America’s preeminent high-altitude mountaineer, Ed Viesturs, knows all about risk. He is the only American (and 12th person overall) to have successfully climbed all of the world’s 14 mountains over 8,000 meters, and only the sixth person to do so without the aid of an oxygen tank (which he feels can be burdensome). Over a 23-year span, Viesturs went on 29 Himalayan expeditions and summited mountain peaks of over 8,000 meters on 21 occasions. He stood atop Everest seven times, with his first successful ascent of the mountain in 1990 and his last in 2009. (…)
What makes his track record so remarkable is his generally conservative nature with respect to risk in the mountains. He never lost a team member on a climb, and no one was ever seriously injured, which is an astounding feat. (…)
In 1987, on his first Everest attempt, Viesturs backed off just 300 feet below the summit because the conditions were not right. It was this steadfast commitment
to safety that allowed him to climb mountains with such great success. As he says, “Getting to the top is optional. Getting down is mandatory.”
Viesturs believes most accidents and deaths on the high peaks are due to human error, with ambition and desire overpowering common sense. What some people
call “summit fever,” he calls “groupthink,” which is when a majority of the group, desperate to reach the top, disregards dangerous weather, route conditions, or other important factors. The least experienced climber tags along thinking if everyone else is going, then it should be just fine.
According to Viesturs, “It’s almost a lemming-type effect. People get swept up in it, it’s that psychological feeling of safety.” No one gives any thought to the acceptable level of risk.
Quoting from a 2010 interview Viesturs gave to Slate magazine titled “Into Thin Error”, recounting a 1992 expedition to K2 in Pakistan:
About halfway into the day, the clouds below us slowly engulfed us, and it started to snow pretty heavily. I always contemplate going down even as I’m going up, and I was thinking, “You know what? Six, seven, eight, nine hours from now, when we’re going down, there’s going to be a tremendous amount of new snow, and the avalanche conditions could be huge.”
I talked to my partners and they were like, “What do you mean? This is fine.” So I was kind of alone in my quandary. I knew I was making a mistake; I knew I should just simply go down… I kept saying, “Well, let me go on for another 15 minutes and then I’ll decide.” And then after 15 minutes I’d say, “Let me go on another 15 minutes and then I’ll decide.” And I just couldn’t make a decision, and I put it off so long that I got to the top.
Even though we succeeded, I don’t ever want to do that again. We just got really, really lucky. There were moments I was convinced we weren’t going to make it down, when I said [to myself], “Ed, you’ve made the last and most stupid mistake of your life.” When we got to camp, I was just so angry with myself….
… It doesn’t matter how long you’ve been there, how much money you’ve spent, how much energy you’ve expended. If the situation isn’t good, go down. The
mountain’s always going to be there. You can always go back.
Since 2009, we have climbed several mountains in the investment world and it is fair to say that in both the fixed income and the equity markets, we are pretty close to an eventual summit. As we get higher and higher, the fog gets thicker, making the tops difficult to see clearly. But being into thin air, we know we are getting close.
Mian quotes again from Viesturs’ book:
When I am climbing, I listen to the mountain. All the information is there, which helps me decide what to do. Arrogance and hubris need to be put aside, and humility and thoughtfulness are essential. I truly believe that is how I survived so many expeditions into a dangerous arena.
What information is there for us these days?
- The U.S. domestic economy has slowed from already low growth rates in spite of very low interest rates, much reduced oil prices, rising real wages and a strong stock market.
- U.S. exports are suffering from a strong dollar and generally slow global economies.
- Profits have stalled under weak revenue growth and lower margins.
- Inflation remains below the Fed’s target. In fact, all central banks in the world are aiming at higher inflation.
- The Fed has stopped injecting liquidity into the economy and is prepared and willing to raise interest rates.
American sherpas, headed by Janet Yellen, are now warning us all about potential dangers ahead, a radical change from their strong push toward aggressive risk taking since 2009. They are already rationing oxygen and threaten to take it completely out pretty soon if we keep climbing up.
European sherpas are providing ample oxygen to their climbers but they are just getting started from base camp. They are on a very slow, difficult walk up, aggravated by complex group dynamics and some handicapped climbers.
Chinese sherpas are at the crossroad between a dangerous shortcut or a long and winding road to the summit. They are likely to go the slower way unless their large crowd of climbers gets too restless.
That said, many investors remain optimistic, even while being accused of succumbing to “summit fever,” or “groupthink”.
In fact, after exposing Viesturs’ risk management philosophy, Jawad Mian pits himself in the keep climbing group. From his apparent vantage point, the outlook appears very beautiful to him:
Now, the global macro stage is beautifully set.
The US household debt-to-income ratio is back to its 2002 level, and the decline in interest rates has brought down the cost of servicing this debt to affordable levels. Credit growth has revived, and business confidence has healed, which should now bring about a resumption in capital spending.
With the unemployment rate at 5.4%, labor markets are strong enough to boost wage inflation. (…) Job and income gains have encouraged housing demand to return. (…)
Strong momentum in the labor market, ongoing recovery in the housing market, and the sharp decline in energy prices should combine to generate robust consumer-led growth. (…)
Mian’s unbridled optimism spans across the world. Europe is turning around thanks to the ECB and faster credit growth from recapitalized banks. Japan has entered a “virtuous cycle of positive change and rising asset prices” and the weaker yen has given the country its most competitive position in 40 years.
The roaring bull market in Chinese stocks on record volume and breadth implies that the Chinese economy is not as bad as the pervasive gloom suggests and might indeed surprise positively in the year ahead. A stock market rise of such scale is certain to have powerful effects on the real economy. This will likely lend support to Asian and emerging economies more generally as well.
Even commodities have firmed up in the last month, particularly industrial metals, which may indicate that the Chinese economy is stabilizing, at the very least. Real
interest rates in China are among the highest in the world, so there is significant scope to ease its monetary policy stance.
This year promises to be the first year since the 2008 crisis where the odds are moving decisively in favor of a fortuitous synchronized global growth upcycle.
Economic prospects are slowly brightening and macro risks diminishing, rather than intensifying. From a cyclical vantage point, I believe both new information and
a changing interpretation of existing information will be beneficial for stocks, to the detriment of government bonds in general. (…)
I wouldn’t be surprised to see stocks become even more richly priced in the current cycle. Although valuations for the US stock market have risen sharply in recent years, global equity valuations are not unduly high by historical standards. If I’m right about the global growth upcycle, then valuations have room to climb much further. I see no reason why US stocks can’t trade at 20 times earnings over the next several years.
Frankly, given the slow and fragmented nature of this recovery, it is still too early in the investment cycle to worry about valuations. Historically, valuation is a poor timing tool, and valuation considerations only matter once the economic expansion looks exhausted, which is certainly not the case right now.
Considering the current low-yield environment, the US equity risk premium remains fairly generous. If we assume the fair value for the real 10-year yield to be 1% (it is currently only 0.25%), then the S&P 500 earnings yield today would need to be 5% to generate the same average equity risk premium of 4% that prevailed over the 1960 to 2007 period. As it happens, the current earnings yield for the S&P 500 is closer to 6%, which suggests US stocks still have meaningful upside.
This is a truly beautiful view: synchronized growth from all corners of the world, robust consumer-led U.S. growth, accelerating wages, rising commodity prices, controlled inflation and fairly stable interest rates. In such context, Mian sees “no reason why US stocks can’t trade at 20 times earnings over the next several years.”
I suspect Ed Viesturs would not be very keen following Mian much higher into thin air. He would quickly point out that U.S. stocks have very rarely traded at or above 20 times earnings over the past 70 years. Climbing rarely used paths can be very dangerous as history has amply demonstrated…
Viesturs might also suggest that synchronized growth, accelerating wages and rising commodity prices are expressions generally not combined with other expressions such as controlled inflation and stable interest rates. Mian would need to chose only one of these routes since Nirvana has not been attained just yet.
Viesturs might also frown at statements like
- “since 2008, the world has never looked as good as it does today”
- “Don’t let memory get in the way of such a jolly market.’
- “investors should adapt to the new reality”
- “The market is telling you something completely different”
- “valuation is a poor timing tool”
- “Although margin debt is at all-time highs, I don’t view it as a sign of concern”
- “From an Elliott Wave perspective…”
Youth is so dangerously wonderful!
From Business Week…
This is the longest period of practically uninterrupted rise in security prices in our history… The psychological illusion upon which it is based, though not essentially new, has been stronger and more widespread than has ever been the case in this country in the past. This illusion is summed up in the phrase ‘the new era.’ The phrase itself is not new. Every period of speculation rediscovers it… During every preceding period of stock speculation and subsequent collapse business conditions have been discussed in the same unrealistic fashion as in recent years. There has been the same widespread idea that in some miraculous way, endlessly elaborated but never actually defined, the fundamental conditions and requirements of progress and prosperity have changed, that old economic principles have been abrogated… that business profits are destined to grow faster and without limit, and that the expansion of credit can have no end.
…late in 1929. This was via John Hussman who adds:
“This time” is not different. There’s no question that investors have come to believe that somehow quantitative easing has durably changed the world – that central banks have (or even can) put a floor under the markets as far as the eye can see. But if you examine the persistent and aggressive easing by the Fed during the 2000-2002 and 2007-2009 plunges, it’s clear that monetary easing has little effect once investor preferences shift toward risk aversion –which we infer from the behavior of observable market internals and credit spreads. Monetary easing only provokes yield-seeking speculation when low-interest money is viewed as an inferior asset.
I will also mention that while margin debt is not a direct cause of market downturns, it certainly acts as a magnifier of the downturns as margin calls trigger more and more selling. Similarly, while high corporate debt levels have a positive effect on growth in good times, they can have a devastating impact during economic downturns. Viesturs is so right: summit fever, or “groupthink” is when a majority of the group, desperate to reach the top, disregards dangerous weather, route conditions, or other important factors. The least experienced climber tags along thinking if everyone else is going, then it should be just fine.
The reality is that deleveraging has ways to go as these charts show:
Low interest rates have driven investors towards higher risk instruments while market makers have been de-risking. When the music stops…
James Paulsen (Wells Capital Management) recently wrote an interesting article (Has Stock Market Stability Increased Vulnerability?) which received little media attention and obviously escaped Jawad Mian:
The emotional state of investors has long been recognized as central to the stock market’s overall risk-return profile. Typically, stocks do best when the investor community is something less than comfortable. A culture of anxiousness about the future tends to keep portfolio exposures low and valuations reasonable augmenting stock market prospects. Conversely, an exuberant or even comfortable investor is typically less discriminating about values, more focused on good stories rather than good fundamentals, and is often already “all in,” mentalities which simultaneously elevate risks and lower prospective returns. (…)
Lately, the U.S. stock market has trended steadily higher with remarkably low volatility. Indeed, during the last 36 months, the stock market has experienced one of its most stable advances since 1900! While this steady stock market action has improved investor sentiment, it has also probably worsened the near-term outlook for stocks. Since 1900, the median annual percent change in the U.S. stock market has been about 8% and it has suffered annual declines only about 34% of the time. However, when this measure of investor sentiment has been as high as it is today, the U.S. stock market has historically declined in the coming year more than half the time suffering a median percent decline in the next 12 months of about 1.5%.
Paulsen measured investor sentiment using the degree of stability exhibited by the stock market.
The R-squared derived from a regression of the stock market against time provides a good measure of stock market volatility and thereby a good proxy of investor sentiment. R-squared ranges between 0 and 100 and measures the portion (in percent) of the total variability of the stock market which can be explained by its trendline. (…) Essentially, stock markets that produce a high R-squared (i.e., are highly predictable) imply positive investor sentiment whereas a low R-squared connotes a stock market with bearish investor overtones.
(…) by this measure, investor sentiment is currently at one of its highest levels since 1900! There have been only 14 periods since 1900 when the R-squared has risen above 90% and today it is near an all-time high record at slightly above 97%!
For eight of the 13 signals, the stock market either immediately or fairly soon suffered a bear market (i.e., 1906, 1929, 1937, 1946, 1956, 1965, 1987, and 2007). After both the 1926 and 1998 signals, the stock market eventually suffered a correction and after both the 1952 and 1994 signals, the stock market was essentially flat and volatile during the subsequent two years. Only the caution suggested by the 2003 signal proved inappropriate. Finally, the timing of a few signals were remarkably clairvoyant (i.e., September 1929, September 1987, and December 2007).
Forecasting equity returns is a fools’ game. The smart game is to assess probabilities of rising or falling markets. While the U.S. stock market has declined 34% of the time since 1900 (on a yearly basis), Paulsen’s R-squared readings reveal that when the R-squared has been above 90%, the stock market has declined in the coming year almost 52% of the time!
Paulsen’s measure missed many other bad markets, proof that investor sentiment is not a pre-requisite to negative equity returns. The Rule of 20 valuation method has a much more consistent track record.
Interestingly, in all but 3 of the 90%+ R-square periods, the Rule of 20 also showed equities as overvalued. It correctly rated equities as very cheap in 1926 and 1952, having a rare miss in 1956. The Rule of 20 shows U.S. equities currently 5% overvalued but on their way to much more dangerous territory.
After several bounces off the “20” fair value line, U.S. equities have finally traversed into overvalued territory, generally a pre-requisite to most equity market downturns. Based on trailing 12-month EPS of $111.62 after Q1’15 and 1.8% core inflation, the S&P 500 Index is selling at a Rule of 20 P/E of 20.9 (trailing P/E of 19.1 + inflation of 1.8%), some 5% above fair value, the highest premium since September 2008.
We are walking along a crevasse high on the mountain. Given current forecasts for Q2 and Q3 earnings, trailing EPS will decline 0.7% to $110.84 after Q2 and regain 0.3% to $111.22 after Q3. The earnings tailwind will not reappear until Q4’15 earnings season next February, assuming current forecasts hold.
We thus need lower inflation to keep us close to fair value. Otherwise, we must rely on a tight grip from a Fed which is much more inclined to let us loose.
That assumes that the economic reading from Mrs. Yellen et al. is correct and that the economy accelerates along with inflation. Experienced bull David Rosenberg, very aware of the nearby valuation crevasse, goes out of his way to reassures us that Goldilocks will take care of us on the way up:
Even with the Q1 setback, real GDP growth is running just below 3% on an annual basis and core inflation is running at +1.8% YoY.
Going back to 1960, this has been the best growth-inflation backdrop for the S&P 500 – when GDP growth is 2-3% and core inflation was 1-2%, the S&P 500 tends to advance, on average, at over a 15% annual rate.
Hmmm…55 years of data might seem impressive but a quick look at the chart below reveals that 1-2% inflation periods are concentrated before 1965 and after 2009 and only account for 20% of the period.
- The S&P 500 troughed in June 1962 at 15.7x trailing EPS (Rule of 20 P/E of 17.0) and, from these cheap levels, gained 70% to December 1965 when the trailing P/E reached 18.3 and the Rule of 20 P/E ended the year at 20.
- The S&P 500 troughed at 666 in March 2009 when the trailing P/E was 14.6 and the Rule of 20 P/E was at 10.2. Equities multiplied by 3.2x since.
This is where Rosie’s 15% average growth rate comes from. Given that the current trailing P/E is 19.1x and the Rule of 20 P/E is 20.9, he must also see no reason why US stocks can’t trade at 20 times earnings over the next several years..
Then, there is the GDP growth rate Goldilocks. The U.S. economy has grown erratically to average 2.2% since 2010. Growth was within 2-3% in 7 of the last 21 quarters. Even good economists like Rosenberg can’t really forecast GDP growth 4-8 quarters ahead.
What we know, however, is that despite a tepid overall economy, the Fed has its finger on the trigger and is only waiting for a few economic signals to start raising interest rates to more normal levels. But not to worry says David Rosenberg:
(…) in the past 6 decades, the average length of time from the first tightening to the end of the business cycle is 44 months; the median is 35 months; and the lag from the initial rate hike to the end of the bull equity market is 38 months on average, 40 months for the median. (…)
This means that even if the Fed begins the eventual move off from the ZIRP this Fall, the historical record would suggest that the next downturn would not start until Q3’18 and the stock market won’t begin to price this until late the spring of that year at the earliest.
Hmmm…More averages and medians…I extensively researched this in 2014 (EQUITIES AFTER FIRST RATE HIKES: THE CHARTS SINCE 1954):
(…) It is thus shocking to see how uncooperative the S&P 500 was in 7 out of the surveyed 15 rate hike cycles (1965, 1967, 1971, 1974, 1977, 1983 and 1994).
(…) in each of 1961, 1965, 1980, 1983 and 1987, the first 25% of the tightening cycle was, in fact, the best part of the stock market cycle. Not because equities rose appreciably, but rather because of what happened during the next 75% of the cycle…
(…) in reality, there seems to be no consistent nor typical pattern after the first rate hikes.
However, digging a little more into the history book, I found that in 6 of the 8 years when the S&P 500 rose during the initial rate hike, inflation was actually diminishing or stable (2004). This did not verify in 1987, although the market eventually avenged itself and in 1999 when internet speculation blinded everybody.
Maybe we got ourselves a bit of a rule here: rate hike cycles are not damaging to equities in as much as inflation is not rising at the time. Since profits are generally still rising when the Fed takes its foot off the pedal, stable or declining inflation rates help sustain P/E ratios as demonstrated by the Rule of 20.
Let’s not forget one of the main objectives of the current Fed: get inflation above 2%. Actually, this is the goal of every major central bank in the world today. I would put my money on their eventual success.
By the way, from the April 20th NEW$ & VIEW$:
The various measures used by the Cleveland Fed suggest that core inflation is running at +0.2% per month, nearly +2.5% annualized.
In the May 19 NEW$ & VIEW$:
Curiously, this Eurostat inflation release got very little space in mainstream media this morning. Yet, it reveals that deflation has given way to inflation in 2015. Core inflation in the Euro area has sharply accelerated this year:
- January –1.8% MoM
- February +0.6%
- March +1.4%
- April +0.3%
- Last 4 months: +0.5% or +1.5% annualized (-0.9% annualized in Germany, +1.2% in France, +1.5% in Italy)
- Last 3 months: +2.3% or +9.5% annualized (+ 3.6% annualized in Germany, +7.4% in France, +15.6% in Italy)
As a result, April YoY core inflation reached +0.6% in the Euro area (+1.1% in Germany, +0.5% in France, +0.3% in Italy).
Let’s all agree that there is no recession out there. But equities can and do correct, often severely, even without a recession as this Doug Short chart illustrates:
Some drops out of thin air:
- -22% in 1966 after the Rule of 20 P/E hit 20.
- -10% in 1971 after the Rule of 20 P/E hit 24.
- -19% in 1977-78 even with a Rule of 20 P/E around 15.
- -9% in 1984 even with a Rule of 20 P/E around 15.
- -34% in 1987 after the Rule of 20 P/E hit 23.
- -16% in 1998 after the Rule of 20 P/E hit 27.
- -22% in 2011 after the Rule of 20 P/E hit 19.2.
When valuations are high, investors are generally on their toes looking for reasons to sell and lock profits in. Reasons for corrections can be very diverse, often unpredictable and self-feeding, especially when margin debt is high. However, rising inflation, what our central bankers are shooting for, is generally not equity friendly as we saw in 1977-78 and in 1984.
John Hussman now receives little media and investor attention after crying wolf throughout this bull market. Among the chorus of bulls out there, it is important to keep listening to the smart, hard working bears:
The last week of December, the NYSE registered 478 new highs and 72 new lows. Last week [May 11-15], with the S&P 500 registering a marginal record high, the NYSE registered only 198 new highs, with 118 new lows. Since December, in weeks when the S&P 500 has declined, NYSE trading volume has increased from the prior week by an average of 351 million shares. In weeks that the S&P 500 has advanced, NYSE trading volume has contracted by an average of 565 million shares. On broad indices, the general pattern resembles a narrowing wedge with a relatively flat overhead resistance area and increasingly shallow dips. What we observe here is a market that continues to struggle internally and shows persistent signs of distribution, but is still keeping its best foot forward, for now.
Valuation may be a poor timing tool, among all other tools. But valuation is the best tool to navigate in high altitude and avoid summit fever, “group think”, which is currently as prevalent as it was back in 2009.
Viesturs motto has always been that climbing has to be a round trip. All of his planning and focus during his climbs maintains this ethic and he is not shy about turning back from a climb if conditions are too severe. His story is about risk management as well as being patient enough for conditions to allow an ascent. Ultimately, in his words, “The mountain decides whether you climb or not. The art of mountaineering is knowing when to go, when to stay, and when to retreat.”
The goal is not to sell right at the top, rather to objectively listen to the mountain and safely descend when danger is near so we can climb again when conditions improve.