Juggling Dynamite

The investment marketing world urges that every day is a valuable buying opportunity and fear of missing out is a formidable bait.

This is especially true since many participants have never lived through a typical bear market (where the average S&P 500 decline was 29% over 12 months if the economy was not in recession and 42% over 16 months when it was.)  Others have seen bear markets but have blocked out the experience (willful blindness) or chalked it up to one-off-bad-luck, unlikely to repeat–aka, this time is different.

After a decade of ‘easy money’ policies aimed at inflating asset prices at all costs, mean reversion is a much-needed value-restoration force. Many securities have made some promising downside progress, year to date, to be sure.

However, in terms of the eight indicators proven to have the best predictive power of forward-10-year real equity returns–we aren’t at enticing investment value yet. Mark Hulbert summarizes the data well in WSJ: Are Stocks Undervalued Yet?:

On balance, these eight indicators at the mid-May low stood at more than twice the average valuation of the bear-market bottoms seen in the past 50 years. And, seen in comparison with all monthly readings of the past 50 years, the average of the eight measurements was in the 88th percentile.

Mark’s summary table below shows the eight latest metrics (in blue) at the top end of the monthly distributions over the past 50 years.

While the S&P 500 trailing 12 months’ earnings per share (first line above) has come down in 2022, as of mid-May, it remained 16% above its average level at the lows of the past 50 years.

Moreover, this price-to-earnings (PE) reading is with backward-looking 12-month corporate earnings still near record highs. As earnings inevitably come off the boil, the dropping denominator will elevate this ratio until the numerator (price) tumbles significantly further–as has happened at every bear market bottom in history.

One of the most telling value indicators of the group is the average investor’s equity allocation as a percentage of their financial assets—equities, debt and cash (second blue bar above). The latest Fed data available was at the end of 2021, when equity allocations were at the 99th percentile of all readings over the past 50 years.

Infamously, the masses hold the most risk near market tops (and the least cash), so they look smartest just before they lose in bear markets and have the least ability to invest near bottoms (when prospects become the best of the decade). Doing the opposite of this behaviour isn’t easy, but it’s recommended.

History assures that financial stability and meaningful investment opportunity is earned through math-based analysis, patience and personal discipline. The lack of these is why many win for a while but end up worse.

We will know we are near a valuable cycle low when the majority is liquidating equities and thinks buying is a bad idea; not there yet.

Useful insight in this discussion on consumer spending, ETF/mutual fund liquidity risks, common allocation mistakes in housing and investment portfolios, and the value-add lacking in mainstream financial advisory services. Worth listening.

Ted Oakley interviews Danielle DiMartino Booth about her outlook on global economics, inflation, U.S. housing, Federal Reserve policy, and how it will affect investors. Ted Oakley interviews Danielle DiMartino Booth about her outlook on global economics, inflation, U.S. housing, Federal Reserve policy, and how it will affect investors. Here is a direct video link.

The chart below since 2005 (courtesy of Isabelnet.com) shows that the value of equities has been dropping for the last six months, but their weight in broker-advised accounts remains near all-time highs at 62% of assets under management. Sentiment may be bearish, but the broker/advisory crowd still keeps client funds in the equity fire (where fees are most lucrative for the firms). So far, clients are still holding the exploding dynamite; this too shall pass. Capitulation selling is yet to come.

When money is cheap/low-yielding, the masses tend to borrow and overspend while investment capital is ploughed into dumb, counter-productive things.

With money virtually free for a decade, a historic era of financial madness has ensued.

Zombie companies and Ponzi schemes are similar in that neither generates enough cash flow to meet their commitments. They can only continue so long as they can attract more feckless lenders and investors. As rates rise and asset bubbles burst, feckless funds run low, and the unsustainable finally comes to a crashing halt. See:  Missed payments, rising interest rates, put ‘buy now, pay later, to the test.’

What’s refreshing about the implosion phase is that math, prudence and self-discipline come back into vogue, and more people are willing to call out naked Emporers. It’s started. Private equity is one area that’s particularly ripe for sober review, see Parts of Private Equity look like a Ponzi, Amundi CIO:

Some parts of the private-equity market are beginning to resemble a Ponzi scheme, according to Amundi SA’s chief investment officer.

Vincent Mortier said in a virtual press briefing Wednesday that the volume of money raised in recent years by private-equity houses had driven up valuations and incentivized firms to buy assets from one another at inflated prices…

“The vast majority of deals are currently done between private equity players, “ Mortier said. “One private equity player will sell to another one who is happy to pay a high price because they have attracted a lot of investors.”

“That ability to sell to peers has enabled firms to avoid marking down the value of the assets they own despite a broader selloff in public markets.“When you know you are able to exit your stake to another private equity house for a multiple of, let’s say, 20, 25 or 30 times earnings, of course you won’t mark down your book,” Mortier said. “That’s why I’m talking about a Ponzi because it’s a circular thing.”

Also, see SPACS are warning they may go bust WSJ May 27, 2022:

“The SPAC boom brought a wave of companies to the public markets, promising years of rapid growth and profits to investors. Two years since the boom began, many of these companies are already warning they may go bust.”

Credit strategist Mike Green explains in the segment below that 25% (about 700) of the Russell 3000 companies are zombies that cannot keep afloat without a constant supply of new cheap credit–something that’s increasingly scarce as rates rise and credit conditions tighten.

Does the road to a recession begin in the small caps?

That’s where Simplify Asset Management Chief Strategist Mike Green is looking. Hear his take on why an index full of “zombie companies” is putting the economy at risk: pic.twitter.com/oFZjN4psJN

— CNBC’s Fast Money (@CNBCFastMoney) June 1, 2022