By John Authers
Jan. 24, 2022
Time to Question Assumptions and Experience
We all face one risk when investing that's greater than perhaps any other: the risk that we are wrong. It’s all too easy to be convinced by your own logic and let confirmation bias do the rest. When investing, it’s worth having conviction, but it’s also necessary to take out some insurance against the possibility of being wrong, even if this dilutes returns.
We also have to deal with the fact that we are captive to our own experience. Only a fool doesn’t learn from this — but what if your experience, or the historical lesson you choose to look at, is misleading?
U.S. stock markets have suffered a nasty start to the year, while many of the more popular speculative investments of recent times are in a selloff for the ages. That brings back the arguments about the direction of the market, and of the possibility of a burst bubble, that have endured for the best part of a decade now.
My own belief, for a long time, has been that the stock market is vulnerable to a big selloff once liquidity is withdrawn and interest rates rise. Despite many scares, money has stayed plentiful for the last decade, rates have fallen, and anyone who did much to protect themselves against the risk of a decline would have done badly by it.
Meanwhile, a large and successful coterie of bulls argue that the environment remains set fair for stocks, and that even a fall in bonds would ram home the fact that there is no alternative to equities. They've been right for the best part of a decade.
This being 2022, the debate often gets personal and aggressive. People on both sides tend to the impugn the motives of the others rather than deal with evidence and arguments.
So, here is my best attempt to go through the arguments on both sides, and find areas of agreement, and places where I’ve been wrong.
The Hurdle for Leaving Stocks Is High
Nobody seriously disagrees that over the long term, equities tend to perform better than bonds. History brooks no argument on this. The following chart was produced for Goldman Sachs Group Inc.’s investment strategy group, headed by Sharmin Mossavar-Rahmani, and it shows what we knew — in the long run, profits grow and share prices go up with them. It pays to be in the market most of the time:
Not only that, but buying when the market is expensive isn't such a bad idea. Nobody (including bulls) denies that the market is pricey at present. But this chart from Mossavar-Rahmani shows that the returns from buying when stocks move into the ninth or 10th decile (more highly valued than they have been 80% or 90% of the time) have been great. There’s risk in being out of the market altogether:
This helps to explain the Goldman group’s persistent bullishness since the crisis, which has of course been proved right so far. This chart shows all the times they have recommended buying stocks over that period:
However, there’s another way to put this. When stocks reach a true bubble, and valuation goes far above the long-term trend, they tend to go into a “blow-off" phase at the top. Jeremy Grantham, founder of GMO in Boston and one of the world’s most revered experts on asset allocation, published a piece last week in which he reaffirmed his aggressive call from last year that U.S. stocks had entered a bubble. Using cyclical earnings multiples, he shows that previous bubbles have seen blow-off tops, and this looks like another:
If you’re one of the lucky people who’s made a 133% return on the S&P 500 since it entered the 10th decile of overvaluation in 2016, therefore, it might be a good idea to think about taking some of those profits.
Grantham’s arguments don’t contradict the notion that we should be in stocks most of the time. But they do suggest that we shouldn’t be valuation-agnostic, and that there is money to be made betting against a blatant bubble.
It's About Inflation, Stupid
If there’s a key difference of opinion between bulls and bears, it’s over inflation. The following chart from Mossavar-Rahmani points out that valuations have been higher during periods of low and stable inflation, as theory predicts and as the chart below shows. Stocks aren’t much cheaper now than at the peak of the dotcom bubble. On the face of it, if you think that inflation is going to settle in at a higher level, then you should also brace for valuations to move from the pale blue circles in the Goldman Sachs graphic down to the level of the dark blue bars:
With this, Grantham appears to be in total agreement. His model for price-earnings multiples is based on the return on equity (or profitability) of stocks, and the volatility of inflation and of economic growth. When inflation is higher, investors should demand a lower earnings multiple to combat that inflation. Since 1925, GMO’s model has worked beautifully. It’s only gone wrong twice — in 2000 at the top of the internet mania, and now. Current levels of inflation volatility are mightily difficult to reconcile with stocks at such expensive valuations:
I'm not going to rehash the arguments over inflation. But there’s a reason I spend so much time on it. If inflation really stays this high, current stock market valuations are untenable. Period. There’s a very reasonable case that it will soon come down — but so many people are betting so much on this that they aren’t leaving much room for the risk that they’re wrong.
Concentration — Maybe It’s a Red Herring
The dominance of the big internet platform groups worries many. There are plenty of social reasons for concern about the “FANGs,” and they certainly go a long way to explain protracted U.S. outperformance of the rest of the world. But they don’t have so much to do with overall overvaluation of U.S. stocks. On this too, surprisingly, bulls and bears seem to agree.
For a bullish take, here is Mossavar-Rahmani’s chart showing equal-weighted versions of the index have actually outpaced the market cap-weighted version during the bull run. This is very different from the experience in 1999:
That said, the steady and inexorable decline of smaller stocks and the most speculative tech names, underway for a year now, gives cause for concern, as Grantham shows in this chart:
Further, strong breadth could even be construed as a reason for anxiety. The following charts come from John Hussman, a fund manager and market theorist who has produced a series of research reports over the last decade suggesting U.S. stocks are overvalued. In his latest missive published this month, he splits the S&P into deciles according to valuation — and shows that every one is more expensive than it has been before. Previous booms may have been based on a few companies, but this time everything looks rich:
Adjusting for size renders the same finding. The following chart divides the S&P by market cap, and both the smallest and largest are more expensive than they were in 2000 — although the smaller stocks are still below their recent high:
You would expect low rates and ample liquidity to drive up valuations of everything, and that is what has happened. The corollary, of course, is what might happen if liquidity seems to go away.
Profits Still Look Great
The “Buffett indicator” (the ratio of the U.S. equity market cap to GDP popularized by Warren Buffett) is at an all-time high. But as Goldman shows in the following charts, this only reflects corporate earnings. They are also at a record share of GDP:
We can expect growth to slow somewhat from the hectic pace of 2021. But if profit margins remain robust, it grows harder to see how earnings and hence share prices can fall much. I spent much of the last decade expecting margins to revert to the mean. And as Goldman Sachs shows in this chart, companies are becoming ever more profitable in a way that seems to be sustained. The step change following China’s accession to the World Trade Organization is clear and dramatic:
Earnings season is underway and should tell us a lot. But the bearish retort to the Goldman numbers might be: Yes, the inexorable increase in profits since cheap Chinese labor became available might well support and justify valuations — but this only shows how important China is to the U.S. economy. At present, that should be a concern. The exercise also shows that the stock market would be vulnerable to tighter margins.
This gets mixed up in a broader societal debate. How much longer can current levels of inequality be tolerated? Higher wages and tighter profit margins might help to alleviate inequality; and the resulting damage to the stock market would alleviate inequality still more.
Another point matters. Liquidity, particularly from the Federal Reserve, has come to matter far more than corporate earnings since the desperate rescue operations over the financial crisis in 2009. As Savita Subramanian of BofA shows in the following chart, expected earnings are far less helpful in explaining market outcomes since 2010 than they were before. Meanwhile, changes in the Fed’s balance sheet, the amount of money it’s making available to markets, have become hugely important:
What About the Fed Put?
That brings us to the crux. The models of Grantham, Hussman and others might show that the stock market could fall by 40% or 50%, but would the Fed ever let this happen? Ever since Alan Greenspan, there has been an apparent Fed “put option” that cushions the fall.
Grantham is clear that two massive declines after bubbles burst this century shows the Fed put can't be relied on:
Greenspan invented the put. He was passionate about the new economy and the golden era of the internet. But the Nasdaq still went down 82% on his watch. He stopped it at trend. Every bubble before it had gone below trend, but he made it bounce at trend. Bernanke couldn’t stop the non-existent housing bubble from going back all the way to where it came from. And he couldn’t stop the S&P from falling 50%, even though it wasn't that overvalued.
Another way to look at this concerns inflation. The Fed has stepped in to arrest market routs on several occasions over the last quarter-century, but throughout this period low inflation was a constant. If consumer prices are rising, it grows much harder for the central bank to come to the rescue. Or, it could give up on fighting inflation, in which case the stock market’s real returns will suffer (although it will still perform better than bonds).
Still another way concerns what the put is meant to protect, and who is really offering it. Michael Gayed, the investor who publishes the Lead-Lag Report, points out that the Fed wants to protect the likes of The Vanguard Group and BlackRock Inc. which hold the unit-linked pensions of many Americans, mostly in passive funds linked to large-cap stocks. The Fed has done nothing to stop the rout in tech stocks or cryptocurrency (and there’s no reason why it should). But the S&P 500 matters for public policy now. People’s retirements are riding on it, and the effect on spending of a big drop in 401(k) statements is difficult to contemplate. This is true now to a far greater extent than in the past, and it should color bears’ confidence that the stock market would be allowed to dive a long way.
But then, who exactly is offering a put? As Goldman Sachs points out, flows of money into mutual funds and exchange-traded funds have overwhelmingly favored bonds over equities for the last decade:
It’s not as though stocks’ valuations have been buoyed by big flows from investors. However, the flows into bonds have had the effect of propping up equity valuations. How can people still be buying bonds in such numbers?
The answer again I suspect lies in the changing structure of the investment industry. Pension money is now dominated by target-dated funds that automatically reallocate between stocks and bonds to maintain fixed proportions. For the last decade, that has meant regular selling of stocks and buying of bonds. This has helped keep yields low. Target-dated funds have a placed a put option under the bond market, which in turn has supported stocks. That will continue unless bond prices fall as fast as stocks.
Where Does That Leave Us?
The hurdle to leave the equity market altogether is very high. But it’s possible to spread your bets. Betting on stocks to continue on their current course requires confidence that inflation will come under control, and earnings will keep growing. Betting on a crash entails confidence that there will be no “put,” whether from the Fed or the target-dated fund industry. History suggests extreme vulnerability to a selloff, so some evasive action, like adding to cash from bonds and shifting toward cheaper stocks more likely to prosper under inflation, seems like a good idea.
In the short term, we have some preliminary growth data for the U.S. coming up this week, along with a meeting of the Federal Open Market Committee, which will come hours after a Bank of Canada meeting that is expected to result in a rate hike. Given current levels of anxiety, the chances of a “dovish surprise” in which the growth data disappoint and central banks aren’t as aggressive as feared, seem rather greater than a hawkish surprise.
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