The Coming Depression, Part I: Devil Take The Hindmost

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  • As US tech giants post record profits, the real economy continues to worsen.
  • The rosy picture Wall Street paints of a "V" recovery is quickly giving way to a much more ominous reality.
  • The trajectory of negative rates in the US remains intact.

"A mighty bubble of wealth is blown before our eyes, as empty, as transient, as contradictory to the laws of solid material, as confuted by every circumstance of actual condition, as any other bubble which man or child ever blew before."

Devil Take the Hindmost: A History of Financial Speculation by ...

One book that I believe should be required reading of all finance students is Devil Take The Hindmost: A History of Financial Speculation By Edward Chancellor. The book chronicles stock market speculation from the 17th century to the present. In studying financial history, one comes away with the notion that while the history of financial speculation is the topic, the real learning takes place in discovery of social phenomena. That while the generations of human beings come and go, their behavior in the marketplace stays the same. Every generation is subject to the same social and psychological patterns. As Charles Mackay stated in his book Extraordinary Popular Delusions and the Madness of Crowds:

In reading the history of nations, we find that... whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first...Money, again, has often been a cause of the delusion of multitudes. Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper... Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.

What is clear is that we are now in a period of financial speculation. How bad of a period will only be known in hindsight. But as we see the real economy faltering, the stock market is soaring. Leading many market participants to wonder, "What is going on?"

After the market close last Thursday, US tech firms put up an unbelievable earnings report. There is simply no way to adequately convey how impressive these firms are to put up record breaking profits in the middle of an economic malaise. On the surface, it seems simple, everyone is converting to a virtual world, the cloud has never been in higher demand, and people are buying everything online. But when we get into the depths of the earnings reports, we realize just how impressive they are.

For example, Amazon (AMZN) posted record profits of $5.2Billion, even after spending over $4Billion on Covid-19-related costs. Truly an impressive quarter for the big five (Alphabet (GOOG) (GOOGL), Facebook (FB), Microsoft (MSFT), Apple (AAPL), and Amazon (AMZN)), which make up an increasing percentage of the S&P 500's gains and are the direct beneficiaries of positive tech fueled deflation. The blow-out earnings reports led to a rally on Wall Street to close out the week and the month of July. Still Wall Street remains positive on the market reasoning, as it has before, that there is no alternative to equities even as stocks continue their rise to historically overvalued levels.

"The individual investor should act consistently as an investor and not as a speculator."- Ben Graham

This leads one to wonder how much longer can this continue? How high can their valuations go? The market is currently pricing these companies as if there is no limit to their valuation, no end to their rally. We know this is not true. At some point, in the future, market participants, even pundits, will question how they lost their senses and paid such an enormous price for a share of stock relative to its earnings and growth rates.

Looking at the PEG ratio for the big five, we are left wondering why investors are willing to pay such exorbitant prices to be owners of these businesses. The PEG ratio takes the price and earnings of the company within the context of its growth rate. (Price/Earnings Per Share)/Growth Rate. Generally a PEG of 1 is desired as it shows the value of the company is reflected in the price. Thus a PEG over 1 indicates overvaluation and a PEG below 1 indicates undervaluation in a general sense. How do the big five score?

  • Apple currently trades at a PEG of 2.78
  • Alphabet currently trades at a PEG of 6.25
  • Facebook currently trades at a PEG of 1.99
  • Amazon currently trades at a PEG of 3.79
  • Microsoft currently trades at a PEG of 2.50

These stocks make up a significant portion of the stock market index and represent ALL of the stock market's gains YTD. This is not sustainable, nor is this an indication of a healthy rally. Investors are flocking to the only companies in the market that have what they believe to be sustainable earnings growth, even willing to pay any price for said growth. But just like all the other periods of financial speculation, this will not end well.

In a recent analysis on Barron's, Jefferies Global Equity Analyst Sean Darby stated:

"Sentiment is starting to become euphoric, similar to the 'Four Horsemen' during the late 1990s." During the 1999-2000 period, Darby points out, the market was similarly dominated by four stocks-Microsoft, Cisco Systems (CSCO), Dell, and Oracle (ORCL). He sees strong similarities to that period and this one, and he notes that today's FAANG stocks are "making a similar trajectory as previous bubbles."

US Equity Market Valuations Soar

"The great challenge of bubbles is that they can really only be identified in hindsight. A bubble-like market can remain aloft far longer than its detractors can believe. As long as the market's apogee is still unknown, there is always a ready source of market defenders. It takes the passage of time and a clear peak in price to convince the vast majority of market participants that a bubble did indeed take place." - Tadas Viskanta

The US equity market seems to be a runaway freight train. Nothing can stop this rally, or so it seems. Driven by quantitative easing policies, and a "There Is No Alternative (TINA)" mindset of market participants, the market is now approaching three standard deviations from the mean, a valuation level not hit since the great tech bubble at the beginning of this century.

I do believe it is possible that stocks can continue their rise higher for the time being, but that does not change the reality that we are incredibly overvalued. The S&P 500 is trading at a P/E of over 23x earnings, an average multiple would be around 15-16x, so even if we adjusted for lower rates, we would arrive at a multiple of 19-20x, yet we trade at 23x with no end in sight.

It seems the sentiment expressed by noted stock bull Dr. Jeremy Siegel, Professor of Finance at The Wharton School, University of Pennsylvania, in March of 2000 right before the 80% crash in the Nasdaq, is becoming more and more applicable to our present day.

"Many of today's investors are unfazed by history - and by the failure of any large-cap stock ever to justify, by its subsequent record, a P/E ratio anywhere near 100."

Many will be quick to note that today is not like 2000. After all we have a different economy, and these businesses are at a different stage, with solid earnings and top-notch balance sheets. Many of them are even mature dividend payers. As investors are starved for yield and looking to stocks to provide their desired income and capital appreciation, these stocks have become go-to investments. However, this does not mean that the laws of mathematics or valuation have been suspended. Benjamin Graham is famous for saying that short term the market is a voting machine, but long term, it is a weighing machine. Currently, many of the businesses leading the market trade at excessive P/Es including some in excess of 100x.

Eventually, reality will seep into this market. The fact that earnings power for many businesses has been significantly, and in some cases, permanently impaired, will matter. The music will stop, and investors who flocked to this market for growth and income will all head for the same narrow exit.

In fact, the recent rally in government bonds may be predicting trouble ahead for the stock market. A recent piece by A. Gary Shilling seems to think we are repeating an ominous pattern:

Recall that yields on 30-year government bonds started to decline on Jan. 2, anticipating the fallout from the budding coronavirus crisis that had taken hold in China. Yields fell from 2.34% on that day to 0.94% on March 9, as the price of the benchmark 30-year bond leaped 29%. Only on Feb. 19-seven weeks later-did the S&P 500 Index begin its 35% slide. Fast forward and 30-year yields have fallen from 1.66% on June 8 to a recent 1.19% as their prices climbed 9%. The question is whether stocks will follow again, and with a similar lag of about seven weeks.

The bond market is always smarter than the stock market, and I believe, as I laid out in my last piece The Coming Financial Crisis, that trouble lies ahead. With markets incredibly overextended, no matter how you measure it, and the real economy showing signs of worsening, the US Treasury security offers investors a unique port in the storm.


The market continues to resemble a frantic herd trying to be the first to find the next earnings growth story. We have seen stocks like Tesla (TSLA) rally triple digits, while stocks like Hertz (HTZ) and Kodak (KODK) have given us a frightening example of the type of frantic mania present in today's market.

We are currently in a world where deflationary forces are gaining steam, debt burdens are overheating, restrained GDP growth is a reality, and central banks that are in uncharted territory, experimenting with negative rates, and in the process showing their desperation to create some level of inflation and stave off what they really fear... a full on deflationary depression.

The risk of another deflationary depression is beginning to come into focus; only time will tell if central bankers can defeat it. I hope they can. What everyone really fears is that 10-year Treasury at 0.559%. Investors need to realize the intense risks during this period of time. As Seth Klarman said in his April 2017 client letter: "When securities prices are high, as they are today, the perception of risk is muted, but the risks to investors are quite elevated."

The bond market continues to tell investors the truth; the question now is whether investors will listen or continue, in the words of Charles Mackay, to disregard the facts and speculate in stocks based on their theory that there is no alternative to equities.

The bond market continues to tell investors in words that cannot be misunderstood; don't take risks.

I leave you with a passage from Charles Mackay's classic tome concerning the tulip craze in 1630s Holland. It is particularly instructive in the behavior of crowds, and in its revelation that the motivations of market participants do not change. This time is not different. The psychological factors that propelled the tulip bubble to extremes in Holland in the 1630s are at work in our present day, propelling a handful of stocks higher and higher, and taking market averages with them.

Mackay's brilliant analysis of human behavior in 1841 is alive and well in 2020. Greed, stupidity, herd mentality, the reckless belief that the rules of economics have somehow been suspended in this instance, and that this time was different are all driving dangerous speculation in risk assets. The time has come to reassess the risks in your portfolio and prepare for the possibility that history will repeat itself and the depression is coming.

"People who had been absent from Holland, and whose chance it was to return when this folly was at its maximum, were sometimes led into awkward dilemmas by their ignorance... By 1636, special markets for trading in tulip bulbs were established on the floor of the Stock Exchanges in Amsterdam and other towns. Many people grew suddenly rich, and others, not wishing to be left out, began speculating madly themselves.

At last, however, the more prudent began to see that this folly could not last forever... It was seen that somebody must lose fearfully in the end. As this conviction spread, prices fell, and never rose again. Confidence was destroyed, and a universal panic seized upon the dealers. A had agreed to purchase ten Sempers Augustines from B, at four thousand florins each, at six weeks after the signing of the contract. B was ready with the flowers at the appointed time; but the price had fallen to three or four hundred florins, and A refused either to pay the difference or receive the tulips.

Defaulters were announced day after day in all the towns of Holland. Hundreds who, a few months previously, had begun to doubt that there was such a thing as poverty in the land, suddenly found themselves the possessors of a few bulbs, which nobody would buy, even though they offered them at one quarter of the sums they had paid for them. Many who, for a brief season, had emerged from the humbler walks of life, were cast back into their original obscurity. Substantial merchants were reduced almost to beggary, and many a representative of a noble line saw the fortunes of his house ruined beyond redemption."

This article was written by

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Disclosure: I am/we are long US TREASURY BONDS. 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: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor. This article does not constitute tax advice. Every investor should consult their tax advisor or CPA before acting on any information contained herein.

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