When the long-always crowd starts switching around their seats (on the equity titanic), it is historically a sign that the great risk-rotation has finally arrived in earnest. The below portrait of the small cap Russell 2000 Index divided by the S&P 500 Index since 2002, nicely maps out the cyclical recovery for risk assets from 2003 to 2007, the cyclical bear of 2007 to 2009, the cyclical recovery of 2009 to 2013 and the break down once more, year to date (similar to 2007).
Also shown is where this risk ratio was rolling over in the late fall of 2012 before “whatever it takes” promises of Q’Ever from Central Banks prodded yet one more speculative leg in stocks to 2014. Since January, QE hope appears to be losing the battle in the stand-off with ugly valuation reality.
Lest one is distracted by the media parade banners this morning of a “robust” official first guesstimate of US Q2 GDP at 4%, it is important to appreciate that following
-2.9% today revised to -2.1% annualized growth in Q1 (following a handy redefinition of how GDP is now calculated), this “big beat” for Q2 amounts to annualized growth in the first half of 2014 at a 1.1% 1.9% rate (on a rather alarming build in inventory produced but not sold–and likely to detract from Q3 orders as a result). And as always, there will be several more revisions coming to the first guesstimate before the number is firmed, and historically these revisions are lower not higher. So growth less than 2% in the first half with stocks in a select group of all time high valuations alongside 1929, 2000 and 2007. Good to know.
A smile this morning courtesy of one of my favorite Irish cousins:
A woman was flying from Melbourne to Brisbane …Unexpectedly, the plane was diverted to Sydney. The flight attendant explained that there would be a delay, and if the passengers wanted to get off the aircraft the plane would re-board in 50 minutes.
Everybody got off the plane except one lady who was blind. A man had noticed her as he walked by and could tell the lady was blind because her Seeing Eye Dog lay quietly underneath the seats in front of her throughout the entire flight. He could also tell she had flown this very flight before because the pilot approached her, and calling her by name, said, ‘Kathy, we are in Sydney for almost an hour. Would you like to get off and stretch your legs?’ The blind lady replied, ‘No thanks, but maybe Max would Like to stretch his legs.’
All the people in the gate area came to a complete standstill when they looked up and saw the pilot walk off the plane with a Seeing Eye dog. The pilot was even wearing sunglasses.
People scattered. They not only tried to change planes, but they were trying to change airlines! True story…
Remember……things are not always what they seem and a day without laughter is a day wasted.
Stock floggers like to talk about how dividend yields are “attractive” today relative to cash and bonds. Except that in their imaginary world, capital risk in equities is always “contained” to fleeting “corrections of 5 to 10%” that always bounce back quickly. Sure.
In reality, the inconvenient byproduct of stock prices at the very top end of historic valuation ranges is that dividend yields are also necessarily at the very bottom end of historical ranges (the S&P 500 today is yielding less than 2%). And the larger routinely glossed over point here–not to be missed–is that stocks have no face value, no maturity date, no contractually prescribed income rate and absolutely no collateral assurances in the event of the issuer’s insolvency.
Not surprising then that as stocks have soared farther and farther away from reasonable reward for the risk prospects, international flows have been steadily moving out of emerging markets and high risk bets into the relative safety, maturity and contractually prescribed coupon payments of government bonds. In particular North American government bonds, which as we mentioned here a couple of weeks ago offer the highest yields of the 11 largest, most liquid, bond markets in the world today.
With global instability mounting and the US dollar in relative favor, the US 10-year is now revisiting support in the 2.4% range, and lower North American yields appear the path of least resistance over the next several months.
Waiting for the inevitable mean reversion of this epic Fed-led speculative episode can feel tedious (if we let it). Seeing familiar false prophets (who have already been revealed as unworthy leaders several times over the past 15 years), paraded like heroes is emblematic of foolish times. But the payoff for those with patience and the discipline of a value-based rule set promises to be one for the history books.
Given the conditions we are presented with, each adult must pick their own strategy, and run this race his or her own way.
But we should make no mistake–this is no sprint. Secular bears are a long, hilly marathon–the triumph of endurance over speed, mind over ego.
Carter Worth, chief market technician at Sterne Agee, says that despite what the U.S. market cap may suggest, small and mid-size groups are “starting to falter”.Here is a direct video link.
Yes Virginia, don’t let the salesmen assure you otherwise, we have a massive equity bubble on our hands today. Govern your savings accordingly. See John Hussman’s excellent weekly: Yes, this is an equity bubble, for some simple facts on today’s flashing red risk warnings:
“My sense is that investors have indeed abandoned basic arithmetic here, and are instead engaging in a sort of loose thinking called “hyperbolic discounting” – the willingness to impatiently accept very small payoffs today in preference to larger rewards that could otherwise be obtained by being patient. While a number of studies have demonstrated that hyperbolic discounting is often a good description of how human beings behave in many situations, it invariably results in terrible investment decisions, particularly for long-term investors. As one economist put it, “they make choices today that their future self would prefer not to have made.” In effect, zero interest rates have made investors willing to accept any risk, no matter how extreme, in order to avoid the discomfort of getting nothing in the moment…
Make no mistake – this is an equity bubble, and a highly advanced one. On the most historically reliable measures, it is easily beyond 1972 and 1987, beyond 1929 and 2007, and is now within about 15% of the 2000 extreme.
The main difference between the current episode and that of 2000 is that the 2000 bubble was strikingly obvious in technology, whereas the present one is diffused across all sectors in a way that makes valuations for most stocks actually worse than in 2000. The median price/revenue ratio of S&P 500 components is already far above the 2000 level, and the average across S&P 500 components is nearly the same as in 2000. The extent of this bubble is also partially obscured by record high profit margins that make P/E ratios on single-year measures seem less extreme (though the forward operating P/E of the S&P 500 is already beyond its 2007 peak even without accounting for margins)…
Remember how these things unwound after 1929 (even before the add-on policy mistakes that created the Depression), 1972, 1987, 2000 and 2007 – all market peaks that uniquely shared the same extreme overvalued, overbought, overbullish syndromes that have been sustained even longer in the present half-cycle. These speculative episodes don’t unwind slowly once risk perceptions change. The shift in risk perceptions is often accompanied by deteriorating market internals and widening credit spreads slightly before the major indices are in full retreat, but not always. Sometimes the shift comes in response to an unexpected shock, and other times for no apparent reason at all. Ultimately though, investors treat risky assets as risky assets. At that point, investors become increasingly eager to hold truly risk-free securities regardless of their yield. That’s when the music stops.”
North American investment grade bond prices have rallied strongly this month, even as stocks have levitated on 3
guys computers trading. The benchmark US 10 year Treasury is nearing the next downside test at 2.4%.
Meanwhile other key risk-on bets (that are typically correlated with equity prices) like high yield bonds below and the Canadian dollar (bottom chart) have not been feelin’ the love.
The rabid risk trade–at the highest valuations since 2000–seems to be getting a little confused as we head toward the
Autumn fall. Oh well, wild-eyed speculators never get it all their way forever.
I have long appreciated Ed Easterling’s excellent and detailed historical data, some of which can be seen at Crestmont Research. At the end of June he updated the valuation measurements for the S&P 500 and notes that while stocks gained 5% in the second quarter, normalized earnings increased just 1% over the same period.
In fact over the past 24 months, 80% of the gains in stock prices have been driven by the willingness of buyers to pay a higher and higher premium for each dollar of expected earnings. At the end of June that premium had ballooned to more than 26 times 10 year average earnings and nearly 19 times consensus forward expected earnings. Easterling reminds us:
“historically (and based upon well-accepted financial and economic principles), the valuation level of the stock market has cycled from levels below 10 times earnings to levels above 20 times earnings. Except for bubble periods, the P/E tends to peak near 25…
The peak for P/E generally occurs at very low and stable rates of inflation. When inflation falls into deflation, earnings
(the denominator for P/E) begins to decline on a reported basis (deflation is the nominal decline in prices). At that point, with future earnings expected to decline from deflation, the value of stocks declines in response to reduced future earnings—thus, P/Es also decline under deflation.”
He also stresses that secular bears (where PEs mean revert from above 25 to below 10 again) are measured in distance not time.
They either get to the end zone via a period of sharp, steep declines from here (as in -55ish total return over the next 5 years, or -45ish total return over the next 7, or -26ish over the the next decade–want to see the Sharpe ratio on any of these outcomes?), or through a long, slow slog sideways of 2% nominal total returns annually over the next 20 years as earnings move up and prices stay flat long enough for PEs to finally grind lower. Pick your poison (aka strategy) accordingly.
In any of these outcomes, it requires suspension of reason to justify holdings stocks at present valuations and call them “investments”. See: The PE Report.
Investment grade bond yields have been falling in tandem with global growth forecasts over the past 7 months again, leaving the consensus, who are expecting a pick up in inflation, on the wrong side of the trade.
This segment offers a good summary of some of the reasons that present inflation expectations are likely to continue to over-estimate as demand and growth continue to slow. Here is a direct video link.
The largest factor not mentioned in the clip however, is debt. Debt is future consumption denied, and the world has tried to borrow its way out of the debt crisis of 2007-08 by adding on trillions and trillions of more debt every year since. The weight of this debt at all levels of the economy now from households to governments and large cap business has left a large hole in potential demand over the next few years. This means, slower growth and disinflation, not to mention necessary deflation in financial assets as markets finally recouple with the reality that the world economy is driven by customers not central bankers.
Danielle was guest today with Kerry Lutz on The Financial Survival Network talking about recent trends in the world economy and markets. You can listen to an audio clip of the segment here.
It was one thing when the world was in love with high tech shares in 2000 or with US banks, home-builders and construction materials in 2007. Those were extremely dangerous times to be sure and many oblivious and greedy “investors” deservedly learned brutal lessons of loss. But seniors and risk averse people still had a reasonable investment option back then. Interest rates at both of these prior market peaks were still within the normal range and savers could still earn 5% in guaranteed bank deposits and investment grade bonds without facing high risk of loss.
Today cash rates are less than 2% and even locking into 20 or 30 year government bonds will earn less than 2.7% interest. The madness of zero-interest rate central bank policies the past 5 years, has increasingly corralled gullible throngs into the arms of investment “advisers” who have sold them over-valued bank shares, sector ETFs and mutual funds at the most extreme valuations seen to date (see chart below of the Canadian bank index ETF).
Since these “conservative, dividend-paying” bank shares lost 50% in both of the last down cycles, the carnage this time threatens to be even deeper and more wide spread than in 2001-02 or 2008-09. Only this time, victims will be even more exposed, that much older and less able to recover or make ends meet.
We rented this film on iTunes last night. It is one of the most entertaining and thought-provoking works I have seen in a while. Film maker Margarethe von Trotta made some brilliant choices in telling this story of the real life events that found German philosopher and writer Hannah Arendt reporting for the The New Yorker on the war crimes trial of Nazi Adolf Eichmann. The real life footage of Eichmann’s testimony is skillfully interwoven into this narrative focused on friendship, love and thought.
This film examines the thinking and rationalizations after World War II rather than the war crimes themselves. As a concentration camp survivor and world-renowned political theorist, Arendt begins her attendance and coverage of Eichmann’s trial looking for understanding of human behavior. In the process she finds not the simple black and white of monsters and heroes, but a complex web of culpability that divides and infuriates many of her contemporaries. Here is the trailer.
In the end Arendt concludes that it is each individual’s ability to think for ourselves that defines our humanity. Good reminder amid the intense spin and pull of mainstream thinking and consensus views in our own time.
I love Stuart McLean’s Vinyl Cafe and yesterday had the good fortune of being stuck in weekend cottage traffic long enough to enjoy his entire Sunday show. The inspiring true story read from Michael Gallagher of Hope, Main is one for the ages. You can hear it by advancing the playbar to 11:30. Here is the direct audio link.
Senators Elizabeth Warren (D-Mass) and John McCain (R-Ariz.) continue as forceful advocates for the intelligent and obviously necessary return to a Glass-Steagall-like division preventing banks from levered speculating backed by the American taxpayer. This clip from 2013, is a good reminder of some of the history of this fight and why congress and the business media continue to oppose this return to reason with all of their bank-sponsored might. Here is a direct video link.