The Laws of Investing
The Wall Street Journal asks Has the Fed Rewritten the Laws of Investing?
It has been an odd year with the Covid-19 crisis hammering the economy, but stocks recovering from sharp losses and then powering to new highs. As a result, standard measures show valuations are at rarely-seen levels that have typically ended in tears.
The S&P 500 trades at 22 times analysts’ expected earnings—its most expensive level since the dot-com bubble. It also trades at its richest multiple to its inflation-adjusted earnings over the past decade—the valuation method popularized by economist Robert Shiller —in nearly 20 years. The total value of U.S. stocks as a percentage of the U.S. economy, which Warren Buffett once called “the best single measure of where valuations stand at any given moment,” is now higher than at any point during the dot-com years.
Stocks vs Interest Rates
Some suggest stocks may not be as expensive as they seem because that interest rates are extremely low.
John Hussman has pointed out the fallacy of that theory many times. The Journal explains the fallacy this way.
The 10-year Treasury largely reflects investor expectations of what the overnight rates set by the Fed will average over the next decade. The Fed responds to what is going on with the economy, setting rates higher when it is trying to cool things down, lower when it is trying to heat things up. So low yields are tantamount to a low-growth, low-inflation economy—one in which profit growth would be low, too. Why pay up for stocks under that scenario?
Stocks vs Bonds
Some argue that stocks are cheap compared to bonds. But that is like saying truffles are cheap compared to moon rocks.
It sounds good on the surface but makes little sense if you think about it for more than a few seconds.
TINA
Then there’s TINA: There Is No Alternative. The idea behind TINA is people have to invest somewhere, they want to be liquid, so they pick stocks and bonds making bubbles out of both.
The problem with TINA is that it is based on the discredited sideline cash theory, all this cash on the sidelines has to go somewhere.
No it doesn’t. Someone has to hold every dollar, every stock, every bond, every bitcoin, every Euro, and every ounce of gold 100% of the time.
It is impossible for money to flow into any of those instruments.
If I take $100,000 and buy Bitcoin, gold, stocks, bonds or even real estate, I have whatever I bought and someone else has $100,000.
All that has occurred is a swap. I have an asset and someone else has cash. Thus, it is possible for individuals to reduce cash levels, but impossible for cash levels to drop in aggregate as a result of asset purchases.
Fed’s Commitment
Let’s circle back to the WSJ for a new theory.
The Fed this year revamped how it sets policy, abandoning its practice of pre-emptively raising rates to head off inflation. In its efforts to help the economy recover, it has committed to hold short-term rates near zero until inflation reaches 2% and “is on track to moderately exceed 2% for some time.” That means that rates over the next several years will be lower than they would have been under the Fed’s previous policy. Perhaps stocks can carry higher multiples and still be reasonably valued.
The rules of investing have changed in the past, after all. Investor and financial historian Peter Bernstein noted how veteran Wall Streeters blanched when the dividend yield on stocks fell below the yield on the 10-year—a sure sell signal, they told him. What they missed was the phenomenon of companies reinvesting more of their earnings rather than paying them out. It would be a half-century before dividends surpassed Treasury yields again.
Maybe the Fed’s actions this year have changed how investors should think about valuations, but it is early going and that hypothesis has yet to be put to the test.
Valuations Stretched For Years
That explanation might help explain the quick recovery this year, but valuations have been stretched for years.
For example, the Shiller PE was 33.31 on January 1, 2018. It’s only a tad higher today at 33.74.
Not Hyperinflation
It’s not a function of the US dollar either, and please do not bring up the ridiculous notion of hyperinflation.
The US dollar is not going to zero vs the Yen, Euro, Gold, etc. etc. etc.
Do You Understand the Ramifications of Passive Investing?
Please consider Do You Understand the Ramifications of Passive Investing?
I post some excellent video clips thanks to @TheBondFreak @GratkeWealth @DiMartinoBooth and @profplum99 and others.
In regards to passive investing, there is one case in which sideline cash can matter. That is cash on hand at mutual funds.
The bulk of cash on sidelines is either active players or players who do not want to be in the markets for whatever reason. These people are price sensitive, or at least sensitive to something.
Mutual funds, largely representing buy and hold passive investors, have no cash on the sidelines. They get money in and have a mad rush to put it in play.
Simply put, the Mutual Funds buy and someone else has the cash. But what happens when people panic? Stocks drop, then again, then again. Redemption requests come in. The funds have to sell, but to who?
Not One Thing
So, take the Fed, free money from Congress, Robin Hood day traders who have never seen a bear market, etc. and you have this massive sentiment that stocks will never go down.
Passive investing and the Fed fuel the sentiment that nothing can go wrong.
These factors are all in play. And it is impossible to figure out in real time precisely why people react the way they do.
But bubbles by definition burst. Don’t ask me or anyone else when. This has gone on far longer than I thought would happen.
Finally, please note that stocks do not crash from valuations or in overbought scenarios. There are too many dip buyers waiting on the sidelines.
Stocks crash in oversold setups in which redemption requests come in and the pool of dip buyers has dried up.
Party on.
Mish
“The bulk of cash on sidelines is either active players or players who do not want to be in the markets for whatever reason. These people are price sensitive, or at least sensitive to something.”
One might as well say that cash in the stock market is on the sidelines, as well, considering people run for safety when the market threatens the value of the stocks being held.
At short time ago, somebody in the USA figured out that China and Japan are the largest holders of US Treasuries and that their existence is totally dependent upon US consumers buying their products. The dollar can wiggle up and down with the economic gyrations, massive increases in US debt, world turmoil but unless China and Japan are ready to eat $3T in losses the corrupt people pulling the US levers will continue to stuff their own pockets and create chaos and keep people like all of us guessing as to when the accumulation hits the oscillating device rotating on the ceiling.
Mish – I get your point about money on the sidelines but what about money from the Frontline (i.e. from Fed’s creation). As you know Fed started buying junk bonds and ETFs in this crisis. So consider this scenario, had Fed not intervened, a holder of Junk bond might have gotten say $80 for the instrument, but because Fed decided to increase its balance sheet and with the newly created money buys this junk bond say for $98. The seller got extra 18 Dollars. Right? Now this seller could spend this extra $18 chasing stock or some other asset. Wouldn’t that be a reason for driving asset prices up?
And with ongoing massive QE why would this behavior not continue?
Price to earnings and price to yield are the same, and the Fed is actively, and perhaps more to the point, -successfully-, suppressing yields i.e. pushing the divisor down so the schiller index goes up. You might imagine that when the Fed is incapable of holding down yields that the index will then collapse, however, the reason for ineffective yield control by the Fed will be inflation in which case the dividend, the number on top, will go up i.e. high schiller index.
From that, you can imagine that the end of the high schiller index will be the abandonment of yield control by the fed. Can anybody see that? No.
Saying that someone always has the $100,000 just misses the point of “money moving into stocks “. It’s an observation with little meaning. Money moving into stocks simply means people are willing to pay higher prices for the stocks. In addition, if someone takes the cash and pays off debt it does actually reduce the amount of money on the sidelines due to the magic of fractional reserve lending, in reverse.
A new variable, is the Fed has told for years and often, that would use it’s “tools” much more quickly and upfront – earlier – than previously.
It did. It front loaded QE by handing out abt $3 trillion once Covid impacted the economy. More stuff follow (“stimulus” etc).
So, if the bubble bursts, we know for Fed words and now actions, that will respond very quickly to turn the bubble around.
Old geezers used to collect stamps, and they would go up in value as other old geezers competed to buy them.
The stamps were just little squares of paper, some with pretty pictures and some did not. You generally couldn’t use them for postage, but the valuable ones were worth many, many times the face value printed on them.
Try selling a stamp collection today.
That’s a hint for you.
Paintings with a rotten banana taped to it still sells.
The Fed and the People’s Bank of China are more alike than different. They both have blown bubbles for so long that they have no idea how to escape bubble-blowing business without it finishing in massive unemployment followed by the hangman’s noose for those presently in power.
this is correct.
The “I” in ROI, is supposed to be the American middle class.
The wealthiest 10% of Americans own 70% of all stocks, as for the job creation –
“Trickle down” “Job creating” tax cuts for 40 years has definitely created massive jobs, in China, India, Mexico, and everywhere else in the world where labor is less than American wages….at the same time household debt went from ~ 65% to ~110% now.
For the ROI, seems maybe a good time we try a “trickle up” approach, math seems to say.
I find myself moving away from the view that the Fed is managed by the biggest idiots around, towards the view that they must be stretching and seriously compromising the stability of the financial markets on purpose, for the sake of some greater objective down the road. Who knows, perhaps a “great reset”?
In any case, it is clear that the Fed will not ever interject in order to “cool things off”. They appear to only have one path remaining, and with that they are progressing full speed ahead.
There must be secret plans in Washington for what they will do when the next massive sell-off arrives … surely they are smart enough to know that they cannot goose this bull market forever … and they won’t be able to escape a deflationary depression under current law.
Conservative investors and shorts have been beaten near to death. The equity markets do not do price discovery any more. They are rigged in one direction. Who dares to act like markets work?
You seriously overestimate these people and their competence.
They think they’re at the helm of the globe, steering the ship of state in sometimes treacherous shoals. They think they have life by the balls, and have hired echelons of sycophants surrounded by phalanxes of PhD herd thinkers, creating herd immunity and ritual perfection against any kind of real contrariness.
There is no plan. They think it’s surely not for nothing that they’ve been appointed by the powers that be to guide the ship and be in charge of the machine’s levers.
I think the driver is you have naive investors who got a bunch of unemployment money and are not paying rent putting the money into the market. It will end badly for them.
Tesla has the most over valued market cap I’ve ever seen. There were some crazy prices in 2000, but not in a company with as big a market cap. They’re worth 612 billion and are are never cash flow positive. 7th largest market cap in the world for a company that supplies 1.5% of autos.
I think you are correct. Also, some moved home to mom and dads and are not paying rent. They have been making money in the stock market too! Quanta Solar might be more overvalued. It has a valuation of has $35 billion market cap and has not ever sold one battery yet.
$26 billion. Not $35 billion
I think we also now can clearly state the Fed is going to bail out pension funds via the bond market going forward. This will levitate the stock market longer than anyone can imagine. The real problem the Fed has now is every time they want to reduce support, the market tanks by 25% and screams for more like a crying baby that needs milk. This is what happen in December of 2018. The Fed won’t be able to reduce support until the next crisis comes, what ever that crisis is.
“Stocks crash in oversold setups in which redemption requests come in and the pool of dip buyers has dried up.”
Very good point.
My strategy was always meant to benefit from inflation. If the Fed can create inflation, I’m okay with the Fed. So far that seems to be the trend, at least in the assets I like….but we all know (or should know) it’s built on a house of cards..
If we have a series of deflationary events, i.e. a massive sell-off in risk assets, I’m not nearly as happy.
I don’t know about TINA….but most of us do need a return. Decent returns all involve too much risk these days. A two year bank CD will getcha 1%. At that rate, I need to have a nest egg of 20 millions bucks to net 100K a year in retirement. I’m still a little short.
Party on.
You have to play the game or get left behind. Well done Eddie!
Should have said I need 10M in a 1% CD to net 100K. I’m sure somebody caught that mistake.
yep
The reason it has gone on is we have entered the era of debt monetization like Japan. The other reason it has gone on is more money has entered the US markets from overseas in 2020. Valuations are low in emerging markets. I predict 2021 sees money come out of US markets and back into foreign markets in a big way as the world begins recovering.
Whatever could go wrong? A permanent high plateau…
Connected richies will be the first out at the top. Passive investors and FOMO fools will realize they’ve been tricked again, for the third time in 25 years.
But first time for many.
Selling due to fear is when most people lose money. If you put money into the S&P500 in 1995 and held until today, then you would be up just over 1,000% including dividends today. Even if you invested only at the peak of the dot-com bubble you would be up over 300% today. Invested in S&P500 in 1990 and forgot about it? Today you are up 21 times! I do believe that S&P500 is over valued now, but still adding more. It doesn’t matter when you buy, but better not panic sell when the next crash comes. It will go up again, even if it takes 10 years…
Google S&P500 total return index and you can see the progression