- Long-term financial indicators are at danger levels.
- Markets and the Fed are fixated on avoiding the last collapse.
- The next bear market might not start with interest rates.
- Some investing rules.
Janet Yellen's recent statement that stock market valuations are within normal ranges is something of a forced confession - Fed chairs aren't allowed to say that the stock market is too high. One should expect this kind of thing, like Ben Bernanke's "the subprime crisis appears to be well-contained." I'll give you a good rule though - whenever the chair of the Federal Reserve is found in the position of denying there's any problem, you should be certain that there is indeed some kind of problem. The question is when said problem will come to harrow our lives.
Yellen's statement does ignore some meaningful metrics: The price-to-sales ratio for the S&P 500 is currently at 1.72, nearing the all-time record of 1.77 set in the first quarter of 2000.
The ratio of market cap to GDP has surpassed every level but that of the tech bubble:
The Shiller P/E ratio is at a level reached only 3 times in the past: 1929, 2000 and 2007.
Tobin's Q is practically reasonable compared to the late 1990s, so perhaps that is what keeps the market within "normal" range.
But as any half-decent professional trader knows, all of the above are long-term indicators that can remain at extended levels for many months. Ironically, this knowledge actually helps to fuel bubbles: traders are always, always certain that they can get out with minimal losses once a bull market breaks, so the usual action in the face of peak ratios is not to reduce risk, but to maximize short-term trading opportunities before the end can get here. Trading for the blow-off top also has the potential prospect of drawing in extra buying from non-believers and performance laggards. So here's a second good rule: When market skeptics finally start acknowledging that the end of the bull market is nowhere in sight, then the end of the bull market is indeed coming.
Stocks could soldier on a bit longer based on the negativity effect: When the worst fears do not come to pass, the market rallies. The Fed didn't pull of a surprise rate increase (last month). Russia didn't invade the Ukraine (yet). Greece didn't vote to leave the EU (2012). Second quarter earnings will be better than feared (a game played every quarter nowadays): According to Zacks, estimates are down to +2.9%. With Q1 earnings at 2.1% and the weather rebound in full swing, that looks like another very easy target, even easier than the first quarter's target of an earnings decline. Upcoming economic data should reflect the delayed rebound in the weather for about another month or so.
Reasons for the market to embark on a pullback very shortly begin with the fact that the S&P is overbought short-term, medium-term and long-term (mega overbought). There is near-overwhelming conviction (on Wall Street, not Main Street) that stocks must go higher. Even hard-core unbelievers like CNBC's Rick Santelli thinks that stocks will (undeservedly) keep going up. Finally, there is Flynn's Third Rule, which is the more pressure I feel to get longer - to buy something, anything - the more likely the stock market is about to head in the other direction. It works pretty well.
We still have those pesky problems of valuations, gravity, and - going by Yellen's latest observations - crazy undisciplined markets. Valuations alone don't cause a market to correct, but they do largely determine the depth of the fall. Over the last fifty years, there have only been a few occasions when stock prices have doubled and tripled over a five-year period. The record is not encouraging. The first triple (simply calculated, using month-end prices for the S&P) came in the summer of 1987. The second triple came at the end of 1999. I think most of you know what happened afterwards. We are about to hit a triple from the March 2009 low, though I suspect that traders will move past it with bravado (and cheering from CNBC) - all things being equal, they're not likely to worry until we get to the triple off the closing lows, about 10% higher than where the index is now. Even five-year doubles don't last long without running into trouble.
Yellen is probably at least vaguely aware of some of the metrics above, partly because people like Robert Shiller are talking about them and partly because all of the data is available from the St. Louis Fed. I found her Wednesday discussion with IMF chief Christine Lagarde suggestive, as she seemed to detail a wish-list of rules and regulations that taken together evince a desire to essentially ban the financial system from getting into crisis mode. Art Cashin noted the irony of the Fed chair telling market players not to be risky when its very policies have been pushing financial actors to do just that.
Last September I wrote a piece entitled "The Fed's Last Waltz," in which I expressed the fear that the Fed had come to believe in the "fine-tuning" fallacy, a belief that bankers can so master monetary and fiscal levers that short-term policy goals can be achieved at will alongside long-term ones. It led to the stagflation of the 1970s, and I sometimes wonder if Yellen isn't going to join then-chairman Arthur Burns in the ranks of Fed chiefs who got it badly wrong. I am not alone, as an article by Stephen Williamson that recently appeared on the St. Louis Fed website posed some of the same questions and doubts.
It does make sense for the Fed to get tough with lending and credit standards in select areas - it certainly would have helped if they had done so with housing ten years ago. It doesn't make sense for the Fed to believe that cap charges and liquidity buffers can head off collapse of the stock market values that the central bank so assiduously inflated and has seemed sworn to protect. In that respect, Yellen seems to be the classic case of the general fighting the last war, trying to prevent another Lehman or AIG instead of noticing the problems at hand. She surprised me by singling out housing as an area for special attention, even though its lending standards are the tightest they've been since the Depression.
The tech wreck had nothing to do with the S&L crisis that brought on the previous recession, nor did technology investing play any meaningful role in the Great Recession. The 1998 Long Term Capital crisis that saw stocks fall 28% (saved by Greenspan and the tech bubble) was brought on by a hedge fund and overseas developments. Similarly, the next bear market is most unlikely to be brought on by a cascading failure of US financial institutions, though the net result may be to freeze the bond markets just the same. It may not be brought on either by the sudden sharp spike in interest rates that the entire investing world seems to be using as the warning bell for the end of the bear market.
Indeed, investors have adopted central bank liquidity as having the same unstoppable force that housing and asset-backed liquidity had eight years ago, that the Internet had fifteen years ago, or that leveraged financing (junk bonds) had twenty-five years ago. Isn't it logical to question that belief in the light of previous results? Ben Bernanke used to pepper his speeches with laments about the limitations of central bank policy and the need for Congressional action. Janet Yellen has dropped all those references. That worries me.
So imagine something simpler than another Lehman. Imagine instead that the economy continues to creep along at about the same pace it's been at the last four years. Simple. Now imagine that being six years old, our feeble business cycle begins to run down in 2015, a casualty of old age, oil prices, Chinese financial collapse, maybe all of the above. In the meantime, stock prices kept rising because the Fed has backstopped equities and some form of minimal growth was maintained. The S&P makes its triple, most valuation metrics are at all-time highs, and then the real cause of bear markets comes along - business isn't getting better, it's getting worse. Because valuations are so high, people start to sell. And then a little worse gets a lot worse, and we have another gut-wrenching 50%-plus decline.
What will happen to that huge slug of boomers about to retire? Angry will be putting it mildly. What will happen to the Fed, that tried to cure problems by reflating asset prices three times in a row? Somehow I don't think Congress will be amused, notwithstanding the fact that legislatures the world over have been using central bank policy as a free pass for avoiding change. Finally, what will happen to us? I don't know, but it keeps me up at night.