The Showdown That Never Came: Part II

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The very high CAPE is a reason to be cautious right now.

High debt, low interest rates and the point in the business cycle make high future growth highly unlikely.

Interest rates haven't been so low in decades and possibilities for high profits in different investments are limited, but don't justify a high CAPE.

In Part I of our analysis we used different indicators to demonstrate that the US stock market - in particular the S&P 500 (NYSEARCA: SPY) and the Dow Jones Industrial Average (NYSEARCA: DIA) - is overvalued. What we didn't really discuss is the question if the obviously high valuation can't somehow be justified. We will focus mainly on the CAPE as valuation method in this article and talk about two different possible reasons that could supposedly justify the high valuations. And once again I will return to the question if I have been wrong with my thesis that the stock market needs a correction.

Really obvious?

If many indicators point towards an overvaluation (as argued in Part I) and if these indicators are known by many investors, we have to raise the question why stocks are still rather expensive. And if it is so simple and so obvious why haven't I been correct with my prediction almost two years before, that the stock market would not be able to climb much higher? To clarify: stocks have not really been climbing since the fall of 2014 and the same yearly return would almost have been possible with a 10-year treasury bond (at least by holding it till the end) and with less volatility and without the risk and stress having to suffer through the four mentioned drops in Part I. But as the stock market hasn't undergone a big correction either we seriously have to ask the question if the high valuations are probably justified. So, in the next two sections I will try really hard to come up with a good reasoning for the high CAPE, but - spoiler!!! - the outlook is rather bleak.

Make America great again?

High valuations in form of a high P/E can be justified if a single company, a sector or the entire economy of a country is expected to grow. If the earnings are expected to grow the P/E will automatically go down (the same goes for the corporate equities to GDP ratio). Donald Trump as the elected president is promising tax reductions, a GDP growth of 4% a year and 25 million new jobs. Can the CAPE of 26.5 be justified by the future growth potential in the years ahead?

There are many comparisons right now between Donald Trump and Ronald Reagan and under Reagan the US economy did grow 4.6% in 1983, 7.3% in 1984 and 4.2% in 1985. So why shouldn't Trump also be able to stimulate growth and get a 4% GDP growth for the years to come? Although I would not deny that there are some similarities between Reagan and Trump, there are far too many differences to expect a 20-year bull market like in the 80s or 90s.

We look at four different aspects to show why it is highly unlikely for Trump to keep his promise of 4% growth and why we can't expect the stock market to grow for many years ahead:

  • First of all I have to admit that I withheld important information. Under Reagan the GDP grew more than 4% in the years 1983 to 1985, but if we also consider that the US was going through a recession in the time before the growth doesn't seem so surprising and impressive any more. In the early cycle (first two years) of a business cycle - or Short Term Debt Cycle as Ray Dalio (p. 19) calls it - a GDP growth of 4% or higher is to be expected, but this is not the case in the tightening phase in which we are most likely right now (How the economic machine works - a short, but good introduction).

US Real GDP Growth Chart

  • Debt: The government debt to GDP ratio is 105% right now and as high as it hasn't been since World War II. The household debt to GDP has gone down since the financial crisis in 2008, but the overall picture is not one of deleveraging. At the end of 1980 the government debt to GDP was 31.9% (just before Reagan became president); in 1989 when Reagan left the Oval Office the same number was 52.9% - in just eight years the debt to GDP grew about 66%. I really don't think that Trump can apply the same loose spending policy - considering the debt levels in the US right now and considering there are only 10 countries worldwide with a higher government debt to GDP ratio.

US Government Debt Chart

  • Interest Rates: At the time Reagan got into the Oval Office inflation was at extremely high levels (about 12-13% at the time Reagan became president) and therefore interest rates were similar high (for a very short time even 20%) and marked the beginning of an almost 35-year bull market in bonds. Although high inflation (and high interest rates) are not necessarily positive for the economy, they opened at least the opportunity to decrease interest rates and therefore stimulate the economy in times of recessions. If the United States should tumble into a recession right now, aside from initiating QE4 the FED has very limited possibilities to stimulate the economy. Although I would not argue that the starting position for Reagan was better, the inflation and interest rates show how absurd it is to compare these two points in time.

10 Year Treasury Rate Chart

  • Stock Market: It is not really a big secret, that the stock market moves in cycles and stocks don't climb or fall forever, but it is rather an interplay between bulls and bears. At the beginning of the 1980s the stock market was at the end of a very long bear market, while we are soon about to enter the eighth year of the current bull market. This rather long bull market led also to a very high CAPE of 26.5. In contrast the CAPE at the beginning of the 1980s was as low as 6.6 (there were only two phases in the 20 th century when the CAPE was lower).

Is it different this time?

But not just future growth can justify high valuations. Very often you hear another argument for high valuations. The argument itself is always different, but the theme is more or less the same. Aren't we in a very special situation right now, that has never been there before? Interest rates in many countries are almost zero and the bonds of some countries even have a negative return for investors. The central banks of many different countries (FED, ECB, BoJ) are trying to devaluate their currencies or did it a few years ago and therefore investors don't really have any alternatives besides investing in stocks. The stock market will continue to climb as more and more people are going to buy stocks, because there is no other way to gain profits.

If I hear arguments like these I immediately think of all the examples from the past where it always has been different this time (Shiller's Irrational Exuberance comes to mind - especially chapter five of the 1 st edition). It is really just another case of new era economic thinking. Maybe the Tulip Mania, the Great Depression, the Dot-com Bubble or the Financial Crises didn't go down exactly the same, but it was never different - people expected a new era, but the end result was always the same: a big crash! Furthermore, it is not true that a situation like now has never been there before - maybe only a few people remember it as you have to be about 87 years old, but rates near zero are nothing unique in the US. The last time rates were almost near zero was in the 1930s and these times are not really remembered for a great long bull market (a very extensive study on the US deleveraging by Ray Dalio, p. 60-119).

And there is another story about rates that needs to be told. After almost eight years with rates near zero we seem to forget that interest rates can actually rise (yes, more than just 25 basis points). What happens if there is another rate hike in December? Right now the interest rate for the US 10-year treasury is about 2.308% and if the FED raises rates it could be 3% or higher in a rather short time. With a P/E of 26.5 the expected return is 3.77% and very soon investors seriously have to rethink their willingness to take on the risks associated with stocks if the expected return is only slightly higher.

What now?

Once again, I have to ask myself why I haven't been correct with my prediction if all the indicators point so clearly towards overvaluation and if there is no real possibility to justify that. The simple truth is that I am not able to predict short-term stock market movements (and even predicting the long-term development is very difficult). Neither myself nor anybody else can know with absolute certainty what will happen in a few weeks or three months from now. Like I already said in Part I: A great investor just thinks in probabilities and rarely uses the word "certainty".

But what I do know for certain is that I don't want to invest in the US stock market right now (except maybe in a few selected stocks, that seem undervalued to me - but it is getting harder and harder to find them). I don't see massive growth in the near future ahead and it is not going to be different this time. At some point in time the high valuations can't be justified anymore, because the expectations for higher earnings, for big growth potential or just higher stock prices can't be justified either.

I know I said that it is not really possible to predict short-term movements in the stock market, but I will try it anyway. I would expect that we could see a similar scenario as one year ago: For the remaining weeks of the year stocks will probably climb a little higher (maybe the DJIA will manage to reach 20,000), but - especially if the FED raises rates again - the stock market will decline sharply in January as it did a year ago. I am absolutely sure (a good investor doesn't use words like that, I know!) that the S&P 500 will fall below 2,000 again and I am also sure that we will see quotations lower than 1,810 again (the lows of 2015 and 2016). If this will be the case in 2017 or 2018 - I don't know!

Deutsche Bank published an analysis a few days ago in which they claim: "We're more confident now that the S&P will reach 2,500 in 2018 before suffering its next bear market." Is it possible that the S&P 500 will rise to 2,500? Yes, of course, it is absolutely possible. In fact, some very smart investors like Druckenmiller expect a very bright future. The S&P 500 could climb to 3,000 and/or we could have a CAPE of 40 again - nobody knows. There is no single indicator that can tell us what is about to happen. But if the risk that the ship is about to sink is too high, I don't want to be on board. And I don't really care if this is going to happen in a week from now or three years and I also don't care if I could have a lot of fun in the meantime as stock prices eventually take off once again. You wouldn't gamble with your life by going on the Titanic and you shouldn't gamble with your money.

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.

Additional disclosure: I am shorting the Dow Jones Industrial Average using a certificate emitted by Commerzbank AG.

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