When you look back on this day & remember the bubble...

Summary: We’re in a time of great events. Like all such, it consists of breaks with the past combined with periods of deceptive calm. This is a transition between the post-WWII era and the as yet unknowable new regime that lies ahead. The stock market provides a mirror in which we can see these great events play out. {1st of 2 posts today.}

When you look back on this moment…
These things are matters of perspective.
Is this an investment bubble?
What’s different this time?
What’s next?
This series about our bubble economy.
For More Information.

(1) When you look back on this moment in history

Wise words by John P. Hussman (manager of the Hussman Funds, former professor of economics at U MI): “When You Look Back On This Moment In History“. The full essay is well worth reading.

There are moments in time when durable history is made; history that others observe much later, shaking their heads, at a loss to understand how the events that followed could not have been obvious at the time. When you look back on this moment in history, remember these things.

When you look back on this moment in history, remember that spectacular extremes in reliable valuation measures already told you how the story would end. Among the measures best correlated with actual subsequent S&P 500 total returns, capitalization-weighted market indices such as the S&P 500 were more richly valued in only 54 weeks of history, 21 of which represented the final advance to the 2000 market peak, with the remaining 33 representing the retreat from that high to present valuation levels, on the way to a 50% loss in the S&P 500 Index and an 83% loss in the Nasdaq 100 Index.

… When you look back on this moment in history, remember that the valuation of the median stock was never higher. Ever. Even at the 2000 peak.

… When you look back on this moment in history, remember that S&P 500 returns had never materially exceeded zero over the decade following similar valuations.

…When you look back on this moment in history, remember that rich valuations had not only been associated with low subsequent market returns, but also with magnified risk of deep interim price losses over shorter horizons.

… When you look back on this moment in history, remember that dismal return/risk prospects were grounded in objective historical evidence, not simply opinion.

… When you look back on this moment in history, remember that the strongest historical prerequisites for a market crash were already in place.

(2) These things are matters of perspective

Grade-A investment professionals laugh at Hussman and love this environment because they bet on the government (although they’re rock-ribbed conservatives, even Libertarians about policies where the government doesn’t help them). Betting on the government has been the path to wealth since 1932. Fortunes were made by betting on government action when the fiscal and monetary stimulus started in early 2009 (Obama signed the first large fiscal stimulus bill on 17 February), and on the subsequent rounds. Many key New Deal era regulations were removed during the 1990s (Wall Street owns both parties), so money can be made using simple trend-following programs during both the crash and the recovery.

Non-professional investors get destroyed by crashes. Fees, inflation, and taxes (retirement accounts are only tax-deferred) erode their returns to absurdly low levels. Any attempts at timing add to their underperformance. But why should they have money? As Mr. Potter said in “It’s a wonderful life” (as it was for him in the film)…

“What does that get us? A discontented, lazy rabble instead of a thrifty working class.”

The 1% don’t care. Fluctuations in the value of their assets don’t affect their spending, and much of their wealth is non-financial assets (e.g., land, directly owned businesses, art). Depressions keep the lower classes properly fearful and provide opportunities for big bargains (as Mr. Potter did in the film, and Joe Kennedy did during the Great Depression).

(3) Is this an investment bubble?

Hussman nails this. It’s a stock market bubble. That’s a feature — not a bug. Wall Street and Silicon Valley use bubbles as educational opportunities. At the end they have the tuition (and it’s costly tuition); investors have the education. Few learned in the first tech bubble, so the class has been repeated. Bubbles are an inherent aspect of free markets, but we are the first generation to have two large bubbles (we are exceptional!).

For details see The key things to know about the great American bubble machine. Also see these views of the market using standard valuation tools: price/earning ratios and 4 broad metrics. For a more exciting perspective, consider current valuation metrics if compared to the pre-bubble past (1950-1997), or current numbers to historical medians (a definition of average insensitive to outliers). It’s a matter of perspectives.

(4) What’s different this time?

The foundational assumption of standard valuation metrics is that the world remains constant. Most importantly, that the long-term growth rate of the economy remains more-or-less constant. But it’s slowing with each cycle. Look at real GDP growth for 25 quarters after the recession trough (indexed to 100):

1982 Q4 to 1988 Q3: 30.9%
1991 Q1 to 1996 Q4: 21.1%
2001 Q4 to 2007 Q3: 17.6%
2009 Q2 to 2015 Q1: 13.3%

Economists forecasts of long-term growth have been falling since the crash. We’ll see today if the Fed takes their forecast down again {Update: they didn’t. Slashed 2015 growth, slightly lifted 2016 and 2017. Long-term unchanged at 2.0-2.3%.}

This has not affected stocks since earnings metrics (e.g., profit margins, earnings/GDP) have grown, a consequence of the 1% cumulative and decisive wins since 1980. Having broken our will to resist, the class conflict enters the pursuit phase — exploiting their power to influence corporate and government policy in their interest. Slowly the inner party has begun to realize this — announcing their discovery that Fed policies, such quantitative easing, benefited the 1% more than the public. Duh.

But all good things come to an end. Recent wage increases by Walmart and by McDonalds show that forces boosting profit margins have reached their limits. Now growth depends on US and world growth — which appears slow, and so likely not to justify today’s elevated valuations.

However, it’s important not to alarm the sheep. Hence the increasingly frequent announcements that there is no bubble: by Warren Buffett, VC firm Andreessen Horowitz, the CEO of Salesforce.com, and countless others.

Seeing the future — Ron Chapple/Getty Images

(5) What’s next?

The rate of technological progress has slowed from the heady rate of 1860 – 1960 (details here). Now other factors add their own drag, creating secular stagnation. The good news is that the next industrial revolution has begun, slowly — but with the potential for unimaginable progress ahead of us.

The bad news: the past two industrial revolutions included periods of severe disruptions when the costs and damages of the transition outweighed the advantages. Since we’re making no efforts to prepare, we should assume that this will happen to us as well. See all posts about secular stagnation and the Third Industrial Revolution,

To see more about the clashing forces that will make our future…