Wall Street Legend Helps Us Understand Markets Today…
Investors have been trained by the financial industry that market timing cannot occur. That is very much a self-fulfilling teaching as if they did show that it could be done, then they would be out of business close to half of the time, as revenues would dry up. It is critical to understand secular cycles, as you have to invest very differently in a secular bear market than a secular bull market. The former provides massive ups and downs, so an investor has to have some form of market timing system to survive. That is where we are at today. Let’s look at one critical reality that is being ignored today due to the high level of investor confidence…
Let’s look at price-earnings levels on a historical basis, relative to where we are at today. Both historical averages as well as prior peak levels in the markets. Most investors fall prey to herding….following the trend. When confidence in the economy and stocks are at a high, investors feel great and want to be invested. Is it logical – NO, as usually this is a point where markets are near peak. I am referring to investors, not traders, as the latter go with the trend and momentum. Investors must understand risks, especially in a major secular bear market.
I worked for Merrill Lynch when they were up in Canada as one of their top investment advisors. One of the legends from ML is Bob Farrell, who for decades was considered one of the smartest individuals in the business. Even post-retirement, many tried to get onto his exclusive email list to continue to get his wisdom. Here are ten major observations of the markets he concluded over his four decades:
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- Markets tend to return to mean over time
- Excesses in one direction will lead to an opposite excess in the other direction
- There are no new eras – excesses are never permanent
- Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways
- The public buys the most at the top and the least at the bottom
- Fear and greed are stronger than long-term resolve
- Markets are stronger when they are broad and weakest when they narrow to a handful of blue-chip names
- Bear markets have three stages – sharp down, reflexive rebound and a drawn-out fundamental downtrend
- When all the experts and forecasts agree, something else is going to happen
- Bull markets are more fun than bear markets
Some simple, yet brilliant words. I could not have said it better myself (someone has to trump my horn). Here is what you should take from this, as where we are at today is very relevant to Farrell’s key thoughts.
First, forget about new paradigms. I sold a quarter billion of client assets in stocks back in 1999-2000 due to ridiculous valuations, at the horror and anger of the firm I worked for. Fees went down, and they tried to profess that you could not market time. I was a little less investment – sophisticated back then, but probably more read and knowledgeable than 95% of the industry. I do not say that to toot my horn, but just to point out that I was a student of the market for over a decade at that point in time. I lived and breathed markets (yes, I was a little to one-dimensional back then, but I have learned); read and studied them, and understood history.
So, when someone tells you that the times are different today, forget it. They will revert to mean (1st rule), and the current excesses will end, and end badly (3rd rule). The reason we expect a massive correction is that major excesses, and we are there today, always lead to opposite excess in the other direction (2nd rule). Markets have run further than most would expect, and we think there is one more runup after the current correction runs its course (4th rule). Once we see extreme numbers in sentiment and confidence (we are close today), we will expect a major meltdown to begin. Few out there will expect it, and many of my clients will challenge me. I have learned that emotional investing destroys portfolios; logical investing based more on contrarian investing builds great wealth.
The reason I created Fortrus was so that I could advise customers what is really going on. If you are selling products, you have to have a positive slant OR your earnings will collapse at best, or you will lose your job. Not great options, so advisors will always take a long-term buy and hold approach. It fails investors during secular bear markets. Just look at the two market crashes since 2000, and one to come to prove it. Sadly, most investors buy near the top and least at the bottom (5th rule). Let’s even take this rule further and say most investors sell near the bottom due to fear (6th rule).
This year markets have been driven by the FAANG stocks – Facebook, Amazon, Apple, Netflix, and Google. You can probably add Tesla to this list as well. They have had huge moves this year, and if you omitted them from indexes, returns would be sub-par. This is called weak breadth, or narrow markets. These are weak markets, not strong ones, and signify we are close to the end of this cyclical up cycle that has been in place since March 2009 (7th rule). By the way, this is one of the longest growth cycles in history:
If you look at the green highlighted lines, you will see that the current cycle is 98 months old, from the last trough to date. The second longest cycle was 106 months in the 1960’s and the longest at 120 months during the 1990’s. The average since 1945 is 58 months, so we are now 69% longer than the average. Yes, this growth cycle is very long in the tooth.
We are not in a bear market as of yet, but as it states, they start with a sharp down, a rebound to keep investors invested, and then a slow fundamental break down, as economic growth contracts leading earnings and stocks down 8th rule). The problem today will be compounded due to the excessive margin (borrowed money) in the stock market and excessively valued markets.
We closely watch sentiment data on investors, advisors, economists, etc., as once everyone (at least the vast majority) throw in the towel and believe this bull market cannot end, if the final dagger that will tell us that it is over (9th rule). We use other technical and fundamental indicators as well, but sentiment is probably the most telling.
The 10th rule is why so many investors herd – bull markets are more fun than bears. Bear markets are painful, and as humans, we try not to go there, as we all have enough stresses in our life. The lesson I want all my customers to learn is that investing is not about your emotions – fear vs. greed; happiness vs. sadness – but instead should be looked at in a non-emotional logical manner. The best investors do this. Are markets overvalued today – big time, so we know we have to be on alert, as the markets will revert to mean and probably well beyond it on the downside. But markets also go up higher than anyone could anticipate. That is why we know our foundation is weak, risks are very high, but we stay invested until our timing tools kick in. They force us to be logical in our approach and will get us out.
Savvy investors will make money on the downside – and potentially a lot. When markets roll over, they tend to do it much faster than the prior bull market. What we expect to happen is that most investors will lose most of their profits due to lack of action. We will be screaming at our customers – whether they listen or follow the herd is up to them.
A quick look at a valuation tool that should not be ignored – price-earnings (PE) ratio. Here is the level of PE at market peaks historically:
Bull markets are enjoyable, but they always end.Unfortunately, the world we live in today, with zero interest rates; huge Central Bank capitalization of stock markets; a record level of borrowing to keep the economy and stock markets alive; and hedge funds who leverage like crazy to push stocks up.All this means is the upside is bigger than should occur but the downside will be huge once the deluge starts.
The above chart shows that bull markets have ended (excluding the 9.1x outlier) at PE levels from 13.7 times and as high as 28.9 times.Today we are at the second highest level in history at 25.5 times.At the peak in 2007, the trailing 12 month PE level was only 17.3 times. We are47% higher than that today.
Here is a chart on the SP 500 trailing PE ratio:
This chart shows that from 1870 until 1990 stocks traded within a reasonable range from the median level of 14.65.The range tended to be within 5 to 25, with the former very undervalued markets and the latter very overvalued markets. Since 1990, things have changed.We attribute this to two primary factors, the growth of hedge funds which utilize massive leverage to drive stocks up; and more importantly, the fact that we are at the end of a long-term growth cycle that is ending that started in 1932.At the end of such cycles, there is a belief that the world is different, but it really isn’t. It is just more dangerous.
As you can see, the all-time low PE level was 5.31 in 1918 and the all-time high 125.75 in 2009.It is important to understand that the high was due to earnings collapse, not a overvalued stock market that had run up.Instead, the SP 500 had collapsed at this point by over 50%, but stocks collapsed much more.The first chart gives a better idea of where PE levels are at the end of a cycle. This chart does show that at 25.51 PE level, the market is 74% above the historical mean. Even if there has been an adjustment up in PE levels, the market is still very overvalued.
Here is a chart on the SP 500 PE levels for the past ten years:
Again, you have to ignore the 2009 bloated PE level, as it was due to collapsing earnings. Today, we are at record earning levels, yet the market is trading at extremely high valuations. It is 25% higher than the 5-year average and 32% higher than the 10-year average.These are expensive markets, no matter how you look at them.
Yes, the markets can become more expensive, but when they finally rollover, it will be ugly. Make sure you have key indicators to tell you when to leave this irrational party or you will go down with the ship.
Founder & Chief Investment Strategist
Fortrus Investment Coaching