As always, strong convictions held loosely, and we reserve the right to be wrong.
STOCK MARKET
Are We in a Stock Market Bubble?
Seemingly defying all that‘s going on in the United States at the moment, the stock market continued its general upward trend in the beginning of June. The tech-heavy NASDAQ Composite Index even reached a new all-time high, closing above 10,000 points for the first time on Wednesday, shrugging off the COVID-19 pandemic and the slew of negative economic indicators that came with it. While the NASDAQ’s latest rally was greeted with celebrations by some people, others were eyeing it with suspicion, worried about what looks like a growing disconnect between the stock market and reality.
All three major indices in the U.S. are now up more than 40 percent from their late March lows, despite the fact that the U.S. is now officially in a recession and the world economy is facing its biggest contraction since World War II this year. “The gap between markets and economic data has never been larger,” Matt King, global head of credit strategy at Citigroup wrote in a research note in April and several analysts have chimed in since, calling the recent rally a huge disconnect from reality. So is the stock market really overheated or are investors simply looking beyond present conditions, anticipating a strong recovery for 2021?
One way of looking at stock valuations is the market value of all publicly traded companies as a percentage of GDP, which Warren Buffett described as “the best single measure of where valuations stand at any given moment” in a Fortune interview in 2001. “Two years ago the ratio rose to an unprecedented level,” Buffett said shortly after the tech bubble had burst. “That should have been a very strong warning signal.”
As the following chart shows, the ratio of market capitalizations (as measured here by the very broad Wilshire 5000 index) to GDP is even higher now than it was shortly before the dot-com bubble burst. Using quarterly average closes of the Wilshire 5000 Total Market Index and dividing it by quarterly GDP figures shows that the ratio is unprecedentedly high at the moment, which, following Buffett’s rationale, could be seen as an ominous sign of things to come. — Statista
Bears can’t win the long-game, the probabilities are stacked against them as stocks (DJIA) have generated positive returns for almost 70 percent of the last 100 years
Bears also face a relatively new (since the 1990s) headwind, that is rent-seeking behavior of the investment markets, where the rules of the game are changed when the market moves in the bears’ favor
Stocks remain divorced from economic reality and are not optimal initial conditions for a sustained and stable new bull market
Good question, easy answer.
Probabilities Are Against Bears
First, the bears begin in a big hole with the probabilities stacked against them. We wrote an extensive analysis on this subject in our March 2019, Permabulls For Long Run.
The above data show the stock market in terms of the Dow Jones Industrials has generated positive returns for almost 70 percent of the past 100 years. Those are difficult probabilities to bet against and remain solvent.
Growth
The stock market is invariably linked to the economy over the long run, and the natural state of the economic trajectory is for growth, which, in most cases, generates profits that fuel stock rallies. Betting against that scenario for a prolonged period is the fastest way to the poor house.
Rent-seeking Shareholder Class
Second, we have been working on a piece for weeks, which has turned into a tome, Rent-Seeking Nation. It should be out soon but our idea was sparked by an excellent piece written by our good friend, Joe Calhoun, CEO of Alhambra Investments, titled Here Come The Crony Capitalists.If you haven’t read it, run don’t walk to consume it.
Joe understands what is current at stake for the global economy, the consequences of bad policy, and understands risk, and how to manage it. We mentioned in an earlier post that we live in times where it is important to have an experienced portfolio manager, who understands how to manage left-tail risk. Joe is one of the best.
Rent-Seeking
Rent-seeking
the fact or practice of manipulating public policy or economic conditions as a strategy for increasing profits. “cronyism and rent-seeking have become an integral part of the way our biggest companies do business – Lexico
Bears face another difficulty in that the investor class, led by Wall Street and the financial media have tremendous influence over public policy, monetary policy, in particular.
It seems evident, at least to us, that when market forces assert themselves to pressure stocks to move back to more realistic and reasonable valuations, monetary policymakers intervene and change the rules of the game against the bears. We are not arguing this the primary objective of monetary policy but it is, in fact, the end result.
The Stock Market and Economy
The chart below illustrates how divorced the current stock market is from economic reality. It is just another form of our favorite valuation metric, stock market capitalization-to-GDP.
The above data show that the annual trend growth of the S&P500 and nominal GDP tracked quite well up until the dot.com bubble, which began in the mid-1990s. The major bear markets of 2000–02 and 2007-09 caused the stock market to revert back close to trend GDP but stocks were soon reflated again by easy monetary policy.
There are many plausible reasons that caused this structural shift, which we won’t go into now. Contact us if you’re interested.
Economic Stability
The optimal and most stable dual path, in our opinion, is where both series track each other as was the case pre-1995.
At current levels, the stock market is way out of line with trend GDP. Yet, we heard, even today, on the financial television that we may be at the start of a new bull market. Seriously?
Stare at the chart for a few minutes and ask yourself, is that a realistic, high probability scenario? It is possible the laws of gravity with respect to stock valuations have been permanently suspended but we don’t think it is likely.
What is also notable from the chart is that the bubbles keep getting larger and larger. In fact, stocks may now be so far out of line with the economy that it is impossible to “land the plane” without destroying the world. How did we allow ourselves to get here?
Laws Of Economics Suspended
There is now a rapidly growing group of people who think the laws of economics have been suspended. That is there are no constraints on financial resources and don’t seem to have a problem with trillion-dollar deficits, most of which are now monetized, weak bond auctions (today’s 10-year), and a weakening currency
As macro observers, we are not fond of that cocktail, though, given the COVID crisis we don’t seem to have much choice on the massive deficit and debt monetization.
The macro boys at GMM remain uncomfortable, however, and that is why our position remains in cash and gold. Let them have their bull market.
Note this is not the case with our stock picker, Carol, who is fighting some health issues and probably would have weighed in here.
Initial Conditions For A New Bull Market
By the way, the average initial valuation of new bull markets from 1974 to 2009, was a stock market capitalization-to-GDP of 53.1 percent. The new bull market, which they tell us began on March 23rd was almost double that at 105.3 percent and now approaching 170 percent, more the 25 points above the peak level of the dot.com bubble. Sure the economy has bottomed and should get a record bounce in Q3, but stunning, nonetheless.
Upshot
The market — well, not really a market anymore after the Fed has effectively nationalized the bond markets — looks like a screaming short given the above chart. Just remember bears, you’re betting against the long-run probabilities skewed against you, and also understand that the referees will change the rules of the game if you start winning big. Rent-seeking is ubiqutious and now trumps market forces, which is a major factor why even the United States is morphing into a zombie economy.
The World Bank published its latest Global Economic Prospects report on Monday, providing us with another glimpse of the expected economic fallout of the COVID-19 pandemic. According to its revised forecasts, the global economy will shrink by 5.2 percent this year, which would mark the deepest recession since World War II.
“This is a deeply sobering outlook, with the crisis likely to leave long-lasting scars and pose major global challenges,” said World Bank Group Vice President for Equitable Growth, Finance and Institutions, Ceyla Pazarbasioglu, who urged the global community to “unite to find ways to rebuild as robust a recovery as possible to prevent more people from falling into poverty and unemployment.”
While countries with high case and death counts and those relying heavily on tourism, global trade and commodity exports are expected to be hit hardest by the pandemic, this is a truly global crisis affecting more countries than any other economic downturn since 1870, according to the World Bank. As our chart shows, the economic impact of the coronavirus outbreak is expected to be severe across the globe, with no regions spared. Compared to its January 2020 projection, the World Bank revised its global growth estimate by 7.7 percentage points, with the Euro Area and Brazil suffering the biggest hit to their economic growth prospects. – Statista
Cue the “Buffett is an idjit” Tweets. Then run like hell.
Frame it. Epic, will be in the financial history books with Irving Fisher. I’d love to be an idjit worth $80 bn. BTW, I have this most incredulous side bet that Buffet will be right, I can’t even believe it. @GTCost @Carol_Kohlberg @JoeCalhoun3@slangwise@ThinkInTheMorn
We have been teasing you over the past month about rolling out the CK-35 portfolio of GMM’s new crack stock picker, Carol K. The CK-35 has a nice ring to it, no? Kinda the like the NIkkei 225?
Huge Outperformance
We feel fortunate to have Carol on board because she is a much-needed voice to balance our macro views and brings a very unique and strong set of analytical skills, a vast amount of experience in investing, and a pretty damn good track record.
Health Issues
Carol has some ongoing health issues she’s currently battling — nothing a former USMC Captain can’t lick — and would be presenting and writing this post herself if not for feeling under the weather. We have also disagreed on whether GMM should try and monetize this information.
Carol wants to provide to it our readers for no charge but given my greedy capitalist instincts, I thought GMM should get paid for such quality work. She won but if you feel inclined you can make a donation clicking the widget on the right side of the webpage.
Portfolio Changes
We are rolling it out tonight because Carol is considering tweaking the portfolio and making some changes. This way you will have the original picks and can go back and recreate the returns we began posting and revealed a few months ago. Our credibility remains intact and you know we are not promoting some mystery valise of supercharged stocks
100 percent of Carol’s Work
This is all Carol’s work and nobody else at the Global Macro Monitor has anything to do with it. She deserves full credit, not only because of the massive YTD outperformance relative to the S&P but, what impresses us even more. is the outperformance on the downside since the February high.
These stock picks are just Carol’s opinions and favorites, which she may or may not own in her own personal account, and are not recommendations or investment advice.
Find A Good Investment Manager
If you’re looking for advice, I suggest — not Carol speaking — you find a good manager that is experienced and knows how to manage left-tail risk. I can think of a few.
I also don’t think passive investing or a 60/40 portfolio are going to fare well over the next few years.
Feel free to contact us if you have any questions.
Note the exact returns may differ a few bps as some data sources may have a slightly different December 31st prices
The information in this post represents our own personal opinions and are not investment recommendations. We may or may not hold positions or other interests in securities mentioned in the post or have acted upon what has been written.
All information posted is believed to be reliable and has been obtained from public sources believed to be reliable. We make no representation as to the accuracy or completeness of such information.
Microsoft was a great company in 1999. $MSFT was still a great company in 2017 – it would take you 18 years for you to break even if you bought it in 1999. Valuation, the price you pay matters even for a great company. pic.twitter.com/Z0f8jwz2A5
Bloomberg QuickTake Originals
Research shows that our brains are designed to be distracted. Scientists from Princeton University and the University of California found that our brain refocuses our attention four times every second. So as you read this sentence your brain is periodically scanning your surroundings to see if there is a more important location to focus on.
Panic buying is a type of behavior marked by a rapid increase in purchase volume, typically causing the price of a good or security to increase. From a macro perspective, panic buying reduces supply and creates higher demand, leading to higher price inflation. On a micro level (e.g. in investment markets), fear of missing out (FOMO) or buying triggered by a short squeeze can exacerbate panic buying, into a so-called melt-up. – Investopedia
This whole FOMO thingy is kind of perplexing to us.
We maintain Issac Newton learned the real lesson of gravity in a FOMO trade gone bad,
Back in the spring of 1720, Sir Isaac Newton owned shares in the South Sea Company, the hottest stock in England. Sensing that the market was getting out of hand, the great physicist muttered that he ‘could calculate the motions of the heavenly bodies, but not the madness of the people.’ Newton dumped his South Sea shares, pocketing a 100% profit totaling £7,000. But just months later, swept up in the wild enthusiasm of the market, Newton jumped back in at a much higher price — and lost £20,000 (or more than $3 million in [2002-2003’s] money. For the rest of his life, he forbade anyone to speak the words ‘South Sea’ in his presence. – Open Culture
Then, again, we don’t bother trying to understand the markets anymore as they are no longer markets, and have been essentially nationalized and now tools of the state.
Nevertheless, let us pontificate one more time.
We Get FOMO
Yes, I get it and recall my hedge funds days of missing out or being caught on the wrong side of a big rally. In fact, it resulted in me leaving the industry.
Here’s the short of it:
Venezuela Migraine
I was in Venezuela pre-Chavez for a week to do some due diligence, “kick the tires,” and meet with government officials. After arriving at the Caracas airport (long drive over the hill from downtown) for my return to NYC, with connecting flights through San Juan/Miami, I called my favorite salesman for a market update.
He proclaimed excitedly, “the market is screaming, some bonds are even up 5 percent on the week.”
I had learned, through many expensive lessons, to trim down my long positions when I traveled.
Upon hearing my bond sales guy, I instantly came down with a massive migraine and with no ibuprofen. I missed another big move, which I thought was unwarranted, but knew I had to go back to the office and explain to my boss, a Master of the Universe legend, why I was now underperforming.
Making the three connections back to New York, I spent much of my time in the air in the restroom doing the technicolor-yawn. After touching down at JFK, I had made up my mind to leave the business and venture out on my own. True story.
Anyone who thinks trading or investing, especially other people’s money (OPM) is easy, why aren’t you on your yacht in the Caribbean reading this post?
Career Risk Of Missing Out
We understand and have experienced first hand the “career risk” and fear that professional traders and portfolio managers face missing big FOMO rallies, even if they are fully cognizant the moves are unwarranted and unsustainable. So, dear readers, spare us the email lectures.
Chasing The Titantic Rally
But this rally? Almost everyone knows it’s absurd yet some still chase.
It reminds us of passengers chasing down the Titanic, knowing full well it is going to sink before docking at the Chelsea Pier on New York’s West Side but just can’t resist the four days of partying and world-class cuisine. Seriously?
If you have been around the block a few times, this isn’t the first time you witnessed a Chasing The Titantic rally.
This is exactly what I was warning of in the May 1st Afternoon Audit. Day trading replacing sports betting / gambling as America’s past time. This is material retail volume. Partly explains disconnect between economy and the stock market. Be skeptical of current prices. pic.twitter.com/C04dezRuzL
We keep every market we follow or trade, in the context: Is it cheap, is it expensive?
For some markets, such as commodities, which trade purely on supply and demand it’s not a relevant query.
Though my background is a trader, one of the first principles I learned as a Wall Street newbie was from my boss who sat me down before bestowing the firm’s capital to my trading book,
“I don’t like being long anything that is expensive without being girded by strong fundamentals.” – Tom ____
The current U.S. stock market is at its most extreme valuation levels in history measured by our and Warren Buffet’s favorite metric — total stock market capitalization-to-GDP. We now estimate (based on a Q2 GDP estimate) the metric at 164 percent, which is 20 points higher than the dot.com bubble peak, almost 15 percent on a proportional basis.
Initial Valuations Of New Bull Markets
In addition, the beginning valuation of the new bull market, which began on March 23rd was 105.3 percent, almost double the average starting valuations of all prior bull markets since 1974 of 53.1 percent. Not a stellar initial condition for a sustainable and stable bull market.
Moreover, the fundamentals are horrendous.
We recognize the current GDP now Q2 estimate of -53.8 percent does not reflect the true underlying fundamentals of the economy. But nobody knows and can measure the economy’s health as we are still in the midst of the COVID hurricane. We are taking the under, however.
This is not news to anyone but if you really believe the fundamentals are priced, well, good for you!
We also can’t understand how the President’s advisers think a stock market close to its record highs, coupled with depression level unemployment makes for good politics? Voters may question again, as they did in 2016, who really got bailed out: Wall Street or Main Street?
We are also looking forward to taking several Benjamins and Grovers from our friends who make their political bets, based purely on emotion. We made a few bets before the 2016 election that Trump would win the electoral college and Clinton would take the popular vote. One friend responded to our election eve email, “sure you didn’t make a typo?”
We didn’t bet with our emotion or political bias but based on the analysis of how the Hispanic vote was dispersed throughout the country and an approval rating for Congress, which was less than 10 percent, if our memory is correct.
Here’s to hoping a Democratic government will realize they can only achieve their objectives with a strong economy driven primarily by a healthy and dynamic private sector. The hard left of the Party still doesn’t seem to get it. You can’t spend and print your way to prosperity.
Watch The Next Two GDP Prints
Some argue the market rally is pricing in the “recovery.”
There is no doubt a record Q3 GDP growth print is coming, quite possibly by a factor 2x the largest post-war quarterly growth Q1 1950 print of 16.7 percent. Note the headline number is the annualized Q/Q growth.
The Atlanta Fed GDP now just marked down their estimate today of Q2 growth to — are you sitting down? — -53.8 percent, which translates to a Q/Q decline of 17.6 percent.
That would put real output at the end of June almost 19 percent below its Q4 2019 level.
Even if headline Q3 GDP comes at a whopping plus 30 percent, the real economy would still be 13 percent below its 2019 end-of-year output.
We estimate the quarterly GDP prints needed to get the economy back to even in the table below assuming the latest GDP now estimate holds. For example, for a full V-shaped rebound by Q3 2020, the headline number for Q3 would have to print at 127.3 percent. Not likely.
To get back to even (Q4 2019 levels), the quarterly GDP headline number would have to average 14.7 percent over the six quarters beginning in Q3 2020. Not likely.
Do you really think the stock market is pricing a V-shaped economic recovery or even understands and has internalized the following scenarios in the table?
Our answer? NFW!
Upshot
Setting aside the fact the stock market is no longer driven by market forces, including and especially fundamentals, the only sense we can make of the recent price action is that it signals the beginning of the Venezuelan model.
That is, stocks are sniffing out some big-time future inflation and are now the inflation hedge of choice. Not a zero probability but kind of a stretch at this point.
What is most likely occurring, in our opinion, and I haven’t run this piece by our crack stock picker, Carol, who has a much longer time horizon, is the asset bubbles were only partially allowed to deflate before being reinflated by the largest monetary stimulus in the history of the world.
Even still, unless the market is morphing into the Venezuela model, the stock market in a macro sense is at dangerously high levels and I, personally wouldn’t touch it even with your 50-foot pole.
Carol always reminds us, however, money can still be made in individual stocks and not everybody has the flexibility or the desire to wait patiently in an all-cash/gold position.
One Last Point
If you have been reading GMM over the years, you know we are big fans of Robert Shiller,
We think Shiller’s best work was Market Volatilityand specifically the following,
The Ambiguity of Stock Value
Stock prices are likely to be among the prices that are relatively vulnerable to purely social movements because there is no accepted theory by which to understand the worth of stocks….investors have no model or at best a very incomplete model of behavior of prices, dividend, or earnings, of speculative assets.
Shiller nails it here. Stock values are ambiguous as there are no models to determine their “true” price.
Macro Ambiguity
Currently, nobody knows the long-term damage that the COVID crisis has done to the economy, how robust the recovery will be or how much hysteresis will exist as the economy fully reopens,
Hysteresis in the field of economics refers to an event in the economy that persists into the future, even after the factors that led to that event have been removed. – Investopedia
In other words, there’s a lot of macro ambiguity and uncertainty out there.
Asset bubbles thrive in an environment of ambiguity and easy money.
The passive crowd, quants, technicians, and algos couldn’t spot a bubble if it smacked them square in the face. Most are just way too myopic and have no context of valuation.
To rationalize this price action is their world? The market is going up because it’s going up.
