The Market Is Dumb And Getting Dumber

May 5, 2017

The Market Is Dumb And Getting Dumber

  • The number of analysts is declining, stocks don’t react to earnings nor news anymore, and the underlying economic environment is rigged.
  • However, as investors, we have to always look at risk and reward as there is always a way to profit.
  • Protecting yourself from market ignorance doesn’t even cost much.

Introduction

I would define a dumb investor as one who doesn’t think about risk in relation to reward, and therefore I fearlessly say: the majority of investors are behaving in a pretty dumb way.

This is a heavy statement, especially considering markets have performed nothing short of spectacularly in the last 8 years. As evidence, the S&P 500 is up three-fold since 2009 and continues to strongly march ahead.


Figure 1: The S&P 500’s performance is mind-blowing. Source: Yahoo Finance.

Where does my conviction come from that the markets are dumb and don’t think about risk? Well, from the fact that corporate earnings haven’t tripled in 8 years and people have been paying more and more for the same earnings. A few charts will better describe what I mean.

S&P 500 earnings are at the same level they were before the financial crisis. This means that corporate operational efficiency has decreased because the S&P 500 is a biased index due to the survivorship bias where the losers get quickly cut out and winning stocks get included, and due to massive share buyback activity which has cost corporations trillions of dollars with the sole purpose of raising earnings per share, not aggregate earnings.


Figure 2: S&P 500 earnings are at the same level they were in 2007 and 2012. Source: Multpl.

Now if something doesn’t earn more money, it means it isn’t growing which means it should be valued at the same price through time. This hasn’t been the case for the S&P 500 as it’s price to earnings (P/E) ratio has been continually increasing in line with the growth of the S&P 500.


Figure 3: The higher the P/E ratio, the higher the risk. Source: Multpl.

If the price of an asset just keeps increasing while earnings don’t grow at all, then the asset is riskier. Something investors often overlook is giving more attention to risk, i.e. what can go wrong. Let me show you just one of the many examples of what can go wrong with the S&P 500.

Let’s say the economy continues to do well and inflation stabilizes at a level around 2.5%. With inflation at 2.5%, the Federal funds rate should be around 3% to prevent the economy from overheating. Consequently, the 10-year Treasury yield should be around 5% and expected stock returns around 7%. For stocks to have an earnings yield of 7%, their P/E ratio should be around 14. A P/E ratio of 14 with current S&P 500 earnings would see the S&P 500 at 1,336 points.

Remember, this is if the economy does well. I won’t even go into what could happen if the economy falters, inflation increases, low interest rates don’t help anymore, etc.

Another interesting risk for the S&P 500 could arise as the baby-boomers retire. You can read more about that here.

Who Is Responsible For Such A Risky Market?

The first finger can easily be pointed at the FED. The FED has been doing everything it can to prevent or postpone a recession since 2009. But recessions are healthy as they weed out the bad in the economy, increase de-leveraging, and keep the economy growing at a sustainable pace.

Interest rates have been kept artificially low and the federal balance sheet large in order to keep liquidity high and money cheap. Cheap money and high liquidity pushed all asset prices higher.


Figure 4: The FED has waited too long for significant action. Source: FRED.

The second finger can be pointed at corporate share buybacks. With the increased liquidity provided by the FED and low interest rates, corporations have loaded up on debt and bought back as many shares as possible.


Figure 5: Share buybacks have surpassed $3 billion in the last 5 years or about 15% of the market’s capitalization. Source: FACTSET.

Additionally, investors have started to think that passive investing is the smartest thing to do and have piled their money into ETFs and passive mutual funds. Those funds have transferred the new funds into the market and pushed prices higher.


Figure 6: ETF inflows are at record highs. Source: Bloomberg.

All of the above has led to the market being dumber. And, this isn’t just because I think so or because investors don’t pay attention to risk. A recent scientific study showed that ETFs are making the market dumber.

Israeli, Lee, and Sridharan from Herzliya, Stanford, and Ermory University have found that an increase in ETF ownership leads to:

  1. Higher trading costs as ETFs always and immediately pay the asking price increasing the spread between the ask and the bid.
  2. Increased stock returns synchronicity. This means that stocks prices tend to increasingly follow the market and are less dependent on news about the business.
  3. A decline in the future earnings response coefficient. This means that a good or bad guidance from the company doesn’t matter anymore, all that matters to an ETF is the market capitalization of a company which determines how much of the stock the ETF should buy.
  4. A lower number of analysts. As earnings, business news, and economic performance don’t matter anymore, there’s much less need for analysts. If analysts don’t analyze stocks, the market becomes inefficient.

Higher costs, increased correlation in stock price movements, irrelevance of earnings, and fewer analysts is a clear indication that the market is getting dumber. On top of it, with the high risk level the market is having now, I feel comfortable in saying the market is just plain dumb. But the question remains, what can you do?

Conclusion & What To Do

What to do is easy. Get out of the S&P 500 and similar investment vehicles that are completely detached from common sense because the risk is too high for the low expected return.

As described above, the S&P 500 could easily fall more than a thousand points if the economy does well while the expected earnings yield is just 4%.

Now, many fear of missing future S&P 500 gains by getting out now. This is logical as there is always an opportunity cost by staying out of the market, but since 2014, the S&P 500 hasn’t performed as well as many ETFs may want to present.

Let’s suppose you pulled your money out of the market when the S&P 500 crossed the 20 times earnings level. This happened in December 2014. A P/E ratio of 20 implies a return of 5% per year. 5% per year is exactly what an investor exiting the S&P 500 in December 2014 would have lost.


Figure 7: The S&P 500 has grown only 15% since December 2014. Source: Yahoo Finance.

For me, a yearly return of 4% or 5% according to the current S&P 500 P/E ratio is a very small return when compared to the risk of a 40% decline if the economy does well, or a 60% decline if the economy enters a recession.

However, you don’t have to be totally out of the market. There are plenty of opportunities to reach 5% returns or more with less risk. Merger arbitrage is one way of doing it, or emerging markets as they offer safe dividends that are higher than 5% for much less risk, or many other opportunities.

The important thing is to focus on risk first. The return will come smoothly afterward.