The road to hell is meant to be paved with good intentions.
But nothing good ever comes from deception.
Central banks have done everything within their (considerable) power to pave the way for economic and asset price growth.
Savers sacrificed. Dollars printed. Debts accrued.
But all of these measures are artificial. They don’t produce real growth or real value.
The following charts show that since the events of 2008/09, US corporate earnings have risen with each Fed sugar hit or government tax cut.
But once that stimulus passes through the system, earnings growth dips back into negative territory.
Source: Charlie Bilello
Why are earnings so soft?
The underlying economy is not in good shape.
And that’s showing up in the cash registers.
So, if the economy is spluttering, what’s propelling the US share market to new highs?
Glad you asked.
DB (Deutsche Bank) Global Research has looked under the market’s engine and found the boom has been fuelled by corporate buybacks.
Source: DB Global Research
Corporate America has been issuing bonds — left, right and centre — to any mug punter looking for yield.
The borrowed funds are used to buy back shares, boost prices and put the executive share options ‘in the money’.
While the queue of yield starved investors remains snaked around the corner, then this neat little scam that Wall Street has going, can continue.
All previous attempts to create an artificial market — Charles Ponzi comes to mind — have failed and so will this one.
The difference between Wall Street and your average Ponzi scheme is that when the con is revealed, the Dow Jones or S&P 500 index won’t be rendered valueless.
How much could the market lose?
Best case 50%. Worst case 80%.
At a time when the S&P is hitting new highs and the Dow is within a whisker of doing so, these figures seem absolutely ridiculous.
What’s ridiculous is that people don’t seem to realise that markets ALWAYS fall from high points. They NEVER fall from a low point.
The conditions are ideal for an epic fall. Longest bull run. Highest market ever. Unbridled belief in the Fed’s ability to take rates lower and markets higher.
The scene is being set for a classic collapse. One for the ages.
Without higher earnings, some of those corporates are going to struggle to meet their commitments to bondholders.
Once the defaults start, it’ll have cascading effect. The queue of yield starved investors will dry up. Then it’s game over. The market goes into freefall.
That’s when the journey on the road to hell begins…for those in the market.
Markets always react on emotion and eventually balance out on mathematics.
Real earnings do have a real value.
But determining that value is not always easy in a world where there’s so much manipulation.
Fortunately, the market’s 140-year history does provide us with some clear valuation pointers.
The unemotive way to assess the probable damage to portfolios is to use the proven mathematical principle of reversion to the mean.
Shiller PE 10 Valuation Method
The PE10 is a valuation method originally developed by Benjamin Graham (Warren Buffett’s mentor).
The current price is divided by the average of the last 10 years of earnings. The methodology smooths out the lumps and bumps in earnings to provide a better read on long-term value.
Based on 140 years of market data, the current PE10 reading is almost 80% ABOVE the mean.
That’s not a good place to be. The previous times the US stock market has been in this territory is 1929 and 2000. Both of which preceded epic crashes.
Source: Guru Focus
The following table works through a few scenarios. From Really Lucky to Really Unlucky.
Source: Guru Focus
If the market defies the odds for the next eight years, then the US market (mathematically) would return 2.8% per annum. Not a great return considering the risk.
However, should the market overshoots the mean — like it’s done in the 1930s and early 1980s — then the Really Unlucky scenario is a LOSS of 9.8% per annum for the NEXT eight years.
On a simple maths basis, that’s nearly 80%.
Do you risk losing up to 80% for a gain of 2.8% per annum?
GMO’s seven-year forecast for the US Stock Market
The highly respected Jeremy Grantham (co-founder of GMO) has previously raised the possibility that valuation metrics (from earlier cycles) may not be a reliable indicator for the current market.
Having said that, every quarter GMO publishes a ‘7-year Asset Class Returns Forecast’ based on reversion to the historical mean.
The latest forecast for US share investors is not all that different to the Shiller PE10.
If the US market does revert to the mean, then US share investors can expect to lose, on average, 3.7% PER ANNUM for the next seven years.
And there are others warning US investors of tough times ahead.
Hussman Funds highly accurate valuation model
John Hussman of Hussman Funds has developed a highly accurate forecasting method — one that has a 93% correlation between what was forecast and what the stock market subsequently returned over a 12-year period.
Hussman’s method is based on the Margin-Adjusted P/E (MAPE).
There are times in the business cycle when earnings are pumped up by fatter than usual profit margins.
Corporate America is currently enjoying a period of very healthy profit margins due to a combination of…wage suppression, access to cheap finance, adoption of improved technology.
These purple patches never last.
Eventually, profit margins succumb to ‘mean reversion’ and earnings are deflated.
Hussman’s valuation model adjusts the PE 10 to allow for a reversion to the mean of US profit margins.
When you apply this brilliantly simple piece of logic to the valuation model, you get THE MOST EXPENSIVE in history…exceeding the nose-bleed level of 1929.
Source: Hussman Funds
Are you seeing the pattern in all this valuation data?
These are like ‘WARNING: DANGER AHEAD’ road signs…ones written in bright red.
In his latest report, John Hussman tells us what the road ahead looks like (emphasis is mine):
‘[…] a 50-65% market loss over the completion of this cycle would be consistent with a century of history, given present valuation extremes, and investors remain fully vulnerable to the same downside risks they faced in 2000 and 2007.’
That’s a sizeable sink hole.
And, if the US market plunges 65% in value, you can bet the Aussie market will go (some or all of the way) with it. And if you are still not convinced of the perils ahead, here’s…
A combination of indicators
Every month, Advisor Perspectives provide a chart on the combination of four historical valuation methods.
Source: Advisor Perspectives
The current reading is 117% ABOVE the historical mean.
Making this the second highest reading in 120 years.
That’s not good.
This hardly qualifies as a cheap or even fairly valued market.
Once again we can look at history to show us what these valuation signpost tell us about the road ahead.
Advisor Perspectives produce the next chart showing the nominal (not inflation adjusted) 10-year return.
PLEASE NOTE: the left hand scale is INVERTED…it goes from MINUS 5% down to 25%-plus.
Source: Advisor Perspectives
This table combines the information from the two charts to show us there’s a very clear pattern between valuation levels and future returns.
% Above or Below MEAN
Subsequent 10-year return
+20% per annum
MINUS 3% per annum
+12% per annum
+21% per annum
+3% per annum
+18% per annum
MINUS 3% per annum
+13% per annum
The pattern is a simple one to follow…
BELOW the mean = ABOVE average future returns. ABOVE the mean = BELOW average future returns.
Take a look at where the current market is…117% ABOVE the mean.
If the pattern is to be repeated, then BELOW average returns are in our future.
The two previous times the market entered into this territory, subsequent 10-year returns were in the MINUS 3% per annum range.
The road ahead
Unless this time is completely different and the Fed can somehow repeal the valuation cycle, you have to err on the side of caution.
If I’m wrong, the downside of having cash is you’ll have 100% of your money is earning 1–2%.
If I’m right, you’ll have avoided a head-on collision with a stock market that’s sped out of control.
All the data — and even IMF observations — point towards this market being overvalued.
History is quite emphatic on this point…overvaluation leads to underperformance.
How the market goes about delivering this underperformance is an unknown.
In 1929, it came fairly abruptly.
After 1966, it came by a death of a thousand cuts. Down. Up. Down. Grinding valuations (and animal spirits) much lower.
720 Global produced the following chart on the possible journeys a market can take to lower future returns.
Source: 720 Global
Scenario 1 is an immediate correction followed by a long steady recovery. That’s the 1929 experience.
Scenario 2 sees the market rise, fall and rise to a zero-sum gain. This is somewhat the experience of the 1966 to 1982 market.
Scenario 3 is an overvalued market continuing its skyward trajectory and then suffering a significant crash.
Perhaps, this is the path the current market will take. Time will tell.
The one thing time does tell us is this market offers far more risk than it does reward.
This graphic helps frame our thinking.
Understanding and appreciating the various pathways the market may take to its inevitable collision, helps us remain patient.
Obviously, Scenario 1 is the preferred path for cashed up investors. But we have to recognise it’s only a one in three probability.
So, ‘are we there yet?’.
The valuation signposts are indicating we are well past our destination.
And who knows, the market could go much higher before its spectacular flame out. In that case, we’ll have travelled down Scenario 3.
Irrespective of whatever path we take, the final destination is hell.
PS: WARNING – Here’s two reasons why the AUD could collapse in 2020. Download your free report.