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Brace for Data Impact

Not a bad trick!

The government shuts down, and the Administration threatens default; the stock market drops a few percent, and then rallies to new highs. Then the shutdown ends, and the stock market rallies again because the shutdown ended.

I lose track of the mental gymnastics required to reconcile prices rising perpetually no matter what the news – or, what is worse, rising regardless of whether the news is “A” or “not A.”

I saw an analyst report recently in which the writer argued that stocks were not overvalued per se; they were only one standard deviation above fair value. I don’t disagree very much, quantitatively, with that view…it sounds about right. But the way it is expressed is somewhat misleading. We know that roughly two-thirds of a normal distribution is contained between +1 standard deviation and -1 standard deviation from the mean. This implies that only about one-third is outside of one standard deviation, and only half of that on the upside. In other words, a market which is “only one standard deviation above fair value” is in the 84th percentile or so of richness. Or, if we were to throw darts randomly at the distribution, about five of those darts would represent “down” and one would represent “up” from that level.

Now, whether or not we call that “expensive” or a “bubble” (I don’t think it qualifies as a bubble) is mostly a linguistic argument rather than a financial argument. The financial/investing argument is whether it is smart to be invested in an 84th percentile market or not.

The answer isn’t quite as clear as it seems because it depends on how rich the market is when you sell it. If you buy at the 84th percentile and later sell at the 84th percentile, then you’ve gained the growth in earnings and any dividends over that period. So it’s not an automatic loser. Similarly, if you are holding a bad poker hand but push all your chips into the middle, you might win against someone else’s hand in the event that theirs is even worse. But that doesn’t mean it’s a good move. In investing, as in poker, you win by making your biggest bets when odds are favorable, and avoiding bets when odds are adverse. And sometimes, that means you have to sit at the table for a long time waiting for good odds! So, whether stocks are “expensive” or not at the 84th percentile is to an important degree irrelevant to me. What is relevant is sizing my bet to reflect my chances of winning, which aren’t very good right now.

Bonds are back in rally mode for now. The traditional seasonal pattern, which calls for a peak in yields on September 4th, has been strikingly useful this year (the high closing yield for the 10-year note was actually September 5th). But the main portion of that seasonal pattern is coming to an end. Yes, the Fed is continuing to buy bonds, but core inflation is now heading higher rather than lower as it was prior to last month, and we all realize that the can has only been kicked for a couple of months. Still, the VIX plunged on Wednesday and Thursday, so investors clearly don’t anticipate any near-term volatility in markets. That seems really odd to me, since we are about to see the densest economic release calendar we have seen in many years. When I was an options trader, we scaled volatility by the density of economic releases (weighted by the importance of the release). I can’t imagine wanting to sell volatility when we have the Retail Sales and Existing Home Sales reports on Monday, Employment Report and Chicago Fed on Tuesday, New Home Sales on Thursday, Durable Goods on Friday, and lots of corporate earnings besides; and the following week has PPI and CPI and the Chicago PM and ADP and ISM.

And meanwhile, in somewhat astonishing fashion today the dollar got clocked, falling to the lowest level since February. There are certainly some people in Washington scratching their heads on that one. All in all, I am not convinced by the VIX’s brave face that it is the right time to sell such insurance. I would be a better buyer of volatility at these levels.

  1. BMB
    October 17, 2013 at 7:25 pm

    Reblogged this on A Bit More Bull and commented:
    “I lose track of the mental gymnastics required to reconcile prices rising perpetually no matter what the news – or, what is worse, rising regardless of whether the news is “A” or “not A.”
    Ain’t that the truth…

  2. Mark B. Spiegel
    October 17, 2013 at 7:36 pm

    >>Now, whether or not we call that “expensive” or a “bubble” (I don’t think it qualifies as a bubble) is mostly a linguistic argument rather than a financial argument.<<

    It actually *is* "a bubble" because that analyst's valuation metric (which I assume is PE-derived) is based on an "E" which is nonsensically exaggerated by the Fed's money-printing. The proper way to determine whether or not we're in a bubble would be to guesstimate where S&P earnings would be if interest rates were normalized relative to inflation and the Fed weren't creating $85 billion a month out of thin air. What would auto and housing and iPhone sales look like THEN? Maybe in that case S&P earnings would be more like $80 and not growing right now and thus the market multiple would be a bubble-icious no-growth 22x against a normalized 10-year yield of at least 3.5%.

    Nevertheless, as investors we must play (or refuse to play) the hand we are dealt and not the hand we SHOULD be dealt.

  3. eric
    October 17, 2013 at 8:43 pm

    Doug Short does lots of posts where he rates Valuation based on regression to trend, and based on the usual nerdy metrics: (CAPE, Q ratio, price/gdp, etc.) and by all those measures we are more than 2SDs overvalued. That’s closely related to Mark’s point, which is that earnings are themselves out of whack. But I dont think that has much to do with the fed, but rather with both personal and government debt.

    • Mark B. Spiegel
      October 17, 2013 at 8:46 pm

      >>…earnings are themselves out of whack. But I dont think that has much to do with the fed, but rather with both personal and government debt.<<

      Sure, but it's the Fed that has enabled both of those things.

      • eric
        October 17, 2013 at 8:52 pm

        Maybe. But I’m not sure how. In any case that’s an open question; while the more proximate claim–that’s it due to increased debt–is close to accounting identity.

  4. eric
    October 17, 2013 at 8:50 pm

    On the other hand, pace the bell-curve, his charts make it pretty clear that markets get more overvalued than they do get undervalued (and I guess spend more time being undervalued!). 2000 was over 3SD by most measures! But I dont think we’ve ever been 3SD’s below. So, even though it violates the basic math of the model, we probably spend more than 2.5% percent of the time over 2SDs.

    • October 18, 2013 at 7:56 am

      Ah, not the basic math…just the basic assumption that market returns are normally distributed. Which we know they’re not…which means in turn that standard deviation is a fraught measure.

      Mark’s point is very good that earnings are almost surely on a cyclically high ebb since these margins are not likely to be sustainable. But I didn’t feel like fighting that battle in this article. :-) And I like Mark’s comment about playing the hand you’re actually dealt, not the one you should be dealt! Good stuff.


  5. Chris
    October 18, 2013 at 3:06 am

    “In investing, as in poker, you win by making your biggest bets when odds are favorable, and avoiding bets when odds are adverse. And sometimes, that means you have to sit at the table for a long time waiting for good odds!”

    Very good comparison. (Un)Fortunately most players can’t afford waiting very long without losing most of their clients (Jeremy Grantham somewhere said the client’s patience is 3.0 years….) So they recommend to their clients to invest, which further prolongs the valuation cycle. With low rates and QE the FED enables and prolongs the debts cycle which in turn enables and prolongs the high profit margins.

    Who can afford and is mentally able to wait for many years for interesting investments?

    • October 18, 2013 at 7:52 am

      You don’t have to wait- you can also short the market.

      • October 18, 2013 at 7:57 am

        I wouldn’t short a market like this. But with implied volatility very low, I WOULD look seriously at put protection, which is quite cheap now.

  6. HP Bunker
    October 18, 2013 at 1:12 pm

    Mike, I don’t think you’ve addressed this in any of your posts here, so I thought I’d point out what seems a real oddity of the post May-June 2013 investing world: since Bernanke first proposed a September taper (we all know how that turned out, but it’s not relevant here), we had first stocks and bonds falling substantially, and then stocks (but for the most part not bonds) rallying back up to new highs.

    Given that TIPS have not particularly outperformed nominal treasuries, it sure looks like what’s being “predicted” by the overall market is strengthening economic growth in the absence of significant inflation. Otherwise, one would assume a stronger correlation between stocks and treasuries, no? In other words, presumably there were (in April of this year, for example, when 10-yr yields were briefly around 1.4%) some buyers of stocks who would have at the current 10-yr yield of 2.6% preferred treasuries. The decoupling between the two investments, combined with continued lack of interest in inflation-protected securities, only makes sense if investors as a group expect stronger economic growth going forward in an environment of “contained” sub-2% inflation.

    My point here is that the current market, while obviously Fed-supported to some extent, also is forecasting a “rally” in the real economy as well, and much more so than was the case earlier this year. I haevn’t personally seen much to be excited about in recent economic data releases, but I’d be interested in your perspective on whether the above interpretation of stocks vs. treasuries performance is correct, and if so, whether you see US economic growth taking off from here?

    • October 18, 2013 at 4:55 pm

      A simpler way to get to the same answer is to note that TIPS real yields…which ought to reflect expectations for real growth…have moved way higher. But they’re still quite low, with 10y around 0.50%. Now, that PROBABLY just means that the Fed is still holding real yields artificially low…and in general, I’m loathe to take any signals from the bond market at face value when one guy owns a couple trillion of them and keeps buying.

      But in any event, the expectations for future growth are higher. If stocks reflected the same 0.5% real growth that are reflected in TIPS (and by extension, Treasuries), I wouldn’t call them overvalued. But they currently reflect real growth of around 5% for ten years, which would be probably unprecedented over the last century or so. So yes, bonds ARE forecasting that growth will improve from -1% to +0.5%, but stocks are forecasting 5% (average over ten years). And that seems to me to be a stretch! 🙂

      • eric
        October 18, 2013 at 5:38 pm

        I think its also worth noting, in this context, that all the valuation metrics I mentioned above, which put stocks at 2SDs above mean valuation, assume that GDP growth over the next ten years will be in line with trend. I guess in that context, the relevant number is nominal growth, which I guess is around 6%. So, if you believe the bond market AT ALL (and here, I think I maybe disagree with Mike a bit: I don’t think the fed can influence long term interest rates all THAT much) then stocks are even more overvalued. If the next ten years look like the 90’s in Japan (and that’s what the bond market seems to be saying) then stocks might be even more overvalued than they were in 2000. Of course, stock prices SHOULD reflect the next 50 years of growth, not the next 10 years. But we know they never do what they should.

      • October 18, 2013 at 9:40 pm

        Good point. Although with respect to the last point, note that cash flows beyond 10 years, discounted at equity discount rates, aren’t worth very much at all…and 50 year cash flows essentially zero. So you don’t lose that much by focusing on 10.

      • HP Bunker
        October 19, 2013 at 4:02 pm

        Thank you both for the detailed replies. Mike, Could you explain the statement “stocks are forecasting 5% real growth (average over ten years)”? I’m just wondering how that calculation was made (not saying it’s wrong).

      • October 21, 2013 at 8:29 am

        It’s an off-the-cuff estimate made roughly as follows:

        10-year real return = dividends + real growth + pull-to-fair The pull-to-fair (the way I calculate it) is a drag of 2.75% per year, which means the implied growth from stocks that supports this level of valuation is about 2.75% higher than my long-term growth assumption, which is 2.25% per year.


  7. eric
    October 18, 2013 at 11:37 pm

    Is that true even if you are assuming the cash flows are growing 6%/year?

  8. Michael
    October 21, 2013 at 11:04 am

    Michael, you are an inflation hawk. I sense an anomaly.
    The book “Aftershock” has stated clearly that the market is over valued, perhaps by a substantial margin. The book also states that this is because of an inevitable double digit inflation spiral to start sometime between 2013 and 2016; which is due to tripling the money supply with Quantitative Easing; (only one of three inflationary pressures, the other 2 being printing money and deficit borrowing).
    Paranthetically, Aftershock also states that residential R.E. is also in for a major correction, implying a second housing bubble.
    I find it difficult to reconcile that book’s erudite opinion with your Blog today on the value of equities. Some guidance please?

    • October 21, 2013 at 11:29 am

      Well, I agree that the stock market is overvalued…so no difference there! And I see inflation heading higher, potentially much higher, and I’ve said that while it’s not my central tendency forecast, all of the inflation tails are to the upside. You just need velocity to jig slightly higher and you get a bad outcome. So no difference there.

      I think housing is again overvalued, but far from being in bubble territory. However, it does seem to be headed there. If prices corrected now, they wouldn’t have to have a “major” correction to get back to fair. But in my view they ARE back to being overvalued. So perhaps a mild difference there.

      Does this help?

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