Much to the consternation of those who continue to insist that we are not in a bubble it is my opinion that we are in a bubble at the moment and one that is being blown ever larger by investors who want to believe that the money machine will continue to spew forth profits and the risk of malfunction is extremely low. There can be no question that my views that QE has failed and that we are now at the upper end of a cyclical bull market within a secular bear market are not popular views. Those who believe in the efficacy of QE are very quick to point out that my views are - at this point - utterly useless as I have been wrong for the entirety of the year.
Just to set the record straight on that point here is what I said back in January:
My best case scenario for 2013 is a range basis the S&P of 1600 on the high side and 1260 - the 2012 lows - as the low side.
I missed the high by at least 12% - not a particularly good call to say the least. I of course am not alone in my views that we remain in a secular bear market nor am I alone in my call on when we will start the next cyclical bear market - both in the sense of timing and magnitude. It will of course do that - enter a new cyclical bear market that is - as it always does. Furthermore, when the market gets stretched to far in one direction it tends to overshoot in the opposite direction.
Doug Short's chart below makes note of the fact that even though the dotcom bubble - at it's peak - was the beginning of the current secular bear market - the market sell off in 2000 fell well short of what was seen in previous secular bear markets. In fact the 2000 market sell off didn't even bring the market back to the regression trend line. The 2008 sell off did push the market slightly below the line - 11% to be precise - but even this sell off fell well short of all previous pull backs.
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The chart above is expressed in inflation adjusted real terms and is decidedly different in appearance than the chart reflecting nominal price. To fully confirm that we are now in a secular bull market we need to take out the all time high of 2012.84. If we are able to do that we would need to redraw the chart above with a blue line coming off the 2009 low indicating we entered a secular bull market in 2009.
Of course even if we did take out the all time high and in so doing labeled the rally from the 2009 lows as a secular bull market it would not preclude the possibility that we could move back into a secular bear market thereafter as we did after peaking in 1929 at 81% above trend.
Equally relevant when viewing this chart is the October 2007 high of 1725.46. There is no instance in the historical data where a cyclical bull rally exceeded the previous cyclical bull rally without also taking out the prior all time high so just using this metric alone it seems entirely possible that we could take out the all time high leaving no question as to whether or not the rally off the 2009 low was in fact the beginning of a secular bull market. The chart below is the same chart as the one above without regression channels but the actual data points were available reflecting the value of the all time high and the 2007 high and allows one to take these specific values into account.
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The fact that we did take out the 1725.46 high suggests that we may take out the all time high as well. Assuming that we do this then it seems reasonable to assume that the extreme upside before reverting to trend would be no greater than the 153% above trend recorded in 2007. That value though would end up dramatically expanding the regression channel as it would push the real price to roughly 2654 not taking into account the fact that the regression trend line value would be at a much higher level than it is today.
Using a value of 84% above the trend line - the next most extreme percent above the regression trend line recorded in the chart above - the market would peak at roughly 1946 before reverting to trend. That seems a more plausible scenario as I will explain and has to do with the effectiveness of QE - the obvious driver of the market today - but before going there one more calculation seems useful.
Assuming we do continue higher and reach the 84% above the best fit regression line value in the coming weeks and months and thereafter enter a cyclical bear market we will fall short of the 2012 level needed to redraw the line coming off the 2009 low as a blue line indicating that we entered a secular bull market in 2009. If we do then begin a cyclical bear market where do we bottom out?
The average drop below the best fit regression line is 47%. Using that value as a basis to estimate the downside risk to the market if we do enter a new cyclical bear market the downside would project to 560 calculating the level based on the current level of the regression line.
Before moving on to the efficacy of QE and the probability of this monetary policy continuing to fuel the bull rally I want to share with you some of John Hussman's thoughts in his most recent weekly commentary:
Investors who believe that history has lessons to teach should take our present concerns with significant weight, but should also recognize that tendencies that repeatedly prove reliable over complete market cycles are sometimes defied over portions of those cycles. Meanwhile, investors who are convinced that this time is different can ignore what follows. The primary reason not to listen to a word of it is that similar concerns, particularly since late-2011, have been followed by yet further market gains. If one places full weight on this recent period, and no weight on history, it follows that stocks can only advance forever.
What seems different this time, enough to revive the conclusion that "this time is different," is faith in the Federal Reserve's policy of quantitative easing. Though quantitative easing has no mechanistic relationship to stock prices except to make low-risk assets psychologically uncomfortable to hold, investors place far more certainty in the effectiveness of QE than can be demonstrated by either theory or evidence. The argument essentially reduces to a claim that QE makes stocks go up because "it just does." We doubt that the perception that an easy Fed can hold stock prices up will be any more durable in the next couple of years than it was in the 2000-2002 decline or the 2007-2009 decline - both periods of persistent and aggressive Fed easing. But QE is novel, and like the internet bubble, novelty feeds imagination. Most of what investors believe about QE is imaginative.As Ray Dalio of Bridgwater recently observed, "The dilemma the Fed faces now is that the tools currently at its disposal are pretty much used up. We think the question around the effectiveness of QE (and not the tapering, which gets all the headlines) is the big deal. In other words, we're not worried about whether the Fed is going to hit or release the gas pedal, we're worried about whether there's much gas left in the tank and what will happen if there isn't."
I agree with Hussman and Dalio on the efficacy of QE and will focus the balance of this article on that subject but first a bit more of Hussman:
A log periodic pattern is essentially one where troughs occur at increasingly frequent and increasingly shallow intervals. As Sornette has demonstrated across numerous bubbles over history in a broad variety of asset classes, adjacent troughs (say T1, T2, T3, etc) are often related to the crash date (the "finite-time singularity" Tc) by a constant ratio: (Tc-T1)/(Tc-T2) = (Tc-T2)/(Tc-T3) and so forth, with the result that successive troughs come closer and closer in time until the final blowoff occurs.
Frankly, I thought that this pattern was nearly exhausted in April or May of this year. But here we are. What's important here is that the only way to extend that finite-time singularity is for the advance to become even more vertical and for periodic fluctuations to become even more closely spaced. That's exactly what has happened, and the fidelity to the log-periodic pattern is almost creepy. At this point, the only way to extend the singularity beyond the present date is to envision a nearly vertical pre-crash blowoff.
Back in January I too assumed we would peak in April or May. By the way we did peak in May temporarily on the basis of the Fed's taper talk only to soar ever higher when the Fed rapidly backed off of taper talk. It does seem reasonable to assume that the Fed is now a prisoner to their own policy. If they do even hint at taper we sell off rather rapidly - a situation that is truly problematic for the Fed at this point.
The efficacy of QE
The truth is monetary policy and in particular QE is not working as intended. The Bank of England's paper - The United Kingdom's quantitative easing policy: design, operation and impact - does a very adequate job of explaining how QE is supposed to work. As is often the case - we gain insight from the work of others and in this instance I only learned of the BOE paper by reading BOE Paper Signals Worrisome Outlook for Equities Post QE authored by Adam Butler, Mike Philbrick and Rodrigo Gordillo. It is worth reading.
The following excerpt is from the BOE paper and sets the stage for a discussion of what has and has not worked as it relates to QE. As a point of reference the BOE paper was written in the 3rd quarter of 2011 and therefore allows one the opportunity of measuring efficacy from the vantage point of hindsight.
How do asset purchases affect spending and inflation?
The aim of undertaking asset purchases was the same as a cut in Bank Rate, to stimulate nominal spending and thereby domestically generated inflation, so as to meet the MPC's 2% inflation target in the medium term.(1) As discussed in a previous Quarterly Bulletin article by Benford et al(2009), there are a number of potential channels through which asset purchases might affect spending and inflation.(2) Purchases of financial assets financed by central bank money should initially increase broad money holdings, push up asset prices and stimulate expenditure by lowering borrowing costs and increasing wealth. Asset purchases may also have a stimulatory impact through their broader effects on expectations and by influencing bank lending, though this channel would not be expected to be material during times of financial crisis. These channels are considered in more detail below with Figure 1 providing a simple pictorial representation.
How does the economy adjust to asset purchases? The overall effect of asset purchases on the macroeconomy can be broken down into two stages: an initial 'impact' phase and an 'adjustment' phase, during which the stimulus from asset purchases works through the economy, as illustrated in Chart 1.
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Bank lending effects:When assets are purchased from non-banks (either directly or indirectly via intermediate transactions), the banking sector gains both new reserves at the Bank of England and a corresponding increase in customer deposits. A higher level of liquid assets could then encourage banks to extend more new loans than they otherwise would have done. But, given the strains in the financial system at the time and the resultant pressures on banks to reduce the size of their balance sheets, the MPC expected little impact through this channel.
As discussed above, in the impact phase, asset purchases change the composition of the portfolios held by the private sector, increasing holdings of broad money and decreasing those of medium and long-term gilts. But because gilts and money are imperfect substitutes, this creates an initial imbalance. As asset portfolios are rebalanced, asset prices are bid up until equilibrium in money and asset markets is restored. This is reinforced by the signaling channel and the other effects of asset purchases already discussed, which may also act to raise asset prices. Through lower borrowing costs and higher wealth, asset prices then raise demand, which acts to push up the consumer price level.
In the adjustment phase, rising consumer and asset prices raise the demand for money balances and the supply of long-term assets. So the initial imbalance in money and asset markets shrinks, and real asset prices begin to fall back. The boost to demand therefore diminishes and the price level continues to increase but by smaller amounts. The whole process continues until the price level has risen sufficiently to restore real money balances, real asset prices and real output to their equilibrium levels. Thus, from a position of deficient demand, asset purchases should accelerate the return of the economy to equilibrium.
According to the BOE paper during the impact phase of QE money supply and asset prices spike higher. We should also see a spike in inflation and GDP. During the adjustment phase real asset prices, GDP and inflation fall back to what the BOE refers to as economic equilibrium.
What's particularly useful here is the fact that the BOE tells us what is supposed to happen. That means we are able to see what really happened in order to observe the efficacy of QE. Let's do that. We will start with a look at M2:
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QE is supposed to drive money supply growth sharply higher during the Impact Phase at which point the rate of growth stabilizes during the Adjustment Phase. After the start of QE we did get a significant increase in the rate of growth of M2 but thereafter we didn't stabilize - rather M2 growth actually fell to a point where it was actually contracting by almost a full percentage point. Whoops - that didn't work so what did we do - more QE. Again a sudden and significant expansion in the M2 growth rate but again a sharp contraction in M2 back into negative territory. So what did we do - QE 3 and again a spike in M2 growth but not nearly as dramatic as QE1 or QE2.
The efficacy of QE as it relates to the BOE's explanation of how it is supposed to work shows that it is having less and less impact and clearly not working as intended as it pertains to M2. Furthermore each successive version of QE is showing that the Law of Diminishing Returns is in full play here.
In order to achieve the intended impact on inflation M2 needs to grow at a faster rate than GDP. Here is a chart of M2 along with nominal GDP:
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Again not exactly what the BOE suggests we want to see. Most of the quarters since the start of QE show GDP growing at a rate that is above M2 which implies that we are not getting any significant inflation. Granted we did get a nice spike in GDP based on QE 1 but the impact to GDP since QE1 has been negligible and for the most part we have hovered in a range between 1% and 2% in spite of successive QE attempts. To confirm that the extremely slow rate of M2 expansion in spite of unprecedented levels of QE has prevented the Fed from achieving its desired goal as it relates to inflation here's a look at 2 different inflation metrics:
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The chart above shows both PCE and CPI. In both cases the Fed is falling far short of its stated goal of 2% inflation. QE 1 worked as the BOE suggests it should work but in each successive round of QE the impact has been less and less. Again QE since QE 1 has been ineffective - we just aren't getting the job done here. In fact the chart since the middle of 2009 looks much like the BOE chart that shows the rate of growth in inflation slipping lower during the Adjustment Phase. The problem is the Fed is still pumping money into the system through QE and at an ever faster rate meaning that we are - as a practical matter - still in the Impact Phase even though the chart would suggest we are in the Adjustment Phase. Again the Law of Diminishing Returns is in full play.
Here is a look at stock prices - one of 3 asset classes we will look at:
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QE 1 worked as intended. According to the BOE though once stocks peak at the end of the Impact Phase growth rates in stocks are supposed to fall back to more normal levels of growth. Then again - are we in a really, really long Impact Phase here. Obviously we are as we ramped up QE again at the end of 2012 and have maintained that rate of Fed asset purchases ever since and so the one area that does seem to be working as it relates to the BOE's chart is stocks which continue to climb higher at a rate that is much higher than the long term norm.
Unfortunately that is the only metric that has continued to respond to the Impact Phase of QE as intended. Actually, the chart above does look pretty much like the BOE's chart suggests it should look up until the announcement of QE 3 in September of 2012.
Here is the problem and why there can be no question that stocks are in bubble territory. The desired level of inflation is 2%. We are running at less than 1/2 that rate. One would assume GDP growth should be in the 5% to 6% range and we are running at about 1/3 of that rate. In order to support GDP growth M2 needs to be increasing at a rate in excess of GDP and that hasn't been happening. So far the only metric we've looked at that is continuing to respond to QE is stocks but let's look at the bond market.
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The chart above is a chart of the 10 year yield and since bond price and yield are inversely correlated the spike higher since late 2012 shows that bond prices are falling rather dramatically. Bonds are indeed a problem and perhaps the single biggest problem for the Fed. Clearly the Fed is still buying at the highest rate since the start of QE and it can be argued that we are still in the Impact Phase yet bond prices - as one of the 3 asset classes - are coming down rapidly suggesting we have entered the Adjustment Phase yet we know that isn't the case.
Real estate prices are another metric that the Fed focuses on and here is a look at the rate of growth in real estate prices since QE started:
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The chart above shows that real estate prices are also responding as intended for the Impact Phase of QE and perhaps this gives the Fed hope that more of the same will continue to have a positive impact on real estate prices.
So are assets in bubble territory?
If I were Ben Bernanke or Janet Yellen I would claim - just as they have - that QE has had a positive impact on the economy. I would point to stocks and real estate prices as evidence of the efficacy of QE and I would note that QE 2 and QE 3 have produced dramatic gains in these 2 asset classes.
However, when asked if QE was producing bubble like conditions I would have to say the answer is yes. Here is the problem - if the Fed continues QE and eventually achieves its goals as related to robust GDP growth in the 5% to 6% range, 2% inflation and 6% unemployment where will stock and real estate prices be at the point they achieve that goal?
It can be argued that even though inflation, GDP and unemployment are moving in the right direction at this point we are a long ways from the target levels and a lot more QE seems to be needed. That is not to say we need to increase QE but assuming we maintain it at the current level for an extended period - where will that put real estate and stock prices when the other metrics reach the Fed's targets?
On the other hand stock prices have probably exceeded the levels one would have hoped for at the onset of the Impact Phase of QE and real estate prices are finally moving to levels that would allow one to conclude that the real estate market is fast approaching the desired level. Both of these asset classes should experience a rapid and immediate drop in growth rates yet one wonders how that can occur if the current levels of QE continue. And if QE is reduced one wonders if the economy is able to push inflation higher, GDP higher and unemployment lower.
The real problem is one of an imbalance in the intended impact of QE in that some metrics have responded far more positively than others - specifically stocks and to a slightly lesser degree real estate. The problem is exacerbated by the fact that corporate performance in terms of sales and profits are slowing down dramatically as stocks continue to soar.
A look at the cyclically adjusted PE ratio or CAPE shows that multiple expansion is clearly in bubble territory. Some will argue that even though the PE multiple is high it can go a lot higher and that is true. We see that in 1929, 1999 and 2007 and in each instance these multiple levels were followed in very short order by market crashes.
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And what is happening with the earnings growth rate. Here is the nominal growth rate of the S&P 500 (SPY) earnings:
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And here is the top line sales growth rate for the S&P 500:
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The next chart is the S&P 500 dividend yield:
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Considering the fact that corporate sales and earnings growth are falling and dividend yields are very close to all time lows one wonders just how much higher the market can go using the logic that all one can do is continue "chasing yield".
The long term investment perspective
I want to again quote John Hussman in his most recent weekly commentary that I referenced above:
The problem with bubbles is that they force one to decide whether to look like an idiot before the peak, or an idiot after the peak.
The point is we may have a little further to go on the upside but the idea that we can continue to move higher from these levels based on anything that remotely resembles logic is just not true. Sure the Fed can continue with QE and investors can continue to drive the markets higher for a little longer. Maybe we can even move to 84% above trend as I suggested above - a move that would put the S&P 500 at 1946. If we were to do that I would have missed my top call back in January by about 22%.
It is also true that if we do that in the coming weeks we will move another 8% higher from current levels. Since the October 9th low we have moved up roughly 9% so it seems plausible that we could add another 8% from these levels in short order although I am by no means suggesting we will. That said, the momentum is as strong in recent weeks as it has been since the start of the bull market back in 2009 so it is a possibility.
If we are in a bubble at the present and if it does burst as all bubbles do then what? Even a move back to the regression trend line brings us back to around 1000 on the S&P 500 and if we move 47% below trend we fall clear back to the 570 area. The idea that this can't happen assumes we are really making significant economic progress with QE but the truth is the only thing that is really in an upward trajectory is the stock market.
I tend to agree that over the long haul a buy and hold strategy makes sense but only on the condition that one raises more and more cash as stocks get more expensive and employees more and more cash as stocks get cheap. Sy Harding did a really great piece for Forbes magazine recently in which he referenced a quote from Warren Buffet back in 1999. Here is what Buffet said back then:
"What I am about to say - assuming it's correct - will have implications for the long-term results to be realized by American stock-holders. . . . . Over the next 17 years, equities will not perform anything like - anything like - they have performed over the past 17 years. . . If I had to pick a probable annual return it would be 4% after inflation, and if 4% is wrong, I believe the percentage is as likely to be less as more."
Was Buffet right back in 1999. Well in real terms the S&P 500 is less today than it was in 1999. Of course Buffet's view is decidedly different than most. Buffet actually likes to see stocks fall as they present opportunity to acquire stocks at a bargain. Of course at critical junctures such as in 1999 Buffet raises cash so that he can take advantage of those bargain basement prices when markets fall. Again quoting from Sy Harding's article in Forbes:
So should we be concerned that, according to the latest SEC filings of Berkshire Hathaway, Buffett has again raised and is sitting on, $49 billion in cash? And in a recent interview said, "Stocks have moved a long way. They were very cheap five years ago. That's been corrected. . . We're having a hard time finding things to buy."
The message Buffet offers is decidedly different than the message the industry as a whole offers. It is rare to hear a money manager suggest going to cash as being a good idea. The usual question asked of pundits is where should you put your cash - not should you go to cash. The industry just isn't set up that way. It is designed to find places for you to invest your money and necessarily must do everything possible to convince you not to go to cash in order to prosper and thrive - or at least that is what they think they must do. It is a sales pitch and not the advice of a prudent money manager although that is what almost all of them profess to be - that is prudent money managers.
What if those calling for another crash are right? Are you prepared to take advantage of that should it occur? To do so you will need to have a significant percentage of your total portfolio in cash and in those instances where markets do revert to trend that is far and away the best place to be.
There are many pundits who continue to insist we are not yet in bubble territory but since there is no hard and fast rule or a single metric we can use to identify a market as being in bubble territory those who suggest we are not yet in a bubble are no more credible than those who say we are. More importantly those who say we are not in a bubble are encouraging investors to buy stocks or hold stocks at all time highs in nominal terms. Combine that with very stagnant economic growth fully dependent on a policy that is producing marginal results at best and the fact that corporate sales and earnings growth are falling and it seems reasonable to suggest that even if we aren't in a bubble at this point we are very close.
As Hussman correctly points out if we do move much higher from here it will happen in a parabolic, blow off top manner and will thereafter be followed by a major stock market crash. We are at a point where it is extremely dangerous for stocks to move much higher and we are in desperate need of a legitimate correction. My own view is that we are probably past the point of no return and when the market does finally correct it won't be a correction at all but the beginning of a cyclical bear market that could easily take us down 40% to 60% in the coming months.
One can argue that I have been wrong all year and that is true. That said I want to close by relating a true story that forms my views on irrational bull markets and bubble tops. It is a story of irrational greed and its consequences.
The year was 1973 and the month was May and I had a very aggressive trader who was a raging bull on commodities - all commodities. He had opened an account with me for a meager $2,000 and bought a couple contracts of wheat. Wheat went up and he used profits to margin into a few corn contracts. As time went on the market continued to levitate and he used profits to margin into cattle contracts, silver contracts, pork bellies, soybeans, soybean meal and soybean oil. If there was a futures contract he bought it and the bull market we were in at the time allowed him to amass significant profits.
By late August my trader had taken that $2,000 into over $200,000 - an impressive 100 fold gain in just 3 months. My boss and mentor - his name was Don Roskam - came to me and suggested I advise my trader to take some profits as he was heavily leveraged and the markets were showing all the signs of a blow off top. I passed that advice on to my trader who reluctantly took profits on a significant portion of his positions but we didn't call the top as the market continued higher for a few more weeks.
At one point my trader called and instructed me to put the trades back on. He was clearly angry at me for advising him to take profits. I did as instructed and within a week the market did finally break. Furthermore it wasn't a modest break - it was a limit down crash that lasted for several days. When the smoke cleared my trader - who had accumulated over $250,000 at the top - had lost all his profits, his original capital and was in deficit to me for over $100,000.
I looked like an idiot to him when I advised him to take profits and go to cash as I wasn't able to call the top but in the end who was the idiot? As Hussman so aptly pointed out "The problem with bubbles is that they force one to decide whether to look like an idiot before the peak, or an idiot after the peak."
Additional disclosure: I am also long PCLN puts and NFLX puts