A common feature of the years 1929, 1972, 1987, 2000 and 2007 is that in each of these instances a major crash put an end to a seemingly endless bullish trend that continued to push equity valuations ever higher in the face of “old timers” who preached caution…
Market crashes and downtrends are in fact a natural part of the boom-bust cycle and have been a feature of all markets pretty much since time immemorial. As Sir John Templeton once said, the most dangerous saying in the markets is “this time it’s different”. What he meant by that was that as the “wall of worry” had been overcome, so the path of least resistance with most market participants “in” the market and fully invested is then down.
Another common feature of each of the periods listed above is that a crash occurred when the market was exhibiting signs of being both overvalued and overbought, and also when investors were overly bullish for a prolonged period of time. Investors essentially misprice the “risk” inherent in equities and so the gap between price and intrinsic value becomes ever more stretched until at some point it snaps. The trick of course is finding that “snapping” point. During the aforementioned years, the appearance of these signals brought about rapid crashes out of clear blue sky. Indeed, so rapid were the declines that most investors were hit without being able to cut their losses. We deem it as being akin to taking a punch from Mike Tyson out of the blue – it very likely stuns you to such a degree that you are temporarily debilitated (thankfully we have not taken such a thumping from Mr Tyson!).
Generally (but not always) there is an exogenous development that leads investor sentiment ever higher. This rise in sentiment changes investors’ risk perceptions and drives them into riskier assets in a search for ever higher returns. These higher returns, instead of preventing investors from buying (as valuations become higher) actually invoke the opposite of what supposedly rational investors should do. That is they attract additional investors to the market at a time when value has disappeared (another reason why momentum investing always invariably ends in tears).
While this cycle lasts, everyone seemingly becomes wealthy and makes juicy profits. The doomsayers look like fools (this is in fact where our saying – “the market can make geniuses look like fools and fools look like geniuses” comes from) as the uneducated masses appear to become ever more richer (and cleverer). The now departed Tony Dye known as “Dr Doom” would pay testimony to this.
A genius playing the fool!
We have opined at length for nearly six months now about the caution we resolutely feel is warranted in the U.S equity market in particular. We did catch the early part of the year correction, but nothing upon nothing seems able to stop this juggernaut. Every bear has been flattened and the word on the street now is that the sheer magnitude of money printing by “Helicopter” Ben and his successor Janet “I’m a Yellin” has created a sort of perma plateau which continuously supports equity prices. Poppycock is our polite response! We are, in our opinion and from long experience, literally now at the last orders stage of this party. Anyone chasing momo stocks, small caps, tech plays, indeed almost every sector of the market here has quite simply MISSED the bull market. You really are picking up pennies in front of the freight train.
The chart below shows just how long in the tooth this market now is.
Still,while the markets look overvalued, overbought, and investors remain overly bullish the correction still does not come. In other words, the market does not seem to be willing to revert to intrinsic value. So what is an explanation for this?
This time we have the Fed pumping eternal happiness into the system. Three rounds of huge quantitative easing have depressed interest rates and yields to such an extent that investors simply do not have any other option available to them than to seek out riskier assets, certainly while cash yields effectively zero and bonds nominal levels even in countries that remain basket cases. The flaw in this search for yield however is that the underlying GDP growth rate remains muted. This is the real long term driver of equity values – profits as a share of GDP and underlying GDP growth are, in the former’s case, at record levels and so likely to fall. And in the latter, largely dependent upon monetary easing.
With inflation everywhere but in the official figures, it doesn’t take a genius to work out that a major “accident” is likely to happen. In fact, with PE ratios and many other present value measures at the top end of their historic bands, on a 7 year horizon, historically, equities have delivered almost zero.
We believe that the markets are fated to correct and to correct dramatically at some point, probably in the very near future. At Titan, in our main Macro fund, we have moved to a maximum short position in recent weeks and believe that this is now a game of capital strength, patience, position sizing/structuring and trusting one’s instinct.
We suspect that the next taper or sight of the final one in October will be the straw that breaks the camel’s back. Once sentiment turns, given the overloaded bullish boat, the market cycle will feed on itself to the downside just as it has to the upside in recent years. A precursor to the type of sell off we think is just around the corner is what occurred in the summer of 2011 when Euro-region woes flared up out of nowhere. Of course, central bankers could do the same again and extend QE a fourth and a fifth time but that would just be loading trouble on top of trouble and really cause inflation to run and of the type that the official stats cannot hide (and as we are seeing in housing markets now – which typically follow equity price appreciations, next step is wider inflation in the economy as the “wealth effect” trickles down).
We leave you once more with the Shiller P/E ratio chart that has been rising substantially and currently sits at over X26, a measure which is very high by historical measures. If this is not enough to reverse positions at this point, it should at the very least be seen as an alarm bell by those that remain fully invested and those “trend followers” that currently crow of their genius. They would be well advised to remember our saying re “geniuses and fools”…