeb really bullish. As usual, there are a lot of smart guys on each side.
This got me thinking a lot about why the bears have got it so wrong for so long (so far... they will eventually be right! I remember (before my time, but I read about it) how Joe Granville, one of the prominent technicians of the 1970's called for a crash in the market with the Dow at 800. He was proven correct; only problem is the market crashed from 2700 to 2200, so it didn't help at all that he was short from 800. Oops.)
What bubble?
One of the first things that come to mind when hearing all this bubble talk is that, to me, the stock market still doesn't feel at all like a bubble. OK, there may be some pockets of excess. But in general, I'm not getting the sense of a bubble. Nobody asks me about stocks. Nobody brags about their stock winnings. I am not reading about people quitting their jobs and playing the market to make a living (one of my biggest dollar wins on the short side ever was when I short Apple a while back when articles about people quitting their jobs and living off of their Apple stock gains started popping up, and they were on TV laughing at the skeptics saying that they 'just don't get it' (I am hearing/reading that now about Bitcoin, though! Japanese housewives, young people doing nothing but trading bitcoin and convinced they will never have to work again).
I don't hear any of that talk relating to the stock market. At all.
Plus, here's the other thing. People keep talking about how great the market has performed in recent years as another sign of a bubble.
But the problem with that, to me, is that a lot of that is just regaining what we lost during the crisis. If a stock tanks 50% and then doubles the next day, is the stock really overbought? I dunno.
Check out this long term chart of the S&P 500 index. I made it a log chart so we don't go, oh my god, it's parabolic! I do believe that parabolic patterns tend to collapse, but it is useless over long time periods.
And ignore the font and background color stuff... I was just playing with Excel, which I haven't used in a long time. But due to various issues (OneDrive being one of them), I have gone back to using Microsoft products and am trying to relearn this stuff. Google sheets is great, but very buggy and frustrating to deal with.
Anyway, if you look at the 1929 bubble, the market went far above it's previous peak. Just eye-balling, the market sort of peaked out at around 10 in 1910 or so, and then rallied to 31 in 1929. That's more than a triple of the old high. Before black monday the S&P 500 rallied to 330 before crashing, and the old high was around 100, so again, the market more than tripled before tanking. During the 1999/2000 bubble, the market went to 1500. If you use the old high of 330, the market rose by 4.5 times. if you use the 1993/1994 area high of 500, the market basically tripled that.
During the Nikkei bubble, the Nikkei rose from 8,000 (the early 1980's high) to 40,000 for a five-bagger in less than a decade. But a five-bagger off the old high, not bear market low.
Where are we now? The previous high was around 1,500 for the S&P, and it's now at close to 2,600. So it hasn't even doubled. And that's a high from 17 years ago. Even using the recent pre-crisis date of 2007, that's more than 10 years.
S&P 500 Index -> 4500!
I am no expert on bubbles, but to me, this is not a bubble. I would call this stock market a bubble if we tripled the old high, or if the S&P went to 4500 or something like that.
Yeah, you heard it hear first. S&P 500 index at 4500. That's what I would call a bubble.
This is sort of consistent with my idea that the market P/E would have to get to 50x for me to be convinced that the market is in bubble territory. You can read my old posts on why that is (based on interest rates. And don't forget, I use what I consider to be 'normalized' interest rates, not current levels).
So, if you ask me, I see no bubble at this point. At all.
Real Fed Funds
The other thing that popped into my head the other day was the comment, "Never short the market with negative real fed funds rate!". For no reason at all, this comment popped into my head and I couldn't get it out. This kept bugging me. The idea made a lot of sense, but I wasn't sure exactly where it came from. Of course, we all know not to "fight the fed", so this is a version of that, I suppose.
So when I got the time, I decided to just plot the real fed funds rate, and below is the chart:
And here's the thing. It seems like in recent history, the market has basically never gone into a serious bear market or crash with the real Fed Funds rate in negative territory. This makes logical sense. A negative FF rate means money is easy, and when money is easy, asset prices tend to go up. Shorting into that, I guess, is like fighting a tsunami with a teaspoon. Why would anyone do that?!
People keep saying that owning stocks at these levels is speculating, not investing. And yet, some of the folks who say that lose money when the market rallies, which means they are short. I don't know about you, but for me, shorting is speculating and has nothing to do whatsoever with investing. People seem not to understand the asymmetric risk/return involved in shorting versus just owning stocks.
Static versus Dynamic Models
Here's the other baffling thing. Much of the world seems still to be stuck in the world of static economic models. If something goes up, they must go down. If an expected return is low, the price must eventually decrease (ignoring the fact that expected return can remain low for a long, long time).
This all reminded me of an old book that confused a lot of conventional thinkers, and I think people who haven't read it should read it. Even now:
The Alchemy of Finance
(for some reason, my Amazon bookstore is dead... oh well. I haven't looked at it in a while and now it's just totally gone. I must have missed an email or two from Amazon (probably thought it was spam and ignored it)).
30 years later, it seems like economists still think the old way and haven't really modernized. I suppose there have been new developments in behavioral economics, but I don't really see much of it when people talk about the market and economy; they all still sound like they did back in the 1980's.
But then again, I guess it doesn't really matter all that much, because most people we see or hear about are asset gatherers and spend most of their time telling people what they want to hear. They don't really care as long as they can gather assets. The ones incorporating new models and making money won't talk about it.
Anyway, I think the Soros book is very timely right now as we probably are in the midst of some sort of virtuous circle. I admit this can't go on forever and things will eventually turn.
But figuring out when it will turn is something nobody will be able to do. If I had to guess, you know what I would say. I already made a case in previous posts that a market P/E of 50x or more would indicate to me a clear and present danger of a serious bubble. And now with the added analysis of a S&P 500 index at 4500 (this is not a forecast or projection!), that to me would also indicate a serious possibility of a bubble.
This Time is NOT Different
The bears always say, "This time is not different. Bulls like to think this time it's different". Well, I dunno. I am not necessarily bullish (I am a market perma-agnostic!), but I too agree that this time is not different.
I believe the market would have to get to bubble levels before we are at risk of a serious bear market. Also, in addition to the market and P/E levels I mention above, I will now also keep an eye on the real Fed Funds rate as the market has never in the past entered a serious bear market or crash with negative FF rates.
So no, this time is not different at all. And if it's not different, we shouldn't see a big bear or crash any time soon (famous last words! I know the market will start to tank right after I hit the "publish" button, but that's OK!).
p.s.
...Oh, and by the way, as I was cleaning out a bunch of spam in the comments section, I accidently deleted a bunch of valid comments. Sorry about that. As you know, I don't delete comments from real commentors, even if they disagree with me, criticize, or whatever...
Thanks for posting. Buffett agrees with you for one of the same reasons - low (real) interest rates.
ReplyDeleteWhat Soros book are you referring to?
ReplyDeletehttps://www.amazon.com/Alchemy-Finance-Reading-Market-1994-05-06/dp/B01A65GK8Y/ref=sr_1_2?ie=UTF8&qid=1510854962&sr=8-2&keywords=alchemy+of+finance
DeleteIt's always nice to see a new post from you. I wonder if there's a psychological element to short selling; (the usually male) fierce desire to "be right" and get plaudits from peers and fans that drives short selling despite its money making potential often being rather capped and it sometimes taking years for the trade to work out? I think Tesla is 90% snake-oil and fantasy and has so far lost billions, but I have no idea when (if ever) the stock will turn, so shorting it seems way too risky with limited upside and so many Kool Aid drinkers talking their book.
ReplyDeletegreat post. bears always seem to talk about how loooong the market has been going up (x axis), and say that based on the length of the recovery/bull market we are destined for a crash.... but it has never been clear to me why it should be the x axis that matters. These same bears seem to simultaneously talk about how shallow the recovery has been (y axis). why should the x axis matter more than the y axis? if the recovery has been shallow, then shouldn't that mean there is more room? i dunno...
ReplyDeleteAnother good post. I look at it through the same lens as that Buffett article in 1982 or so where he says that the market is expensive even below book value. The ROE of the market has continued to be ~12% / decade. So you can do all of the same math. P/B is ~3.15, the index retains earnings at ~4% / year and pays out the rest, so the return (or perhaps more accurately the rough annual gain in intrinsic value) should be ~ .04% + .08/3.15 = 6.5%. That seems roughly fair with st bonds at 1.5%. Maybe a little overvalued but not a bubble. And certainly very expensive if rates go up to 4-5%.
ReplyDeleteBut the other thing that I think you agree with is that doesn't mean that there aren't good investments out there. I think there are certainly things that will return LDD. Kind of like JPM in 2008 where you still would have done well through the cycle.
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ReplyDeleteGreat job, as usual. Would only add the observation that being contrarian or bearish plays to peoples fears. If one is selling news letters, research or commentary supported by advertising, you get more mileage out of the bearishness and sound more intelligent. As usual, its the incentives that drive peoples behavior. In this case the prognosticators market calls or advice. (Hopefully its obvious that I am not referencing this blog in the foregoing)
ReplyDeleteGood points.
ReplyDeleteWhile your Real Fed Funds chart is interesting, there are many other graphs (e.g., Hussman's graphs, CAPE, Q ratio) which would show that every single time the market has been at similar levels, horrible crashes were not too far distant.
ReplyDeleteYes, but the problem I have been pointing out with these posts is that none of those charts reflect interest rates. Asset prices are determined by the present value of all future cash flows, and the above charts (CAPE, Q) don't reflect that at all and ignores it. I think that's why most bears using those types of indicators have been so wrong for so long (I've seen charts like that since the 1980s!).
DeleteI think there is a logical fallacy in your idea that there must be a "bubble" prior to a crash. Let's say the market prices simply outpaced intrinsic value growth by 3% a year for a long period. No "bubble". No parabolic rise. Yet eventually it would collapse of its own weight. Eventually the market realizes valuations matter. Indeed, eventually the market forgets all about valuation ON THE DOWN SIDE, becoming irrationally pessimistic and fearful.
ReplyDeleteActually, I agree with that. That is not exactly what I mean. A bear market can happen at any time for any reason. The financial crisis started, for example, without any of the usual signs of a bubble in the stock market (there was in other areas; real estate, credit etc.).
DeleteBut I only wanted to point out to people who claim that this is a bubble unseen since 1929, 2000, Nikkei 1989, that this is no bubble compared to those periods at all despite the CAPE.
In any case, none of this matters at all to me; I don't use this stuff in my own investing activities. I would if the market was at 50x P/E or some such, in that case, I probably would get very liquid and even load up on puts, etc... (I would act very un-Buffett-like... lol...)
On real fed funds rate...
ReplyDeleteIs this fed funds less CPI YoY? If so I've always had a struggle with fully understanding that.
The same CPI YoY figure is used for overnight money, 1 year money, 5 year, etc. How can that be? Sure it's all annualized, but I don't fully subscribe to that as correct matching.
I don't have an alternative so guess this is the best thing for now.
Oh...and for a post idea what about the demographic effect? I always like to think of economies demographically with a population stack. After all, we are all people and people are the ones making investment decisions (for now, some would say...though not me)
Perfect example is Japan (top heavy) vs. India (bottom heavy). Many more variables come into play, but secular trends can certainly be gleaned from the capital investment decisions of different age brackets in a population. Same thing for U.S. states....the western and southern states have a better population stack and overall growth rate vs. U.S. as a whole.
Just some food for thought.
Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.
ReplyDeleteCapitalstars
Thanks for your post.
ReplyDeleteI would like to know how you refer to the Market Cap/ GDP ratio that right now is 140%?
Hi,
DeleteGood question. I don't really care for that indicator at all. The problem is that interest rates determine asset prices, and when interest rate are low, assets prices are high. Therefore, obviously, P/E ratios will be higher, and the Market Cap/GDP ratio will be higher too. But that doesn't really tell you anything, right? It just indicates that there is a reason why asset prices are high. And if it is because interest rates are low, then it doesn't mean anything.
Then, to prove that the market is overvalued, you either have to prove that the stock market is way to expensive given interest rate levels; this is not true now and has not been true for the last few years, or you have to prove that interest rates are too low.
I sort of proved that interest rates are too low by using the nominal GDP level as a proxy for long term interest rates (history shows that inflation + real GDP growth is a good estimator of long term rates).
And I showed that the market is still undervalued even assuming a normalized interest rate environment.
The market cap/GDP ratio is just a result of all of this and on its own doesn't really show or prove anything.
Also, separately, big firms are increasingly global and that makes this measure more and more irrelevant too. For example, if P&G and Unilever merge, then the market cap/GDP ratio would go up, right? As the new firm would include sales and earnings from overseas. Many companies, like Goldman, had most earnings in the U.S. years ago, but now earns 1/2 overseas. Maybe in terms of revenues. Google too. So this market cap/GDP can be impacted by things like that, which also makes it a not-so-good indicator of anything.
Anyway, that's just the way I look at it.
Thanks for dropping by.
If I go with your line the falling in 2008 could not be expected because the 10 years Treasury Rate in 2007 were 4.7% and the S&P500 yield 5.8% - the ratio between them 1.23 (5.8% / 4.7%) when In November 2018 the ratio is no far and around 1.43. The Realestate problem were the trigger for the 2008 crises.
DeleteIn the other hand with your line I could expected the 2002 crisis because the 10 years Treasury Rate were around 5.7% and the S&P500 around 3.5%, everage in the years before.
So In general there have two situations and in the first case an something exogeny can change the situation and of course we dont know If and what :-).
thanks for your reply.
Yes, there was no stretched rubber band in 2008. The strains were elsewhere, especially in real estate and credit markets.
DeleteThe so-called Fed-model is not perfect. There will be times when markets enter bear markets without valuation issues (like 2008), and bull markets from not-so-depressed levels.
But as an overall sanity-check, and assuming the interest rates are really the gravity or north star of asset valuations, then it's a reasonable indicator as long term historical data seems to show.