Yes, This Is An Equity Bubble

A few notes on valuation and investment returns. First, as I’ve noted frequently in recent comments, it’s quite reasonable to argue that lower interest rates can “justify” higher valuations, provided that one also recognizes that those higher valuations will still be associated with commensurately lower future equity returns. At present, we estimate zero or negative nominal total returns for the S&P 500 on horizons of 8 years or less, and about 1.9% annual total returns over the next decade. If these prospects seem “fair” given the level of interest rates, that’s fine – one can then say that low interest rates justify current valuations – but that doesn’t change the outcome: the S&P 500 can still be expected to experience zero or negative total returns on horizons shorter than about 8 years ( ).

Second, one can quantify the impact that zero interest rates should have on valuations with simple arithmetic. Consider a 10-year zero-coupon bond that would be expected to yield, say, 6% in a world where Treasury bills yield 4%. That bond would trade at $55.84 (100/1.06^10). Now suppose Treasury bill yields were expected to be held at zero for 3 years, returning to 4% thereafter. Given the normal 2% yield spread, it would now be competitive for the 10-year bond to return just 2% for the first 3 years, then 6% thereafter. The price today that would produce that outcome is $62.67. So how much of an increase in valuation does 3 years of expected zero short-term interest rates (versus a normal 4%) have on valuation? 12%. Why 12%? 3 years times 4%. The higher valuation today essentially removes that amount of future returns. The same result holds in every scenario, and holds for equity valuations as well.

If you google “Hussman December 2010” or “Hussman March 2011” or anything simlar, for dozens of examples, you will read exactly the same thing as in this article. It’s been a bubble for at least three years, for him.

He is incredibly smart but his analysis excludes two overarching considerations. One is: As interest rates approach zero, bonds (and the anticipated rise in rates from such low levels) present enormous risk to the corpus values of said bonds. Meanwhile, almost every other form of coupon-bearing investment bears similar risks. Except for all manner of easily-found US stocks, the largest and most liquid and probably best managed companies in the world. Here, a mere 1.6 points from its all time highs, you can buy Verizon and get a 4.3% yield. You can buy Intel at the highest price it has been in a dozen years and get a 3% yield. And you can buy XOM and get a 2.7% yield or COP and get a 3.2% yield. And if you believe those stocks are at lofty valuations you can protect your stock investment(s) with collars or puts for nominal cost. So you don’t have to dig deep nor turn over heavy rocks to find these. If you don’t want individual issue risk you can buy SPYders and get a 1.8% yield.

So, you take a company like XOM or any of several other major oils or INTC, or any other several large drug companies. Here are companies with massive management in place, with operations on every continent, with projects that take 6 months, a year, 5 years, and 10+ years to realize, and you either think those companies are deluded maniacs or you trust a guy working in front of his computer using some arcane model.

So if you believe Hussman, you believe the entire world has nothing better to do than to bid up the price of stocks, but furthermore, you completely neglect the notion that there is no other place to put money with the same kind of liquidity that US stocks have. His is not in my view a complete conceptualization of savings and investment.

I have always been a deep skeptic of Fed ZIRP policies and I do not expect them to end well, but despite all my skepticism, I have to give the Fed credit: For the interim, they indeed have managed to repeal all the laws of economics.

And finally: You cannot bet on the end of the world. Because 1: it only happens once, and 2: if you are correct and you win, there will be nobody around to pay off your bet.

I agree that XOM and INTC are fine companies, and I do hold large quantities of such stocks. I just didn’t buy at the present prices, and don’t intend to.

As the Fed tapers, it seems pretty likely that mid and long term interest rates will start to rise. Since the bond market is in something of a leveraged bubble, this could happen quite abruptly. I could see the 10-year T-bond going from 2.5% to 4% in a month or two, accompanied by a furious stampede out of bond funds.

What will this do to the net present value of the future earnings of these fine companies? Unless the interest rise is due to an actual boom in business, the stocks are likely to fall substantially. Companies like INTC are good buys at 12 or 13 times trailing earnings in such an environment. For oil companies, I don’t usually pay more than 10 times trailing earnings.

To reach these prices, a 10-20% haircut would be required. It is certainly not out of the question.

It is ABSOLUTELY not out of the question. No argument. But stocks are vulnerable to 20% corrections at virtually any moment in time. That includes 1000, 2000, 3000 and 5000 DJ points ago. At *any* of those times, stocks could have corrected by that amount, and they have, and they will again. But I would make the following 3 comments:

1: You don’t have to buy all your stock(s) at one time. After all, if you are at a Schwab or equivalent, if you save a mere 10 cents on 100 shares, you’ve paid for your $10 commission.

2: I disagree that bonds would make a 2.5% > 4% move in mere months. Slightly north of those levels and the US would detonate in terms of being able to service its debt. If the market demanded such a level of interest on public debt, it would in effect bankrupt itself. From 2.5% to 4%, a 62% move, would arguably if not unquestionably affect stocks very negatively, but it would affect the corpus of bonds massively worse. There, you *would* see roughly that same 60% loss in face value instead of 20-30-40% I completely agree you *might* see in stocks. In other words, the total certainty of the destruction such a rate rise would produce in bonds is much less a certainty when it comes to stock prices. Sure, erosion would occur...but the face value of bonds is connected to interest rates with a much more robust iron bar than it is with stocks.

3: These scenarios discount the idea that on the other side of such an interest rate rise are literally the most powerful financial forces on earth. To think that they would not resist with all they had the implicit self-implosion is not that believable.

Believe me, I am far more bearish on stocks than my arguments sound. But I also believe that your and my money in stocks is not as risky as is often held, and, if indeed we have it invested in quality stocks, we are not spending it that day or that week on bread or rent. Plus there is this preference conundrum: The day you are selling your stock, you are saying either that you fear a decline in same, and at the same time saying there’s a better place to deploy your capital. While there certainly *may* be, we always take that “new home” risk when switching investments.

Just trying to present a more balanced view, not saying either one of us is right or wrong. Nobody can predict the future.

“He is incredibly smart but his analysis excludes two overarching considerations.”

Sorry, but someone with his record, and who seems to be unable to learn anything year after year could hardly be classified as “incredibly smart”. He seems to fault the market for not “obeying” his model!

What’s missing from his model is the most important component of all - human behavior. And until people figure out how the mind of humans work, any analytic finance and economic model will have the same shortcoming, i.e. they won’t work.

“His is not in my view a complete conceptualization of savings and investment.”

Asset classes fluctuate relative to each other depending on where the investing herd goes. So if one wants to maintain the buying power of his nest eggs (and maybe grow it a bit), diversification and periodic rebalancing among the various asset classes is key. Harry Brown implemented this concept a long time ago with his “permanent portfolio’ idea. Backtesting of his model has proven to beat the S&P500 over long periods of time.

If you want to do better than that, then you have to understand human nature very well, the way Buffet does. He understands the investing herd (”When blood runs on the street, that’s the time to get greedy”). His yearly letter to stockholder is filled with his observations of human nature. He does not rely on analytical models.

” I have to give the Fed credit: For the interim, they indeed have managed to repeal all the laws of economics.”

The reason most people have been wrong (so far) about the impact of all the money printing by the fed and their ZIRP is because they assumed that the same lending criteria would continue as existed prior to the financial debacle. Well that assumption was false. It is much more difficult to get a loan today than 8 years ago. Additionally laws were passed that require banks to have a much stronger balance sheet, which also curtailed lending.

So because of the much fewer qualified borrowers, most of the money that the fed printed didn’t end up in the “economy”. Instead most of it ended up back with the fed as “excess bank reserves”. If you look at the feds balance sheet there’s several trillions dollars in reserve.

Obviously not all of the printed money went into reserve, some did go into the economy. But the QE tool that the fed uses is a very blunt instrument. The fed has no idea of or control over what happens to that money once they buy treasuries or mortgage securities, though one cam make a reasonably good guess. Who are the big holders of the treasuries that the fed buys back? Well my guess would be pension funds, hedge funds, mutual funds, investment companies, banks, foreign sovereign funds, rich people, etc.

And what will these people do with the cash that they get once they sell the treasuries to the fed? Well they’re all going to look at the remaining asset classes that they THINK will give the best return - stocks, commercial bonds, real estate, foreign stocks, gold, commodities, etc. And these are the asset classes that have gone up as a result of all the QEs.

Some of it may even get spent buying goods and services. But because people that own treasuries tend to be rich or at least well off, the type of goods and services that they buy will most likely be the luxury types. This is not going to result in inflation of the basic necessities (like most people expected). (Yes they have gone up some, but it’s not because of demand, it’s because the price of the commodities were bid up by investors) At best (or worst) it may cause the price of luxury goods and services to go up some.

But this economic activity at the high end does trickle down to the middle class - after all it’s still the workers that build and provide the luxury goods and services. So you will see some increase in employment, but it will be mild. And that is exactly how things have played out.

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