I was struck the other day by an article by Byron Wien, vice chairman of Blackstone Advisory Partners. He recently wrote that in his view, the market could keep going for some time – perhaps into 2019 – because the usual factors that warn of impending bear markets are simply not in evidence at this time, and that markets do not die of old age. There is no inverted yield curve, he observes that retail investors are not euphoric about equities as they were in 2000 and 2007 for instance, hedge fund net exposure shows a mood of caution, the leading indicator index has been climbing steadily since 2016, corporate earnings have been increasing, and he asserts that strong business activity exists in the US, Europe, Japan, China and India. There is a lot of investor complacency, as evidenced by the very low VIX index readings, but as long as the economy continues to grow, he thinks that maybe that is not all that negative. Under those circumstances, a major crash-and-burn kind of stock market outcome seems to be unlikely in the near or even intermediate future. Since I myself have been cautious about the markets, and continue to be so, it struck me that I am either too pessimistic or Wein is too optimistic – and which is the more likely outcome? I do agree with Wein that the usual indications of a bull market peak are not present. That does not mean that strong bear market indications are absent, however, nor that this market is not very long in the tooth.
At the top of that list of bear market indicators is the lack of intrinsic value as we at my company, Strategic Analysis Corporation, measure it, notably in the S&P 500 and the NASDAQ 100. I recall that early in the year 2000, the S&P reached a valuation in which our Fair Market Value (FMV – our intrinsic value upside/downside determination) fell to zero. It actually bumped against that zero value level three times early in that year before the market finally slipped into the bear market mode that prevailed for the next 2 years into mid-2002. While the clear signs of rampant speculation in the dot-coms may be what most investors and commentators remember about 2000, for me it was the zero FMV potential which is what I recalled most vividly, and which – in my view – was what caused the market to run out of gas. Speculative excess, yes! But I said then and I would say again, I do not think that markets can run on negative energy – which is what they are trying to do now. Wein, of course, has no measure that matches our FMV and is therefore entitled to ignore it (at his peril, perhaps).
A second enormous issue is the massive and continuous efforts by the central banks to prop up markets through Quantitative Easing (QE) which they have been hard at work in executing since the horrific lows of 2008-9. Investors now expect that the central banks will maintain their programmes of stimulation – even if, for a moment or two in time, they falter at this task, or decide to end their current QE programme and replace it with some Quantitative Tightening (“Tapering” or QT) in order to wean the markets and the economy off all of that stimulus. That is thought to be a ‘temporary measure’ at worst, to be repealed at the first sign of serious market weakness. QE, in all of known market history, has never been tried before, and the comforting notion that the Fed will always be protecting the backs of investors is certainly a driving force behind steadily rising market values. I do not know what will happen when the Fed actually tries QT instead, and, as reassuring as their words may be that QT carries ‘no adverse consequences’, “tapering” definitely can not have the same positive effects as “easing” has had (although this proposition has yet to be tested).
Chief among those who claim that they cannot see any market tops in sight are those who observe that there does not seem to be any visibly obvious valuation excesses such as the Nifty-Fifty stocks of the early 1970s, the dot-com stocks in 2000, and the housing bubble which peaked in 2007-8. In some ways, this is the easiest claim to refute because the valuations (in price/book terms) of today of some of the very largest of stock market capitalizations easily match the extremes of the dot-com stocks in 2000. The measured downside risk of most of the FANGS are enough – if they were experienced (again!) – to cause massive losses of investment capital, and the investor pain that goes with it. Facebook carries a forward PE Ratio of a mere 28, while Invidia has a 50x PE Ratio for 2018, Netflix has a 106x PE Ratio, with Amazon being the champion at 138. Amazon, Invidia, and Netflix have all had histories of stunning percentage price declines in weak markets. Apple, another market favourite, is also not immune to huge price declines. The problem with such massively capitalized stocks suffering price declines in line with their own historical magnitude is that they drag down more stocks with them the further that they fall.
Observing the popular crypto-currency movement as well as the willingness of investors to blindly put their money into vehicles that they don’t understand and can’t measure in any case is to harken back to the Mississippi Bubble era of three centuries ago. As well, with more than 1000 bitcoin issues public right now (and rising steadily), it is looking almost worse than the dot.com market of 2000. Does the world really need all those cryptos and what – if anything – is their intrinsic value in any case? My guess – based on long and sometimes bitter experience – is that most will die in the coming period, the survivors will be seriously tarnished, and the speculators who own them will be severely mauled.
In the meantime, investor expectations appear to be very powerfully optimistic. Merrill Lynch finds that their clients are holding the lowest allocation to cash in the last 13 years. The Market Vane poll show that 71% are bullish and 65% of respondents expect stock market prices to be higher in the next 12 months. There are also a record number of speculator futures contracts which are short the VIX. Technically, at any rate, those numbers are concerning. It is really difficult to assert that investors are anything but rampantly bullish!
Further, I are intrigued by the extremely low VIX levels averaging about 0.3% a day (the measure of volatility of the markets which historically has served to measure the comfort of investors with the valuations in evidence). I vividly recall, for instance, the one-day market crash of 1987 which was preceded by a long period in which the daily fluctuations of the market averaged close to 2%. One day, that 2% change just kept on going – down 28% before finding a bottom (in price/book terms, from about 2 times down to about 1.5 times book in a single day). In other words, that crash was clearly signalled – or perhaps “clearly in retrospect” would be a much more accurate way to put it. Our advice to our clients at the time was “the market is levitating”, although we hardly expected a one-day termination of that condition. Today, there is no obvious parallel between October 1987 and October 2017 in VIX terms, save to observe that an extremely low VIX may be a sign of extreme investor comfort and complacency – for all the reasons that I noted above, especially the promise of Fed intervention should anything untoward occur. Do keep in mind that in 1987 Fed intervention also occurred – vigorously – but not until the day after that market crash. Curiously, the same set of conditions applied then as do now, namely all of those market algorithms that kicked in to sell out investors as the market plunged are alive and well today as trading robots (“bots”), resetting stock allocations on the go, as it were. I am hoping that the automatic stabilizer mechanisms remain in place that were put in place after 1987 – but I doubt it as none have been tested in a real-life meltdown. Simulations, maybe, but reality? Recent one-day “mini-crashes” do not give me confidence that a serious setback will not be exacerbated by all of those bots. And how is one to know when the next “mini-crash” occurs that it is merely an error in someone’s programme or the start of something much more serious? Not that I am expecting anything like another 1987, but current valuations are a sleeping tiger best left unmolested. I do note, however: the market is levitating again.
Evidence that the economy is actually slowing is abundant (although the IMF just raised its 2018 outlook!). Auto sales are long in the tooth and home sales plus auto sales are starting to run in negative territory (below). Like others, I am also wondering if the householder is running out of discretionary spending ability after a 9-year Fed-encouraged spree. However, consumer confidence remains quite positive, thank you very much. The ECRI’s US Weekly Leading Index growth has fallen to a 79 week low, indicating thqt economic growth is as good as it is going to get. (Is this a precursor to much slower conditions – or is this move into negative ground merely a temporary condition?)
What about tax reform in the US, however? Surely with corporate taxes coming down, earnings per share would move strongly upwards in 2018-19. That assumes, however, that tax reform is even remotely possible and in the cards. The huge issue with tax reform is how to pay for it – that is to say, what is the offset to slashing taxes for corporations (and the wealthy by inference)? Reforming Obamacare (that is, slashing spending on Obamacare) died aborning, and other alternatives do not seem to appeal much either. Cutting corporate taxes when US corporations are buying back their stock does not really seem to make much sense, and capital spending in the US is quite tepid in any case. I have made the case, complete with the detailed mathematics, in The Limits of Debt (see my blogsite, The Occasional Contrarian) that US GDP cannot grow rapidly because of the very issue that the congressional leaders are concerned about – the size and sheer weight of the US debt on the economy. This would be exacerbated if taxes were to be cut without a balance elsewhere. And in a “lifeboat economy” (my Limits of Debt term) “I” am not prepared to reduce “my” share of the economy only to see “you” get “more”. I fully expect that tax reform will fail to get off the ground.
An Elderly Market, With Clear Signs of Aging
And so I come back to my question – how will this market finally reach its end and does it need the kinds of signals and indicators that in the past have been clear precursors of bear markets? I would observe that to a considerable extent, all of the usual precursors are already here. Complacency, mass speculation, and ultra high valuations are already part of the current investment condition. With the Fed trying to pull off Quantitative Tapering, at least one more rug will be removed from under the feet of investors. In medical terms, the patient has a very weak pulse (the VIX), it has no energy to keep going (zero overall intrinsic upside value potential in evidence), and the doctors are actively planning on pulling the life support plug (QT is coming). Personally, I really don’t want to bet too heavily that this sclerotic market is facing a long and healthy life ahead!
But – one last question – how would we “know” when the end finally does come? Does the stock market just lie down and refuse to get up one morning? Like General MacArthur’s ‘old soldiers’, does it just fade away? Or does it suddenly fall by 20% (or whatever)? What about a 10-20 day cascade of prices? I strongly suspect that when the VIX awakens this time, things will not be pretty. Byron Wein can’t see it and the investing public is acting as if there is no end in sight. I would be less than candid if I were to say that I am able to, either. However, the market got here by unusual measures, and its demise should be unusual, too.
What I am doing is what I have done in the past, that is to rely on our valuation measures to tell me when a break is coming. As we did at the break in the market is 1987, 2000, and 2008, I will rely on our technical signals to sound the alarm. Already, the intrinsic potential of the S&P and the NASDAQ are sounding a warning that the market is out of gas. I have not yet seen the technical break that I saw in 2008, but it is close by in percentage terms. A break below the 2400 level (2.5 times adjusted book value, and the ceiling valuation for the S&P for the 2002-8 market period) for the S&P will signal the end of the bull market for me.
For the time being, I have to say that no break has been signalled and that a bull market therefore remains in force, however poorly supported that it may be. I am, however, happy to be defensively positioned with a good cash holding.