Dear Diary,
The Dow rose 100 points yesterday. Gold was up one lousy dollar.
We’ll take the gold, thank you very much. Because our guess is that this stock market is living not only on borrowed money but also on borrowed time.
With the addition of Chinese Web portal Alibaba, there are now 44 start-ups preparing to enter the public markets. Each of these has a valuation of more than $1 billion.
The last time there was this kind of action in the IPO market was 2000, just before the dot-com bubble blew up. And the last time stocks were this expensive was 2007, when the subprime/finance bubble blew up.
That was also the last time share buybacks by US corporations passed the $600 billion mark, which they will do again this year.
Yes, dear reader, the party has gotten out of hand – thanks to all the free booze supplied by Ben Bernanke and Janet Yellen. It’s time to look for the car keys.
Party On!
This is not to say that it won’t go on longer. And it is not to say that it won’t get wilder, too. There are already people with lampshades on their heads. And girls are dancing on the tables.
But at least no one has called the cops… yet. You don’t want to be there when they do.
What might make stocks go up further?
Well, the Fed might decide to hold off on more QE cuts, for example. The economy is not recovering and the Fed knows it. A shock or two in the stock market or bad employment numbers would probably convince Yellen & Co. to stop their “tapering” of QE… at least for now.
Or, like the European Central Bank, the Fed could announce a new scheme of unspecified interventions. Instead of the higher interest rates everybody expects, US interest rates could go lower… and it would be “party on” again, with higher stock prices to boot.
Thanks to the ECB, Italy is now able to borrow at 13 basis points lower than the US. Lenders are giving money to France at a yield 114 basis points lower.
Are France and Italy more creditworthy than the US?
Well, that’s just the thing: When it’s party time, people stop doing the math. The eyeshades, pencils and calculators are put away. As long as the music plays, speculators will dance.
The IPOs don’t have any earnings?
So what?
Italy can’t pay back its debt?
Who cares?
Call us an old fuddy-duddy. We’ll sit this one out.
“Buffett-itis “
We have been talking about investment theory… and practice. Long-term readers will find this unusual. We’ve been writing about money for the last 15 years. Never before have we shown much interest in investing it.
What happened?
Friend and colleague Porter Stansberry (the founder of Stansberry & Associates) persuaded us to write a paid monthly investment letter.
All of a sudden, we had to think not about economics and politics but about investing! And then, when we got into the subject matter we found ourselves coming dangerously close to the one thing we can’t tolerate: positive thinking.
In economics – at least at a public policy level – positive thinking is a trap. Every intervention is a mistake. Small ones are nuisances. Big ones are disasters. Earnest economists – who believe they can improve the world with laws and policies – are a constant threat to human happiness and progress.
But what about investing? Does positive thinking pay off?
You, dear reader, having watched this infection develop… first as a minor scrape on our cynical Efficient Market Hypothesis… and then as a serious case of “Buffett-itis.”
That’s right, we were beginning to think the man from Omaha was right all along: The EMH is seriously flawed. Serious investors who are willing to do the hard work can beat the market.
It seems obvious…
The “market” – especially when prices are high and the music is loud – is made up of people who are not serious and who are not willing to do the hard work. If you can put on your positive thinking cap and do a better job of figuring out how much a stock is really worth, you’ll probably do better than the average investor.
And if you don’t want to do the hard work yourself, find someone who does…
Regards,
Bill
Further Reading: One investor who’s been beating the market is Bill’s old friend and colleague Chris Mayer. As Bill wrote last week, Chris just had the track record for his value-focused Capital & Crisis newsletter verified by outside auditors.
The results are stunning… Excluding dividends, the annualized return for Capital & Crisis was 16% over the last decade versus 4.8% for the S&P 500.
A “Hidden” Bear Market Is Brewing
Will market historians look back on the $21 billion IPO of Alibaba – the biggest US IPO in history – as signaling the top of the five-year rally for the S&P 500?
Only time will tell…
But we note with interest that almost half of Nasdaq stocks (47%) are down 20% from their peak over the last 12 months (the official definition of a bear market).
And 40% of Russell 2000 small-cap stocks are in bear market territory.
This compares to just 6% of S&P 500 stocks that have fallen 20% or more from their peak over the last 12 months.
But we can’t see into the future. Maybe the “hidden” bear market brewing in the Nasdaq and the Russell 2000 – two indexes that are more growth-sensitive than the S&P 500 – will go into hibernation again. Maybe it won’t.
But our beef with the bulls isn’t based on looking into the future. It’s based on: (a) the valuations conditions we observe in the present, and (b) what we know about investor psychology.
Investing is all about taking on risks in the present in the hope of future reward. And as Bill has been warning, the prudent time to do that is when valuations are low relative to their historic average, not when they are high relative to their historic average.
We’ve talked a lot in these pages about various price-to-earnings ratios and why these should give US stock market bulls pause.
But it’s not just on a price-to-earnings basis that the S&P 500 looks overvalued…
Another way to value the market – one that Warren Buffett described in an interview with Fortune magazine back in 2001 as “probably the best single measure of where valuations stand at any given moment” – is to look at market capitalization relative to GDP.
In 2000, the ratio of market cap to GDP for the Wilshire 5000 (a good proxy for the US stock market) reached 153%.
This didn’t stop investors pouring money into US stocks… which went on to deliver a negative total return over the next 10 years.
Fast-forward to today, and the ratio of market cap to GDP for the Wilshire 5000 stands at 125%. That’s not as high as at the peak of the dot-com bubble. But it’s higher than at the 2007 peak of the recent credit bubble.
And it’s more than two standard deviations above the average – a measure legendary contrarian fund manager Jeremy Grantham uses to pinpoint a bubble.
Which brings us to investor psychology…
As we’ve said before, most investors – even card-carrying contrarians – are deeply conformist.
When Nifty Fifty stocks are in vogue, they buy Nifty Fifty stocks. When Internet stocks are in vogue… they buy Internet stocks. When high dividend payers are in vogue, they buy high dividend payers. And so on…
The only problem is that the conventional wisdom is almost always flawed.
If everyone believes – as they do now – that the S&P 500 is the best investment, it’s because everyone already owns the S&P 500.
And if this is the case, prices are high and future returns can be expected to be low.
Eventually there are no more bears becoming bulls… and there is nobody left to buy. At this point, five years of gains will reverse… and opportunities to buy at low prices will come along.
That’s when the superior investor deploys cash to snap up bargains…
P.S. If you are fed up with the lack of profitable investments on offer today, you may be interested in an unusual strategy for “forcing” extra income out of the stocks you already own.
It’s something our income-investing experts Jim Nelson and Kelly Green have been working on. They reckon it has the potential to triple the income you’d normally earn by investing in dividend-paying stocks.