'In any event, the worst possible situation is when market conditions provide neither investment merit nor speculative merit – a combination of hypervaluation, price overextension, and early deterioration in market internals. In my view, investors presently face the worst possible situation.
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..If a central bank allows base money to persistently expand at a dramatically higher rate than the output of real goods and services, it results in a chain of short- and long-term distortions that can include inflation, asset price bubbles, financial crises, loss of fiscal discipline, or a combination of all of them. The only question is which distortion comes first.“Toto, I’ve got a feeling we’re not in Kansas anymore.”
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Now that we’ve reached the most extreme valuations in the history of the U.S. financial markets, all that needs to happen for Fed policy to become ineffective is for investors to consider the possibility of meaningful losses; to become concerned that others will attempt to take profits before they do, in a market where the bulls are all-in and the only ones out are historically-informed, value-conscious investors like us, whose skin is like the finest Corinthian leather, and who know that run-of-the-mill valuation norms are less than one-third of current levels. Nothing in our discipline relies on ever seeing those norms again, but we certainly expect a far more interesting trip ahead than many investors seem to have in mind.''Over the 14 years from May 1995 to March 2009, passive investors enjoyed two separate bubbles, suffered two separate crashes, and ended up nothing to show for it beyond the returns of risk-free T-bills.
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..Ben Graham’s observation: “All my experience goes to show that most investment advisers take their opinions and measures of stock values from stock prices. In the stock market, value standards don’t determine prices; prices determine value standards.”
When extreme stock market valuations are the starting point, one often finds that bonds or even Treasury bills have outperformed stocks even a decade or two later. As I’ve often noted, the total return of the S&P 500 lagged even Treasury bills from 1929-1947, 1966-1985, and 2000-2013. That’s just what overvalued markets do.
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An important feature of going nowhere in an interesting way is the word “interesting” – even if the market goes nowhere on balance for quite a long time, good opportunities can regularly appear in the interim. As concerned as I’ve been about this bubble, even the peak-to-peak “mini-cycle” we’ve experienced since the February 19, 2020 pre-pandemic market high has been just fine for our flexible discipline.
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Given some set of expected future cash flows, investors may very well respond to lower interest rates by raising valuation multiples. But those higher valuations are precisely the mechanism by which expected future market returns are driven lower, in order to align with the lower interest rates. Worse, if interest rates are low because growth rates are also low, no valuation premium is justified at all, because the lower growth rate has reduced expected returns already. In that situation, a valuation premium just adds insult to injury.
In short, once you know the estimated cash flows and the observable price, you can directly estimate the investment return that connects the two. Nothing else is required. There’s nobody else in the room. To paraphrase Julia Roberts in Notting Hill, “I’m just a cash flow, standing in front of a price, asking it to love me.”
The valuation gauge that we find best correlated with actual subsequent market returns across history, including recent decades, is the ratio of nonfinancial market capitalization to corporate gross value-added (including foreign revenues). Presently, MarketCap/GVA stands at 3.55, easily the highest level in history. This compares with a historical norm of 0.99 (a level that has historically been associated with subsequent 10-12 year S&P 500 total returns of about 10% annually), and a previous record of 2.43 at the 2000 bubble peak.
Assuming that U.S. nonfinancial gross value-added (including foreign revenues) grows at the same 3.7% annual rate as it has during the past 20 years, even a retreat to valuations no lower than the 2000 bubble peak would imply roughly zero change in the S&P 500 Index over the coming 10-year period.
The arithmetic here is: (1.037)*(2.43/3.55)^(1/10)-1 ~ zero.
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It may be the greatest collective error in the history of investing to pay extreme multiples for extreme earnings that reflect extreme profit margins and extreme government subsidies, while imagining that those multiples also deserve a “premium” for depressed interest rates that reflect depressed structural economic growth.
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Graham makes another observation that shouldn’t be missed. Even if one embraces the idea of a new economic era, “The central level of values will be raised, but the fluctuations around these levels may well be just as wide as in the past, in fact, one might expect even wider fluctuations.”
See, a high level of valuations means that investors have placed a greater price on a given set of expected future cash flows. But that also makes the price far more sensitive to small disappointments in expected cash flows, and to small changes in the expected returns required of investors.
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When investors are inclined to speculate, they tend to be indiscriminate about it. For that reason, we find that the best gauge of investor psychology toward speculation or risk-aversion is the uniformity or divergence of market internals across thousands of individual stocks, industries, sectors, and security-types, including debt securities of varying creditworthiness. Our primary gauge of market internals has been unfavorable in recent months, but I’ve refrained from adopting a hard-negative outlook until recently, as divergences have become more obvious in the equity components. Now it’s serious.
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Presently, we are at the most optimistic point of the most overvalued market bubble in the history of the nation.
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This bubble has been built on near-universal confidence that serious market losses can be ruled out, and that in Ben Graham’s words “any setbacks will be made up speedily.” Couple lopsided bullish sentiment with record margin debt relative to GDP, and you now have an “all-in” market. Unfortunately, that’s also a market where the first question speculators will hear as they enter their sell orders will be – “To whom?”
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As Graham & Dodd observed in 1934, investment means buying a security at a valuation that is associated with a reasonable expectation of acceptable long-term returns, based on a careful analysis of the relationship between the current price and expected future cash flows. Speculation means buying a security in the expectation that its price will advance. In my view, intelligent investment requires careful consideration of the arithmetic that links current prices with future cash flows; and the historical evidence that relates reliable valuation measures to subsequent returns. Intelligent speculation requires careful consideration of the condition of investor psychology (which we gauge using market internals) as well as the extent, if any, that prices are compressed in a way that provides them substantial room to run.
The best possible situation is, of course, when market conditions provide both investment merit and speculative merit – a combination of undervaluation, price compression, and early improvement in market internals. I expect that even the coming quarters will provide good opportunities for rational speculation (mostly likely with a safety-net) well before we see this full combination, and that’s fine.
In any event, the worst possible situation is when market conditions provide neither investment merit nor speculative merit – a combination of hypervaluation, price overextension, and early deterioration in market internals. In my view, investors presently face the worst possible situation.
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Meanwhile, it’s worth noting how wildly the Fed has strayed from its mandate under the Federal Reserve Act:
"The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production"
– Federal Reserve Act, Section 2AThere’s a reason for that line. If a central bank allows base money to persistently expand at a dramatically higher rate than the output of real goods and services, it results in a chain of short- and long-term distortions that can include inflation, asset price bubbles, financial crises, loss of fiscal discipline, or a combination of all of them. The only question is which distortion comes first.
“Toto, I’ve got a feeling we’re not in Kansas anymore.”..
Now that we’ve reached the most extreme valuations in the history of the U.S. financial markets, all that needs to happen for Fed policy to become ineffective is for investors to consider the possibility of meaningful losses; to become concerned that others will attempt to take profits before they do, in a market where the bulls are all-in and the only ones out are historically-informed, value-conscious investors like us, whose skin is like the finest Corinthian leather, and who know that run-of-the-mill valuation norms are less than one-third of current levels. Nothing in our discipline relies on ever seeing those norms again, but we certainly expect a far more interesting trip ahead than many investors seem to have in mind.
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A century of market history suggests that major losses are already effectively baked into current hypervalued extremes. The problem with a speculative bubble is that you can’t make the short-term outcomes better without making the long-term outcomes worse, and you can’t make the long-term outcomes better without making the short-term outcomes worse. Now it’s just an unfortunate situation.'
- John P. Hussman, Ph.D.,
The Folly of Ruling Out a Collapse, August 8, 2021
Context'We’re currently farther away from “typical” expected returns than at any moment in history, including the 1929 and 2000 market peaks.‘'..I’ve lost all respect for monetary economists..''Confirmation that China’s Bubble has been pierced, with dire ramifications for Bubbles across the globe.'(Banking Reform - English/Dutch) '..a truly stable financial and monetary system for the twenty-first century..'