The Elephant in the Room
“Being wrong on your own, as Keynes described so eloquently in Chapter 12 of theGeneral Theory, is the cardinal crime of an investment manager. The management of career risk results in very destructive herding. Investors should be aware that the U.S. market is already badly overpriced – indeed, we believe it is priced to deliver negative real returns over seven years [GMO estimates fair value for the S&P 500 at 1100]. Be prudent and you’ll probably forego gains. Be risky and you’ll probably make some more money, but you may be bushwhacked and if you are, your excuses will look thin. My personal view is that the path of least resistance for the market will be up.”
- Value investor Jeremy Grantham, GMO, November 18, 2013
“I cannot look at myself in the mirror; everything I have believed in I have had to reject. This environment only makes sense through the prism of trends. You have got to be in things that are trending. Crashing is the least of my concerns. I can deal with that, but I cannot risk my reputation because we are in this virtuous loop where the market is trending. I may be providing a public utility here, as the last bear to capitulate.”
- Hedge fund manager Hugh Hendry, Eclectica, November 22, 2013
“I am out of justification to fight the uptrend. Up until now, I have had what I thought was compelling evidence to believe in the bearish case, but it has now been revealed to have been insufficient for the task. I am without ammunition to bet on the bears. I don’t like it, because I see the market as overly dependent upon the Fed’s largesse for its upward continuation. I see this as a bubble, but a bubble that is continuing higher even though it should not. I plan to ride the bubble for a while, and will hope to be able to succeed in reading the right [exit] signs."
- Market technician Tom McClellan, November 26, 2013
In a classic case of not only locking the barn door after the horse is loose, but removing its best opportunity to return home, we’re seeing a capitulation by investment managers across every discipline, from technical, to value-conscious, to global macro. Historically extreme overvalued, overbought, overbullish conditions were in place even ten months ago, and my impression is that every further extension worsens the payback will inexorably follow.
Investors Intelligence reported last week that the percentage of advisory bears has plunged to 14.4%, lower than at the 2000, 2007, and 1987 peaks, and every point in-between. I’ll spare a full review of the overvalued, overbought, overbullish extremes we observe here (seeA Textbook Pre-Crash Bubble) – it’s clear that over the past year, even the most extreme variants of these conditions haven’t “worked,” having already appeared in February and May of this year to absolutely no effect. I have no question – at all – that the market has simply climbed a higher cliff from which to plunge, but I learned in 2000 and 2007 that there’s no hope of convincing many investors of this sort of thing – despite the fact that these reckless speculative peaks seem so “obvious” after the market collapses. Even when investors listen, at least some of the tears they would have shed after the plunge are substituted for tears they have to endure while missing the final advance.
We’re faced with a speculative advance that seems unstoppable, despite the absence of any reliable mechanistic link between quantitative easing and stock prices – only a combination of superstition and yield-seeking that has repeatedly ended badly. What’s driving capitulation here is not evidence, or even the faint memory of cycles as recent as 2000 and 2007 – but pain, impatience, career risk, and the demand that all discomfort must arise from conventional behavior. As John Maynard Keynes wrote in theGeneral Theory :
“Human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate… It is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
Keep in mind how investment bubbles work. A bubble always starts with some real factor that takes on increasingly exaggerated importance in the eyes of investors. The bubble expands not on facts but on untethered imagination. People imagine that X will result in ever-increasing prices, and assume that an endless crowd of buyers is still behind them – dot-com stocks, technology, housing, “tronics” stocks in the 60’s, the Nifty Fifty in the 70’s, quantitative easing, tulip bulbs. Regardless of whether the mechanism underlying that concept is fictional, and regardless of how tenuously it is linked to reality, a bubble advances as long as the adherents it gains are more eager than those it loses. What stops the bubble is not the concept itself hitting a brick wall, but pool of new adherents being exhausted. Once everyone is in, who’s left to buy from all those holders with their fingers hovering over the sell button? The question, once the moment arrives, is always the same: Sell to whom? And that’s why markets crash.
With the percentage of advisory bears at the lowest level in a quarter-century, the following bit from mid-2007 is a useful reminder of how all of this works.
“The U.S. stock market now stands at its highest level ever. By most measures, it is as pricey as ’29, or ’68, or 2000. Upon this sea of easy cash and credit, practically every stock market on the face of the planet floats higher and higher. Even some of the greatest and most experienced market observers … have finally given up fighting ‘em. They’ve decided that this really is a New Era of New Capitalism and that this is the time to join ‘em. This worldwide bubble is more worldly and more bubbly than any in history, they say. It may get much, much bigger. And they have good reasons to think so… all those trillions of new money. How can they help but blow this bubble up even bigger – so big even the moon will have to get out of the way. But wait … isn’t there an old market adage: The bull market is over when the last bear throws in the towel? Are there more bears still out there? We don’t know. But there can’t be many of them.”
- Bill Bonner, The Daily Reckoning, June 25 2007
On that subject, for anyone waiting for me to capitulate, it’s important to understand that my views shift when the data shifts. Capitulation is the luxury of those who invest by the seat of their pants. To the extent that I have any latitude to capitulate, the most that one can expect already happened months ago, when we allowed for a "blowoff" in response to the Fed's decision not to taper – a decision that many of the Federal Reserve’s own members have openly described as aclose call, aborderline decision, amissed opportunityand a threat to the Fed’scredibility.
We continue to allow (though not rely on) the potential for a further blowoff in the S&P 500. My opinion about this isn’t driven by the preponderance of historical evidence, which is already strikingly negative, but by the characteristic log-periodic behavior we’re observing in prices (seeA Textbook Pre-Crash Bubble). The associated “singularity” may yet be a few weeks away. As Didier Sornette has observed, numerous past bubbles in financial markets and commodities have featured this signature, which I’ve described in terms ofincreasingly immediate impulses to buy the dip. The pattern was already extreme enough back in April/May of this year, and pushing that singularity further has required the price advance to become even steeper and corrections even shallower and more frequent. The pattern that pushes out to January is the most extreme variant we can fit, but more recent price behavior is more consistent with a mid-December singularity (seelast week’scomment).
Frankly, I don’t think we can rely on markets following math, but the fidelity to these patterns is creepy, and consistent what Sornette described inWhy Markets Crash. In any event, I don’t actually expect investors to retain any of these potential gains even a couple of months from now, nor would I encourage any meaningful exposure to market risk. Still, modest exposures in index call options can have a useful contingent profile since strike prices can be raised even in the event an advance is purely temporary.
The Elephant in the Room
Our focus has always been on outperforming the market over complete market cycles (combining both bull and bear markets), with smaller periodic losses than a passive investment approach. In pursuit of that objective, we’ve always been willing to accept periods where we don’t track the market. By 2009, it was easy to demonstrate the success of that discipline. I was a fully-leveraged raging bull in the early 1990’s; was defensive well before the 2000 bubble peak, was more than absolved by prospering during a market plunge in 2000-2002 that wiped out every bit of total return in the S&P 500, in excess of Treasury bills, all the way back to May 1996; shifted to a constructive outlook in early 2003 as a new bull market took hold; warned loudly about an oncoming credit crisis and severe market losses in 2007; and navigated the crisis well in the 2007-2009 plunge as the S&P 500 lost 55% of its value, again wiping out every bit of total return in the S&P 500, in excess of Treasury bills, all the way back to June 1995.
I’ve been as comfortable being an aggressive bull as I am being a raging bear today. I can hardly wait for the opportunity to change species when the evidence presents itself. But it is purely a function of the data that I’ve been generally defensive in a period where stocks have been so overpriced that the S&P 500 has scarcely achieved a 3% nominal annual total return in over 13 years, and even then only because valuations have again been driven above every pre-bubble extreme except 1929.
What obscures perspective and shakes confidence is the elephant in the room – our disappointing “miss” since 2009. My sense is that many investors are inclined to ignore the objective warnings from a century of evidence because our own subjective experience since 2009 has been disappointing. Before investors dispense with evidence that may very well define their investment future over the next several years, or even the next decade, they may be well-served to understand that most of that miss had little to do with the overvaluation and extremely overbought, overbullish conditions that concern us at present.
As in 2000 and 2007, my concern is deepest for investors who have relatively short horizons until their funds are needed, who don’t have a great number of years ahead in which they’ll be adding to their investments, and who have allocations to stocks that don’t recognize that equities have a duration of 50 years here (so an investor who needs the funds in 5 years should really have no more than 10% of assets in stocks, particularly at present valuations). We presently estimate a nominal annual total return for the S&P 500 over the coming decade somewhere between zero and 2.2%. We are observing overvalued, overbought, overbullish extremes that are uniquely associated with peaks that preceded the worst market losses in history (including 1929, 1972, 1987, 2000 and 2007). Speculators are now leveraged to the greatest extent in history, with NYSE margin debt surging last month to a record high in dollar terms, and 2.5% of GDP in relative terms (a level previously observed only at the 2000 and 2007 extremes). Our challenges of the past few years – most of which trace to a single decision – should not encourage investors to ignore evidence that is specific to the markets.
I believe that more than half, and perhaps closer to all, of the market’s gains since 2009 will be surrendered over the completion of this cycle. Investors will do themselves terrible harm if they ignore theobjective warnings of history based on our subjective experience in this unfinished half-cycle. That subjective experience is far more closely related to my 2009 stress-testing decision than many investors recognize.
The “stress-testing” problem was to develop an alternative way of estimating return and risk that was robust to complete market cycles across history, including not only post-war data, but also Depression-era data, as well as holdout data that was not used as part of the research process. It’s very easy to simply “back fit” a model to historical data. The actual requirements of validating against holdout data are much more challenging, but until we were certain we could distinguish market conditions in the most extreme circumstances, we worked to solve what I called our “two data sets problem.”
Even after we had addressed that problem in mid-2010, there was a smaller issue still to be addressed. The sublety is that valuations have a very strong effect on long-term returns, but since the long-term is just a sequence of short-terms, valuations still feature heavily in estimates of expected market return/risk over shorter horizons, even when market action and other factors are included.
One cannot simply ignore an overvalued market when trend-sensitive measures are favorable. While favorable market trend-following measures do result in further market advances for a while, this tends to continue only until an advance becomes so extended that a syndrome of “overvalued, overbought, overbullish” conditions emerges. At that point, prices are typically so elevated, relative to any threshold that might provide a reasonable exit, that a great deal of ground is typically lost in one fell swoop at the very end. The key to overvalued markets is to embrace favorable market internals only until those overextended syndromes emerge, but no longer. Greed really is punished over time.
By April 2012, we addressed that sublety by incorporating further criteria to limit our defensiveness, even when our return/risk estimates are negative, provided that our measures of market internals are favorable and overvalued, overbought, overbullish syndromes are absent. While this modification is not actually required over the complete market cycle, it does have the effect of improving the capture of returns in markets that are already substantially overvalued.
What our investment discipline has not done is to encourage us to speculate in the face of the unprecedented and uncorrected overvalued, overbought, overbullish conditions driven by investor faith in QEternity during the past year. Investors who wish to rest their financial security on quantitative easing are entirely free to roll those dice on their own.
That said, hardly a week goes by that we don’t look into some factor that might convince us to take a more constructive approach toward QE or the associated advance. My belief that the present situation will end very badly is driven by the lessons from a century of evidence, and the absence of a single testable monetary, economic or technical factor – aside from blind faith in QE – that would have helped to capture gains during the past year without worsening the results of our discipline in past market cycles throughout history.
Given that our approach spans a century of available data, I have no expectation of re-living such stress-testing in any future market cycle, and every reason to expect the resulting approach to outperform our pre-2009 methods in future cycles, not to mention the completion of the present one. Both our 2009-early 2010 miss, and the missed post-correction advances in late-2010 and late-2011 are unfortunately casualties of the credit crisis and the resulting stress-testing.
I’d like to have a better answer to the past year of QE-induced gains other than noting their resemblance to the confidence in dot-com stocks. The fact is that every strategy we’ve tested that might have embraced these gains also fails spectacularly in historical data, largely because some of the worst market losses in history emerged from overvalued, overbought, overbullish extremes that were less extreme than what we observe today. There’s no denying that the present overvalued, overbought, overbullish extremes have endured longer than they have historically, but I’m not inclined to believe that the end result will be sweeter.
I’ve got a very uncomfortable sense that some investors are disregarding objective evidence here, and assuming that extreme overvalued, overbought, overbullish conditions can easily be ignored, on the argument that we’ve had a difficult time of things since 2009.
As investors place all of their valuation hopes on the “Fed Model,” comparing the market’s value on “forward earnings” with the 10-year bond yield, and resting their financial security on the confidence that the Federal Reserve provides a “put option” to protect them against loss, I’ll end with a reminder from the last time the same beliefs carried such weight, just before the stock market lost more over half its value:
“I've done my best to warn loudly, I've put the data out there, and have analyzed this thing to pieces. The Fed Model has no theoretical validity as a discounting model, is a statistical artifact, would never have been materially negative except in 1987 and the late 1990's (even in 1929 or 1972), yet views the generational 1982 lows as about "fairly valued," is garbage in data prior to 1980, and vastly underperforms proper discounted cash flow models and normalized P/E ratios. If investors still wish to follow the Fed Model, my conscience is clear, and my hands are clean. There is no evidence that historically reliable valuation measures have lost their validity. Specu lators hoping for a ‘Bernanke put’ to save their assets are likely to discover - too late - that the strike price isway out of the money.”
- Hussman Funds Weekly Market Comment, August 27, 2007,Knowing What Ain’t True
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