The Herding Instinct Is Powerful

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Readers of the financial press have undoubtedly seen recent articles describing investors’ retreat from actively managed portfolios and migration to passive investments that attempt merely to match market indexes. The latter have done better in recent years. Because investors are invariably trend followers, that phenomenon is very understandable. When markets go up or down for several years in a row, investors have a predictable habit of connecting the dots, creating a trend line and projecting it into the indefinite future. Collectively we expect good news to be followed by good news and bad news by more bad news. Unfortunately, those expectations lead the majority of investors to buy high and sell low.

Mutual fund purchase and sale data demonstrate the perverse buy high/sell low tendency quite clearly. Near market highs, news reports are typically positive and confidence is high. Investors who may have missed much of a rally see how others continue to profit by participating. The siren call to get invested becomes increasingly compelling the longer a rally lasts. Conversely, when markets have declined for an extended period of time, the news invariably turns gloomy and forecasts become increasingly negative. As market prices descend, growing numbers of investors reach their pain tolerance limits and lighten or eliminate their risk exposure. As a result, there are far more fund purchases at high prices and redemptions near the lows. This tendency plays itself out across all sectors of the investment spectrum. And it’s not just a recent phenomenon.

In the twentieth century, it was very common for investment managers to assume the prime responsibility for adjusting investors’ asset allocations. Many investment managers were categorized as Tactical Asset Allocators (TAA), whose approach was to move assets to those investment areas deemed safest and/or potentially most productive. For decades, many of those firms practicing the TAA approach did an excellent job of protecting and growing client assets. The decade of the 1990’s, however, produced a major shift in investors’ attitudes. There were precious few market declines of any consequence, so managers who allocated away from risk almost inevitably were penalized for their caution, not rewarded, as they had often been in the past. As the decade wore on, TAA firms became scarce. Those that survived largely migrated to a more fully invested, fixed allocation approach. The good times lasted so long that even the most patient investors opted to join the crowd and assume greater and more permanent risk exposure. Unfortunately, this shift was just before the 50% stock market decline from 2000 to 2003, when properly executed asset allocation would have been most appropriate.

The tendency for investors today to forego caution and simply go with the flow of free money and rising stock prices is remarkably similar to attitudes prevalent around the turn of the century. Tomorrow is unknowable, but there is substantial reason to expect reversion to the mean in the years ahead as the excesses of the free money era are eventually eliminated. Beware of herd mentality. Remember: what we get to keep is typically what we have at market lows, not what we have at the highs.



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Many ordinary Russians are standing in line at local banks trying to withdraw their savings in dollars. The value of the ruble has been cut in half since the beginning of the year, with the decline accelerating dramatically this week. Obviously weighing heavily on the Russian currency is the plummeting price of oil, now trading at roughly half its price of just six months ago. Economic sanctions imposed by western nations are also taking their toll.

When one of the world’s ten largest economies staggers, repercussions are unpredictable. Questions arise. Who holds the more than $600 billion in external debt of Russian banks and companies?

Apart from Russia, how heavily leveraged are oil companies worldwide who borrowed to expand their drilling activities to take advantage of early 2014’s rising prices? A 50% decline in oil prices, totally unexpected just six months ago, may leave some borrowers on the verge of insolvency. In turn, what lenders might be endangered?

Not surprisingly, such uncertainties make investors nervous. Over the past seven market days, the Dow has fallen 900 points from its all-time high on December 5th. Today showed quite remarkable volatility, reflecting the dichotomy between weakening fundamentals and the expectation of a year-end rally. The Dow opened down 100 points, rapidly rising about 350 points through the morning, then declining by about 360 points through the rest of the day, closing at the low.

Notwithstanding oil, Russia, the threat of contagion, as well as hideous acts of terrorism in Australia and Pakistan, investors have a deep-seated belief that late-December seasonals–especially the highly predictable Santa Claus rally–plus the positive January effect will push prices higher over the next few weeks. With most hedge funds performing far below their benchmarks for the year, there are a great many firms trying to take advantage of any rally opportunities.

That the market was unable to hold its rally on the day before a Fed announcement–an almost universally positive day over the past several years–may introduce further doubts about a prospective year-end rally. As most recently evidenced in mid-October when all world central bankers sang a dovish song to stem the September-October market decline, central bankers have adopted the support of stock prices as an additional mandate. Janet Yellen has the opportunity to provide more support tomorrow (Wednesday) both in the wording of the Fed’s statement and in her press conference to follow.

With just two weeks remaining in calendar 2014, markets may experience abnormally severe volatility as central bankers and seasonal tendencies wrestle with deteriorating world financial conditions. It promises to be a robust conflict.



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At the end of the 1990’s, I wrote an article entitled “The Fiduciary’s Dilemma,” forecasting the likely demise of the then nearly two-decade-old equity bull market. Individual investors and fiduciaries for institutions had reaped substantial rewards from almost twenty years of powerful advances in both stocks and bonds. In fact, there had never before been as profitable a period for the stock/bond combination as that from the early 1980’s to the end of the 1990’s. One didn’t need to be a particularly astute investor; one only had to be invested to make significant profits.

In numerous written commentaries and speaking engagements at the end of the 90’s, I flagged the primary dangerous conditions of excessive debt and extreme stock market valuations. Based on historic precedent, there was good reason to anticipate a long corrective phase, potentially lasting as long as two decades. Prior long weak cycles lasted until the excesses of the previous long strong cycle had been expunged.

From the bull market peak in the early months of 2000, stocks have experienced two devastating 50+% declines followed by two powerful rallies, netting an annualized century-to-date common stock return in the low single digits. For a variety of reasons, most investors have earned even less than this meager amount, despite powerful government stock market support since 2009. We are pleased that Mission clients with us for the entire century-to-date have earned more than the S&P 500 while assuming far less risk than the index.

A decade and a half later, we are faced with conditions very similar to those that characterized the late 1990’s. Stocks have been in a powerful bull market since 2009. Investors who have exercised caution have sacrificed performance. Equity valuations are near historic highs, although below the highs seen at the 2000 peak. On the other hand, debt burdens are considerably more severe today than they were at the peak in 2000.

Just as at the end of the 1990’s, investors hate to give up on the golden goose, which has been so generous for years. At the near collapse of the financial system in 2008, the Treasury and Federal Reserve Board stepped up with unprecedented amounts of rescue money. With the economy never recovering to “escape velocity”, the Fed has continued to pump a previously unimaginable amount of money into the banking system. That flood of money has still not been able to kick-start the economy out of the slowest recovery from recession in the past half century. It has, however, kept stocks climbing, with the Fed stepping up its efforts whenever stocks began to demonstrate even marginal weakness. As a result, investors have developed overwhelming confidence that the Fed has their back and will not allow significant market declines. Near historically low interest rates have made the choice of equities easier. Many believe there is no alternative to equity ownership. As was the case in the late 1990’s, the longer the equity rally continues, the stronger the belief that stock prices will continue to climb, notwithstanding the lengthening list of geopolitical and economic concerns.

The perfect scenario, of course, would be to remain heavily invested in equities to the ultimate market peak, whenever that is, then to get out or go short. History shows, however, that even the most successful investors rarely pull off such a feat–very few even try. Both diversification into various asset classes and remaining relatively permanently invested are concessions to the industry’s inability to identify peaks and troughs with any degree of certainty.

Ours is a business of probabilities, not of certainties. What often gets ignored, however, is investors’ need to weigh not just the probability of an event occurring but the relative consequences of a good or bad outcome.

In 2009, Carmen Reinhart and Ken Rogoff wrote This Time is Different, contributing greatly to the industry’s knowledge about economic and market behavior in the wake of financial crises, such as the world experienced in 2008. They analyzed more than 300 such crisis events worldwide over the course of eight centuries. While circumstances inevitably differed from event to event, there were a great many commonalities.

Reinhart and Rogoff have recently stated that the US and Europe are betting against overwhelming historic odds that they will be successful in guiding their respective economies back to normal primarily through austerity and growth. The authors contend that history argues convincingly that regaining economic normalcy will involve some lengthy combination of restructurings (defaults), financial repression and significant inflation. Clearly, restructurings are a last resort. In this country, the Federal Reserve has been exercising financial repression for years by reducing short-term interest rates essentially to zero, seriously penalizing retirees and other risk-averse investors who prefer to rely upon investment income. The Fed has simultaneously been attempting to erase the sting of our country’s unparalleled debt by raising inflation. So far their actions have penalized those in need of income, but have failed to raise inflation even to their minimal 2% target. Far more significant inflation will be needed to appreciably reduce the negative impact of our overwhelming debt load. What the Fed’s historic economic stimulus program has accomplished is to have boosted the country’s relative debt burden to a level that has created multi-decade economic slumps elsewhere in the world over the centuries. Those actions make restructurings an increasingly likely part of our future. Most of the developed world has become debt dependent to a degree that makes major economic collapse likely if current experimental monetary policies fail.

Even members of the Federal Reserve itself have voiced serious concerns about the course of monetary policy. Richard Fisher, President of the Federal Reserve Bank of Dallas stated: “[N]o central bank anywhere on the planet…has the experience of successfully navigating a return home from the place in which we now find ourselves. No central bank…has ever been on this cruise before.” Earlier this month, former Fed Chairman Alan Greenspan said: “This is an unprecedented period in monetary history. We’ve never been through this. We really cannot tell how it will work out.” More than a year ago, former St. Louis Fed President Bill Poole pointed out that when you look at the numbers, the US is only a few years behind Greece.

We are clearly not in a business as usual environment. Various governments and central banks rescued the economic system from collapse in 2008. They gave banks enough money to lift them from apparent insolvency six years ago. They have not been able, however, to promote normal economic growth, despite historic levels of stimulus. The Eurozone is now perilously close to its third recession in recent years, and most emerging nations – China most importantly – are experiencing economic slowdowns, while the world strains under the most extreme debt burdens ever. It is instructive to recollect that excessive debt has played an integral role in virtually all of history’s great economic crises.

Investors should not alter traditional risk-assumption patterns if the only fear would merely be occasional weak years in which stocks might lose ten or fifteen percent. So far in this still young century the S&P 500 has declined by 50% and 57%. Those bear markets respectively erased seven and thirteen years of price progress. Having already bet the house on the current rescue effort, world central banks would be ill-equipped to rescue markets and the economy if once again needed. If history repeats its typical pattern, we can expect at least one more major stock market decline before the current long weak cycle ends as debt and valuation excesses are extinguished.

While stock prices around the world are still not far below recent highs, there have been quite a few recent indicators of slowing momentum. Although the S&P 500 was up slightly in the third quarter, the average stock in the US and around the world was down. In fact, before last week’s rally, most major domestic and international indexes were down for the year-to-date.

Clearly, fear levels have also risen. Quite remarkably, despite obvious intentions of the world’s central bankers to support equity prices, vast quantities of world investment assets are being held in instruments offering essentially no yield. In fact, concern about dangers in the economy and markets have led investors to pay for the privilege of lending money to seven European countries. Instead of receiving a positive yield, these investors are willing to pay these governments for the guarantee of receiving their money back in one, two or three years. These are giant investors not worried about small consequences, but trying to guard against a mega-collapse. The yields in Europe are at 300-to 500-year lows. Another illustration that this is not business as usual.

Regardless of long-term concerns, stock prices could continue higher. The determination of central bankers to support stock prices was glaringly apparent when markets plunged two weeks ago. Within hours, we heard dovish, supportive comments from officials of the Federal Reserve, European Central Bank, Bank of England, Bank of Japan and People’s Bank of China. The ensuing rally quickly recovered more than half the losses from the September highs. Such government-supported rallies could continue so long as investors remain confident that central bankers retain the will and ability to support markets. On the other hand, given the long list of economic and geopolitical concerns, prices could collapse suddenly if central bankers are ultimately seen to resemble the wizard behind the curtain.

Central bank support has proved to be a powerful stimulus for securities prices since the near collapse of the economy in 2008. At the same time, it’s a fair question to ask what these central bankers see and fear that keeps them actively pursuing history’s largest ever rescue program fully five years since the alleged recovery began.

In such a highly uncertain environment, we have warned that traditionally diversified, relatively permanently invested portfolios could be in considerable danger. Unfortunately, with the future uncertain, there is no clear right answer. Mission has chosen for the equity portion of client portfolios to employ a quantified equity allocation process that carefully weighs dozens of economic and market conditions. The process promotes equity ownership when historical probabilities are favorable and removes equity risk when historical probabilities are questionable or negative. The process is not designed to anticipate news stories or sudden policy changes, but rather to respond to them by measuring their effects on the economy and markets. By measuring those effects well over the past third of a century, the process’s criteria have been able to identify major trends after markets have finished vacillating in the transition period from up to down or vice versa. Successfully identifying major trends has led to participating in (not beating) strongly rising markets and defending against–even profiting from–significantly declining markets. Over full market cycles, the process’s results have outperformed the S&P 500 with fewer and smaller losses.

While Mission has been highly risk-averse since the end of the 1990’s, Mission’s portfolio results since the turn of the century have outperformed the S&P 500, not by matching the strong markets but by avoiding the worst consequences of the weak markets. We expect that protective approach to lead again to significant outperformance over the next few years.

We look forward to the next long strong stock market cycle in which accepting significant equity risk will be prudent, but not until current excesses are expunged. The environment will remain very dangerous until then.


Have We Seen This Picture Before?

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We lived in mid-town Manhattan in the mid-1980’s when the Japanese were actively buying trophy properties. We could look out our 59th story windows and see several iconic New York landmarks that had recently changed hands. In the same era, Japanese buyers acquired the renowned Pebble Beach golf complex to fulfill the golfing dreams of well-to-do businessmen traveling to this country.

Those old enough to remember may recall that Japan at the time seemed to have developed the new industrial paradigm. Japanese companies dominated the electronics industry. Detroit-made automobiles were considered second-rate compared to their Japanese competitors.

Japan was truly a country with an unlimited future. At the end of the 80’s, the Nikkei index measured the progress of the world’s largest stock market by capitalization. The Nikkei closed the decade at just about 39,000.

After powerful rallies over the past several years, that same Nikkei has recently climbed above 16,000–still down almost 60% from its 39,000 high a quarter century ago. Japan continues its desperate attempt to extricate itself from the deflationary malaise that characterized a significant portion of the most recent 25 years.

Today we read about Chinese buyers picking up the venerable Waldorf Astoria hotel for just short of $2 billion. Although we can no longer look out our windows at the latest trophy acquisition, there is a clear sense of déjà vu. With obvious parallels between Japan and this most recent Asian power and its growth prospects, it’s worth leaving some room for doubt about the inevitability of a coming glorious period of economic domination.

Just saying.


The Stock Market Is Holding The Fed Hostage

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The Federal Reserve has apparently assumed a third mandate to supplement its acknowledged dual mandate of maintaining a stable currency and promoting maximum employment. Recent actions confirm their perceived responsibility to include support of stock prices, even at historic highs.

In May 2013, when the Bernanke Fed first indicated its eventual intention to reduce the Fed’s massive bond buying program, stock prices beat a hasty retreat. That response was obviously unacceptable, and several Fed spokespeople stepped forward in short order to assure investors that the Fed was far from abandoning them.

Prior to this week’s Fed meeting, market commentators speculated that removal of the “considerable time” phrasing from the Fed’s communique would receive a frosty reception from Wall Street. Not willing even to slow the inexorable advance of stock prices, the Yellen Fed retained the “considerable time” wording. That choice became somewhat comical during Chair Yellen’s post-announcement press conference, when she was questioned about the current meaning of “considerable time”. She made it very clear that the Fed’s decision about when to begin raising rates was not tied to the calendar. The decision was completely data dependent. What, then, did “considerable time” mean? Apparently nothing. It was just included so as not to upset Wall Street, which had announced that its removal would be a trigger to sell.

Past Feds have been broadly guided by the principle that they were responsible for pulling away the punchbowl when the party was in high gear. The current and recent past Feds seem to be operating with the intent of letting party goers drink so fully that they will be sufficiently inebriated they will not notice when the punchbowl is ultimately removed.

What Do Central Bankers See?

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Short U. S. interest rates have remained at the zero bound for years. Longer rates are only marginally above all-time lows. Most remarkable are European rates, which have descended to the lowest level on record. In some countries, that history spans more than 500 years. Such a phenomenon reflects something other than worry about a mere weak domestic or world economy. Over the decades and centuries the world has experienced all manner of economic weakness, yet rates have never before fallen to these levels. What horror must central bankers see that would justify the lowest or near lowest rates in history?

Developed countries may have painted themselves into such a corner– especially through recent years’ actions by central bankers–that they simply can’t allow rates to rise appreciably in the foreseeable future. With debts having grown to levels that have historically led to economic malaise, future danger is undoubtedly apparent. Perhaps Japan suggests itself as a dire precedent to countries that have not yet felt the debilitating effects of deflation. Central bankers may see all too clearly how heavily debt service will weigh on future economic growth when rates eventually rise. Notwithstanding the many economic and market distortions that are becoming manifest, central bankers may believe they have no choice but to bet the ranch on their grand monetary experiments. They are apparently willing to risk inflation–even hyperinflation–to prevent the destructive effects of deflation in a debt-laden world.

Acknowledged authorities of debt crises through the centuries, Carmen Reinhart and Ken Rogoff contend that developed country central bankers are whistling past the graveyard if they expect to grow their way out of the current debt overload. Almost certainly, developed countries will suffer debt restructurings. Central bankers’ worst fears could materialize with a contagious debt default spiral.


2nd Quarter 2014 Market Commentary

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Investors have long been counseled to diversify investments among several asset types. Over the past two years, however, any diversification away from common stocks has diminished portfolio returns. Thanks to the Federal Reserve’s zero interest rate policy, risk-free cash equivalents provide effectively no return, as has been the case for nearly six years. This has severely penalized retirees or others with little appetite for equity risk.

The traditional refuge for risk-averse investors has been ownership of U.S. Treasury bonds and notes. Unfortunately, that strategy has produced losses since yields bottomed in mid-2012. Despite rising rates over the ensuing two-year period, fixed income yields remain near historic lows. There remains little defense against potentially rising rates and inflation in the years ahead.

Those who have built substantial anti-inflation positions in gold have similarly realized losses over the past two years. While inflation risk in the years ahead is very real, it has not yet materialized in the world’s major economies.

Notwithstanding a relatively stagnant world economy, historic central bank money creation has successfully boosted stock prices worldwide. When stocks have threatened to decline in the past few years, central bankers have quickly stepped in to promise continued stimulus. That promise has overcome concerns about valuations, banking system vulnerability, the threat of sovereign bankruptcies, military conflict and anything else worried investors could imagine.

Not surprisingly, when equity prices have risen for more than five years, especially when other asset categories have been non-productive, there is a clamor for more money to be deployed into equities. A growing number of investors have been increasing allocations to equities from bonds and cash.   History inconveniently reminds us, however, that performance of any asset class is inversely related to its popularity at extremes.

In recent months, the U.S. stock market has demonstrated many parallels to conditions that prevailed around the historic price peaks of 2000 and 2007. Because all pleas for caution over the past few years have been sternly rebuked by ever rising prices, any such comparisons today are dismissed by many as “crying wolf.” Nonetheless, common sense demands that investors respect conditions that have historically proved dangerous, even if markets have sidestepped such dangers so far in this cycle.

The greatest contributing factors to the market collapses that began in 2000 and 2007 were excessive valuations and extreme levels of debt. A composite of the most commonly employed valuation measures puts today’s figures at or above those of the most important stock market peaks in U.S. history–exceeded only by the extremes reached in the mania. Warren Buffett’s favorite measure of value (stock market capitalization as a percentage of GDP) shows the current market to be more overvalued than any in history but the peak in 2000.

Debt figures paint an even more ominous picture. While debt was extreme in 2000 and 2007, it is more extreme today. Nearly every major Western country has taken on substantially more debt since 2007, with debt levels now excessive in all corners of the globe. This month, the chief investment officer of Europe’s largest insurer, Allianz, stated that the euro crisis is not over, that European countries are still building up their debt piles, raising the probability of trouble. The Bank for International Settlements (BIS), the central bank’s central banker, recently declared that debt levels in many emerging markets, as well as (supposedly conservative) Switzerland, “are above the threshold that indicates potential trouble.”

Former chief economist at the BIS, William White, gave an extended interview with a prestigious Swiss business newspaper earlier this year under the headline, “I see speculative bubbles like in 2007.” Several of his contentions deserve serious consideration.

  1. Not even during the Great Depression in the Thirties has monetary policy been this loose. And if you look at the details of what these central banks are doing, it’s all very experimental. They are making it up as they go along.
  2. The fundamental problem we are still facing is excessive debt. Not excessive public debt, but excessive debt in the private and public sectors. To resolve that, you need restructurings and write-offs. (In other words, defaults.)
  3. It’s worse than 2007, because then it was a problem of the developed economies. But in the past five years, all the emerging economies have imported our ultra-low policy rates and have seen their debt levels rise.
  4. We are back in a world where the banks get all the profits, while the government socializes all the losses.
  5. The strengthening growth might be a mirage. And if it does not materialize, all those elevated prices will be way out of line of fundamentals.

Most investors are apparently unconcerned, or they believe that they will be able to exit their equity positions before serious damage may be done. Such complacency was last seen prior to the 2000 and 2007 peaks. The exits during the ensuing price declines proved far too narrow to allow timely escapes.

Other parallels to the conditions surrounding the 2000 and 2007 peaks include the desire to speculate and the willingness to assume great risk. Earlier this year, margin debt exceeded the prior peaks reached near the 2000 and 2007 market highs. And investors are willing to use those margin loans for increasingly speculative securities. Also earlier this year, investors achieved the dubious distinction of supporting initial public offerings (IPOs), 79% of which had “negative earnings” – i.e., losses. That figure matched the percentage of money losers brought to market in February 2000, a month before 2000’s price peak.

Wall Street has proved nothing but resourceful, bringing to market far more junk bonds than ever before at increasingly suspect levels of quality. Today’s bond buyers either don’t know the sad history of such low quality debt, or they’re banking upon the belief that this time will be different. Such financial recklessness, even at far lesser degrees, has attended all prior important U.S. stock market peaks.

While the dangers are certainly real, and have been a legitimate concern for quite some time already, stock prices have continued to climb a wall of worry. That trend is testimony to the power of copious quantities of free money. And while the latest iteration of quantitative easing is scheduled to end in October, Fed Chair Yellen has pledged to maintain a highly accommodative monetary policy for a considerable period beyond that. With ominous parallels to 2000 and 2007, yet a still generous Federal Reserve, it is an open question whether stock prices can continue to power ahead. Much depends on investors’ degree of confidence that central bankers can maintain control of dangerous underlying fundamental conditions.

In dealing with a market that could still provide more profits if confidence prevails but could suffer dramatic and lasting losses should that confidence disappear, Mission employs a strategic equity allocation process that has outperformed the S&P 500 over the past 33 years with fewer and smaller losses than that index has experienced. It is designed to participate in (not beat) equity markets in strong periods and to protect assets in questionable or dangerous environments. After back-testing the strategy for nearly a third of a century, Mission introduced it to clients in late-2012. In just over a year and a half, the process has produced a return of approximately 13% while being exposed to equity risk about 32% of the time. We believe it to be ideally suited for the equity portions of portfolios in a highly uncertain environment.


Janet Sees Little Overvaluation

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Federal Reserve Chair Janet Yellen was prominently in the news again last week. Most of Wall Street’s ire was directed at her for her comment that “…valuation metrics in some sectors do appear substantially stretched – particularly those for smaller firms in the social media and biotechnology industries….” Imagine the temerity of the Fed Chair for looking askance at securities bearing an increasing resemblance to those that made a brief but costly appearance during the mania.

On the other hand, Wall Street largely applauded her assertion that “…valuation measures for the overall market in early July were generally at levels not far above their historical averages….” The latter comment left the investment community confident that for months to come it could count on a continuing stream of new money in the context of the Fed’s zero interest rate policy.

Right or wrong, the Fed Chair is entitled to her own opinion. She is not, however, entitled to her own facts. As I have pointed out in previous valuation reviews, price-to-dividends, price-to-book value, price-to-sales and price-to-cash flow are at or very close to all-time highs but for parts of the bubble period from the late 1990s to 2007. And to use valuations from that period is to make a completely specious comparison. Investors lost huge amounts of money twice in stocks purchased at those historic valuation levels.

The accompanying graphs from the excellent Ned Davis Research service make the point very clearly. We have annotated the graphs with a horizontal line at current levels to illustrate how little time valuations have spent above where they are today. No one doing an honest appraisal can argue that these are “…generally at levels not far above their historical averages….”

Chart 1 (Click on chart to enlarge.)



Chart 2 (Click on chart to enlarge.)

Chart 3 (Click on chart to enlarge.)

Chart 4 (Click on chart to enlarge.)


Price-to-earnings (Graph 5) is the measure of value most easily “engineered”, and it is the only one of the most commonly used measures that is not extreme. It is just very high and in the neighborhood from which most of history’s bear markets have begun.

Chart 5 (Click on chart to enlarge.)


Of course, a composite of valuation measures near historic highs does not indicate an imminent bear market. As the era conclusively proved, disbelief can be suspended for remarkably long periods of time. We do, however, have dozens of decades of data verifying that stocks bought at far above average valuations produce far below average multi-year returns. Precipitous and long lasting market declines also tend to start from similar environments in which valuation warning flags fly.

It is disingenuous at best for the Fed to claim that current valuation measures are anything but dangerous.


Double Tops Not Conclusive But Raise Caution Flags

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In his fact-filled economic commentaries, Gluskin Sheff’s David Rosenberg regularly provides helpful insights. His June 20 issue of Breakfast With Dave offered some stock market information that I had never before seen, despite having paid pretty close attention over a 45-year career in the investment industry.

David argued that in each stock market cycle – at least since 1980 – “each fundamental peak in the S&P 500 actually represented a ‘failed’ peak,” with the market forming a double top at the highs. Additionally, the momentum leading up to the peak was extremely strong, averaging an 11% price increase in the preceding 30 days. He profiled important market tops in 1980, 1987, 1990, 2000 and 2007.

As an avid student of market history, I went back over those time periods and a few more, confirming David’s findings in broad strokes. Not surprisingly, although his conclusions are accurate, putting them to practical use is not quite as easy as looking carefully for the requisite conditions and acting in a timely fashion. Over the decades, there have been numerous instances in which markets have put in a potential double top after a powerful rally in the month preceding the first peak. Many of those did not initiate meaningful declines; the most recent of which was a mere few months ago. This year the S&P 500 jumped about 8% (using intra-day prices) from early February to a peak at about 1880 in early March. A slight pullback ensued, followed by a rise into the 1890’s on declining momentum in early April. While the conditions had been fulfilled, the decline that followed was barely in excess of 4%. The equity market then moved higher in the second quarter.

Experience has taught us that major market tops don’t all look alike. Otherwise, managing investments would be a much easier business. The five major market peaks that David identified did conform to the pattern he outlined. There was, however, a painful 22% decline from mid-July 1998 into October of that year that exhibited no double top, despite a 10% price runup in the month prior to the July peak. And the most devastating decline in U.S. market history, the 89% collapse from 1929 to 1932, began with a rolling single top that accelerated rapidly to much lower levels.

At the very least, David has identified a set of conditions that have historically raised a caution flag. Double tops don’t necessarily lead to major declines, but many major declines follow double tops. The danger is compounded if the initial peak is preceded by a sharp runup in prices. Rosenberg’s computation of an 11% rise in the 30 days before the first peak in his examples includes rallies that ranged from about 4% to about 17%–a significant spread. A loss of momentum leading to the second peak should also raise some concern.

As I mentioned above, these conditions were met earlier this year with no dire consequences. Today we witness similar conditions to a smaller degree. June 9 saw an intra-day peak of about 1956 preceded by a 5% price rise in the prior month. A minor pullback led to a second peak at about 1968 on less breadth and momentum on June 24. While the caution flag flies again, the market continues higher, buoyed by the most monumental monetary stimulus program in the history of mankind. The short-term outcome is uncertain, but the investing public’s overwhelming complacency feels misguided.