Look at this:
The S&P 500 is back at where it was in OCTOBER 2019.
Can it really be the outlook now is just as incredible as it was then?
Because truly, things were priced for perfection even toward the start of last year, before US markets gained 30% in a record melt-up year.
I mean heck, I was writing about bubbles and crashes before coronavirus, so what the hell are markets doing back at these levels now that we have been laid low so fiercely?
The price-to-forecast earnings ratio, an age-old measure of value, is higher now than before the pandemic, because earnings forecasts have fallen further and faster than stock prices.
The severity of the crash must not be forgotten, because within it lies the same drivers which are pushing this bounce further than it should go. A number of factors were at extreme levels, and so the crash and bounce have been extreme too. We are in a period of exaggeration now.
High valuations, high levels of debt, and risk parity funds.
High valuations combined with almost unprecedented low volatility in 2019 meant that many stocks were priced for perfection, and investors were becoming complacent and forgetting what volatility in prices and losses look and feel like. Confidence breeds complacency, and complacency in investing will lead to panic, when the time comes. How can this be?!
High levels of debt make businesses naturally more risky, because even with low interest rates, the more debt you have, the higher your annual interest rate payments on that debt (cutting into shareholders’ profits) and the likelier a default in a crisis situation such as the one we have now.
Finally, risk parity funds.
A diversified stock-bond portfolio, of which there are trillions of dollars’ worth the world over, believes that stocks and bonds are anti-correlated; that is to say, if stocks go down, bonds go up.
However, many of them base their “risk appetite” on volatility in the markets. When volatility goes up in the markets, they have to reduce “riskier” equities.
However, because there are so many of these things, all operating on similar assumptions, when volatility spiked, they all had to start selling as things kicked off. They acted as a turbo-booster for the fears about valuations and debt.
They work in reverse too, and as volatility subsided in the last six weeks, they’ll have been buying back into equities, fuelling the rally too.
But don’t be fooled. They are accentuating these moves, and many people have bought into the idea that the worst is behind us.
However, valuations are now even higher, especially relative to sales or earnings which are struggling. So that problem is worse. And central banks the world over have tripled down on their original idea from back in 2000 – curing market crashes with low interest rates and easy availability of debt.
So, in the tech bust, and the global financial crisis, corporates came out with more debt on easier terms.
This is now the third iteration of that policy response, and so instead of cutting down on their dangerous levels of debt (most of which was spent on buybacks in the last decade anyway), corporates are coming out of the corona-crisis with lower sales, higher valuations and more debt.
Maybe I am wrong, maybe central banks have eased conditions enough that stocks will be okay. I don’t mean to say I am right about this. But I would like to say that the odds of making money from here are much lower than they were six weeks ago, or six years ago, when prices were much lower.
It’s good to think about your odds of success. I would say I was quite early in terms of saying you could start looking for opportunities as things went down in early March.
That’s because, whatever the outlook, your odds of making money improve if markets are at 2,600… 2,400… or 2,200. One must become more bearish the more things go up, never down, remember that.
Why? Take a look at this chart below, of S&P performances after a 25% crash from history:
Source: Man Group
It shows that from the point at which markets have fallen 25%, history tells us that precisely half of the equivalent crashes from the last century have made money. Evens is decent odds, especially if you are selective.
However, when this chart was made over a week ago, your chances had already dropped to 2/8, according to historical precedent.
And now, the S&P is up another 5% or 6%, so your chances dim yet further.
Either way, and I may have mentioned this before so I’m sorry if so, but it’s a good one. In the last 15 crashes of 20% or more, how many have re-tested their initial lows? Fourteen. Black Monday 1987 is the only exception, I believe.
Man Group provided another excellent chart below:
Source: Man Group
And how can we expect things to get better so quickly? Not only is this the most economically damaging event in recent history, but it’s also damaging the weakest economies that there have been.
Just look at this:
Source: Charlie Bilello, on Twitter
You can just about make out that this last economic expansion that just ended was both the longest and the weakest. The economic hit of coronavirus is also significantly bigger than any previous contraction, on an annualised basis.
So, we really must tread carefully.
I do realise that central banks and governments have responded in enormous force to this crisis – see the below image showing the size of bailouts (QE) vs G7 countries’ debt-to-GDP ratios. The implication is that this will be going way up.
That level of monetary and fiscal stimulus could well sponsor a historic boom in economic terms over the next cycle, in the 2020s.
And you know, I was saying this kind of thing before (valuations, debt, etc)… and for the last decade, those optimists who said that central bank stimulus mattered more… well, they were right and I was wrong, and they might have made more money than me.
Luckily, I’ve only been around, in an investment sense, for a few years, but the psychological toll on realists and those who objected to the excesses of the last bull run has, I imagine, been rather severe.
I mean to point out that I do recognise the arguments that exist in the short and long term against what I say. Another reason for balance, whichever way you think things are going (ie, I’m not totally bearish, despite what I’m saying here).
And if you’d rather believe those, perhaps because they’ve served you well in the past, fine, I understand and that’s fair enough.
I just want to urge you not to be overly confident in that view. To take some time to consider the alternative.
As I see it, we have all been given an incredible second bite at the selling cherry. We didn’t want to in January, because there was nothing on the horizon to say that we were due a crash. But now…
We’re not quite at the price levels of January, but oh boy is there a mega swan (black swan doesn’t apply here) flapping its giant grey wings right in our faces.
In a note earlier this week to Southbank Investment Research subscribers, I pointed out this quirk of human nature:
Like many of you I imagine, I have been filling my time by doing more running – myself on the streets of South London where I live.
Yesterday, I had an epiphany on one of these runs.
It’s something I’ve noticed a lot, but yesterday it really crystallised in my mind as an analogy to human nature and investment.
As you run along, you see couples walking side by side. As one oncoming runner approaches, they sidle over to the side and into single file, out of an unusual combination of politeness and terror.
Thirty yards ahead of me, this happened with a couple facing away from me. As soon as the oncoming runner had passed, they reverted to the centre ground and they wouldn’t have been out of place in the queue for Noah’s Ark.
I thought, as I stumbled into the road to get around them, that it was curious that people will make no connection between the oncoming runner and the possibility of runners coming from behind.
If single file and keeping to the side are the sensible option for avoiding people, why only do it when you have a visible threat?
It’s embedded in human nature, isn’t it? We are perfectly happy to deal with the threats we can see, but not particularly good at preparing when we can’t see something going wrong.
It describes investors perfectly. Our number one weakness is not selling when the coast is clear, and not buying when everything looks terrible.
Now, there is a threat we can see, and prices haven’t really fallen that far. Rarely are investors given such an opportunity, I would say.
Selling is so difficult though. Especially when things are going well. It’s a psychological battle more than anything else, even if you truly buy into the negative outlook that I am painting today.
If you are happier as a buyer than a seller, and you do have some cash sitting in the corner, then there are options for you. Whether it’s taking refuge in long-term trends like those we’ve been speaking about in the Beyond Oil Summit this week, or buying more into gold, silver, precious metal miners and such, 100% cash doesn’t need to be the answer.
For example, my pal Nick Hubble’s investment advice service is tailor-made for the current situation – I genuinely can’t think of a better time to check it out. He’s our chief investment strategist here at Southbank Investment Research, and he focuses on protection of wealth and assets that do well in a crisis. Need I say more??
To finish, I’d like to borrow the point Nassim Taleb made about government’s responsibilities regarding coronavirus back on 26 January (!!), as it applies to investors too, in my mind:
You can be paranoid and wrong a thousand times and you will survive. But you only need to be overconfident and wrong once, and you are toast.
Stay safe out there everyone,
Editor, UK Uncensored
PS I wanted to write to you today about Tesla, Elon Musk and why I’m so conflicted about the whole thing (love e-mobility transition, hate shouty nasty unpleasant blokes) but I ran out of space and your time. It’ll have to be next week or the one after.
There’s actually so much more I want to write about at the moment.
The world’s just a really fascinating place right now. Exciting times ahead.
And in the meantime, forget the bank rush, the Greggs Rush is apparently the major threat of the day… bbc.co.uk/news/business-52500880