There’s Only One Reason The Markets Are Rising & Nothing Can Be Done About It

March 15, 2017

There’s Only One Reason The Markets Are Rising & Nothing Can Be Done About It

  • Everybody knows the market is extremely overvalued and risky, but nobody cares as long as it goes up.
  • Funds keep flowing into U.S. equities despite the fundamentals. This will be very painful when the trend reverses.

Introduction

We all know that in the long run, our investment returns are perfectly correlated to the underlying performance of the businesses we own in relation to the price we pay for ownership. If the price is high, our returns will be weak. If what we buy is cheap in relation to underlying earnings, our returns will be great or even amazing. This is a universal truth. However, there are some issues with it.

The first is that even if most agree on the strong correlation between earnings and stock returns, very few like to think about the long term and instead prefer to only think about the short term. In the short term, stock returns are driven by equity flows and there is nothing that we can do about it even if it has been statistically proven that long term returns are perfectly correlated to underlying earnings and the greatest investors, like Ray Dalio and Warren Buffett, keep reminding us of this fact.

The last jobs report showed non-farm payrolls increase by 235,000, the unemployment rate fell to 4.7%, and wages increased 2.8% on a yearly basis. Higher wages mean more disposable income which means more investments, while more jobs mean that more people will be investing. This will increase the flow of funds towards stocks and increase stock prices.


Figure 1: Net domestic equity and ETF flows are overwhelming (in millions $). Source: Investment Company Institute.

In the last two years, equity flows have been extremely positive and directed towards ETFs and domestic equities. The thin green line in the chart above represents the funds directed to global equities, which are still positive but minimal in comparison to domestic flows.

Now, investing logic would say that the difference between domestic and global fund flows is because global markets are expensive while domestic markets are cheap. However the real story is a bit different.


Figure 2: International equity markets rankings by CAPE ratio, PE ratio, Price to cash flow ratio, price to book value, price to sales and dividend yield on 12/31/2016. Source: Star Capital.

The U.S. stock market is the 2nd most expensive market in the world according to the CAPE ratio, has a PE ratio close to the global average, is the 6th most expensive according to the price to cash flow ratio, is the most expensive market by price to book value, price to sales are three times higher than in China, while the dividend yield is lower only in South Korea, India, Ireland, and the Philippines. However, the majority of global equity flows continue to go to U.S. equities.

This is because:

  1. U.S. equities have done extremely well in the last 8 years, and it’s human nature to project the past into the future.
  2. Everybody is investing in S&P 500 ETFs and recommending index funds, from Buffett to Goldman Sachs.
  3. Nobody dares to go against the crowd. Hedge funds have severely underperformed in the last 5 years which exacerbated the underperformance as funds left them to go to index investing,
  4. The economy is doing well and the price paid simply doesn’t matter.
  5. The bullishness surrounding the U.S. dollar in expectation of rate hikes lifts all dollar denominated assets as there is a high demand for them.

Such careless market sentiment can hold on for longer periods, but the longer it goes, the more dangerous it becomes because it isn’t based on sustainable fundamentals.

I could probably write a thousand reasons why the market is overvalued, from analyzing the credit economy and historical valuation to the current increases in wages and interest rates that will put pressure on margins, but all the fundamentals don’t matter as long as people keep mindlessly investing in the S&P 500 and index funds.

There are two main points to be taken out this. The first is that we are in a bubble because the fundamentals don’t justify the valuations and the growth in the stock market. The second is that such an environment is extremely dangerous because people don’t understand what they are getting into. In a bubbly market, it all boils down to behavioral finance as fundamentals have long been forgotten.

What Is The Crowd Thinking Now?

Just ask yourself, how does the Average Joe approach investments at this point in time?

After selling sometime in 2008 or in the beginning of 2009, and losing a lot, the Average Joe has been slowly reentering the market. He is still in negative territory, but as treasury yields and bank deposits have been extremely low, the 2% dividend yield and the constant appreciation of the S&P 500 have been enough to convince him to invest a significant amount of funds in the stock market.

Those who weren’t a part of the 2009 carnage are fully invested as stocks are, relatively speaking, still the best investment when compared to treasuries and bank deposits. However, the average investor can’t understand the risks that his investments bring. If I were working for an investment bank, I would show this to my clients:


Figure 3: S&P 500, T Bills, and 10-year treasury performance since 2009. Source: Damodaran.

I would say that stock returns are a bit more volatile, but stocks have been the best historical investment and have returned 9.52% since 1928, while treasury bills have returned 3.42%, and 10-year treasuries have returned 4.91%. Most people would invest, I would get my commission, and the annual management fee. Investors would go on to their hobbies and their work which probably isn’t related to finance, and I wouldn’t hear from them until they see a headline like the one below.


Figure 4: New York Times headline from 2008. Source: The New York Times.

Will we see such a headline again? Yes, because the same greedy behavioral forces that are driving investors into U.S. equities will make them panic and sell as greed turns into fear. When this happens, the market will quickly turn from overvalued to undervalued and the brave will start investing again. The same pattern happened in the 2000 – 2002 period when the dotcom bubble burst, as well as in 2009. A fund salesman wouldn’t be able to make a living if he went around showing the chart below as an indication of risk.


Figure 5: S&P 500 since 1977. Source: Google.

Nobody would invest if they knew that every 10 years, a crash of 50% occurs. It will happen again, and relatively soon because the market is detached from fundamentals. This disconnect between the average investors’ perception of risk is what makes the market go higher, creates a bubble, and leads to pain when the trend eventually reverses like it always does when it isn’t the fundamentals that are leading the way.

Conclusion

Listening to stories of how much money average investors lost in 2001 and 2008 makes me sad because investing quickly turns from an interesting game where you can make nice returns to shattered dreams, if not lives. People count on their money for early retirement, their children’s university tuition, or to pay off their mortgage. A market crash destroys these hopes and makes many lives miserable.

Another sad fact is that few make real money on the stock market as buying high and selling low is the norm. Those who make money are consistent in what they do, be it investing fixed amounts over time, reinvesting dividends, or really specializing and learning about both the quantitative and behavioral characteristics of the investment world.

I’ll conclude with what I do. I like to own businesses and the more I own of a great business, the happier I am. I can own more of great businesses if stock prices are cheap. Thankfully, as you can see from figure 2 above, there are lots of markets where businesses are still cheap. Tomorrow we’ll discuss what can be earned by sifting around emerging and other cheaper markets.

What To Do: The Essentials I’ll Never Get Tired Of Repeating:

  • Own businesses, not stocks.
  • Have a worst-case market scenario plan prepared. What would you do and can you afford a 50% drop in the S&P 500?
  • Align your portfolio with your investment goals. Don’t bet on something and risk too much of your life savings.
  • Reverse engineer your strategy for the next 10, 20, and 30 years. See if you like it, and if you do, stick to it no matter what. Selling in a panic and buying in euphoria are the worst things you can do, period.