Rationality Versus The Market

Sprott Money's picture

Rationality Versus The Market

Posted with permission and written by John Rubino, Dollar Collapse


Rationality Versus The Market - John Rubino

The late stages of financial bubbles are always tough for rational analysts. Focused as they are on the numbers, such analysts are relatively immune to the emotion that drives the action at market extremes, so they find themselves making predictions that turn out to be “wrong” for months and sometimes years.


Then the cycle turns and the rational analyst is vindicated – though often far too late for his bruised ego and diminished client base to easily recover.


[Recall the scene in The Big Short where hedge fund manager Michael Burry, after suffering months of abuse from his clients for shorting the 2006 housing bubble a bit early, is lambasted by a client who can’t believe Burry has, after the crash, gone long equities — because they’re clearly going to zero. In both cases Burry was right and his clients wrong, but he nevertheless closed up shop and quit the business.]


Anyhow, we’re there again, with governments manipulating all major markets to valuation levels at which previous crashes have occurred. This is leading analysts who focus on historical norms to issue warnings, which turn out to be wrong (stocks are setting new records as this is written), which draw derision from people who see no reason why the party ever has to end.


A good example is John Hussman, whose eponymous family of funds has been on the wrong side of this market for an uncomfortably long time. Yet he persists, because the numbers don’t lie. From his most recent report to clients:

So the mindset, I think, goes something like this. Yes, market valuations are elevated, but, you know, low interest rates justify higher valuations. Besides, there’s really no alternative to stocks because you’ll get what, 1% annually in cash? Look at how the market has done in recent years. There’s no comparison.

Value investors who thought stocks were overpriced in recent years have been wrong, wrong, and wrong again, and even if they’re eventually right, being early is just the same as being wrong. The best bet is just to invest in a passive index fund for the long-term, and ignore the swings. There’s really no alternative.

What’s notable about this mindset is its excruciating reliance on three ideas. The first is that low interest rates “justify” rich valuations. The second is that market returns simply emerge as a kind of providence from a higher power, perhaps magical gnomes, or the Federal Reserve if you like, and that those returns have no particular relationship to valuations even in the long-term. The third is that market returns during the recent advancing half-cycle are an accurate guide to future outcomes.

In effect, stocks are viewed as good investments because they have been going up, and the evidence that stock prices will go up is that stock prices have gone up. Every additional market advance makes stocks look even better, based on past returns. Indeed, the more extreme valuations become, the more convinced investors become that extreme valuations don’t matter.

And that’s why we’re all gonna die.

A few insights may help to deconstruct this mindset. First, if one is going to invest one’s financial future in the stock market here, it’s worth making at least a cursory study of 5, 10 or even 20-year growth rates in population, labor force, productivity, S&P 500 revenues, earnings, real GDP, nominal GDP, and virtually every other measure of fundamentals. That exercise will quickly inform investors not only that the growth rate of fundamentals has persistently slowed from post-war norms in recent decades, but also that the underlying drivers of growth (primarily labor force demographics and productivity growth) are now running at rates that are likely to produce real GDP growth on the order of just 1% annually over the coming decade, while even a sizeable jump in productivity would likely result in sustained real GDP growth below 2% annually.

Unfortunately, this has implications for how one responds to interest rates, because the argument that “low interest rates justify higher valuations” relies on the assumption that the growth rate of underlying cash flows is held constant. Any basic discounted cash flow analysis will demonstrate that if interest rates are low because growth is also low, then no market valuation premium is “justified” by the low interest rates at all. Indeed, if both growth rates and interest rates are x% lower than their historical norms, then even a historically normal level of market valuation would be associated with subsequent market returns that are x% below historical norms. No valuation premium is required to produce this result.

The most reliable valuation measures we identify (those most strongly correlated with actual subsequent market returns) are about 2.5 to 2.7 times their historical norms here. Paying a valuation premium in this case simply causes prospective future market returns to collapse.

In order to provide the longest perspective possible, and also to offer a measure that can be easily calculated and validated should one choose to do so, the chart below shows my variant of Robert Shiller’s cyclically-adjusted P/E (CAPE), which has a correlation near 90% or higher with actual subsequent 10-12 year S&P 500 total returns in market cycles across history.

What investors presently take as a comfortable environment of pleasant market returns and mild volatility is actually, quietly, the single most overvalued point in the history of the U.S. stock market.

Hussman’s conclusion is, obviously, that a horrendous crash is coming. The problem is that this – and most other valuation measures – started flashing red in 2013, so warnings based on them now have a hollow ring.


Will they end up being be right? Without a doubt. And the longer the current exuberance goes on the bigger will be the subsequent crash. Somewhere out there is the perfect moment to short the hell out of this and pretty much every other country’s stock market. But only a tiny handful will nail it.



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Rationality Versus The Market

Posted with permission and written by John Rubino, Dollar Collapse


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Maestro Maestro's picture

Back to publishing stupid articles for this Sprott Money outfit.

You simply cannot win by going short this market. Because this is NOT a stock market.

A real stock market reflects what is going on with revenues and profits. With revenues and profits down or flat, the stock market must go down. This one doesn't, so the Dow Jones, the S&P 500 and NASDAQ are NOT stock markets.

These financial markets reflect one thing and one thing only: the domination of the world by the United States of America. As long as American supremacy reigns, the so-called stock markets (in reality, barometers of American primacy in world affairs as instantiated by the Americans' ability to print dollars out of thin air and buy your ever willing collective asses lock, stock and barrel with it, you despicable vermin) will NEVER go down, irregardless of economic, political and military turmoil or travails no matter how disastrous they are.

In short,

If you're buying stocks (or bonds) today, you're buying the myth that America will last forever and Americans can do whatever they want.

The moment the world acquiesces that the emperor isn't wearing any clothes at all, the dollar and ALL fiat currencies which are only different names for the dollar, will crash. NOT the stock market, which will probably go much higher in nominal terms but lose 99% of its value in real purchasing power.

In short, the stock market today only signifies HUBRIS.

You will NOT win by shorting it because the currency in which you hope to get reimbursed will crash as the indices charge higher.

You will NOT win by going long the stock market because the currencies will be obliterated if America is repudiated as the going paradigm.

Cryptos = CIA

Tell me, do you know why sugar is sweet and blue is blue? Did the human race got together 10,000 years ago and decided that it is so?

Just like practically all of you believe that gold and silver derive their value from consensus?


Now you can go short to your heart's content.

Honest Sam's picture

"Instantiate", eh???

At least I learned a new word today. 


cluelessminion's picture

I won't be nailing this market at all.  Removed my meager nest egg out of the market completely about two weeks ago.  And it really hurts to realize that once again, I cost myself money.  I've accepted the fact that I'm terrible at the stock market but I'm too risk adverse to go on.  And I'm going to pay for it.

Identify as Ferengi's picture

Thanks, Mr. Rubino, this cogent summary far exceeds my poor understanding. All I've had was a, "feel." You've given tools that may help me to help relatives and friends.

GeoffreyT's picture

It shits me to tears when people abuse the term 'rational' - pretending that it means something other than what it means. It's like people who claim that 'utility' is solely hedonistic and solely derived from consumption of goods and services, and does not incorporate others' utility/disutility - when any notion of a utility functional can easily incorporate utility interdependence,

Rational  - in the context in which it is used in economics - means using a decision-making process that seeks optimal outcomes, based on preferences, information set (including some model of how the world works), and constraints (including endowments and technology).

Note that 'cognitive ability' is part of endowments; 'tards gonna 'tard, but they're still being completely rational so long as they're seeking the best outcome.

There is nothing irrational about trend-following an overvalued market if your analytical process concludes that the trend is likely to continue irrespective of the reasons why it continues. But you best oughtta be thinking harder and harder as the trend progresses.

Rational is as rational does: if you exclude sentiment, trend, momentum and other non-valuation metrics from your analytical method, you're not "irrational" - you're just a fucking retard.

Same same if you only use non-valuation approaches (because valuation is the strong long-term attractor - along with demography and technological change).


Those of you who've read my market-related blatherings here and elsewhere since late last millennium, will have noticed that I specialise in poking my nose in - advocating vocally for entry against the trend - when trends are primed to reverse.

Just a few obvious examples are (in no particular order)

  • the downtrend in BTC during the MtGox fiasco;
  • the downtrend in BP.L after Deepwater Horizon;
  • the downtrend in the DAX in Feb/March 2009;
  • the uptrend in gold above $1700;
  • the downtrend in gold at $1170;
  • the downtrend in VW.DE after the emissions scandal.

Look at my comment history on this site - do be aware that you will have to wade through a bunch of histrionic screeching about other shit because I've stopped bothering about financial markets (I've been super-busy doing other shit that's way less lucrative but way more interesting).

You will notice that a few times I've mentioned having run up a string of 100 or more individual trades that were exited with a profit (most recent strings was 173 consecutive trades across DAX, Oil, Gold, NIK, DAX, Dow, yadda yadda; prior to that was 130-ish). 

Some were shorts, some were longs. All were counter-trend. Some of these were intraday, and had holding periods of less than 10 minutes and were never underwater for more than 2 ticks; others were held for weeks or even months and put more than half of capital at risk. I never use stops, but I will exit a trade that is underwater if my method says that the probability of an eventual profitable exit has fallen below 90% - that's usually how my streaks end. 

Honest Sam's picture

You and, "Maestro Maestro", need to get a room.

Juliette's picture

All the smart guys and girls (me included) need to get over it already: The market is always right! It doesn't matter if a company got negative "earnings" only, or whether Bitcoin got any real world use at all ... if the market likes and buys it, you better get aboard for the ride! The only caveat there is that you should be lucky enough to get out on time, before the much anticipated crash finally hits (if ever), but until then you make shitloads of money.

ReturnOfDaMac's picture

He is suffering from analysis paralysis, STFU and BTFD. That is all.

iconic's picture

The trend is your friend. This is the mother of all trends. Why trade any other market? Buy the selling and make lots of money. It is just that easy.