Voters in the United Kingdom shockingly decided to leave the European Union? The stock market barely blinked. Voters in the United States unexpectedly elected a brash promoter over a well-established political insider? The stock market didn’t care. It told the media elite to take a hike, then promptly climbed to higher ground.
The S&P 500 really doesn’t care what you think. It takes what it wants when it wants. The Federal Reserve continues to raise overnight lending rates? The yield curve flattens like a collapsible Surface tablet. And yet, stocks hang within 2% of all-time record highs. Forget the popular bull and bear references. The U.S. stock market is as “bad-ass” as the legendary honey badger.
It is difficult to imagine anyone with access to YouTube having missed one of the most entertaining nature videos ever made. If the hilarious three-minute clip miraculously eluded your sensibilities, however, you may want to discover why the Guinness Book of World Records anointed the honey badger as the “World’s Most Fearless Creature.”
What may be more impressive than the S&P 500’s seeming immunity to geopolitical risk and to the reduction of monetary policy stimulus is its durability in the face of obscene valuations. Nearly any method for determining whether one is getting a bargain or paying a premium for participation comes up unfavorable; that is, on nearly any metric, U.S. stocks are 25%-124% overpriced.
The less traumatic estimates – EV/Sales, GAAP-based price-to-earnings (P/E) – appear to portend eventual “reversion to the mean” losses for equities in the 25%-30% range. And that’s only if stocks fell to fair value levels. History tends to be less kind during bearish retreats such that stocks will often trade at significant discounts.
Some of the more alarming valuation tools – market cap-to-GDP (“Buffett Indicator”), Cyclical P/E 10 (Shiller CAPE) – forewarn of the strong potential for a third 50%-plus decline for U.S. stocks in the 21st century. Indeed, it is difficult not to look at present circumstances as being more precarious than 1929, and wonder why many participants are heartened by the notion that we may not have approached the insanity of the dot-com bubble in 2000.
The uninformed will continuously point to the more favorable borrowing costs today (interest rates) versus 1929 or 2000. Yet those very same people are completely unaware that the 10-year yield as well as borrowing costs were every bit as favorable from 1935 to 1954. Yet valuations over the 20-year period never came close to escalating out of control, not the way that they have here in 2017. Moreover, those ultra-low rates did not prevent four destructive descents from transpiring — 1937-1938 (-49.1%), 1938-1939 (-23.3%), 1939-1942 (-40.4%), 1946-1947 (-23.2%).
When extreme valuations are present, elite media personalities like Jim Cramer explain why this time is different. It is different today because disruptive technologies cannot be valued using traditional metrics. It is different today because borrowing costs are so low. It is different today because underfunded pensions as well as underperforming asset managers and hedge funds have to keep up with the Joneses.
I am not convinced that this time is unique enough to disregard the credit cycle. During the early stages of debt-driven economic expansion, borrowers have little trouble repaying their obligations. At some point, though, debt levels reach heights that destroy the susceptible players. Delinquencies rise. Defaults become more common. We are already seeing this stage in sectors like oil/gas as well as retail.
The next stage is where things become decidedly dicey. Banks that find themselves losing money from lending operations begin reducing the activity. That slows overall economic growth even further. Indeed, there is plenty of evidence to show that financial institutions are restricting credit to both consumers as well as commercial/industrial borrowers.
Keep in mind, the last three recessions witnessed credit cycle booms and busts. Jeff Gundlach of DoubleLine Funds fame recently highlighted the probability that corporate debt as a function of economic growth (GDP) is topping out. If this is accurate, near-record leverage in corporate America is likely to wane. Ultimately, corporate revenue and earnings would suffer. (Note: Is it any wonder why corporate tax reform has become the “solution du jour” for an over-leveraged business world?)
By now, everyone should recognize how our country handles credit cycle deterioration. Our central bank (a.k.a. “The Fed”) dramatically lowers the Fed Funds rate. In the early 90s, early 2000s and in 2008, the Fed slashed its overnight lending rate by 500 basis points (5%). Of course, in the 2008 financial crisis, zero-percent Fed Funds rate policy was not enough to stimulate economic demand. So the central bank leadership aggressively pursued unconventional methods; that is, the institution created electronic dollar credits to buy government bonds and mortgage-backed bonds (12/2008-12/2014) to further reduce borrowing costs. With this “quantitative easing,” $3.5 trillion eventually found its way into stocks as well as other risky assets.
Here’s the dilemma: The Fed Funds rate is roughly 0.87% (0.75%-1%). This time around, it will never get anywhere near 5%; monetary leaders will not be in a position to battle recessionary pressures by lowering the target 500 basis points. Indeed, they’d be lucky to get anywhere close to a 2% target. What does that mean? It means that whenever the next economic downturn arrives, the Fed will be forced into wackier tactics from creating electronic dollar credits to buy other types of market-based securities (e.g. low-rated corporate debt, stocks, etc.) to acquiring massive amounts of Treasury bonds so that the federal government can send huge checks to households for spending purposes.
Is the next Federal Reserve stimulus package really that far off? Maybe not. The central bank’s own measure of employment well-being, the Labor Market Conditions Index (LMCI), shows a relatively dreary picture. The last time that the gauge (6-month moving average) of 19 underlying labor health indicators peaked? Back in the 4th quarter of 2014 when the Fed finished its third iteration of quantitative easing (QE3). Conditions have essentially been weakening over the last two years and three months.
Again, though, today’s honey badger stock market is not much worse for the wear. Thick-skinned. Insanely audacious. And few natural enemies, apart from humans.
And this is it how it hits me. Computerized, algorithmic-driven trading and corporate stock buybacks may be the mind behind the curtain of non-existent market volatility. But the heart? The heart still belongs to human participation. Emotion-driven greed and fear.
Right now, the crowd may have a voracious, honey-badger-like appetite for risk. What about rebalancing to lower your exposure to overvalued equities while others are greedy? Had you done so leading into 2000 and leading into 2008 – when investor greed had soared alongside stock valuations – you might have been able to purchase stocks when others were panicky in 2002 and 2009. You did not need to “time” everything to perfection; you just needed to lighten your exposure. The signs were plentiful.
Those that held the S&P 500 SPDR Trust (SPY) this century? Even with an eight-plus year record run, 4.5% compounded falls far shy of the stock promise of 9%-10%. It also falls short of inflation-protected government bonds. An exchange-traded tracker like iShares Inflation Protected Securities (TIP) or a mutual fund like Vanguard Inflation Protected Securities (VIPSX) would have done close to a comparable index at 5.5%. And when you adjust for inflation? The 17-plus year “real” return for SPY is only 2.35%. How do you think these returns through record-breaking highs of 2017 will look when a bear finally gets a grip on this honey badger stock market?
Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.