Francesco Filia: The World"s Twin Asset Bubbles Could Collapse Under Their Own Weight

In this week"s MacroVoices podcast, Erik Townsend interviews Francesco Filia, a fund manager at Fasanara Capital. After exchanging pleasantries, Townsend begins the interview by asking Filia, an analysts who"s widely regarded for his research about how post-crisis monetary policy has impacted distorted markets, about the different metrics he uses to determine whether a certain asset is in a bubble.

Filia begins by ticking off a laundry list of metrics that all point to the same conclusion: That today’s market is more overvalued than at any point in recent history – including the run-up to the financial crisis.

Thank you, Erik. I think the equity bubble is quite uncontroversial, is quite unambiguous. There are a lot of different valuation metrics for those that care to look into them. They’ve been valid for over a hundred years of modern financial markets. And this time is no different in that respect.

 

There are the usual metrics that the valuation guys are looking at, like financial assets to disposable income that shows that this market is way more expensive than at any point in history including the big dot com bubble and the Lehman moment in 2007-2008.

 

But there are other metrics like the Buffett Indicator (market cap on GDP), the median debt on total assets, the corporate debt to GDP, the price on sales, the price to book, enterprise value on sales, enterprise value on EBITDA – there are a number of different metrics. They all convene that this is a market bubble that has not been seen before in history.

Filia said he created his own valuation metric that is loosely based on the famous Shiller PE (or CAPE) ratio. Economist Robert Shiller, who teaches at Yale School of Management. Filia"s ratio helps filter out distortions caused by the drop off in corporate earnings caused by the crisis.

But we at Fasanara, we developed our own indicator just to try to add something to what was available already. And we started with one of the most famous of all the indicators in this respect, which is the Shiller adjusted PE ratio, or the CAPE ratio. This is the most famous of them. Professor Shiller got a Nobel Prize in 2013 for it. And for his studies on market inefficiencies and for the ability to infer future expected returns from valuation metrics such as the Shiller PE.

 

 

And, based on the Shiller PE, what it does is simply to compare current prices to not spot earnings of foreign earnings, but a more reliable measure of the average of the last ten years and adjusted for inflation. So the average of the last ten years of real earnings. And on the basis of this index, we find out that the market is as expensive and just a little bit less expensive than it was in 1929 during the Great Depression, the peak of the market before the biggest collapse in equity prices ever seen, and the year 2000. So just slightly cheaper than the year 2000.

Filia"s ratio is loosely based on the work of John Hussman of the Hussman funds, who was the first to utilize peak earnings instead of average earnings in his PE ratio calculations.

What we do is an evolution of the Hussman PE ratio (which is taken from the Shiller ratio) which is to compare – kind of putting all in the basket. So we put the peak earnings as opposed to average earnings, and for peak earnings we really mean the peak. We take the two top quarters over the last 40 quarters. So we cannot really be seen as being any more generous to the current markets, we take the two peak quarters of the last 40 quarters. And then what we do is we compare these peak earnings to potential growth, or trend growth.

 

Because the point here is that what you pay in terms of stocks, should compare, not just to the past or the earnings of proposition, but also to the overall economy generally. Because if the overall economy has a lower potential growth you should be expecting to be able to pay less in terms of multiples than otherwise. The overall economy has a big correlation to earnings and to profit margins, so you should expect the potential growth rate of the economy to be quite relevant when it comes to PE multiples.

Of course, what makes modern markets so uniquely precarious is the fact that investors are struggling with twin bubbles in bonds and equities. However, the former is often overlooked because the public doesn’t have as nuanced an understanding of the bond market. Yet historically speaking, bonds are even more closely correlated with metrics like inflation, as the chart below shows.

However, NIRP and ZIRP has created distortions in bond valuations that have left them extremely overvalued compared with history, meaning that the inevitable regression to the mean will likely take the form of a vicious selloff.

And our point is, look at bonds and look at how they compare to history and how they compare to metrics such as inflation and the GDP – to which historically they are very well correlated – and you find out what this chart on this page, which is showing that we are in totally uncharted territory at present.

 

What is this chart? This chart compares the real rate on German bunds – which are some of the most expensive government bonds on earth and in history – and takes, basically, the real rate on German bunds and compares them to the growth currently experienced by Germany. So the idea – and you see that also in the next slide – the idea is that the real rates in Germany are heavily negative at present.

 

Because what you had was, at the turn of the year, at the end of 2016, inflation started to resurface. So you had deflation and you had a pickup in inflation, which is exactly what you see on the next slide.

 

You see that inflation picked up, whereas nominal rates on German bunds continued their descent. And they continued deeper into negative territory because, obviously, of the ECB policy, of the policies of the central bank. At that point you had a gap opening up between nominal rates and inflation, which means that the real yields were becoming very, very negative. And you see here a table with the negative yields being minus 2.5 on average.

 

And the other thing that interest rates are correlated to is growth. We know that very well, that long-term interest rates, they tend to converge on nominal growth expectations for the economy. So here, in this one indicator which we call the real rate of growth ratio, we put it all together so we compare the nominal rate to inflation to growth. And we end up seeing this.

 

That these bonds have never been so expensive, because they are in deep negative territory – despite a GDP which has resurfaced. It’s not any more zero negative; it is close to 2% as far as Germany is concerned.

Having discussed the bubbles in equity and bond markets, Townsend proceeds to the next logical question. Now that we know we’re in a bubble, how can we tell if the bubble is going to burst? To his credit, Filia admitted he has no idea what the catalyst might be. Furthermore, there doesn’t necessarily need to be a catalyst for these bubbles to burst – but once their valuations have reached a kind of tipping point, they could implode on their own.

There can be a catalyst. Or there can be no catalyst. If you talk about catalysts, I could argue that can be inflation, for example. At the moment, we have seen that inflation resurfaced. We have seen some tightness in the job market. It has not translated yet into wages growth and therefore inflation. But we could just be about to see that. And, in that case, rates would rise and they would provoke as a catalyst the kind of downfall that we expect. Or the catalyst could be political. A lot of quantitative easing is being created and it is benefiting only the top 1% of the population. And it is resulting in this so-called income inequality concept.

 

 

And, so much, the central banks are pushing the wealth effect as they try to make people easier for them to spend more in the economy. But in reality what they are really triggering is income inequality. The consequence of income inequality is populism. Populism can provoke a regime change. Regime change can then affect quantitative easing if the result was not to help the real economy and the middle classes but only the top 1%.

 

So the catalyst could be political.

 

But I can also argue the catalyst could be China. China has a huge problem over indebtedness. It is said to be between 300% and 600% of GDP. GDP is $11 trillion. So it is a monumental credit bubble that could give troubles at any point. And if it gives troubles you can expect the whole world to listen carefully like it did in August of 2015 and January of 2016, and even more than that.

 

I think that it can be also no catalyst. And why is it no catalyst? Because at moments in which the market is overvalued you can never know for sure how much further the bubble can go. But at some point, it reaches a tipping point, a critical mass, where the probability is higher and higher for it to fall down.

At a certain point, swollen valuations reach a level where they no longer make sense, bids evaporate, and prices plunge. But it’s exceedingly difficult to pinpoint just when that point might be.

Three Easy Pieces

Authored by 720Global"s Michael Liebowitz via RealInvestmentAdvice.com,

If someone told you that the President of the United States in 2028 would be a Democrat and a woman from the state of New York, could you guess who it might be? We highly doubt it. In 1998, ten years before being elected president, Barack Obama had just been re-elected to the Illinois State Senate and was on no one’s radar as a Presidential candidate. In fact, had you been told at that time an African-American Democrat from Illinois would be president in 2008, it’s likely you would have assumed that two-time democratic presidential nominee Jesse Jackson would be the 44th President. In 1990, George W. Bush had just bought the Texas Rangers baseball club and was still four years from becoming Governor of Texas. In 1983, Bill Clinton was ten years out of law school and serving his second term as Governor of Arkansas. We could keep going down the line of presidents, and you would realize that even armed with some key details about the future, it would be extremely difficult to predict who a future president might be.

Stock investing is a little different. If you know the future level of three simple data points, you can calculate to the penny the price of any stock or index in the future and the exact holding period return. This precise prediction will hold up regardless of wars, economic activity, natural disasters, UFO landings or any other event you can dream up.

Unfortunately, those three data points are not readily available but can be inferred using historical trends, future expectations and logic to project them. With projections in hand, we can develop a range of price and return expectations for an index or an individual stock. In this paper, we provide an array of projections based on those factors and provide return expectations for the S&P 500 for the next ten years.

Factor 1: Dividends

Dividends are an important and often overlooked component of stock returns. To emphasize this point, an investor guaranteed a 3% dividend yield based on the current price, receives a 30% gain (non-compounded) in ten years. In other words, the investor has at least a 30% cushion to guard against price declines over a ten-year period.  That is what Warren Buffett refers to as a “moat,” and it is a wonderful benefit of investing in dividend-paying stocks.

The scatter plot graphed below compares the S&P 500 dividend yield to the Ten-year U.S. Treasury Note yield since 1980.  This historic backdrop helps project the S&P 500 dividend yield for the next ten years.

Data Courtesy: St. Louis Federal Reserve (FRED)

From 1980-1999, Treasury yields and dividend yields behaved alike. The trend line above, covering these years, has a statistically significant R-squared of 0.84 (84% of the move in dividend yields can be explained by moves in the 10-year yield). Since the year 2000, that relationship has all but disappeared. The R-squared for the post-financial crisis era is a meaningless .02.

Around the year 2000, dividend yields appear to have hit a floor ranging from 1-2%, despite a continued decline in Treasury yields. The reason for this is that many companies want to entice investors with higher dividend yields. As such, they raised dividends to keep the dividend yield relatively attractive. Had the regression of the 1980-1999 era held, dividend yields would be below 1% given current Treasury yields.

The graph above makes forecasting the future dividend yield relatively easy. As long as Ten-year U.S. Treasury yields stay below 5-6%, we expect dividend yields will range from 1-2%. Accordingly, we simplify this analysis and assume an optimistic 2% dividend yield for the next ten years.

Dividend Yield – Base/Optimistic/Pessimistic = 2%

Factor 2: Earnings

Over the long-term, earnings are well correlated to economic growth. Our ten-year analysis easily qualifies as long-term. Over shorter periods, there can be sharp variations due to a variety of influences such as regulatory policies and tax policies all of which influence profit margins. To arrive at reasonable expectations for earnings growth, we first consider economic growth. The following chart plots the declining trend in GDP growth since 1980.  Given the burden of debt, weak productivity growth and the obvious headwinds from demographics, we think it is likely the trend lower continues.

Data Courtesy: St. Louis Federal Reserve (FRED)

Next, we consider S&P 500 earnings growth rates. Earnings growth over the last three years, ten years and since 1980 are as follows: 3.18%, 4.38%, and 5.93% respectively. Given the economic and earnings trends, we believe a 3% future earnings growth rate for the next ten years is fair, 5% is optimistic, and 1% is pessimistic.

Earnings Growth – Base/Optimistic/Pessimistic = 3.00%/5.00%/1.00%

Factor 3: Valuations

Robert Shiller’s Cyclically Adjusted Price-to-Earnings ratio (CAPE) is our preferred method of valuation as it averages earnings over ten year periods. In doing so, it avoids short-term volatility of earnings and provides a more consistent baseline reflective of a company’s or indexes true earnings potential.  Currently, the CAPE of the S&P 500 sits in rare territory, as shown below. In fact, outside of the late 1990’s tech boom, there were only two months since 1881 when the Shiller CAPE was higher than today’s level – August and September of 1929.

CAPE has a history of extending well above and below its mean. Importantly, it also reverts to its mean after these long stretches of time. It does not seem unreasonable to expect that, over the next ten years, it will again revert to its mean since 1920 of 17.29. An optimistic scenario for 2028 is a CAPE reading of one standard deviation above the mean at 24.77. The pessimistic case is, likewise, one standard deviation below the mean at 9.70. Further, as shown below, we also present an outlook assuming CAPE stays at its current level of 31.21.

The graph below shows CAPE and the three forecasts along with the current level.

Data Courtesy: Robert Shiller http://www.econ.yale.edu/~shiller/data.htm

CAPE – Base/Optimistic/Pessimistic = 17.29/24.80/9.70

What does 2028 hold in store?

The following graph and table explore the range of outcomes that are possible given the scenarios outlined above. To help put context around the wide range of expected returns, we calculated an equity-equivalent price of the 10-year U.S. Treasury Note and added it to the graph as a black dotted line. Investors can use the line to weigh the risk and rewards of the S&P 500 versus the option to purchase a relatively risk-free U.S. Treasury Note. The table below the graph serves as a legend and reveals more information about the forecasts. The color shading on the table affords a sense of whether the respective scenario will produce a positive or negative return as compared to the U.S. Treasury Note. The far right column on the table indicates the percentage of observations since 1881 that CAPE has been higher than the respective scenarios.

Data Courtesy: Robert Shiller http://www.econ.yale.edu/~shiller/data.htm and 720Global/Real Investment Advice

As shown in the graph and table above, only scenarios 8 through 12 have a higher return than the ten year U.S. Treasury Note. Of those, three of the five assume that CAPE stays at current levels. Scenario 8, shaded yellow, has a negligible positive return differential.

Summary

The bottom line is that, unless one has a very optimistic view on earnings growth and expects valuations to remain elevated beyond what historical precedent argues is reasonable, the upside is limited, and the downside is troubling. The odds favor that a risk-free investment in a 10-year Treasury note will provide a better return through 2028 with less volatility. With current 10-year note yields at roughly 2.25%, that should emphasize the use of the term “troubling.”

The lines in the graph above are smooth, giving the appearance of identical returns each period. Markets do not work that way. These projections do not consider the path taken to achieve the expected total return and they most certainly will not be smooth. The best case scenario, and the one least likely to occur is for volatility to remain low. This would generate the most orderly path. Given that the post-crisis VIX (equity market volatility index) has averaged 17.7, current single-digit levels are an aberration and it does not seem unreasonable to expect more volatility in the future.

Even if one of the scenarios plays out exactly as we describe, the path to that outcome would be very choppy. For instance, if the worst case scenario played out, an investor may lose 60-80% of value in a matter of one or two years. However they would most likely have better than expected annual returns in the years following.

In a follow up to this article we will take this thought a step further and discuss the so-called path of returns. We show you the expected and actual path of returns from 2005 to 2015 and argue that an investor armed with the three factors, and a little discipline, may have generated much better returns than those earned by investors using a buy and hold approach.

Central Banks Are Well Behind The Asset Bubble Inflation Curve

By EconMatters

We discuss the Tech Earnings and the Gap Ups in the Market Opening today in this video, very reminiscent of the Tech Bubble Days in Financial Markets. It is obvious that Central Banks are way behind the interest rate hiking curve, we should be 300 basis points or 3% higher across the board in global interest rates. The run-up in these Tech Stocks prior to earnings and then the additional crazy gap ups considering what has already been priced into these stocks the entire year just screams bubble liquidity conditions. Hello, Central Banks I have found your elusive inflation that you are working so hard to find! Just check out the latest Shiller PE Ratio also known as the Cyclically Adjusted PE Ratio (CAPE Ratio) for your historical Bubble Reference Point.

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The Curious Case Of Missing The Market Boom

Authored by Raul Ilargi Meijer via The Automatic Earth blog,

“The Cost of Missing the Market Boom is Skyrocketing”, says a Bloomberg headline today. That must be the scariest headline I’ve seen in quite a while. For starters, it’s misleading, because people who ‘missed’ the boom haven’t lost anything other than virtual wealth, which is also the only thing those who haven’t ‘missed’ it, have acquired.

Well, sure, unless they sell their stocks. But a large majority of them won’t, because then they would ‘miss’ out on the market boom… Some aspects of psychology don’t require years of study. Is that what behavioral economics is all about?

And it’s not just the headline, the entire article is scary as all hell. It reads way more like a piece of pure and undiluted stockbroker propaganda that it does resemble actual objective journalism, which Bloomberg would like to tell you it delivers. And it makes its point using some pretty dubious claims to boot:

The Cost of Missing the Market Boom Is Skyrocketing

Skepticism in global equity markets is getting expensive. From Japan to Brazil and the U.S. as well as places like Greece and Ukraine, an epic year in equities is defying naysayers and rewarding anyone who staked a claim on corporate ownership. Records are falling, with about a quarter of national equity benchmarks at or within 2% of an all-time high.

If equity markets in places like Greece and Ukraine, ravaged by  - in that order - financial and/or actual warfare, are booming, you don’t need to fire too many neurons to understand something’s amiss. Some of their companies may be doing okay, but not their entire economies. Their boom must be a warning sign, not some bullish signal. That makes no sense. Stocks in Aleppo may be thriving too, but…

“You’ve heard people being bearish for eight years. They were wrong,” said Jeffrey Saut, chief investment strategist at St. Petersburg, Florida-based Raymond James, which oversees $500 billion. “The proof is in the returns.” To put this year’s gains in perspective, the value of global equities is now 3 1/2 times that at the financial crisis bottom in March 2009.

If markets crash by, pick a number, 20-30-50% next week, will Mr. Saut still claim “The proof is in the returns”? I doubt it. Though this time he might be right. As for the ‘value’ of global equities being 250% (give or take) higher than in March 2009, does that mean those who were -or still are- bearish were wrong? Or is there some remote chance that the equities are part of a giant planetwide bubble?

Aided by an 8% drop in the U.S. currency, the dollar-denominated capitalization of worldwide shares appreciated in 2017 by an amount – $20 trillion – that is comparable to the total value of all equities nine years ago. And yet skeptics still abound, pointing to stretched valuations or policy uncertainty from Washington to Brussels. Those concerns are nothing new, but heeding to them is proving an especially costly mistake.

$20 trillion. That’s a lot of dough. It’s what all equities in the world combined were ‘worth’ 9 years ago. It’s also, oh irony, awfully close to the total increase in central bank balance sheets, through QE etc. Might the two be related in any way?

Clinging to such concerns means discounting a harmonized recovery in the global economy that’s virtually without precedent – and set to pick up steam, according to the IMF. At the same time, inflation remains tepid, enabling major central banks to maintain accommodative stances.

‘Harmonized recovery’ is a priceless find. But you have to feel for anyone who believes it. And it’s obviously over the top ironic that central banks are said to be ‘enabled’ to keep rates low precisely because they fail to both understand and raise inflation. Let’s call it the perks of failure.

“When policy is easy and growth is strong, this is an environment more conducive for people paying up for valuations,” said Andrew Sheets, chief cross-asset strategist at Morgan Stanley. “The markets are up in line with what the earnings have done, and stronger earnings helped drive a higher level of enthusiasm and a higher level of risk taking.”

Oh boy. He actually said that? What have earnings done? He hasn’t read any of the warnings on P/E (price/earnings) for the (US) market in general –“the Shiller P/E Cyclically Adjusted P/E, or CAPE, ratio, which is based on the S&P 500’s average inflation-adjusted earnings from the previous 10 years, is above 30 when its average is 16.8”– or for individual companies (tech) in particular?

The CAPE ratio has been higher than it is now only twice in history: right before the Great Depression and during the dotcom bubble, when tech companies didn’t even have to be able to fog a mirror to attract billions in ‘capital’. And the chief cross-asset strategist at Morgan Stanley says markets are in line with earnings? Again, oh boy.

No, it’s not earnings that “..helped drive a higher level of enthusiasm and a higher level of risk taking.” Cheap money did that. Central banks did that. As they were destroying fixed capital, savings, pensions.

The numbers are impressive: more than 85% of the 95 benchmark indexes tracked by Bloomberg worldwide are up this year, on course for the broadest gain since the bull market started. Emerging markets have surged 31%, developed nations are up 16%. Big companies are becoming huge, from Apple to Alibaba.

Look, emerging markets and developed economies have borrowed up the wazoo. Because they could. Often in US dollars. That may cause a -temporary- gain in stock markets, but it casts a dark spell over the reality of these markets. If it’s that obvious that a substantial part of your happy news comes from debt, there’s very little reason to celebrate.

Technology megacaps occupy all top six spots in the ranks of the world’s largest companies by market capitalization for the first time ever. Up 39% this year, the $1 trillion those firms added in value equals the combined worth of the world’s six-biggest companies at the bear market bottom in 2009. Apple, priced at $810 billion, is good for the total value of the 400 smallest companies in the S&P 500.

To cast those exact same words in a whole different light, no, Apple is not ‘good for the total value of the 400 smallest companies in the S&P 500’. Yes, you can argue that Apple’s ‘value’ has lifted other stocks too, but this has happened in a time of zero price discovery AND near zero interest rates. That means people have no way to figure out if a company is actually doing well, so it’s safer to park their cash in Apple.

Ergo: Apple, and the FANGs in general, take valuable money out of the stock market. At the same time that they, companies with P/E earnings ratios to the moon and back, buy back their stocks at blinding speeds. So yeah, Apple may be ‘good’ for the total value of the 400 smallest companies in the S&P 500, but at the same time it’s not good for that value at all. It’s killing companies by sucking up potential productive investment.

And Apple’s just an example. Silicon Valley as a whole is a scourge upon America’s economy, hoovering away even the cheapest and easiest money and redirecting it to questionable start-up projects with very questionable P/E ratios. But then, that’s what you get without price discovery.

Overall, U.S. corporate earnings are expected to rise 11% this year, on track to be the best profit growth since 2010. And after years of disappointments, European profits are set to climb 14% in 2017, Bloomberg data show. The expectations for both regions are roughly in line with forecasts made at the beginning of the year, defying the usual pattern of analysts downgrading their estimates as the months go by.

Come on, the European Central Bank has been buying bonds and securities at a rate of €60 billion a month for years now. How can it be any wonder that officially stock markets are up 14%? Maybe we should be surprised it’s not 114%. Maybe the one main point in all of this is that the ECB is still buying at that rate, and thereby signaling things are still as bad as when they started doing it.

Meanwhile, Asia is home to some of the world’s steepest rallies, led by Hong Kong stocks that are up 29% this year. Shares in Tokyo also hit fresh decade highs this week, bolstered by investor confidence before the local corporate earnings season and a snap election this month. “Asia will benefit from continued improving regional growth, stable macroeconomic conditions and undemanding valuations,” said BNP Paribas Asset Management’s head of Asia Pacific equities Arthur Kwong. Any pullback in Asian equities after the year-to-date rally presents a buying opportunity for long-term investors, he wrote in a note.

In Japan, so-called investor confidence is based solely on the Bank of Japan continuing to purchase anything that’s not bolted down. In China, the central bank buys the kitchen sink as well. How, knowing that, can you harp on about increased investor confidence? As if central banks taking over entire economies either isn’t happening, or makes no difference to economies? Buying opportunity?

Global economic growth has been robust in most places, with Europe finally joining the party and the euro-area economy on track for its best year since at least 2010. The region’s steady recovery has eclipsed worries about populism, which a few years ago would have been enough to derail any stock market rally.

No, global economic growth has not been ‘robust’. Stock market growth perhaps has been, but that’s only due to QE and buybacks. Still, stock markets are not the economy.

“I’ve never been so optimistic about the global economy,” said Vincent Juvyns, global market strategist at J.P. Morgan Asset Management. “Ten years after the financial crisis, Europe is recovering and we have synchronized economic growth around the world. Even if we get it wrong on a country or two, it doesn’t change the big picture, which is positive for the equity markets.”

Oh man. And at that exact moment the ECB announces it wants to cut its QE purchase in half by next year.

Nowhere is the shifting sentiment more pronounced than in Europe, where global investors began the year with a election calendar looming like a sword of Damocles. Ten months later, the Euro Stoxx 50 Index is up 10%, Italy’s FTSE MIB Index is up 17% and Germany’s DAX Index is up 13%. The rally is even stronger when priced in U.S. dollars, with the Euro Stoxx 50 up 23% since the start of the year.

Sure, whatever. I don’t want to kill your dream, and I don’t have to. The dream will kill itself. You’ll hear a monumental ‘POP’ go off, and then you’re back in reality.

Nobel Laureate Richard Thaler: "We Seem To Be Living In The Riskiest Market Of Our Lives"

Robert Shiller isn’t the only Nobel Laureate who’s worried the US stock market is sleepwalking toward disaster.

In an interview with Bloomberg’s Jeanna Smialek, Thaler, who was awarded the Nobel Memorial Prize in Economic Sciences on Monday for his pioneering work in establishing that humans are “predictably irrational”, said that the stock market’s complacency in the face of the North Korean nuclear threat and political uncertainty at home is disconcerting.

“We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping,” Thaler said, speaking by phone on Bloomberg TV. “I admit to not understanding it.”

Adding his voice to a growing chorus of Wall Street analysts who suspect that the Trump administration’s tax reform ambitions will be dashed by a handful of intransigent senators, Thaler said any investors who’ve been paying attention should have “lost confidence” by now.

“I don’t know about you, but I’m nervous, and it seems like when investors are nervous, they’re prone to being spooked,” Thaler said, “Nothing seems to spook the market” and if the gains are based on tax-reform expectations, “surely investors should have lost confidence that that was going to happen.”

US stocks have continued to hit a string of records since President Donald Trump’s upset victory over Hillary Clinton in November while volatility has plunged, with realized vol reaching its lowest level on record in October.

As Bloomberg points out, Thaler, who has made a career of studying irrational and temptation-driven actions among economic actors claimed that the market’s complacency was fundamentally misguided.

Thaler’s comments echoed comments from Shiller, a professor at the Yale School of Management who won his economics Nobel in 2013, who warned during a July interview with CNBC, Shiller expressed concern that his Shiller CAPE ratio had crossed above 30, signaling that equity valuations were dangerously stretched. During the history of the stock market, stocks have only traded at richer valuations during one period - June 1997 to September 2001 - as the dotcom farce blew and burst. Historical data for the index is available going back to 1881.

Thaler also took a shot at President Donald Trump, mocking the president’s fondness for bluster and notorious aversion toward reading books.

“His ratio of certitude to knowledge is nearing record highs,” Thaler said on Bloomberg Radio with Tom Keene and David Gura. “We all need a lot of humility, and especially about the economy.”

He also added that the UK’s vote to leave the European Union was decision based on emotions, not rationality.

“I don’t think that the leave votes were based on any implicit spreadsheet running in people’s heads - it was just like, ‘I’m angry, and I’m voting no,’” he told Bloomberg TV’s Vonnie Quinn and Mark Barton. Of the Brexit process, he said: “It doesn’t seem to be headed in any productive direction.”

Thaler was perhaps one of the world’s best-known contemporary economists before receiving his award. His theory of "nudge" economics,  where humans are subtly guided toward beneficial behaviors without heavy-handed intervention, was the theme of a 2008 book that was well received around the world.

How To Survive And Thrive In A "Zlatan Ibrahimovic" Market

Authored by Daniel Nevins via FFWiley.com,

 

REPORTER: “Who will win the World Cup playoff?”

ZLATAN: “Only God knows who will go through.”

REPORTER: “It’s hard to ask him.”

ZLATAN: “You’re talking to him.” 

REPORTER: “What did you get your wife for her birthday?”

ZLATAN: “Nothing. She already has Zlatan.” 

ZLATAN: “I can’t help but laugh at how perfect I am.”

In case you don’t pay attention to soccer, here are three things to know about Zlatan Ibrahimovic:

1. He’s an excellent player.


2. His ego, as you can see, is large.


3. He doesn’t appear to have much in common with Yale University’s Robert Shiller.

I’ll start with the third point and the insightful Shiller, in particular. (I’ll get back to “Ibra” in just a moment.) Shiller wrote an article last week warning of the potential hazards of equity investment. As he often does, he shared a chart showing his cyclically-adjusted price-to-earnings (CAPE) ratio. He reminded us that the CAPE ratio is “somewhat effective at predicting real returns over a ten-year period.” But this particular article had little to do with ten-year forecasts. Here’s the conclusion (with my emphasis):

In short, the US stock market today looks a lot like it did at the peaks before most of the country’s 13 previous bear markets. This is not to say that a bear market is guaranteed: such episodes are difficult to anticipate, and the next one may still be a long way off...

But my analysis should serve as a warning against complacency. Investors who allow faulty impressions of history to lead them to assume too much stock-market risk today may be inviting considerable losses.

He likens today’s market to 1929, 2000, 2007 and other scary market peaks of the past, while pointing to characteristics he considers typical of market peaks. A high CAPE ratio stands at the top of his list, although he also mentions strong earnings and low volatility. Effectively, he says those three indicators should cause us to worry that a bear market could be right around the corner. And he makes useful observations about the CAPE ratio typically being high, earnings growth also somewhat high, and volatility low (although only slightly below average) just before bear markets begin.

With all due respect, though, I think Shiller’s pivot from long-term returns to a short-term outlook was incomplete. Sure, strong earnings and low volatility aren’t necessarily bullish - I get that - but I find it hard to call them bearish, either. My bigger objection, though, is with the CAPE ratio being part of a market-timing argument. (I applaud the “no guarantee” disclaimer, but still.) As a researcher and asset manager, I’ve never found valuation ratios useful for short-term horizons, nor have I found other researchers having much success using them as short-term indicators. From that experience, I would have recommended one more disclaimer for Shiller’s article - that valuation ratios stink for market timing. And I think my disclaimer is more than just a nitpick, for three reasons that I’ll explain with increasing “Ibra-ness.”

“A World Cup without me is nothing to watch, so it is not worthwhile to wait for the World Cup.”

—Ibrahimovic after Sweden failed to qualify for the 2014 World Cup finals

First, certain other indicators actually have helped foretell major market turning points. Nearly all of the past 13 bear markets, for example, were explained partly by some combination of sharply rising inflation, high interest rates, poor credit conditions or economic depression. I state that with conviction, but you can judge it yourself by reading our article “Riding the ‘Slide’: Is This What the Next Bear Market Looks Like.” Our research suggests that the most common bear-market conditions are mostly absent today. It uses Shiller’s data, by the way, although it covers bear-market conditions he didn’t consider in his article. Without being as bombastic as Ibra but being self-serving nonetheless, I recommend reading our research alongside Shiller’s for a more complete picture than either article offers on its own. (And while you’re at it, I highly recommend Eric Parnell’s latest for a third perspective.)

“I didn’t injure you on purpose and you know that. If you accuse me again I’ll break both your legs, and that time it will be on purpose.”

—Ibrahimovic responding to an accusation from Rafael van der Vaart

Second, the market’s current valuation is like Ibra’s ego - both are inflated. But if you’re Rafael van der Vaart or Pep Guardiola or Lucas Moura and hoping for Ibra to change, you’ll probably be disappointed. He’s not likely to become modest tomorrow just because he’s egotistical today, as if one state triggers the other. And the market won’t become a bear tomorrow just because it’s an expensive bull today. When Ibra’s skills finally erode, though, that’ll be a different story. That’ll be a change in the conditions that feed his ego, just as market forecasters should be concerned with the conditions that feed bulls and bears. In other words, market conditions (such as those mentioned in the preceding paragraph) seem more likely to predict the next bear than indicators calculated from market prices (such as the CAPE ratio).

“First I went left, he did too. Then I went right and he did too. Then I went left again and he went to buy a hot dog.”

—Ibrahimovic on how he dribbled around Liverpool defender Stephane Henchoz

Third, the market can be just as tricky as Ibra is with a ball at his feet, which is why you should choose your defenses carefully. In the big picture, your team (portfolio) should have an appropriate balance between attacking and defending elements. When you’re in the moment, though, I would suggest reading short-term outlooks with a degree of skepticism. If you’re prone to biting on feints and head fakes (overtrading), relying on the CAPE ratio for market timing might make it easier for your opponent to dribble around you. And where would that leave you? Apparently, you’d be found somewhere near the hot dog stand.

Conclusions

Like Robert Shiller, we would advise equity investors to have modest expectations for long-term returns (as we advised here). We also advocate diversifying across major asset classes to reduce the damage that could occur in a bear market. But having realistic expectations and diversifying won’t protect against the greatest risk many investors face - the risk of overtrading. Investors tend to sell risky assets at lower prices than they later repurchase them, suggesting that it’s important to build safeguards against overtrading. At a minimum, bullish and bearish indicators should be weighed carefully. By studying which indicators are most likely to predict bulls and bears, investors can build defenses against rash decisions. And that should be especially helpful today, as investors confront an unusually inflated and tricky mark... no, make that a Zlatan Ibrahimovic market.

Author’s note: Shiller’s article caught my attention because he wrote about 13 bear markets shortly after we, too, published an article about 13 bear markets. To identify bear markets, we used Shiller’s data, which he graciously includes on his website. But our 13 bears aren’t exactly the same as his 13 bears, because we defined them differently. If anyone would like to know the differences, just ask and I’ll discuss them in the comments when I have some free time. Also, I took the Ibrahimovic quotes from various websites, such as here, here and here.

Stock Market Bubbles In Perspective (Or Why "This Won't End Well")

Authored by Howard Ma via Meritocracy Capital,

Last week marked the 9th anniversary of the collapse of Lehman Brothers. It was one of the biggest milestones of the Global Financial Crisis (“GFC”) that began approximately a year earlier in 2007. Corporate earnings were abnormally weak during the GFC. I bring that up because a much cited stock market valuation metric that has been prescient gauging past bubbles could be overstated due to those abnormally weak earnings. Those of you concerned about the valuation of the U.S. stock market should read on.

What Does Average Mean?

The cyclically-adjusted price-to-earnings (“CAPE”) ratio is normally credited to Nobel-prize winning economist Robert J. Shiller. It adjusts for the ups and downs of business cycles by comparing the price of the S&P Composite Index to the average, annual inflation-adjusted earnings of that index over the previous 10 years. There are three types of averages: mean, median and mode. The type of average the CAPE ratio uses is the mean (a.k.a. arithmetic mean). Though the CAPE ratio has been shown to be a reliable predictor of future long-term stock market returns, it has also been widely criticized.

One criticism is that the CAPE ratio is susceptible to outliers. For example, those abnormally weak earnings that occurred during the GFC drag the mean, annual inflation-adjusted earnings down. This could make the CAPE ratio of the S&P Composite Index look more expensive than it may actually be. It has been widely reported that the CAPE ratio is currently at a very high level behind only two other stock market peaks: 1) the Tech Bubble, and 2) the stock market bubble that occurred during the Roaring Twenties (immediately preceding the Great Depression). In both cases, the stock market eventually crashed and in spectacular fashion.

One way to adjust for this problem of abnormally weak earnings is to instead use the peak earnings of the past decade. This approach has been credited to investment manager John Hussman. Ironically, the lesser known Hussman P/E currently shows that the S&P Composite Index is at a very expensive level second to only the Tech Bubble. Those who argue the U.S. stock market is not expensive don’t care for this approach.

Using a Better Average

I agree that using an arithmetic mean makes the CAPE susceptible to outliers. I also agree the CAPE ratio can also make the valuation of the S&P Composite (or any stock market index) look more expensive than it may actually be. Though I believe the Hussman P/E is useful, I don’t believe it is a substitute to the CAPE ratio. An average measures a central or typical value. Using a peak figure, as in the case of the Hussman P/E, does not do this. By using peak earnings, the Hussman P/E is in fact driven by outliers.

Mentioned earlier, there are three types of averages. A better type of average would be the median. It literally represents the middle of a sequence of ranked numbers. In most cases, it is not influenced by outliers. By using median (instead of mean) earnings, I refer to this valuation approach as the CAPME ratio. It currently shows the S&P Composite is not the second or third most expensive stock market cycle. This finding supports those who criticize the traditional CAPE ratio of overstating the valuation of the S&P Composite Index. The problem for critics though is using the CAPME ratio still shows the U.S. stock market is very expensive right now. In fact, it is the fourth most expensive, behind the stock market cycle that occurred during the Subprime Mortgage Bubble. Based on the data Professor Shiller uses, you can see this in the graph below that looks back 135 years.

Valuations in Perspective

You will notice in the graph above that the past 5 stock market bubbles were all valued at one point at more than 20-times median, annual, inflation-adjusted earnings. The valuation range of those peaks is wide though given the Tech Bubble was valued at more than 40-times at its peak.  This makes the Tech Bubble potentially an outlier. Furthermore, all 5 stock market bubbles did not last long. They were fleeting.

To put this all into perspective, consider these valuations by their percentile ranks. You can see this from the orange lines in the graph below.

The graph above shows the aforementioned 5 stock market cycles turned into bubbles when their CAPME valuation ratios reached a very high level of roughly the 90^th percentile (red dotted line). In other words, these bubbles formed when their valuations were near or at the most expensive decile. Investors beware: the valuation of the S&P Composite Index is currently ranked at the 94^th percentile.

This puts the U.S. stock market smack-dab at the heart of bubble territory.

It has been argued lots that the high stock market valuation is justified by low interest rates. This argument does not work for me. Let me tell you why. Yields on 10-year U.S. treasury bonds in early-1941 were lower than they are now. Despite lower interest rates in early-1941, the stock market CAPME valuation ratio was quite low at that time ranking at around the 30^th percentile. Furthermore, the amount of debt provided by stock brokers used to fuel the current stock market cycle is at a record level. This could prove problematic given bubbles driven by financial leverage are particularly dangerous.

Summary

The aforementioned 5 stock market cycles turned into bubbles when their CAPME valuation ratios reached the 90th percentile. The U.S. stock market is back there again. Its valuation is squarely in the middle of that very expensive decile looking back 135 years.

The 5 previous instances of stock market bubbles suggest this will not end well. Bubbles never do, particularly ones driven by financial leverage.

The CAEY Ratio & Forward Returns

Authored by Lance Roberts via RealInvestmentAdvice.com,

Over the last couple of week’s (see here and here), I have been discussing the value of Shiller’s CAPE ratio. The Cyclically Adjusted P/E ratio, or CAPE, is often maligned by the media as “useless” and “outdated” because despite the fact the ratio is currently registering the second highest level of valuation is history, the markets haven’t crashed yet.  Of course, the key word is…YET.

In the second article, I shortened the length of the CAPE ratio to make it more sensitive to price movements which sparked a good discussion on Twitter about forward return analysis using a shortened smoothing period. Leave it to my friend John Hussman to do the heavy lifting:

.@ndunivant @LanceRoberts @MebFaber On question about CAPE5 vs CAPE10: CAPE isn"t our own preferred metric by a longshot, but here you go. pic.twitter.com/M8rNB3gdUC

— John P. Hussman (@hussmanjp) March 27, 2017

Of course, the obvious question is what are his favorite metrics? Here you go.

@drenerbas @ndunivant @LanceRoberts @MebFaber Metrics w/ higher and more stable correlation w/ subsequent returns have clearer implications. pic.twitter.com/riXyQKMd68

— John P. Hussman (@hussmanjp) March 28, 2017

Within all of this is a simple point. No matter how you cut it, slice it, dice it, twist it, abuse it, or torture it – valuations matter in the long run.

But therein lies the problem, valuations are NOT, and never have been, a market timing tool. It is about the value you pay for something today and the return you will receive in the future, and a point that Research Affiliates recently took a very interesting approach to in a recent report:

“Academics have suggested various reasons for sustained higher equity valuations, from the microstructure benefits of improved participation and lower transaction costs to the macroeconomic benefits of larger profit shares. We examine the explanation put forward by Lettau, Ludvigson, and Wachter (2008) that rising valuations are propelled by the large reduction of macroeconomic risk in the US economy. Their intuition is simple—investors require lower returns from equity markets when the aggregate volatility of the economy is lower. It should come as no surprise that investors are glad to pay a higher price and accept a lower return for investing in a stock market that delivers less uncertainty.

Today’s economy is drastically different from just a few decades ago, and radically different from a century ago. Judging from the volatility of two major macroeconomic variables—real output growth and inflation—it has changed for the better. From the days before the US Federal Reserve Bank until today, the annual volatility of the economy has tumbled about 80%.

When we plot the measure of macro volatility with the inverse of a very popular valuation metric, Robert Shiller’s cyclically adjusted price/earnings ratio (CAPE), we find an intriguing and significant positive correlation between expected real equity returns and the aggregate volatility of the economy. Under the restrictive assumption that prices are fair and an appropriate return on retained profits, we assert that earnings yields are an appropriate proxy for an equity market’s future real return. For clarity, we name the inverse of the CAPE, an earnings yield, the cyclically adjusted earnings yield (CAEY). 

Research Affiliates makes some very interesting points and the entire paper is worth reading. However, I was most interested in the concept of the Cyclically Adjusted Earnings Yield (CAEY) ratio and its relationship to forward real returns in the market.

While the statement that lower valuations, inflation, and lower volatility are supportive of higher valuations is true, there have also been other issues as well as I addressed last week:

• Beginning in 2009, FASB Rule 157 was “temporarily” repealed in order to allow banks to “value” illiquid assets, such as real estate or mortgage-backed securities, at levels they felt were more appropriate rather than on the last actual “sale price” of a similar asset. This was done to keep banks solvent at the time as they were being forced to write down billions of dollars of assets on their books. This boosted banks profitability and made earnings appear higher than they may have been otherwise. The ‘repeal” of Rule 157 is still in effect today, and the subsequent “mark-to-myth” accounting rule is still inflating earnings.


• The heavy use of off-balance sheet vehicles to suppress corporate debt and leverage levels and boost earnings is also a relatively new distortion.


• Extensive cost-cutting, productivity enhancements, off-shoring of labor, etc. are all being heavily employed to boost earnings in a relatively weak revenue growth environment. I addressed this issue specifically in this past weekend’s newsletter.


• And, of course, the massive global Central Bank interventions which have provided the financial “put” for markets over the last eight years. 

Furthermore, the point suggesting investors are willing to accept lower returns in exchange for lower volatility is intriguing. 

While academically speaking I certainly understand the point, I am not so sure the average market participant does who is still being told to bank on 6-8% annualized rates of return for retirement planning purposes. 

However, this brings us to the inverse of the P/E ratio or Earnings Yield. The earnings yield has often been used by Wall Street analysts to justify higher valuations in low interest rate environment since the “yield on stocks” is higher than the “yield on risk free-assets,” namely U.S. Treasury bonds.

This is a very faulty analysis for the following reason. When you own a U.S. Treasury you receive two things – the interest payment stream and the return of the principal investment at maturity. Conversely, with a stock you DO NOT receive an “earnings yield” and there is no promise of repayment in the future. Stocks are all risk and U.S. Treasuries are considered a “risk-free” investment.

The chart below, which uses Shiller’s data set, shows the 10-year Cyclically Adjusted Earnings Yield. I have INVERTED the earnings yield to more clearly show periods of over and under-valuations.

With the CAEY currently at the 3rd lowest level in the history of the financial markets, it should not be surprising to expect lower returns in the future. Of course, lower returns is exactly what Research Affiliates suggests you will accept in exchange for lower volatility.

Right?

The chart below shows the CAEY as compared to 10-year forward real returns (capital appreciation only).

Not surprisingly, when the CAEY ratio has reached such low levels previously, forward returns were not only low, but negative. Currently, with the earnings yield nearing 3%, forward 10-year returns are going to start approaching zero and potentially go negative in the years ahead.

Of course, such declines in returns will, as they always have, coincided with a recession and fairly nasty mean-reverting event which has historically consisted of declines in asset prices of 30% on average.

But hey, you are okay with that, right?

I mean, after all, you did agree to lower returns when you bought into overvalued equity markets in exchange for lower volatility.

For investors, planning for future wealth and security relies on reasonable assumptions about future expected returns. No matter how you do the math, returns over the next decade, which can be forecasted with a fairly high level of predictability, will be low.

“Long-term trend of mean reversion implies lower-than-average earnings per share in the future due to a decline in productivity. So, we estimate that EPS growth over the next decade is likely to be at about 1%. In reality, the return for the S&P 500 over the next 10 years could be somewhere between zero to low single digits.” – Chris Brightman, Research Affiliates

Remember, while valuations are not a market timing tool in the short-run. Using fundamental measures to predict returns 12-months out is a fruitless endeavor. However, over the long-term, the math is always the same:

The price you pay today is extremely indicative of the return you will receive in the future. 

Just something to consider.

Stock Valuations Enter “Crash” Territory

Hold your real assets outside of the banking system in one of many private international facilities  -->    https://www.sprottmoney.com/intlstorage 

Posted with permission and written by John Rubino (CLICK HERE FOR ORIGINAL)

The Trump Christmas stock market rally has taken valuations beyond a point that in the past has signaled trouble, which in turn has generated a lot of cautionary press like the following:

(CNBC) – While the S&P 500 is reaching all-time highs on optimism over Donald Trump’s economic agenda, some Wall Street strategists are increasingly worried about a widely followed valuation measure that’s reached levels that preceded most of the major market crashes of the last 100 years.

“The cyclically adjusted P/E (CAPE), a valuation measure created by economist Robert Shiller now stands over 27 and has been exceeded only in the 1929 mania, the 2000 tech mania and the 2007 housing and stock bubble,” Alan Newman wrote in his Stock Market Crosscurrents letter at the end of November.

Newman said even if the market’s earnings increase by 10 percent under Trump’s policies “we’re still dealing with the same picture, overvaluation on a very grand scale.”

The Shiller “cyclically adjusted price-to-earnings ratio” (CAPE) is calculated using price divided by the index’s average historical 10-year earnings, adjusted for inflation. Yale economics professor Robert Shiller’s research found future 10-year stock market returns were negatively correlated to high CAPE ratio readings on a relative basis. He won the Nobel Prize in economics in 2013 for his work on stock market inefficiency and valuations.

Other academics agreed the current extreme CAPE ratio of 27.7 is a worrying sign for future returns versus bonds.

“Only when CAPE is very high, say, CAPE is in the upper half of the tenth decile (CAPE higher than 27.6), future 10-year stock returns, on average, are lower than those on 10-year U.S. Treasurys,” Valentin Dimitrov and Prem C. Jain wrote in paper titled “Shiller’s CAPE: Market Timing and Risk” on Nov. 17.

Even based on the more common price-earnings ratio, the market looks rich. The S&P 500’s P/E based on earnings of the last 12 months is 18.9, the highest in more than 12 years, according to FactSet.

“U.S. valuations start off as being high both on a historical basis and also on a peer group. Certainly based on the Shiller PE, the equity market seems expensive,” Jefferies chief global equity strategist Sean Darby wrote on Nov. 29.

The above chart requires a bit of interpretation, mainly because of that spike in 1999 which seems to imply a much higher ceiling for stock valuations. It probably doesn’t, because of the uniquely delusional nature of the tech stock bubble. That market was driven by newly-minted dot-coms and related companies that in many cases had minimal or no earnings, so prices weren’t related to profits. In other words, you can’t calculate a price/earnings ratio if there are no earnings.

“Eyeballs” – that is, the number of people visiting at a dot-coms’ website – had temporarily replaced traditional valuation measures in the hearts of speculators. With disastrous results.

Today’s market, in contrast, is made up of companies with actual earnings, so it might be safe to discount 1999 and use the rest of the chart for comparison. In which case current equity prices look extremely dangerous.

On the other hand, today’s world has departed from past business-as-usual in other ways that might be relevant. Debt no longer seems to matter – witness the US, after doubling the federal debt in a single presidential administration, installing a new president whose platform calls for massive increases in borrowing and spending.

And while monetary policy in past eras operated in an at least partially-constrained environment, today there are apparently no limits on how low interest rates can go or how many and what kinds of assets central banks can buy with newly-created currency.

The Japanese and Swiss national banks, for instance, are already huge buyers of equities. If the Fed decides to join that party – something that Chairwoman Janet Yellen has already publicly considered – then it’s not clear whether P/E ratios will continue to matter. The unlimited printing press is definitely an argument for “this time is different.”

So is it no longer possible to make predictions based on pre-QE history? Or are there financial and economic laws that apply no matter what crazy new tools the world’s governments decide to employ?

Almost certainly the latter. Manipulating one part of the system – by, for instance, buying equities with newly-created currency – just shifts the pressure of financial imbalances to a different, harder-to-control place.

Lately the bond market has begun to show signs of stress – because who wants to own zero-coupon long-term bonds in a world where governments need higher inflation and are willing to do pretty much anything to get it?

What happens if governments respond to bond market turmoil by creating even more currency and buying up all the long-term bonds, as Japan is currently doing in its own market? The pressure will shift to the foreign exchange markets, because who will want to own fiat currencies that are being created at rates far exceeding the growth of the real economy?

Fiat currencies are the one thing governments can’t buy up with newly-created money. All are at the moment falling in relation to artificially-inflated stock and real estate prices, though we don’t notice because currencies are valued against each other. But let a soaring money supply translate into rising general prices (something the bond market is now signaling) and it’s game over. Governments will face rising instability without tools capable of managing it.

At which point will we return to the above chart and wonder why we didn’t trust history?

Please email with any questions about this article or precious metals HERE

Posted with permission and written by John Rubino (CLICK HERE FOR ORIGINAL)