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Missing Bull Market Ingredient and Bear Market Math

Should We Worry That Nobody Seems Worried?

  • Median stock valuations (as measured by P/E ratio) on a percentile basis over time: bad things tend to happen when prices reach the 90th percentile level or higher, with the current level clearly in the danger zone
  • GMO’s latest 7-year model projects negative real returns from every category of stocks except emerging markets, and from all bond categories except US inflation-linked and emerging markets
    • On the volatility front, in early October, VIX has fallen to its lowest level since the measure was created in 1993
  • Question one might reasonably ask is why nobody seems worried if stocks are clearly so expensive. And if nobody else seems worried, is there any reason for us to be concerned?

The Missing Bull Market Ingredient: Euphoria

  • There is an argument I’ve read in many different iterations over the past year or two that investors need not worry about market valuation levels until one sees clear signs of euphoria and speculation
  • Implication is that “you’ll know it when you see it” and that before a market can break, there always has to be a tell-tale “blow-off” top
  • In the late 1990’s, there was crazy speculative behavior and the popular manias surrounding internet, telecom, and biotech stocks. It was also commonplace at the time to read stories in the news featuring completely sane-looking people quitting respectable jobs so they could make more money day-trading tech stocks
  • More recently, in 2005 and 2006, speculators would show up on the opening day of a new housing development and buy five houses on credit in order to flip them later
  • Not seeing that kind of obviously speculative behavior today; in fact, nobody seems particularly euphoric about stocks, which is a little strange given the strong returns of the past few years
    • Most professional managers seem cautious or at least concerned about valuations
  • Sentiment amongst the general public is hard to gauge but the best description of the mood would be something close to ambivalence
    • Certainly, the really cool kids are all too busy buying crypto-currencies and investing in early stage VC, or maybe selling put options on volatility ETFs
  • One could even push the logic further and argue that this lack of perceptible euphoria is, in and of itself, a reason to be bullish about stocks
    • With the global economy finally showing signs of real growth that will start to be reflected in public company earnings, markets could go higher as this translates into earnings growth that could more than justify current lofty valuations
  • For some reason, the financial media appears to have unofficially designated 20% as a standard definition of a bear market
    • It would seem that the penalty for being “long and wrong” by holding a portfolio of over-valued stocks is not terribly onerous
    • I can tell you from experience that this assertion is just not the case

Bear Market Math

  • I view this particular bull market as being somewhat different in character than prior bull markets, driven as it has been by central bank accommodation and low interest rates
  • Also think that many active investors feel that they have been held hostage by a lack of options, and simply have no choice but to participate even if they have reservations about high prices and low prospective returns
  • I do think it is prudent and helpful to be a student of economic and stock market history and to be aware of the possible ramifications of investing when prices are at historical extremes on either side of the valuation spectrum
  • My view is that current market offers enough of the standard warning flags to make it more prone than average to either a significant correction or, if the right conditions were to align, a bear market (certainly doesn’t mean it has to happen soon)
  • I emphatically disagree that bear markets are easily ridden out, either financially or emotionally
    • 20% decline in stock prices from current levels wouldn’t constitute a bear market in my mind; that would be more like a correction
    • Real bear markets tend to follow what I call the 40/50/80 rule: what this means is that when a bear market comes, the best and safest investments in the asset class typically decline in price by 40% on average; median or average investment falls by 50%; then the most risky stuff loses 80% on average
  • Bear market of 2000-2002:
    • S&P 500 fell about 40%; average stock or median stock was probably down 50% in that time; as for the stocks nearest the epicenter of the speculative excess, the NASDAQ index dropped 83% from peak-to-trough
  • In the bear market from October 2007 to March 2009:
    • S&P 500 dropped almost 50%; median stock was easily down 50% or more; anything leveraged or directly related to real estate or the credit markets got hit the hardest, but anything small and illiquid suffered badly too – as a group, this category probably fell closer to 80%
  • Commodity bear market in late 2011 to early 2016:
    • Highest quality securities in the precious metals mining sector probably fell 40-50% and the median stock was easily down 50% or worse; a prominent gold mining ETF, GDX, fell by roughly 80% from late 2011 to early 2016

Why Preparation is Important

  • Stocks have been going mostly up for 9 years now and it feels like they will never come back down
  • When thinking about it in the abstract, most people naturally believe that in times of stress that they will behave rationally, and that they won’t be among those who panic and sell at the worst possible time
  • The reality is that most investors aren’t so rational when the time comes, because when stocks are going down they feel like they might never go back up; in a real correction or bear market, the % losses can be steep and harrowing

Centaur Value Fund September 2017 Report

Image Source: LombardiLetter

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