While it may seem like a distant memory today, recall that Donald Trump repeatedly referred to the stock market as a bubble during his Presidential campaign. For example, in a debate last September, Trump claimed:
Believe me, we are in a bubble right now, and the only thing that looks good is the stock market, but if you raise interest rates even a little bit, that's going to come crashing down. We are in a big, fat, ugly bubble.
The Donald's suggestion that record low interest rates from the Fed have inflated a bubble in asset prices is backed up by plenty of evidence, which I've discussed in a previous article. In this article, I will provide an updated analysis of the monetary mechanics and valuation metrics of today's "big, fat, ugly bubble" in stock prices, with implications for expected future returns and risks for investors going forward.
The Boom/Bust Cycle
First, some theory. When analyzing the macro economy, I refer to the same school of thought that successfully predicted the 2008 Housing Crisis (among other historical bubbles) - the Austrian Business Cycle Theory. The basic premise is that, by forcing interest rates below the market rate, monetary authorities set into motion the boom/bust business cycle.
The process begins when credit expands beyond the supply of physical capital, creating a mismatch between excess demand versus a limited supply of capital. At first, the credit expansion creates the short-term illusion of prosperity - driven by higher borrowing, higher investment and thus greater spending throughout the economy.
However, the initial prosperity is ultimately false and fleeting, because the number of investment projects initiated exceeds the available supply of capital required to see these projects through to completion.
This over-consumption of scarce capital ultimately manifests itself through higher input prices and/or lower output prices, such that many of the investment projects that appeared profitable early in the boom turn out to be unprofitable capital misallocations as the cycle progresses.
Ultimately, an ensuing bust period is inevitable, where unprofitable investments are liquidated en masse across the economy. A recession is the inevitable, necessary process required to rebuild and reorient the economy's capital structure before sustainable growth can occur.
Trump Can't Fight the Business Cycle
The important point for investors today is to recognize the fact that once a boom cycle is set into motion via credit expansion, the ensuing bust (i.e. recession) is inevitable. The recession, while painful in the short term, is necessary to reorient the economy back into a sustainable structure of production in the long term.
The longer this corrective process is delayed by holding interest rates low, the greater the amount of capital misallocation occurs, and thus, the larger the subsequent recession. Thus, regardless of how pro-business the new Trump administration may prove to be, these policies will only prove to be effective in the long term.
In the short-to-medium term, the business cycle and monetary conditions will overwhelm policy decisions. When the cycle ultimately shifts from expansion to contraction, there's very little Trump will be able to do to resist the downturn in the economy and asset prices. The founder of the Austrian School of Economics, Ludwig Von Mises, said it best:
There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner because of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.
The fuel for credit expansion is ultimately provided by monetary authorities. Again, Mises says it best:
The credit expansion boom is built on the sands of banknotes and deposits. It must collapse.
Based on the magnitude of monetary growth that's fueled the current bubble, we're likely in for a doozy when today's bubble pops. The following chart shows how far we've ventured into the monetary madhouse, with a 400% increase in the monetary base since the Financial Crisis:
Since the founding of the Federal Reserve in 1913, it took nearly 100 years for the monetary base to reach $1 trillion. Then, in the span of 8 short years since 2008, we quadrupled the monetary base from under $1 trillion to more than $4 trillion. This is truly the stuff of banana republics. Of course, the implications are nuanced.
Many have incorrectly anticipated hyper-inflation from such rapid monetary expansion, but this incorrect belief stems from a misunderstanding of the plumbing within the financial system.
We haven't seen hyperinflation in the real economy - at the grocery store and gas station - because the newly created money hasn't yet leaked into the real economy, for reasons beyond the scope of this article.
Instead, the money has been contained within the financial sector, and thus, the inflation has gone to bid up prices of financial assets. The simultaneous rise in asset prices across the board, including stocks, bonds, real estate, vintage cars and fine wine to name a few, has given rise to today's "everything bubble." However, there's no free lunch - when the monetary liquidity is withdrawn, the gains in asset prices will reverse.
A Market Addicted to Monetary Expansion
We've seen previews of this process each time the Fed has taken its foot off the monetary pedal and attempted to withdraw liquidity from the financial system at various points throughout the current bull market. These periods include the summer of 2010, the summer of 2011 and again in January of 2016.
In fact, an interesting exercise is to go back and review the history of U.S. QE programs compared to the path in stocks since 2008 - you'll likely be amazed at how closely the stock market has corresponded with monetary policy actions and announcements.
Following the recent rate hike last December, liquidity has once again declined - this time at a rather rapid rate. Yet, the market seems temporarily distracted by the so-called Trump rally. I submit that it will not be different this time, and markets are in for a rude awakening in relatively short order based on the current pace of liquidity withdrawal. More on this later.
Going forward, the Federal Reserve has two options: Either continue draining the liquidity and risk another correction in asset prices, or continue to maintain the excess liquidity and risk the eventual escape of these reserves into the real economy through loan creation.
Converting these excess reserves into loans could potentially give way to a period of devastating inflation, if one considers the 10x reserve requirement that would enable trillions in excess reserves to be converted into tens of trillions in new loans. The risk of such a scenario has increased with the new Trump administration promising deregulation of the financial industry.
For now, the Fed is proceeding with the first option of draining liquidity and raising interest rates, but this will eventually begin pressuring asset prices. As you can see from the chart above, this tightening process began in mid-2014 with the tapering of asset purchases, and progressed with rate hikes in 2015 and 2016.
This removal of liquidity has been a primary driver of the strength in the U.S. dollar. Notice that the 30% decrease in excess reserves corresponded with a similar rise in the U.S. dollar since the mid-2014.
Those who closely follow the market's shorter-term price action will also recognize that, precisely when the withdrawal in liquidity began in Q3 2014, the stock market transitioned from a regime of low volatility uptrend towards sideways and more volatile price action.
In fact, from Q3 2014 through Q3 2016, stocks made no sustained upward progress, while incurring several 5-10% drawdowns along the way. The recent Trump rally marks an anomaly that I believe simply represents a blow-off top, catalyzed by off sides positioning, and accelerating based on misplaced optimism.
Given that the Fed finally appears determined to remove monetary, the critical task at hand is to estimate the degree of risk in current stock prices when the current bubble begins to unwind. Next, I'll review several widely-used valuation metrics that have historically provided robust measures of risk and future expected returns.
CAPE Ratio Shows Stocks Most Overvalued Since 1929
The CAPE (cyclically adjusted price-to-earnings) ratio is a widely-used metric for determining the valuation of the broader stock market. The ratio refers to the 10-year average of earnings in relation to stock prices, which is designed to smooth out fluctuations through the economic cycle. Using data going back to 1900, the median value for the CAPE ratio is 15.64, which compares to today's CAPE ratio of 28.54.
Not only is today's CAPE ratio more than 80% above its historic norm, it's approaching levels last seen in 1929 and 1999 - just before two of the largest bear markets in U.S. history. Further, the level is higher than the peak reached before the 2008 Financial Crisis, as shown below:
If stocks were to revert to their long-term median value of 15.64, that would imply a decline of 45% from today's prices. Of course, it's anyone's guess what the path traveled will look like, but the key point is that research shows the CAPE ratio has historically been a robust indicator for expected returns over a 10-year time horizon. Cliff Asness nicely summarizes the expected 10-year forward returns for stocks based on investing at different starting CAPE ratios:
Based on this data, investors who own stocks at today's prices are likely to experience real returns of approximately zero over the next 10 years. Unless, of course, it's different this time (spoiler alert: it's nearly never different this time).
"Buffett Indicator" Approaches 1999 Levels
The next valuation indicator on our list is one preferred by legendary investor Warren Buffett. In fact, he once referred to this valuation ratio as "the best single measure of where valuations stand at any given moment," which has given rise to this indicator's nickname as the "Buffett Indicator."
The Buffett Indicator is simply a ratio of the market cap of the Wilshire 5000 (considered one of the broadest measures of U.S. public stocks) relative to nominal GDP.
The economic principle behind this measure is straight forward: Since GDP growth reflects all economic transactions throughout the economy, and businesses are typically involved on at least one side of every transaction, then the aggregate value of corporate sales and profits (and thus aggregate stock prices) should correspond with nominal GDP.
Thus, the ratio provides an indicator for when investors are overly optimistic or pessimistic in pricing stocks relative to the actual earnings power of corporations.
Another benefit of this measure is its use of nominal GDP, which inherently incorporates the effects of inflation, without the potential inaccuracies from a mismatch between the CPI calculation (which has changed numerous times over the years) and actual monetary inflation.
At today's prices, the Buffett Indicator shows that investors have only paid more for stocks (in relation to GDP) since the peak of the Tech Bubble in 1999, going back to the 1970s. The current indicator implies a 61% overvaluation in stocks relative to their median value, suggests stocks could fall by 38% before reaching their long-term historic norm.
To be complete, the Buffett ratio fails to consider the changing the mix between public and private corporations, as well as the mix between domestic and foreign corporations. That said, the fact remains that this ratio has proven a useful and robust indicator historically.
Further, Warren Buffett's cash management strategy appears to be confirming the overvaluation reading of his preferred indicator - evidenced by the record cash pile he has accumulated; a record cash pile in recent years as the Buffett Indicator has soared to new highs.
Price to Sales
We'll get back to basics with our last valuation measurement- the classic price to sales ratio. Whereas the earnings picture has been distorted through accounting gimmicks and financial engineering in recent years, sales are infinitely harder to manipulate, and thus the price-to-sales is arguably a more robust measure of valuation.
Further, since earnings must ultimately derive from sales, any trends we can pick up, sales trends should correlate highly with earnings and other valuation trends as well.
Shown below is the price of the S&P 500 compared to its median price to sales ratio. The recent increase above 2.0 reflects the highest price to sales ratio investors have ever paid on record, going back to 1965.
Corporate Fundamentals have not Followed Stock Prices
Of course, one argument is that investors should be willing to pay higher multiples during periods of high growth. This argument is valid, but the fact is that total corporate sales have flat lined for the past four years, since 2013.
There's been an even worse stagnation in total business profits, which are currently running at 2012 levels.
In other words, not only are investors paying a historically high multiple for today's level of sales and profits - but those sales and profits show no signs of growth.
Focus on Liquidity
So if the rise in stock prices since 2012-2013 has not been met with a corresponding increase in fundamental value, measured by corporate sales or earnings power, what's been driving the persistent price gains in recent years? Legendary macroeconomic investor Stanley Druckenmiller says it best:
Earnings don't move the overall market… focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures. It's liquidity that moves markets.
Consider the following chart showing a high correlation between the increase in the monetary base, and the rise in stock prices since overall corporate sales and profits began to stagnate in mid-2012.
The Liquidity Tide is Turning
Also, notice the green circle, which shows liquidity drying up while stocks have diverged towards new record highs following Trump's election. This is the first time in the current bull market where gains have occurred despite monetary tightening. Instead, the recent gains have been fueled by nothing more than investor optimism.
I believe this has made financial markets especially vulnerable, where optimism could evaporate in rapid fashion and stock prices could hit an air pocket. Thus, the short-to-medium term liquidity conditions are poor, and long-term valuation metrics are stretched. Based on the various measures of valuations we've discussed in this article, I believe we could see a correction of at least 30-50% based on current divergence from historic levels.
Of course, the common response I get when presenting this argument to people currently invested in stocks is something along the lines of, "what are you talking about, I just made 20% in small cap stocks last year?" This form of recency bias is one of the most critical errors investors can make - the failure to separate recent short-term outcomes from expected long-term results.
Valuation metrics like the CAPE ratio are not designed to provide any meaningful information about short-term outcomes, like next year's stock market returns. As we saw in years like 1999 and 2007, things often look best at the top.
For example, the CAPE ratio indicated that the Nasdaq was the most overvalued in its history in 1999, yet the index went on to double in value over the next 12 months. Was the smart move to be invested in 1999, or not? Investors who bought the Nasdaq on January 1, 1999 would have nearly doubled their money before the year was over.
But those investors who doubled their money in 1999, and stayed in the market, would have then spent the next 15 years just getting back to even. Thus, valuation metrics like the CAPE ratio tell you nothing about short-term market gyrations - they only work on long-term (i.e. 10-year) time horizons, and thus, you often must be prepared to look like a fool in the short term before making the real money in the long term.
Unless you're gifted with the rare ability to predict where the S&P 500 will be next week or next month, the prudent move for longer-term investors will be to heed these valuation metrics, and be prepared for turbulence and downside risks in the years ahead.
Valuation is Destiny
In summary, it's advisable for investors to avoid the trap of simply buying into the optimism regarding Trump's pro-business policies. It's clear that the Trump administration will mark an extreme divergence from the slow growth policies of the last 8 years, but the simple fact remains that starting valuations define the destiny for investors.
It's folly to expect a return to Reagan-era prosperity just because Trump promises similar policy prescriptions. Reagan came into office when stocks were trading at single-digit PEs with historically high dividend yields, combined with the tailwinds of a declining interest rate environment (after the initial spike in 1980-1982). We're in the precise opposite environment today, with high valuations and low, but rising, interest rates.
I'll close with a graphic reminder of where we are in the valuation spectrum, followed by a quote from a legendary investor that I could have used in place of this entire article:
When prices are high, it's inescapable that prospective returns are low (and risks are high).
- Howard Marks
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.