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Leithner Letter – Are You Listening?

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Chris Leithner Letter No. 200-204: 26 July-26 October 2016; Markets Are Greatly Overvalued: Are You Listening?

… But perhaps the greatest casualty of the announcement [earlier in March 2016, when it reduced the four expected 2016 quarter-point hikes, suggested back in December, to just two] was the Fed’s own credibility, which is now being stretched to the limit. At [Chairman Janet] Yellen’s press conference last Wednesday, CNBC reporter Steve Liesman, who has perhaps been one of the most reliable supporters of the Fed’s policies, seemed to indicate that even he had grown weary of the Fed’s prevarications, saying to Chairman Yellen: “Does the Fed have a credibility problem in the sense that it says it will do one thing under certain conditions, but doesn’t end up doing it? And … if the current conditions are not sufficient for the Fed to raise rates, … what would those conditions ever look like?”
Yellen’s response … boiled down to … “Steve, why have you taken our prior forecasts at face value? We never actually offered firm commitments on anything. Nor did we specifically endorse the things that we seemed to have said. And just so you know, you should expect that the things we are saying now will ‘fully evolve’ over time as well.” Or in plain English: “Steve, don’t you know by now that we have no idea what we are talking about, that our forecasts are just guesses, and since we normally guess wrong, why should you expect greater accuracy now? If anything, it should be obvious that our guesses are biased in favor of stronger growth, as the intention is for those rosy forecasts to positively influence sentiment, thereby helping to obscure the problems that, for political reasons, we are hesitant to acknowledge”.
… The growing chasm between what the Fed says it is going to do and what it is actually doing is getting increasingly hard for the mainstream to swallow. When it stops going down at all, a market shift of considerable proportions could begin in earnest.
Peter Schiff
Two Down – Two to Go
[drizzle](24 March 2016)

Credible Nobel Laureates and the World’s Greatest Investor Reckon Markets Are Greatly Overvalued: Are You Listening?

A year ago, in the wakes of ructions in China, Greece and elsewhere, Australian investors and speculators asked themselves: “are stocks attractively cheap, reasonably priced or unduly dear? Are prospective returns good, fair or poor?” As they virtually always do, “experts” advised that all was well and that the crowd should buy. “Four Reasons Why It’s Time to Buy Shares Now” (The Australian Financial Review, 15 May 2015) typified their mantra:

Savvy investors should start buying up shares, according to Deutsche Bank and AMP Capital, with the recent dip in the market [during April-June the ASX/S&P 200 Index fell from almost 6,000 to 5,400] presenting some good buying opportunities. … The four reasons [to buy shares] are: the dip [during April-June] was due; valuations are reasonable; earnings momentum looks OK; and the current lack of investor sentiment is actually positively correlated to market performance. … Deutsche added that its [one-year prospective] price-earnings ratio model suggested that fair value was a PE ratio of 15.7. The current market [has] a ratio of 16 [see also Figure 5]. “Valuations have dropped to reasonable levels,” said Deutsche. “[They are] justified given record low interest rates.

AMP Capital’s Shane Oliver, whom the article cited, was equally upbeat:

Recent volatility represents just another correction. We remain of the view that we are still a long way from the peak of the investment cycle. Most threats look to be manageable at this stage, and unlikely to threaten the broader cyclical bull market in shares. … [We] see recent moves as healthy and as setting up investment opportunities.

The mainstream’s ebullience about the present and complacency regarding the future continued into the 2015-2016 financial year. According to “Bulls, Bears Predict Market Extremes, Most Reckon 6,000” (The Australian Financial Review, 1 July 2015), for example,

There’s a wide spread of predictions for how the Australian share market – currently around 5,450 – will perform over the next year, with the bulls saying 6,500 and the bears 5,750. But most are playing it safe and saying 6,000 or thereabouts (see also “Second-Half Rebound Tipped for Equities,” The Australian, 6 July 2015).

Got that? In July of last year, NO “expert” polled by the AFR prophesied that the ASX might decrease during the 2015-2016 financial year – and certainly nobody foresaw that the S&P/ASX 200 index would, albeit briefly, plunge below 4,900. Instead, without exception everybody expected that it would rise (Table 1). The most optimistic seer – Credit Suisse – predicted that during the six months to 31 December 2015 it’d zoom 19%; the least optimistic, RBS Morgans, reckoned it’d lift 4%; and the average (“safe”) prediction was an increase of 10%. During the year to 30 June 2016, the average prediction was a lift of 12%.

Figure 1 plots these alleged experts’ average (“consensus”) forecasts against the actual course of the S&P/ASX 200 index during the year to 1 June 2016. It’s hardly a surprise that they haven’t been unable to predict with any reasonable degree of accuracy (see Letter 196-197); equally predictably, their forecasts have been overly optimistic (see Letter 198-199). The professionals reckoned, on average, that during the six months to 31 December 2015 the index would rise to 6,019; in fact, it fell to 5,415. And in the six months to 30 June, they predicted that it would rise further (albeit marginally) to 6,100; instead, early it 2016 it plunged below 4,900 before partly recovering to 5,400.

Overvalued Markets

In sharp contrast, during the past year Leithner & Co.’s communications to its shareholders have been cautious. Its scepticism wouldn’t have impressed the ex-Treasurer (see Doubters Are Clowns, Says Hockey, The Australian, 4 June 2015 and “Talk of Recession Irrational: Hockey,” The Weekend Australian, 5-6 September 2015).1 No matter; its directors have long been reprobates. As it’s been since the Company’s inception in 1999, our concern remains today: the overall level of major market indices such as the S&P 500, which is at or near all-time records, is very – and perhaps dangerously – elevated. So, by implication, is the ASX/S&P 200. If, a year ago, they had chosen to open their eyes and use their brains, “experts” might have discerned these risks (see, for example, “Stock Index Loaded with Risks,” The Australian Financial Review, 27 May 2015). Alas, it’s in their interest – but not in yours – virtually always to remain thoughtlessly optimistic. There were and are, of course, some exceptions to this rule. Alan Kohler, the avuncular face of ABC1’s nightly finance report, for example, wasn’t blind. “It’s clear,” he belatedly confessed to Business Spectator on 30 August 2015, “that the Australian economy of the first decade and a bit of this century was built on a [consumption, interest rate and real estate] bubble.”

Today’s prices and tomorrow’s returns are inversely related; moreover, returns have always – eventually – regressed to their historical means. “Eventually,” however, can take a long time to arrive: indeed, and as we’ll see below, since the mid-1990s stocks have generally been unduly dear; moreover, in an effort to curry the crowd’s favour, experts have spread spurious and even risible ideas that “justify” stocks’ high prices. What, then, to do? Be alert for extremes in markets – very undervalued or overvalued. When you possess a roughly valid and reliable means to detect such extremes, you avoid the problem that arises when, figuratively speaking, you stumble around in the dark over chairs and night stands. Given these means, you can begin to visualise in the dark – which is where investors must necessarily tread. Almost 20 years ago James Grant said: “The future is always unlit. But with a body of theory, you can anticipate where the structures might lie. It allows you to step out of the way every once in a while.” The three measures that I detail below are all (to use another analogy) flashing amber – and perhaps red – warning lights; all indicate that stocks are significantly and perhaps greatly overvalued. Further, they possess the ability – at least roughly – to foretell poor long-term returns. Price is what you pay today; value is what you get tomorrow. Today’s high valuations thus portend – for those who don’t prepare themselves – poor returns and perhaps hefty losses in the future.

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