A Post-Volatility World?

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“The uncertainties are unusual in terms of number, scale and insolubility in areas including secular economic growth; the impact of central banks; interest rates and inflation; political dysfunction; geopolitical trouble spots; and the long-term impact of technology.”

“In the vast majority of asset classes, prospective returns are just about the lowest they’ve ever been.”

“Asset prices are high across the board.  Almost nothing can be bought below its intrinsic value, and there are few bargains. In general the best we can do is look for things that are less over-priced than others.”

“Pro-risk behavior is commonplace, as the majority of investors embrace increased risk as the route to the returns they want or need.”

– Howard Marks, Oaktree Capital Management, “There They Go Again…Again”

Howard Marks’ “Memos” are a must-read.  Years ago, I was invested in Marks’ hedge fund.  We exited our fund of funds business in 2007, though it would have served me well to have stayed in his fund.  Like most great investment managers, he keeps risk front of mind.

Today we all have access to great information.  Type and click.  Ray Dalio, Stanley Druckenmiller, David Tepper, Ken Griffin, David Shaw, Seth Klarman, Paul Singer and Howard Marks to name just a few.  I’m not sure about you, but I want to know what’s on their minds.

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The quotes above summarize what Marks feels are “the four most noteworthy components of current conditions.”

Do valuations matter?  Can they tell us about future returns?  Yes and Yes.  As we do at the beginning of each month, let’s take a look at valuations today and see what they tell us about coming 7-year and 10-year annualized returns.

Art Cashin appeared on CNBC this week and his comments on market cycles and the tendency for challenges in years that end in the number 7 caught my attention.

  • Art cautioned not to get overly excited and said that August is the second worst performing month of the year with September being the worst.
  • He said that years ending in the number 7 (1987, 1997, 2007) have seen the market peak in the first three weeks in August.
  • Serendipitously, I had just finished reviewing an interesting chart from Ned Davis Research (NDR). The chart suggests August 2.

Here is how to read the chart:

  • The blue line is the combined composite line of the one-year seasonal cycle, the four-year presidential cycle and the 10-year decennial cycle. It is based on daily data from 1-2-1900 to 12-31-2016.
  • It looks at what happened to the DJIA in years past and makes a forecast for the current year. Note, this chart was published last year.
  • The red dotted line is the actual DJIA composite January 1, 2017 through July 26, 2017.
  • The trend direction is more important than the level. But interesting how closely the year has tracked.

Bottom line:  Expect a challenging next few months (August through October).


Art concluded his interview saying that over five decades of experience has taught him to always know where the exit door is.  You can find Art’s four-minute interview here.

But the trend remains positive and as you’ll see in the Trade Signals link below, the Don’t Fight the Tape (trend) or the Fed indicator sits at its strongest reading at +2.  The market has historically performed best when the reading is +2.

With that said, what can you do?  For now, the equity market trend indicators remain bullish and there is little sign of recession over the next six months.  But valuations are rich and as Howard Marks shared, there are a number of risks that should stay front of mind.  My two cents: Have a plan to both participate in gains and protect against significant loss.  More defense than offense.  Put stops in place.

You will find today’s read to be short or long depending upon whether you click to Howard Marks’ full piece, “There They Go Again… Again.”  I do hope you find the information helpful.

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Included in this week’s On My Radar:

  • Valuations and What They Tell Us About Coming 7-year and 10-year Returns
  • “There They Go Again… Again” by Howard Marks
  • “Markets in a Post-Volatility World” by Artie Grizzle, CFA and Charles Culver
  • Trade Signals — A Strong +2: Don’t Fight the Trend or the Fed
  • Personal Note – Great Stream Lake, Maine

Valuations and What They Tell Us about Coming 7-year and 10-year Returns

U.S. equities – I’m borrowing from Howard Marks’ memo because I think he sums it up well:

The good news is that the U.S. economy is the envy of the world, with the highest growth rate among developed nations and a slowdown unlikely in the near term.  The bad news is that this status generates demand for U.S. equities that has raised their prices to lofty levels.

  • The S&P 500 is selling at 25 times trailing-twelve-month earnings, compared to a long-term median of 15.
  • The Shiller Cyclically Adjusted P/E Ratio stands at almost 30 versus a historic median of 16.  This multiple was exceeded only in 1929 and 2000 – both clearly bubbles.
  • While the “P” in P/E ratios is high today, the “E” has probably been inflated by cost cutting, stock buybacks, and merger and acquisition activity.  Thus today’s reported valuations, while high, may actually be understated relative to underlying profits.
  • The “Buffett Yardstick” – total U.S. stock market capitalization as a percentage of GDP – is immune to company-level accounting issues (although it isn’t perfect either).  It hit a new all-time high last month of around 145, as opposed to a 1970-95 norm of about 60 and a 1995-2017 median of about 100.
  • Finally, it can be argued that even the normal historic valuations aren’t merited, since economic growth may be slower in the coming years than it was in the post-World War II period when those norms were established.
  • The thing that is clearest is that the low Fed-mandated short-term interest rates make high valuations seem reasonable.  When yields are low on fixed income instruments, low earnings yields on equities (that is, low e/p ratios, which equate to high P/E ratios) seem justified.  As Buffett said in February, “Measured against interest rates, stocks actually are on the cheap side compared to historic valuations.”
  • But he went on to say, “. . . the risk always is that interest rates go up a lot, and that brings stocks down.”  Are you happy counting on continued low interest rates for your investment security, especially at a time when the Fed has embarked upon a series of rate increases?  And if interest rates do remain low for several more years, isn’t it likely to be as a result of a lack of vigor in the economy, which would likely cause earnings growth to be sluggish?

OK, that is a good intro to the next several charts.

The first is my favorite valuation measure: Median P/E (I like it because I have access to great data the shows what 10-year returns have historically been based on current conditions or, in this case, current median P/E).

Here is how to read the chart:

  • If you listed the entire P/Es for all of the S&P 500 stocks on a spreadsheet from highest to lowest, median is the P/E in the middle. I like using it because it removes a lot of one-time corporate reporting issues and gives a simple baseline for valuation purposes.  Just think of it as a useful data point.
  • The red line shows us how median P/E rises and falls over time. I like how NDR zones the P/Es into categories: Very Overvalued, Overvalued, Undervalued, Bargains.
  • The current P/E of 24 compares to a historic average of 17 (see the green dotted line – NDR calls it “Fair Value”).
  • I also like how NDR plots the percentage return to Fair Value.
  • It will take a 29.2% loss to get to Fair Value. With the S&P 500 making new highs (currently at 2470), Fair Value is approximately 1750.


Here is Buffett’s reported favorite: Total Stock Market Cap to GDP

Here’s how to read the chart:

  • The red line is the S&P 500 companies’ total market capitalization (take each company’s total shares outstanding times their current price and them sum up the value of all of the companies in the index).
  • The total current value of the S&P 500 companies is $21.15 trillion.
  • The total U.S. Gross Domestic Product (what we produce as a nation) is $19.23 trillion.
  • The value of the S&P 500 companies is 110% above nominal U.S. GDP.
  • The blue line looks at NDR’s estimate of 3,900 companies and compares it to GDP. The 3,900 companies are worth $27 trillion, which is 140.5% more than $19.3 trillion.

Bottom line:

  • Look at the blue line and see how it rises and falls over time.
  • We sit at the second most overvalued time in history, which is higher than 2007 and second only to 2000.
  • A better opportunity will present when the blue line drops from 140.5% towards its long-term regression line (dotted black line in chart) or 98.6%. That may be a level to shift from “play more defense” back to “play more offense.”


Here is GMO’s 7-year Annualized forecast:

  • -3.9% annualized real returns per year in the coming 7 years.
  • Low returns in all asset classes across the board.


Here is what median P/E tells us about coming 10-year returns:

Sorted by quintile:


Ok, you get the point.  When hamburger prices are low, you get much more for your money.  When prices are high, your money just doesn’t buy as much.  It’s the same with the stock market.  Today the hamburgers are expensive.

“There They Go Again… Again,” by Howard Marks

The point I’m trying to make in this next section is that investor amnesia seems to have come back.  We are in a state of excitement and complacency not unlike 1999 and 2007.

Marks transports us back in time via his writing.  When your clients are calling you with excitement about the market yet concerned their diversified portfolio does not match “the market,” show them this newsletter.  Point your client to Marks’ piece.

His post is long and well worth your time but to give you a quick feel, following are a few excerpts from his letter and his conclusion:


In January 2013, I wrote a memo entitled “Ditto.”  Its thrust was that (a) history tends to repeat, (b) thus my memos often return to the same topics and (c) if I’ve handled them well in the past, rather than re-invent the wheel, I might as well borrow from what I’ve written before.  Ergo, “ditto.”

Few topics are more susceptible to this treatment than the process through which (a) investment fundamentals fluctuate cyclically, (b) investors overreact to the fluctuations, (c) the level of risk aversion incorporated in investor behavior fluctuates between excessive and inadequate and thus (d) market conditions swing from depressed to elevated and treacherous.  Here’s how I summed up this topic in “There They Go Again” (May 2005):

Given today’s paucity of prospective return at the low-risk end of the spectrum and the solutions being ballyhooed at the high-risk end, many investors are moving capital to riskier (or at least less traditional) investments.  But (a) they’re making those riskier investments just when the prospective returns on those investments are the lowest they’ve ever been, (b) they’re accepting return increments for stepping up in risk that are as slim as they’ve ever been and (c) they’re signing up today for things they turned down (or did less of) in the past, when the prospective returns were much higher.  This may be exactly the wrong time to add to risk in pursuit of more return.  You want to take risk when others are fleeing from it, not when they’re competing with you to do so.

Do you see any differences between then and now?  Is there any need to redo this description?  Not for me; I think “ditto” will suffice.  I’ll simply go on to borrow the conclusion from “The Race to the Bottom” (February 2007):

Marks concludes:

Today’s financial market conditions are easily summed up:  There’s a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere.  Thus, as the price for accessing returns that are potentially adequate (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures. 

The current cycle isn’t unusual in its form, only its extent.  There’s little mystery about the ultimate outcome, in my opinion, but at this point in the cycle it’s the optimists who look best.

SB here: I’m all for optimism, but our opportunity will present after the next dislocation.  Let’s get to that opportunity in a healthy way.  And importantly, be mentally prepared to buy when panic is all around us.

“Markets in a Post-Volatility World” by Artie Grizzle, CFA and Charles Culver, Martello Investments

Selected bullet points from the piece:

  • Market Volatility: Global equity markets, and especially the US stock market, have shown remarkable resilience despite elevated valuations and an onslaught of negative news.
  • The last few months have seen increased dysfunction in Washington, rising geopolitical tension particularly saber-rattling from North Korea and increased terrorism in Europe, weak economic growth, and the prospect of the Fed unwinding nearly a decade of stimulative monetary policy.
  • Nevertheless, market volatility sits near historic lows on both an implied and realized basis.
  • Structurally, investors can analyze market volatility in two distinct ways: realized volatility (how volatile something has been historically) and implied volatility (expectations for future volatility based on the price of derivatives).
  • In both cases, US stocks have shown dramatically low levels of volatility in recent years. Implied volatility is easiest tracked using the CBOE Market Volatility Index (VIX), which derives its price from the implied volatility of options on the S&P 500 Index.
  • In May, VIX broke under 10 for the first time since 2007. Indeed, there have been only two other periods since 1990 that the VIX reached a 9-handle; one was in late 1993 through early 1994, and the other in late 2006 through early 2007.
  • In each case, the index ultimately re-rated to higher levels, though in only the more recent example of 2006-2007 was this eventually accompanied by lower equity prices.

Here is the chart:

  • SB here: Note the red dotted line and how the level on the far right went below 10 last month.


SB here: This next chart is most interesting to me.  This chart shows that the volatility of stocks is lower than the volatility in bonds.  That last happened in 2007.  Stocks are inherently far more risky than bonds.  Madness.


Artie and Charlie’s bottom line:

  • In realized terms, equities have delivered volatility that ranks among the lowest in several decades. On a five-year basis, the S&P 500 has posted an annualized standard deviation of 9.6%, compared to a long run average of nearly 16%.
  • By comparison, an index of long-term government bonds has produced a five-year standard deviation of 10.2%., which is roughly in-line with long-term averages. So, the headline US stock index has posted lower return volatility than an asset, which is considered, at least on a credit risk basis, to be risk-free.

SB again: Standard deviation is a measure of risk.  The higher the number, the higher the risk.  Modern Portfolio Theory suggests that you can combine different risks (such as stocks and bonds) and potentially create a portfolio that reduces your risk without materially impacting returns.   It looks like this:


More from Artie and Charles (emphasis mine):

  • There are endless potential reasons for the market’s resilience over the last few years, including easy monetary policy by the Fed, ZIRP/NIRP from global central banks pushing investors into riskier assets including stocks, and fund flows dominating the market due to the growing force of passive investors.
  • Perhaps these forces can continue to support the market indefinitely, leading investors into a glorious post-volatility world. However, with the Fed recently announcing plans to unwind its enormous bond portfolio, the “central bank put” could be in question. In addition, flows from passive vehicles could prove a double-edged sword for markets, meaningfully impactful on the way down as on the way up, particularly for funds with significantly mismatched liquidity.
  • Low volatility does present inherent risks to portfolio construction, particularly for certain types of strategies that use backward-looking volatility metrics for positions sizing and risk management.
  • To be clear, we are not forecasting another 2007-2009 scenario, but we are mindful of the dangers from persistently low volatility on investor behavior and portfolio risk modeling, even more so when leverage is added to the equation.
  • Whether this is the calm before the storm remains to be seen; bubbles are always easiest spotted with the benefit of hindsight. However, at a time when valuations are sky-high by most metrics, margin debt remains near all-time highs, and geopolitical risk is rising, we view the historically low market volatility as a potential sign of apathy, not an all-clear signal.

Well said!  You can find the entire link here.

Trade Signals — A Strong +2: Don’t Fight the Trend or the Fed

S&P 500 Index — 2,468 (8-2-2017)

Notable this week:

Last week, we looked at the Don’t Fight the Tape or the Fed indicator data.  It looked like this:


Notable this week is that the trade signal is now a strong +2.  It looks like this today:


Bottom line: both the trend in interest rates (lower yields) and the trend in the overall market (the tape) are bullish, suggesting a favorable environment for stocks.

As you’ll see in the charts below, the balance of evidence remains bullish for both equities and fixed income.  Both the short-term and intermediate-term gold indicators are bullish.  Investor sentiment has been excessively optimistic, suggesting short-term caution.

You’ll find more information, charts and explanations here.

Long-time readers know that I am a big fan of Ned Davis Research.  I’ve been a client for years and value their service.  If you’re interested in learning more about NDR, please call John P. Kornack Jr., Institutional Sales Manager, at (617) 279-4876.  John’s email address is [email protected].  I am not compensated in any way by NDR.  I’m just a fan of their work.

Personal Note

I arrived Wednesday afternoon at Great Stream Lake in Maine for a gathering of economists and investment managers.  Dubbed Camp Kotok, gathered are some of the brightest minds in the business.  It’s about fishing, eating, debating and drinking fine wine. The conversations at last night’s opening dinner were intense.  I feel like a kid in a candy store.  I hope to share with you what I learn next week.

To give you a feel, Penn’s Wharton School has a channel on Sirius XM Radio (channel 111).  Jeremy Schwartz interviewed Jim Bianco and Martin Barnes.  I sat next to Jeremy on the flight to Maine and he told me it is a good preview of the presentation they will give on Saturday night.  (By the way, I’ll be a guest on the Wharton Channel’s Business Radio on Friday, August 18, at 1:00 pm.)

I really had mixed emotions about the fishing trip.  Susan and I, along with our children, are heading to Stone Harbor, New Jersey.  We have a Saturday-to-Saturday rental and I won’t arrive until Sunday evening.  Regrettably, I’ve left her with all the packing and unpacking.  Coming off her recent knee replacement, that is not a good thing.  She’s amazing.

I’m finishing this letter early Friday morning.  A coffee awaits at the lodge and a full day of fishing ahead.  I owe a heartfelt thank you to John Mauldin for inviting me to Camp Kotok.  Mauldin and I will be in a boat with a guide, and we’ll be fishing for bass and perch.  He just handed me a Bluetooth audio speaker, so we can listen to the Rolling Stones’ “Sympathy for the Devil.”  Rock and roll.  How lucky am I!

Thanks for reading.  Have a wonderful weekend!

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