The Greatest Risk Of All

by: Eric Parnell, CFA

The notion of risk is often misunderstood.

Risk is the potential for something different than expected taking place. It may be much worse than expected, but then again it might be much better than expected.

This is the greatest risk of all facing investors today.

The notion of risk is often misunderstood. Many investors perceive risk to be the potential for something worse than expected happening at any given point. But what is often overlooked is that risk is a double-edged sword. For in reality, risk is the potential for something different than expected taking place. It may be much worse than expected, but then again it might be much better than expected. And such is arguably the greatest risk of all facing investors today. It's not necessarily what could happen on the downside with the U.S. stock market. Instead, it is what could possibly take place to the upside that has the potential to explode capital markets at the end of the day.

What About The Fundamentals?

So how high could we reasonably expect stocks to rise going forward?

To begin with, it is important to note that we have entered a phase of the current bull market where, as many analysts have been proclaiming recently, fundamentals no longer matter. Don't get me wrong, they will eventually matter in a really big way. But for now, the typical market reaction to key fundamental data has largely been suspended.

This, of course, would not be the first time that the observance of fundamentals have been put on hold.

In the last decade we had the housing bubble, where speculators were holding portfolios of tens of houses with zero money down seeking to flip properties and capitalize on robust double-digit price increases in a market that normally grew no more than 5% per year on average. Thankfully policy makers were on top of the situation to make sure things didn't get out of hand. Except of course they weren't, because housing priced had never fallen on an annualized basis nationally since World War II and banks were well capitalized, so there was nothing to worry about.

In the decade before that we had the technology bubble, where speculators were holding baskets of stocks that were increasing by triple-digits annual despite having no earnings or even revenues for that matter but were instead being priced on metrics such as the legendary price-to-clicks and price-to-eyeballs ratio. Thankfully policy makers were once again on the scene to keep a clamp on leveraged speculative activity. Expect of course they weren't, because the technology revolution had ushered in with it a new paradigm of productivity growth that justified substantially higher stock valuations including triple digit P/E ratios for the likes of Cisco Systems (NASDAQ:CSCO) briefly become the largest company in the world by market cap at $555 billion in March 2000 (this is not a knock on Cisco Systems, as I actually look rather favorably on the company today - it's just that a +100 times P/E ratio and a $555 billion market cap were a bit much at the time to say the least - today's P/E of 15 times and market cap of $155 billion sixteen years on from the tech bubble peak seem much more reasonable).

In short, today's investors are no strangers to the world of asset market bubbles. The most recent example, of course, emerged last summer when China's (NYSEARCA:GXC) Shanghai Stock Exchange Composite index soared from around 2000 in mid 2014 to a high of 5178 by June 2015. Although we heard the justification for such an incredible move was the opening and modernization of China's (NYSEARCA:FXI) capital markets, it turns out it was much more so driven not by fundamentals but instead by the encouragement of accommodative policy that was supportive of stock market speculators to say the least. That is, of course, until it suddenly wasn't, then quickly was again, then really wasn't, then . . . Another year has past, and the round trip has largely been traveled with the Shanghai composite still back below 3000.

Why This Time?

Exactly what would serve as the catalyst for the S&P 500 Index to suddenly thrust itself into a spiraling upward bubble phase?

First, one possible catalyst could be a meaningful upswing in global economic growth. One of the things that has been maddeningly elusive for policy makers throughout the post crisis period has been successfully propelling the global economy into a phase of sustained economic growth. But what after pumping so much central bank liquidity into the financial system that the bottleneck finally breaks loose and this goal is finally achieved? This could get stocks going to the upside in a hurry even with the valuation gap that needs to be made up first depending on the magnitude of growth that is unleashed. Unfortunately, I continue to assign a very low probability to this rosy outcome, due to the heavy debt burdens that now overhang the global financial system. With that said, just because I don't think it is likely doesn't mean that it won't end up happening.

Another potential catalyst could be the increasing overflow and spillage of central bank liquidity into the financial system. Although global central banks have expanded their balance sheets by the tens of trillions of dollars since the outbreak of the financial crisis, and a good amount of it has been leveraged for the purpose of inflating asset prices, a ton of it is still sitting idle in various places including in excess reserves for a number of the largest financial institutions around the world. Suppose this liquidity began spilling over more aggressively into the financial system. This could result in forces that could quickly inflate asset prices beyond all recognition or fundamental reason.

Lastly, the TINA thesis starts to expand exponentially on itself. The interest rates on developed country sovereign debt is fast tracking its way into negative territory far out the yield curve for many of the largest, most established and highest quality countries in the world. Following the latest policy announcements from the Bank of Japan and the Bank of England, this appears to be a trend that is likely to continue if not accelerate instead of abate. And with discount rates moving to zero if not turning negative, it quickly creates a world where fundamental stock price modeling could begin to justify stock prices at exponentially higher prices from where they are today. Instead of the "new paradigm" of higher valuations justified by increased productivity growth thanks to technological advancement, it could evolve into the "new paradigm" of much higher valuations justified by terminally low interest rates thanks to extreme and continuous monetary policy accommodation.

How High Can You Go?

So in this bubbly world in which we live in the new millennium, exactly how high could we reasonably expect stocks to rise going forward? We could certainly go through the exercise of overlaying the price chart of today's S&P 500 Index (NYSEARCA:SPY) on the NASDAQ Composite (NASDAQ:QQQ) leading into the 2000 top or China's Shanghai Composite (NYSEARCA:ASHR) running up into its 2015 peaks. Instead, for the purposes of this analysis, I will reference historical precedence to provide a framework for what we might reasonably expect if we saw stocks enter into much frothier phase from here.

The historical comparison I will seek to draw upon is the technology bubble period at the turn of the millennium. My reasoning for using this past precedence is the following.

First, it was a U.S. stock based bubble back in the late 1990s into 2000. By comparison, the financial crisis was driven by a housing bubble and the Shanghai Composite bubble involved Chinese stocks.

Also, the stock market was not without its widespread challenges during the late 1990s including the Asian flu, the Russian ruble crisis and the collapse of Long Term Capital Management, but it blew through all of these blaring stop signs before finally peaking in 2000. The same principles hold true today.

Third, the stock market went through an extended period of corporate earnings declines on an annualized year over year basis in the face of steadily rising valuations from the 1998 Q1 through 1999 Q1. While the magnitude of earnings declines were not nearly as large and did not go on as long as they are today, we saw a key fundamental challenge presenting itself to the market then as it is today, and stocks managed to overcome it then to climb by another +40% in a final blow off top over the next year.

Lastly, I often cite that stocks are trading at some of their highest valuations in history today. The only time that it was higher, and this includes the 1920s bubble leading up to the 1929 stock market crash, was during the tech bubble period.

So with all of this in mind, how high could we realistically expect the S&P 500 Index to climb?

Let's consider the following potential scenario in the current market environment. Being reasonable and forgoing the unattainable nonsense that are the consensus earnings expectations for 2017, suppose corporate earnings stabilize at current levels, find their footing and bounce back higher by roughly 20% to 25% over the next twelve months. This would bring as reported earnings on the S&P 500 Index back to the $105.28 per share to $109.67 range, which is consistent with the rebound in earnings growth during the blow off phase of the technology bubble back in 1999-2000 and would be reasonable given the previous peak earnings were $105.96 in 2014 Q3.

I should reiterate that this is neither my baseline scenario or even my high scenario for earnings, as I am decidedly more bearish on the earnings outlook. But I assign it enough of a probability that it merits consideration in an explosive bubble scenario. After all, consensus analysts' expectations are still calling for a +31% increase in annual as reported earnings in 2017 Q2, so the projection is my bubble scenario is actually still below what analysts are projecting. Of course, these same analysts were calling for more than +20% annual as reported earnings growth for 2016 Q2 at this time last year, and here we are today a year later at -8% for 2016 Q2 and falling fast. As a result, a bit of residual error exists in these forecast models. But if nothing else, it suggests that contemplating such a scenario for corporate earnings a year from now is not completely off the reservation.

In building on this scenario, let's also assume that we see further multiple expansion on U.S. stocks. After all, if there is truly no alternative as interest rates across the fixed income spectrum collapse to zero, it is not unreasonable to think that investors might be inclined to pay even more than what they are paying today for whatever final drops of yield in the capital market desert they can squeeze out.

At the peak of the technology bubble, stocks topped out at an annual as reported earnings multiple of 30.5 times trailing earnings. This is also not completely unreasonable in a bubble top scenario given that we are currently trading at 25.2 times trailing as reported annual earnings today.

So where does that leave us in a blow off top scenario for the S&P 500 Index? Suppose the high side of earnings improvement at $109.67 per share at a 30.5 times multiple, and this puts the S&P 500 Index trading at 3,350 a year from now. This would have the S&P 500 advancing another +54% higher from where it is trading right now.

The Perils Of A Blow Off Top

So why exactly would this be a problem for stock investors? How can a +54% increase in stock prices over a relative short period of time be a bad thing? It would not only be bad, but potentially looms as the greatest risk of all for investors.

For under such a scenario, the market is moving toward its extremes in terms of valuation, artificially inflated earnings and prices. In short, it would be a market that would be completely wrung dry of potential future returns for many years to come. In other words, there would be nowhere to go but down from there.

Again, so what? Couldn't an investor just take the ride to the top and then get out before the subsequent collapse? Possibly, but this is much easier said than done. Unfortunately, many struggle with the idea of leaving a party when it is raging, particularly one that is self reinforcing from a hubris standpoint. This, of course, is what trapped so many investors during the bursting of the technology bubble. And this time around, the losses would almost certainly be more evenly distributed across all asset classes instead of being largely isolated in a few specific sectors.

Also, the sharp acceleration to a blow off top would likely be accompanied by concerns about rising inflation and a financial system that is once again spiraling out of control. This would almost force the persistently cautious Federal Reserve to move much more aggressively with interest rate increases in order to put a clamp on the market. And just like anyone knows who has been driving down the highway at 70 MPH and is forced to slam on the brakes, this can become a hugely damaging experience rather quickly.

Such manic periods also have the uncanny ability of drawing in those that might not know any better along the way. If the stock market starts accelerating to the upside, those that have sat out the post crisis rally to this point may finally capitulate and jump back in, unable to endure the pain of missing out any longer. But by doing so, they would once again be unwittingly buying in near the top and setting themselves up for another agonizing ride lower. Having already endured this pain twice, getting fooled a third time around would likely be enough to turn off a generation of investors to thinking about putting money into the stock market again.

Another dilemma is the perspective hangover that comes with any such bubble. When analysts reflect on the stock bubble that recently burst in China, few if any are celebrating the fact that the market is nearly +50% higher than where it was in the summer of 2014. Instead, they lament the market that is nearly -50% below where it was in the summer of 2015. Once the increase in value takes place, it establishes a new level that investors believe belongs to them. And even though that additional potentially should have never existed in the first place, once investors have it they also acquire the potential pain associated with losing it. And it is this pain that they are almost certain to reflect upon once it comes to pass.

Lastly, it is very likely that policy makers would not have the policy resources to reinflate asset prices after any subsequent crash that would follow such a market bubble. There are reasons why global stock markets in Japan, Spain and Italy remain well below their all-time highs so many years after the fact. It is because they either made policy missteps along the way or lacked the sufficient policy flexibility to catapult their markets back to the upside. And with interest rates already effectively still at 0% and a balance sheet still north of $4 trillion, the Fed's options to try and inspire yet another wave of animal spirits among the stock investor class that would have been badly burned three times over the course of two decades may be not only limited but woefully insufficient.

Putting all of these factors together, such a bubble scenario could lead to an S&P 500 Index trading north of 3,000 amid a blow off top, only to collapse back below 1,400 once the bubble finally bursts. And next time around, there may be no 2009 style sharp reversal to bring markets back to its heights. Instead of a "V", it could end up looking a lot more like a hockey stick "L".

Bottom Line

So much is made of the risks to the downside in the current market environment. Indeed, I spend a lot of time writing about it myself. But in the end, the much greater risk to today's markets lies to the upside. I would still consider this a low probability event, but still meaningful enough that it warrants consideration. For if we find ourselves entering into a massive blow off top scenario in the near-term future, it has the potential to shake the U.S. stock market to its core for generations to come. Hopefully, unlike the last couple of times around, policy makers will intervene aggressively to prevent such an outcome if it were to actually come to pass. But one can not be too sure given past precedence.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.