Perspectives

Into Thin Air

The Highest Peak

In the chart below, Dr. Hussman plotted five very different measures of valuation for the SP500 that all are highly correlated to predicting future long term returns. Market valuations are not useful for short term market timing, but they do provide a good indication of future long term returns and at extremes they imply high market risk.

High valuations lead to lower future returns, low valuations lead to higher future returns on a long-term basis.  At least that is how it has worked for the last 100 years or so.  So it may be of interest that the price of the SP500 index compared to the revenue of the SP500 companies, has only been higher for one week since the inception of the SP500 index – the 2000 stock market bubble.

24 July PR

Yet, when I look at the price trend of the SP500 index and the narrow credit spreads of high yield bond investors I do not see the signs I saw in 2015 that indicated a market correction was around the corner.  There is little risk aversion showing up in the data.

This does not rule out a 1987 situation where the market crashed without any major warning signs, but the odds are we will see a deterioration in some of the signals prior to a large correction. The question is why are the markets indicating little concern for market risk at these elevations.

Future Returns

Dr. Hussman inverts valuation measures into a chart of future returns and shows how closely correlated these measures have been to predicting future long term returns – I added the notes. The red line plotting the actual 12-year returns of a diversified portfolio ends 12 years ago because we do not know the final results of the recent years. But I think the 50 years plotted is enough to see that he may be on to something.

24 July future returns

Over full market-cycle periods of time, long-term future returns can be predicted based on current prices paid.  The reason the future return of a diversified portfolio is today lower than 24 March 2017 is because future returns on bonds is lower than in 2000.

So if you are happy with earning 1% annualized returns over the next 12 years (with inflation running 2%) and you have the fortitude to buy and hold under all conditions, you can buy a Lifecycle fund or just set a diversified allocation. You might not want to look at your monthly balance statements the next 12 years or longer.

I would also like to point out that if you bought at any other time since 1950, your future returns would have been higher than today. So I do not think I am going too far out on a limb in saying that sometime in the next 12 years, you might be able to buy into the market when future returns are higher.  Probably a lot higher.

Again, I am not saying the market can’t go higher.  Nor am I putting out a crash warning, more of a watch.

How we got here

The answer to how we got here is actually pretty simple from a formula point-of-view.

The stock and bond market prices kept climbing while the economy, corporate profits, corporate revenues, business sales and wages all stopped climbing in late 2011.  The first chart shows US corporate profits as reported to the SEC under threat of jail time if they report it inaccurately.  Not to be confused with adjusted earnings reported to investors.

Profits are sitting at the same level as late 2011.  Climbing again recently, but don’t get your hopes up profits will catch up with valuations.

24 July Corporate Profits

The next chart also shows corporate profits, but we have added total business sales. Profits and business sales returned to levels slightly above those in the last cycle and flattened out.  But the stock market just kept climbing.  The market ran out of oxygen in 2015, but the central banks brought alot more oxygen to the climb in 2016.  I think they added a little nitrous oxide to the tanks too.

 

24 July 2017 QE Bubble

 

The Oxygen

The oxygen is money created out-of-thin air and used to buy financial assets such as stocks and bonds.  The removal of this supply of financial assets from the open markets means other investors have to pay a higher price for the remaining supply to meet their demand. No previous market cycle had these “emergency” policy measures let alone have them continue for 10 years. This is a first and explains why a lot of traditional free-market wisdom is not working.

 

Supply-Side_CenBan Assets

The central bank interventions that occur each time the market begins to pull back is the insurance speculators need to take on increasing levels of risk.  The reason the Federal Reserve can talk about a slow reduction of their balance sheet today is explained by the top chart provided by Yardeni Research.  The Bank of Japan and the European Central Bank have ramped up buying since 2015.

Other central bank buying is confounding the Federal Reserve’s weak attempts to tighten financial conditions.  Even the bubble-blind Fed wants asset prices to pullback and are worried that another bursting bubble will do as mush damage as the last one.

With the BOJ and ECB still pouring gasoline on the speculative fires the current central bank driven market cycle may far surpass the 1929 and 2000 market tops.  But there will be consequences.  There are always consequences.  One of them is low future returns – both on capital as discussed above.  The other has to do with return of capital.

Return of Capital

With the lack of strong demand by a beleaguered middle-class, price-insensitive CEOs have taken advantage of the below-inflation interest rates and bought back their own corporation shares as a method of increasing their earnings-per-share reports (and pay).

In a few cases, this is not a bad strategy.  But in most cases, over-leveraging your balance sheet to prop up your earnings in the short term leads to bad results in the long term (long term defined as the start of the next recession).

Today’s SP500 debt-to earnings ratio is higher than after the full force of the last two recessions.  Low interest rates are nice but unlike governments, corporations are suppose to pay the debt back. At some point corporate leverage will limit buybacks.

 

Cause and Effect

And if you want to see direct evidence of a central bank driving the markets (vices free markets), JP Morgan provides a pretty good chart on the abrupt change in risk appetite in the European corporate bond market based on the ECB simply announcing their Corporate Sector Purchase Program (CSPP).  CSPP is buying corporate bonds with money created out-of-thin-air.

The timing of the announcement came within a month of the stock market bottom in early 2016 and the beginning of the market melt up.  Credit spreads collapsed meaning investors were no longer concerned about risk and yields of the riskiest bond fell.

CSPP was one of many central bank market liquidity operations in the developed world along with China’s interventions.

The markets completely detached from reality after 2011 similar to 1998 when profits-don’t-matter stock market bubble extended into 2000 or the party in 1929.

Speculator perceptions of central bank actions and words are all that seem to matter today. Economic news is viewed through this prism.

During this cycle, bad economic news has benefited the stock market and good economic news has hurt the market.  Only in a market driven by expectations of central bank future largeness would such an effect exist.

If speculators perceive the BOJ or the ECB will stop propping the markets up, they will race for the exits. Insiders move before announcements, so it is important to watch for indications of risk-aversion among risk-sensitive investors.  When risk-aversion returns, we will alert our members.

Invest safe, invest smart.

 


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