As the markets push once again into record territory the question of valuations becomes ever more important. While valuations are a poor timing tool in the short term for investors, in the long run valuation levels have everything to do with future returns. The current levels of profits, as a share of GDP, are at record levels. This is interesting because corporate profits should be a reflection of the underlying economic strength. However, in recent years, due to financial engineering, wage and employment suppression and increase in productivity, corporate profits have become extremely deviated. This deviation begs the question of sustainability. As we know from repeatedly from history, extrapolated projections rarely happen. Could this time be different? Sure. However, believing that historical tendencies have evolved into a new paradigm will likely have the same results as playing leapfrog with a Unicorn. There is mounting evidence, from valuations being paid in M&A deals, junk bond yields, margin debt and price extensions from long term means, "irrational exuberance" is once again returning to the financial markets.
The default cycle that should have occurred, given historical patterns of issuance cycles, has morphed (thanks to the Fed) into a refinancing cycle; but while DoubleLine's Jeff Gundlach suggests that fundamentals are supportive, "the valuation of junk bonds as a category is at its all-time overvalued versus long-time treasury bonds." So despite Yellen exclaiming that she sees no bubbles, one of the world's largest bond fund managers has never seen corporate bonds (investment grade and high yield) more expensive. Gundlach goes on to note he has sold some Apple (but believes it will remain range-bound), is baffled by the valuation of Chipotle, and sees 10Y Treasury yields dropping to 2.5% or lower.
I vividly remember how low interest rates and the Fed Model were used as propaganda tool in the late ’90s to justify the stock market’s “this time is different” sky-high valuation
While stock prices can certainly be driven much higher through the Federal Reserve's ongoing interventions, the inability for the economic variables to "replay the tape" of the 80's and 90's increases the potential of a rather nasty mean reversion at some point in the future. Inflation-adjusted, the current rally of 115.56% is the 6th longest in history with the market still below its 2000 peak. We are currently at valuation levels where previous bull markets have ended rather than continued. Understanding the bullish arguments that support markets rise is important, however, the real risk to investors is the eventual and inevitable "reversion to the mean". In other words, what comprises that "light at the end of the tunnel" is critically important to the future of your investment success.
Despite much hope that the current breakout of the markets is the beginning of a new secular "bull" market - the economic and fundamental variables suggest otherwise. Valuations and sentiment are at very elevated levels which is the opposite of what has been seen previously. Interest rates, inflation, wages and savings rates are all at historically low levels which are normally seen at the end of secular bull market periods. Lastly, the consumer, the main driver of the economy, will not be able to again become a significantly larger chunk of the economy than they are today as the fundamental capacity to releverage to similar extremes is no longer available.
With the market more bullishly positioned, more euphoric, and more levered than almost any time in history, it is perhaps worth "pondering" what some of the risks to this optimism could be...
SHLD is making the cut for one of my top 3 picks of 2014.
The past can offer clues to the future but it doesn’t give us a blueprint. The bigger message is that today’s valuations don’t bode well for long-term returns, where long-term means beyond the next market peak. Prices could surely bubble upwards from here, but bubbles are invariably followed by severe bear markets. More importantly, we shouldn’t be fooled by traditional valuation measures. P/Es, in particular, have several flaws. We’ve shown in past articles that we get completely different results when we adjust earnings to account for mean reversion. Either way, our conclusions are a far cry from the “nothing to see here” that we keep hearing from the Fed.
- BAD TRADE #1 For 2014: Ignoring Mean Reversion
- BAD TRADE #2 For 2014: Which-flation?
- BAD TRADE #3 For 2014: Forgetting Late Cycle Dynamics
- BAD TRADE #4 For 2014: Blind Faith In Policy
- BAD TRADE #5 For 2014: Reaching for Yield During Late Cycle
Keep a close eye on China: it is on the cusp between the end of the leverage cycle (where as we reported over the past two days, it has been pumping bank assets at the ridiculous pace of $3.5 trillion per year) and on the verge of having its debt bubble bursting. What happens then is unclear.
The third stage of bull markets, the mania phase, can last longer and go farther that logic would dictate. However, the data suggests that the risk of a more meaningful reversion is rising. It is unknown, unexpected and unanticipated events that strike the crucial blow that begins the market rout. Unfortunately, due to the increased impact of high frequency and program trading, reversions are likely to occur faster than most can adequately respond to. This is the danger that exists today. Are we in the third phase of a bull market? Most who read this article will say "no." However, those were the utterances made at the peak of every previous bull market cycle.
If you have not already, it is time to modify your UST trading strategy to adapt to current market conditions. Buyer beware...
Over 2 years ago when we first discussed the fact that "muddle through" had failed, BCG noted that "there were only painful ways out of this mess." The most painful truth, they suggested, was that "the only way to resolve the massive debt load is through a global coordinated debt restructuring... which will have to be funded by the world's financial asset holders: the middle-and upper-class' who will have a ~30% one-time tax on all their assets to look forward to as the great mean reversion finally arrives and the world is set back on a viable path." However, given the delay (and worst progression), Ken Rogoff warns that temporary wealth taxes may well be a part of the answer for countries in fiscal trouble today, and the idea should be taken seriously; but they are no substitute for fundamental long-term reform to make tax systems simpler, fairer, and more efficient.
While BTFATH has caught on as the new normal meme, Cti's Tobias Levkovich has another that is just as critical to comprehending the current euphoria: LMNOP = "Liquidity, Momentum, Not Operating Performance." In essence, Levkovich notes that the recent sharp move has come about as liquidity concerns have shifted to the sidelines; upward momentum for stock prices following the shutdown ending is just pulling in more short covering while long-only investors also have been buyers given the need to meet alpha generation or benchmark requirements; but operating performance by companies is simply not there in the manner that is perceived. As he concludes, "we have not seen this kind of deviation before and it is troublesome to us... we must admit to being a bit worried that investors might be facing some near term volatility."
Once the economy's capital structure is distorted beyond a certain threshold, it won't matter anymore how much more monetary pumping the central bank engages in – instead of creating a temporary illusion of prosperity, the negative effects of the policy will begin to predominate almost immediately. Given that we have evidence that the distortion is already at quite a 'ripe' stage, it should be expected that the economy will perform far worse in the near to medium term than was hitherto widely believed. This also means that monetary pumping will likely continue at full blast, as central bankers continue to erroneously assume that the policy is 'helping' the economy to recover.