Investing, Markets

Mind The Gaps

A version of this post first appeared in The Felder Report PREMIUM.

About a month ago former Fed head, Richard Fisher, came out and confirmed the idea that the FOMC’s quantitative easing policies over the past seven years have pushed prices of risk assets, including stocks, beyond what would otherwise be supported by their fundamentals.

There are a few ways to visualize this. The first comes from Dr. Ed Yardeni who tracks a fundamental indicator shown below. Notice the yawning gap between the S&P 500 Index and the major economic fundamentals.

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We can also just look at the index versus its components’ earnings. Here’s another gap:

And if you prefer to look at forward earnings estimates, you’ll find another massive gap:

Specifically, Fisher said that the Fed had, “front-loaded a tremendous rally.” All this means is that the Fed pulled returns forward from the future to generate larger gains today. Notice in the chart below that returns have recently been significantly better than valuations (using the Buffett indicator) 10 years ago justified. This is exactly what Fisher is referring to.


The last time this happened was in the late 1990’s. From that peak, stocks fell more quickly than forecast in order to play, “catch up,” to the downside. Interestingly, the 3-year forecasts I generate using margin data show the very same gaps in the late 1990’s and today.


And there are other indicators suggesting these gaps could close sooner rather than later. Bond market risk appetites (very similar to spreads in corporate bonds, junk bonds and leveraged loans) have been falling farther and for a longer period of time than stocks. These are normally very highly correlated to stock prices yet here is another major gap.


Another way to visualize this is to compare bond market risk appetites to stock market volatility. While fear in the bond market has soared recently, fear in stocks is relatively subdued. Notice the gap between them in the chart below.


So when Richard Fisher says he, “can see significant downside,” in the stock market right now, he’s probably thinking about these sort of gaps between stocks prices and economic fundamentals. Between stocks and their earnings. Between stocks and the corporate credit markets. Because he helped create them. And, like Dr. Frankenstein and his monster, nobody knows better what they’re capable of.


Are Passive Investors Taking On Far More Risk Than They Realize?

“The average American is from Missouri everywhere and at all times except when he goes to the brokers’ offices and looks at the tape, whether it is in stocks or commodities. The one game of all games that really requires study before making a play is the one he goes into without his usual highly intelligent preliminary and precautionary doubts. He will risk half his fortune in the stock market with less reflection than he devotes to the selection of a medium-priced automobile.” -Jesse Livermore

These days, the sort of reckless financial abandon Livermore describes is on prominent display in the rapidly rising popularity of, “passive investing.” I first addressed this issue two years ago in a post titled, “one reason I’m worried about the rise of the robo-adviser,” writing:

…as this form of investing becomes more and more popular, the risk of mispricings (and even bubbles) in the markets grows with it because it completely abandons the basic process of analyzing value and risk. When you have a growing stream of buyers who are agnostic when it comes to value – meaning they will continue to buy regardless of price – it’s hard not to see problems arising.

Hedge fund manager, Bill Ackman, recently attempted to quantify the growth of this style of investing, writing, “Last year, index funds were allocated nearly 20% of every dollar invested in the market. That is up from 10% fifteen years ago.” Considering the rapid growth in this form of price-insensitive buyers, he comes to a very similar conclusion:

We believe that it is axiomatic that while capital flows will drive market values in the short term, valuations will drive market values over the long term. As a result, large and growing inflows to index funds, coupled with their market-cap driven allocation policies, drive index component valuations upwards and reduce their potential long-term rates of return. As the most popular index funds’ constituent companies become overvalued, these funds long-term rates of returns will likely decline, reducing investor appeal and increasing capital outflows. When capital flows reverse, index fund returns will likely decline, reducing investor interest, further increasing capital outflows, and so on.

In other words, “passive investing” will ultimately become a victim of its own success. The massive shift to index funds over the past 15 years or so drove the valuations of the largest index components to levels which guarantee poor returns going forward. Poor returns, in turn, will guarantee these inflows will turn to outflows and the virtuous cycle becomes a vicious one.

Danielle DiMartino Booth, formerly of the Dallas Fed, takes it another step further suggesting the rise in index investing is, to a great degree, a result of the Fed’s conscious efforts to stoke, “animal spirits,” over the past seven years or so. As such, it is directly in the crosshairs of its consequences:

“…Investors must reckon with the systemic risk that permeates the markets when boom turn to bust. The bullish cabal continues to insist that if you exclude energy from your calculus, all is hunky dory in the markets. The flaw in such naïve guidance is that excluding energy extends to excluding the commodities supercycle, the emerging markets renaissance it induced and the ‘miracle’ of China’s emergence onto the global economic stage that ignited the engine to begin with. Hence the ultimately systemic outcome of lax monetary policy and the animal spirits it emboldens when seeking out the philosopher’s stone. Maybe a bit more business cycle and less artificiality would have left investors in a better place. One thing is for sure – there wouldn’t have been the wholesale herding into passive funds these last few years. Market behavior suggests that an entire generation of passive investors is about to discover the downside risk of holding highly concentrated positions that have flown blind, free of price discovery. Call the highly correlated nature of their supposed prudent asset allocation a systemic-risk chaser.” [Emphasis mine.]

Ultimately, it’s very difficult to argue that, in pursuing passive investing strategies to the degree they have recently, investors haven’t, ‘risked half their fortune in the stock market with less reflection than they devote to the selection of a medium-priced automobile.’ And, after witnessing first hand the disastrous consequences of such actions nearly a century ago, Jesse Livermore would be shaking his head right now.


Owning Stocks Today Is Risking Dollars To Make Pennies

Charts, Markets, Posts

If History Rhymes This Indicator Suggests Stocks Still Have A Long Way To Fall

The latest NYSE margin debt figures came out this week showing another drop during the month of December. Moreover, the level of margin debt has now spent a few months below its 12-month moving average, which has been a decent bear market signal in the past (first proposed by Norman Fosback).

Screen Shot 2016-01-29 at 9.48.21 AM

Even when adjusted for the size of the overall economy, margin debt recently hit record high levels, greater even than what we saw at the peaks just prior to the dotcom bust and the financial crisis.

Screen Shot 2016-01-29 at 9.48.09 AM

The reason I like to look at margin debt relative to GDP is that is it fairly negatively correlated with forward 3-year returns in the stock market. When levered financial speculation has been rampant, as indicated by a high level of margin debt-to-gdp, stocks have regularly suffered severe losses over the next several years and vice versa.

Screen Shot 2016-01-29 at 9.47.54 AM

Unless you believe, “this time is different,” you should probably expect some rough sledding for the stock market going forward. How rough? Well, after both of the prior occurrences in which margin debt became as substantial as it is today, stocks suffered a 50% drawdown (and 3-year returns of roughly -40% at the lows). If history indeed rhymes, another such decline is not out of the question.

Charts, Economy, Investing, Markets, Posts

Corporate Bonds Pass An Ominous Milestone

The spread between the yield on corporate bonds and that on treasuries passed the 2% mark yesterday for the first time in over three years yesterday.

In the chart above I’ve annotated with red vertical lines the prior two occasions when spreads widened to this degree for the first time in at least two years. Notice that each of the two prior occurrences led to painful bear markets and recessions.

Now this indicator alone isn’t sufficient evidence that another painful bear market and concomitant recession are on their way. However, when you pair it with the all the other data out there, it’s confirmation of the growing probability of both.


Why Recession Is More Likely Than You Think

This Chart Suggests A Bear Market Could Be Lurking


2 Questions To Ask Yourself If You’re Worried About Your Investments Right Now

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” -Benjamin Graham, The Intelligent Investor

Are you concerned about the markets right now? Do you worry about how your investments might fair in a prolonged decline? If so, I encourage you to think them in terms of that quote above.

According to Ben Graham, Warren Buffett’s teacher at Columbia Business School, an investment must meet two simple criteria:

  • First, does it offer safety of principal? In other words, ‘is my initial investment protected somehow such that I’m likely to get it back even if my analysis is faulty?’
  • Second, will it provide an adequate return? In other words, ‘am I being adequately compensated for the risk I’m taking here?’

If you can honestly answer both of these questions with a confident ‘yes’ then you should have no worries.

If you answer either of these with a ‘no’ then you should probably have some sort of stop loss (like the primary trend) in place to make sure you don’t let a speculative position hurt you too badly if it goes against you.

Finally, if you don’t know where to begin in answering these questions then you’re clearly operating outside your own “circle of competence.”

In this case, you probably want to educate yourself a bit more so that you understand how to answer these questions and then focus your efforts going forward on investments that are within your own ability to analyze.

And why not start right where Buffett did with, “The Intelligent Investor“?