Summary: It’s different. You’re screwed.
This is what you’re getting into: Endless bearish rambling of historical market performance over various half and full cycles. In short: you’re screwed.
Graphs galore: You’ll also via several charts, learn how things are different this time – and not in a good way. Debts, profit margins, sentiment, volumes, algo trading, money printing, inflation, price moves, global synchronization, junk bond issuance, stock buy backs, valuations, fiscal and monetary stimulus in the U.S. and abroad are all at historical extremes. Normalization or a full pendulum swing would spell disaster.
Central punks: At the heart of it all sit the central banks, not least the Fed, and their financial repression, pushing savers into overpriced risky assets and inflationary consumption behavior. Zero interest rates have papered over unsustainable debt levels and hollowed out the economy through malinvestments. What’s left is record folly on all accounts, sometimes seemingly appearing to support the house of cards it really is, but is tantamount to having run over a cliff (but not yet plunged) or lifting yourself by the hair.
No silver lining: I offer no solutions (except maybe the one about creating real value, and the other about how to get 20% return per year and an extra marshmallow), no way out, but to wait and hope it’s not too different this time and that there’ll come a decent investment opportunity down the road
Crazy or delusional – your choice
In the previous post we explored a handful of ways to build an investment portfolio. 3 out of 4 basically meant throwing in the towel, closing your eyes and just go for it. The fourth takes a delusional mind, thinking it actually is possible to time markets.
Markets will move. Will you?
There is no doubt that markets do move significantly up and down.
Everybody knows markets sometimes halve in value and single stocks fall by 75-90% or go out of business completely. Nobody is oblivious of the fact that markets dropped by around 50% twice in just the first decade this century.
It’s just the timing part that’s difficult. Most resign before the task and simply buy, hoping it’ll work out okay over time – fully aware that there will come a halving in fortune sooner or later. Others, retarded types like yours truly, still believe it’s better to wait for good (better) opportunities to buy, i.e., practice market timing. In particular after 6 years of rising prices.
It’s the ratios, stupid
It’s not that stocks have to go down nominally, it’s the valuation of probable future cash flows that I have a beef with. I can pay a million dollars for a steak as long as I get a billion in monthly pay. Likewise I’m happy to pay 500$ per Amazon share, as long as prospective annual free cash flows average at least 35$ per share.
Stocks and markets fluctuate between cheap and expensive, and I want to buy cheaply even if it means waiting. There is never a hurry to invest. Opportunities will cycle back. Presently, ratios between pay, prices, profits, sales, debt, risk etc. are more out of whack than usual, leading to the conclusion that…
This time it’s different
I’m not joking. It is different. To see how so we first need a little perspective (even if I think 20 years is too little to truly get perspective on the stock market).
Sure, the 2000 peak in S&P 500 was followed by a 50% plunge, and the 2007 peak ended even worse; setting a lower low in 2009 than in 2003. And, yes, for the 13 years between 1996 and 2009 the most important stock market index in the world got nowhere.
However, the market soared gloriously in between: +250% from 1995 to 2000 and +100% from 2003-2007, not to mention the most recent tripling (+200%) since 2009.
7.5% real return per year
A long term investor that got in right before the central bank-propelled rallies started in 1995, was rewarded by a nice and round +350% increase in (real, assuming dividend=inflation) value over just 20 years or 7.8% per year. Let’s call it 7.5% (since actual inflation probably was a little higher than the average dividend yield).
7.5% per year, every year?! Who wouldn’t want that kind of return? Let’s buy some shares right away!
Just a little note of caution: that return was achieved from trough to peak (presumably) over two and a half cycles. It also took us to the current extreme and utterly unsustainable situation (see more below about how it’s different this time). For the complete two cycles 1995-2009 the annual return was ‘just’ 2.5% per year over 14 years.
Can you really get 2.5% per year over a cycle?
Hey, 2.5% is still much better than current interest rates, let’s go, I’m calling my broker now. (I’m obviously talking to an idiot that just can’t get that the 2.5% return was still predicated on buying at the 1995 generational bottom, albeit selling at a bottom too). There are no guarantees whatsoever you’ll get as good a return as 2.5% per year over an arbitrary cycle.
Before you make the call, let’s look at negative half-cycles first, just to get a feel for the “worst case” scenario. From the peak of 2000 to the second trough of 2009 the total return was a negative 57% or 9-10% real fall per year for 9 years.
If we happen to be near a peak right now and we experienced a similar 1.5 cycles, your 100 would be worth 43 in the year 2024. Obviously it could be even worse, considering the height of the current peak and that the downturn in 2009 was cut short by remarkable political interventions that will prove hard to repeat.
From there (2024) you would need an increase in value by (at least) 133% just to get back to your 2015 par value of 100. That might be done in 5 years time (just look at 1995-2000 and 2003-2007, as well as 2009-2015) but could also take longer (if investors have wisened ever so little over time and don’t fall as easily for bubble blowing the next time round).
Assuming a historically impressive 10% return per year from 2024, it would take 9 years, i.e. until 2033 for you to get back to your current 100 (if we are near a peak now and history repeats, and you then get 10% per year for 9 years in a row). All numbers in real terms and assuming dividends equal inflation.
Are you ready to wait until 2040 for zero returns?
If the economy would slow compared to trend, or inflation or interests rise, making dividends dry up somewhat your outcome would be worse. And, in case you lost track, that would take us to a new peak and you would be required the wherewithal to sell at that peak after 9 strong years in a row just to bag ZERO return between 2015-2033. Well that is if we even get a 133% appreciation after 2024, AND that the fall from now to 2024 is as ‘mild’ as the 2000-2009 bear market. We might have to go through yet an entire 7-year cycle (2038-2040?) to get to or above the 2015 par value.
Uhhh, you’re so damn negative. What about a peak in the year 2022, what would I get between now and then?
Well, you got nothing between the peaks of 2000 and 2007, despite 2007 being a new all time high, inflated by irrational hopes on the BRICS (Brazil, Russia, India, China and South Africa) – such a peak that it had to be followed by a plunge of 60% in the S&P 500, before the largest money printing (and not least very shady new banking accounting legislation) effort in history managed to turn things around.
And you got nothing (actually a negative return) between the troughs (i.e., full cycle) of 2003 and 2009.
Even buying at bottoms is no guarantee for profits
Yes, true story, even if you bought perfectly at the bottom of 2003, you would have lost money by holding on to your investments for 6 years (I just hope that hypothetical investor didn’t buy anything at higher prices in between).
Today’s peak (if that’s what it is – hint: it is) stands 1/3 higher than the 2007 peak, and since 2007 a lot of things have changed (for the worse)… and I am coming to that in a bit. Hence, it would be quite a stretch to hope for the next peak to surpass the current one, considering how ridiculous circumstances are right now.
Buying at peaks all but guarantee no profits for a long time
My best guess is that, peak-to-peak 2015-2022 will produce a flat to negative return (and possibly much worse if inflation takes hold – not unreasonable given the ubiquitous money printing). But the next peak, in 2030-33 just might reach today’s level :D ! Ahhh, is that a smile I see on your face? Even that, however, would take a creative mind, so let’s aim for 2040 instead. :(
If nothing else, perhaps the pre-singularity reverberations (immense advancements in technology and productivity) will lift stock prices to new highs by then. Or money won’t matter at all, but let’s not assume things will be that different just yet.
But, but, but, you said it was different; it sounds as if you’re expecting exactly the same kind of crashes as after 2000 and 2007.
No, it is different. Just much worse. Here’s how:
As brief as I can be: Very particular and unusual circumstances and set of factors have converged and resonated, to elevate stocks to today’s levels (I will soon get to the point of how it’s different – see charts below).
These conditions are not likely to be repeated for a very long time, thus ruling out consecutive epic peaks like the last three (2000, 2007 and 2015), delaying and diminishing coming peaks (2024, 2032, 2040).
Quite to the contrary, these simultaneous overshoots will undershoot, possibly synchronized, to create a generational bottom before normalizing (meaning, recovering from the bottom, but not approaching bubble-like peaks for a while – you really shouldn’t count on every peak being the stupidest bubble ever).
I don’t care if I sound like a broken record. This is how I see it, and if I don’t tell it, then who will? Sure, I’ll play the mentally challenged for some time, but I’d rather look like a fool before the event than after.
Buy stocks if you want, there could be 2% in it per year until 2030 or so
-if that peak turns out as insane as this one
Also, I don’t mean to discourage anybody from buying stocks (yes, I do). I just want to set the record straight, to make sure you know what it is investors actually got from the market historically and under which conditions.
It’s all to easy to see nothing but the recent 200% surge (20% per year for 6 years), or 7.5% annually since 1995, and extrapolate from there, despite even veteran buyers from 15 years back just got 2% per year on average by holding on all the way up to today.
Bull talk: +3.5% per year until 2023 – any takers?
One bullish note, before moving on to the “this time it’s different” charts: If you start buying carefully now, and throughout the downturn and recovery, you might achieve an average price 25% below current levels by the time we hit the next peak (well, if it reaches the current crazy levels).
That’s not too bad; it could amount to +33% return over let’s say 8 years, or 3.5% per year. Just don’t be fully invested right now, but aim for averaging over the full cycle (remember you have already abandoned all hope of timing cycles, so don’t expect to think differently at the bottom).
Everything that’s different
Finally, here it is – everything that’s different.
All that really needs to be said is that there is more debt and credit sloshing around than ever before. Sooner or later the piper needs to be paid, and there just isn’t enough assets to go around. Once selling starts, the higher the debts the worse the eventual fall.
Stock purchases are financed with debt. NYSE margin debt is at its all time high (downturns in levered long trades do not bode well – selling begets forced selling and so on). Margin debt has tripled since 2009 and is higher than the peaks of 2000 and 2007. Is anybody paying attention?
Money printing has lifted spirits and leaked into markets in an unprecedented manner. Fed’s balance sheet has quintupled since the last downturn commenced. That’s 3.7 tn dollars extra. There is a long way down for both the economy and stock markets, if the monetary support wanes (keeping it up is also risky; inflation, dollar crash, import and other trade issues).
Japan has truly gone full retard (“if 20 years of QE doesn’t do it, let’s try harder…”)
Household debt and corporate debt are also at highs, leaving total debt at dizzying heights How does 60 tn USD sound (3.5x GDP)?
There is nothing wrong with debt in itself. As long as the debt is used to finance productive investments that return more than the cost of debt (risk adjusted) you should borrow.
However, when interest rates are close to zero, investors, politicians and entrepreneurs turn to ever lower quality projects and the ratio of value-destroying malinvestments increases.
Corporations are issuing more “high yield” junk bonds than ever and they are using the money for stock buybacks and other poor investments. This practice is building a house of cards of stocks with elevated valuations and companies with high debt that can’t be serviced at normalized interest rates.
They have never been lower. In many places interest rates are even going negative now. What’s really different is that it’s happening at a peak of a business and stock market cycle. What’s supposed to happen in the coming downturn?
The downturn surely will exhibit some different features this time, considering the starting point with maximum debt and zero interest rates.
Banks often run into trouble in downturns, in particular after debt binges. Then tax payers bail them out, adding to the national debt. This time that would occur on top of already record high debt – levels that many already consider unsustainable.
Can this situation with zero interest rates last? What incentive does anybody have to save (which is needed to invest)? Hardly anybody wants to save and many are led to speculate/malinvest, eroding the real base and growth potential of the economy.
Even the Japanese have stopped saving. That’s different this time. Instead the BOJ has to buy all the debt the Japanese treasury issues.
Here is what has happened everywhere:
Bailouts and ever lower interest rates created the impression of very low risk. Investors consequently piled on more risk, pushing up prices on assets (like the stock market). This in turn made stocks seem like the only game in town, almost forcing everybody and their dogs (not my Ronja though) to abandon zero interest bank accounts and treasuries in favor of stocks, pushing the market even higher.
Low interest rates, easy loans (car loans, student loans, mortgages) also fueled consumption despite stagnant wages (the median wage is still at the 1998 level in the U.S.). Hell, you wouldn’t want one idle cent at a zero interest account when everybody else were making big bucks on Apple shares, so you went out and bough a couple of iPhones and some Apple stock. Everybody did that.
This has made sales and profits look better, has caused corporations to hire more people (poorly paid, and part-time, but still hired) and push down official unemployment numbers. With a job it’s easier to get a loan and shop more…
So, low interest rates have made fundamentals (sales, profits, employment) look better while at the same time pushing up valuation multiples (P/E 10 has gone to 17) of those fundamentals through debt financed buybacks and panicked investors feeling left behind.
In the background debt has silently been piled on debt – unnoticed due to near zero interest rates, and borrowed money has been used for consumption and poorly considered investments that will turn sour when interest rates rise or consumers become more fearful.
The climb to the peak continues, as long as risk aversion is low, as long as returns are positive, as long as interest rates are low, as long as debts can be serviced (requiring a solid job market and low interest rates or at least rising stocks).
A system fraught with fingers of instability
The lower the interest and the higher the debt (both are at new historic extremes) the more sensitive the system. The more uncertain and poorly paying jobs (stagnant wages since 1998, albeit higher than 2009; real underemployment at the highest level in decades) and the more interest rate dependent the economy (debt financed consumption, debt financed companies and projects), the more sensitive the system.
Underemployment is at highs:
Usually debt ratios are low and interests rates high before a downturn. In a slowdown interest rates fall, mitigating the debt burdens. Some debtors still default but thanks to the low starting point the resulting debt level isn’t disastrous. This time it’s very different:
Leaving new monetarism and extreme QE aside, any little thing could topple the current situation. Falling stock prices could trigger an avalanche of stop losses and more sell orders.
If investors demand higher interest rates to buy treasuries (as they rightly don’t like the money printing that’s eroding the dollar’s value), the government would need to tighten its budget and lay off people. Squeezed consumers (living off loans) would spend less due to lay-offs and higher interest rates, causing the private sector to streamline (more lay offs…).
Did I mention the market didn’t care about easier money the last two market crashes? (charts from Hussman, showing how the Fed eased all the way down)
Corporate profit margins are at all time highs. Over the last few hundred years, profit margins have been strongly mean reverting due to competition and wage cost/disposable income dynamics for costs, sales and profits.
Right now automation and cheap loans (fueling consumption, i.e. sales, and reducing borrowing costs for the companies themselves) have enabled more sales and higher profit margins from fewer and cheaper employees. In addition, banks are the biggest beneficiaries of all, since they make their living on debt and there is record amounts of it to go around now.
Actually, the digital era that started in earnest 20 years ago, but accelerated further 8 years ago with the milestone product the iPhone, has meant faster churn among the Fortune 500 companies (companies leaving the list), not to mention much higher brand disaster risk (the risk of a 20% drop in brand value in a single quarter over a period of 5 years). This should mean less barriers to entry, more competition, less pricing power, lower margins over time, shorter company and production life spans. This sounds really stupid right now (at current record high margins), but corporate margins should undershoot their average level significantly going forward.
Google, Apple and Amazon might seem invincible and eternal right now but so did Steinway and Kodak at one time.
Valuations are higher than ever (median P/E, EV/EBITDA, P/S, e.g.), based on record high margins expected to last forever, based on low interest rates and only very low-yielding direct projects left on the table all but forcing money into stocks instead (at any price, to not be left behind). Oh, and record buybacks as well (debt-financed at record low interest rates).
When growth falls, profits undershoot, interest rates normalize, buybacks dry up and the public’s penchant for stock market speculation diminishes, valuations are likely to undershoot too. Well, they have to unless the historic average has shifted upward permanently.
It’s different (right now). That doesn’t mean it will continue to be – it usually doesn’t
Chart from Hussman that shows probable forward looking annual returns:
All lines ending in 2015 project the expected annual return over the coming 10 years 2015-2025. Right now it’s around 0% total nominal return per year, meaning the S&P 500 index is expected to be lower in 2025 than today and the difference made up by dividends. The line ending in 2005 at around 8% is the actual 10-year average annual return over the 10 years 2005-2015. That’s about twice the projected level of 4%. Historically such unexpected overshoots have been followed by periods of undershooting the projection. A repeat would mean much worse returns than the projected 0% per year, over the coming 10 years.
As you can see, debt and interest rates infiltrate every corner of the economy and feeds on itself, giving rise to more consumption, higher profits, more speculation & buybacks and higher valuations, while undermining the real economy (lower growth potential ahead) with negative return malinvestments and speculation instead of innovation, investments and production.
Forward Price Earnings ratio is at highs
At some point between the current extreme and a future point, it’s possible that the economy, sentiment, sales, profits and valuations all undershoot at the same time.
If not, it’s bad enough if they normalize at the same time. Heck, even if only one variable normalizes or undershoots over the coming 3 years, stocks are in for a deep dive. In fact, if markets were free to find the clearing price for interest rates, the other variables would normalize automatically
How did we get to this extreme situation, where all important variables have ended up in la la land?
- The Fed’s money printing and ZIRP (zero interest rate policy) have fueled both profits and various forms of speculation, driving reported unemployment lower, profits higher and valuations higher
- Bail-outs causing moral hazard (excessive risk taking since you’ll book the gains and tax payers the losses).
- Algorithmic trading (most don’t care about absolute levels, meaning stocks can drift arbitrarily far from fundamentals)
- Record world participation: China, Japan, the US, UK, Europe, Brazil, Russia – every major economy is stimulating their economies at the same time. The developing world is more important than ever thanks to two decades of high growth. The flip side is that the entire world is facing the same problems at the same time. The strong comeback 2003-2007 depended on the BRICS (not least infrastructure [stimulus] spending in China, Brazil’s and Australia’s commodity boom and Russia’s oil bonanza). That trick is spent now. That’s what’s different this time.
Stock market volumes are dominated by algo trading, HFTs. Some estimates point to 70-85% of all stock market trades being done by autonomous computer programs. Measured as the number of placed (and withdrawn) orders it’s more like 99.99%. It’s not real money out there, don’t try to make sense of what’s happening. It’s just machines playing games with each other.
Much of the remaining 15% real money trading will disappear too if/when algo trading collapses. Despite all computer based trading, volumes are shrinking. And try to fit the 15% real money in these charts:
A week ago, one HFT firm (A) filed a suit against another one (B). The suit was based on firm B’s market manipulating algos hindering firm A’s algos from manipulating markets in its desired fashion.
As another example, a few years ago a person was charged with tricking a market manipulating algo into making mistakes that the person thus benefited from.
We can see the HFT presence in the record high frequency of “market breaks” when exchanges crash.
Other different or ominous developments:
The oil price collapse
The Baltic Dry collapse to all time lows
Record bull advance (length, height). There is a limit to how long investors can become more optimistic every day.
US macro surprise index
On the bright side (no irony) the US economy can only surprise less negatively going forward
Record low number of negative investors
-that’s why stocks have been able to climb so far. Bears have converted to bulls. But it’s no indication of further increases – quite the opposite.
Record weak China house price development
Record high junk bond issuance
Of course companies issue as much junk bonds they can during this search for yield phase. Wouldn’t you? It’s basically money for free. Some saturation can however already be discerned – signalling increasing risk aversion which often is followed by plunging markets.
Junk bond yield signals are not so different
This chart is simply too stupid. Nobody is that crazy:
The USD (DXY index)
Paradoxically getting stronger but first and foremost more mobile – be careful when currencies move faster than usual.
Oh, it’s different
To summarize, it’s different alright; much worse, volatile and inherently unstable than earlier pre crash episodes. In short, it’s the worst time ever to invest. Hussman’s chart below shows (vertical lines) when his thoroughly back-tested ‘ensemble’ of valuation and timing methods have signalled strong sell. Q1 2015 is worse than ever.
The Fed can’t keep funding the deficit, since the dollar would collapse sooner or later – causing all sorts of hell (imported inflation, energy crisis, trade wars). They can go on for a long time, but not indefinitely.
Hence, either inflation erodes savers’ money in order to get debt/gdp under control, or increased taxes will have to deal with the primary deficit problem – unless the U.S. wants to default (unthinkable?).
Perhaps increased taxes (they are at lows), or cut in welfare spending (unlikely), will be the proverbial straw on the camel’s back? Well, better that than revolution or war as Paul Tudor Jones warns.
What to do?
I’m waiting. Shorting and waiting, hoping the fall won’t be too cataclysmic or different (or take to long to get going, which could be the same thing).
If you can’t stand waiting, I unfortunately have very little comfort or advice to offer (see previous post for some more or less desperate possibilities).
Build real value:
- Have fun and live now, before the feces hit the air conditioner. Happiness is real.
- Invest in yourself (skills, experiences, fun) – prepare for the next round
- Build a business, a real business – not speculation. Make other people’s lives better and you’ll make a profit.
- Make sure your debt is strategic, not just built on hopes of eternally low interest rates. Amortize, fix the rate for 5-10 years, use the money for real value building investments, not a bigger house or consumption.
- If you feel you must invest, buy something others don’t. Look among the losers and the small, not the hyped giants. Imagine you buy the entire company and take it private, actually getting its cash flow, not just hoping to sell the stock at a profit to a bigger fool.
Stocks, bonds, metals, commodities – forget it, you simply won’t be long term enough to stand the downturn that most likely is just around the corner. If you are thinking about being fully invested NOW, you most likely will be all out 50-60% down from here.
There is always a silver lining. If you can handle waiting for a normal time to invest, you should get 10% per annum for quite a while after that. Markets almost always dip below levels that promise that kind of returns for a decade.
If you are lucky enough to wait out an epic bottom (don’t hold your breath though – even if I think that’s exactly what’s coming) you could get twice that for several years.