I was flying home from San Francisco not long ago, leafing through the Financial Times, when a particular juxtaposition of articles caused me to order another martini. The first article reported that the S&P 500 Equity Index had hit an all-time (nominal) high. The second article, not even referencing the first, reported that market volatility – the Fear Index – had hit a new low (since 2007).
Now, if you want to sleep soundly at night you can have high prices and high fear, and you can have low prices and low fear, and you can even have low prices and high fear. Those are different but rational investment environments. But high prices and low fear? Head for your fallout shelter.
It’s true, of course, that overvalued markets can become more overvalued and stay there a long time. And that’s just what the market’s done, continuing to rise inexorably. Large thundering herds of investors are thinking, “What the hell, let’s dance while the music’s playing.” But, historically, when overpriced markets keep running, investors give back all those gains and then some. Why ride the roller coast all the way to the top when you know it’s not only going to come all the way down the other side but will then dig itself a big hole in the ground?
If high stock prices were justified by, saying a rip-roaring economy, well, what the hell. But irrationally exuberant investors don’t much care about the state of economy. Indeed, the more underwhelming it is, the better. That’s because the Federal Reserve Bank of the US has stated that it’s going to pump up asset prices and no power on earth can stop the Feds getting what they want. And the weaker the US economy (and labor market), the more the Fed will pump.
Well, maybe the exuberant investors are right. But as I look around the US and global economy, here are some of the things I see:
- Current price levels in the market have been matched for any length of time only during the late 1990s, followed by the dot.com debacle.
- PEs recently approached 20X, even by the myopic traditional calculation of price divided by expected earnings. If we look instead at Shiller PEs…, well, don’t ask.
- A recent Investors Intelligence surveys showed four times as many Bulls as Bears.
- Massive instability in the Middle East has caused oil prices to… drop.
- European banks have ratcheted up their holdings of Eurozone sovereign debt, the very paper that will collapse as it becomes clear that those sovereigns will have to bail out those banks.
- No one seems concerned in the slightest that the Fed is planning to abandon QE this fall, that the Bank of England is likely to raise rates soon, and that the Fed can’t be far behind it.
- Not only has the VIX been ridiculously low, but at one point it had traded for more than seventy-four weeks below its long-run average. The last time we saw this was in 2006-07. Uh, oh.
- Speaking of the VIX, its structure has been alarmingly bi-modal, that is, most investors are asleep at the switch, but a small group of investors are deeply bearish. If you look at the relative sophistication of these two groups, you’d order another martini, too.
- The Great Moderation – the years prior to 2007 – led directly to the Global Financial Crisis. What will the current moderation lead to?
- Collateralized loan obligations peaked in 2006. But that peak was only 15% above today’s level.
- Leveraged loan issuance sets new records every day, at the same time that covenants disappear. Market share of cov-lite loans is led by such paragons of virtue as Credit Suisse (#1), Citi (#2), and Deutsche (#3).
- The IMF and others, including the US Fed, have been lowering their estimates for US growth for 2014. Sure, growth was reported at 4% in 2Q, but it was -2%+ in 1Q. What does that average out to?
- The price of credit default swaps on bank defaults has fallen back to pre-crisis levels.
- The equity markets – and, for that matter, the bond markets – have demonstrated a remarkable ability to shrug off alarming developments: the collapse of Banco Espirito Santo; the callous downing of Malaysian Flight 17; the Israeli-Hamas war.
- Investors in Spanish sovereign debt have demanded the lowest rates since the 18th century.
- Share buybacks by US corporations, always a strong Bear signal, peaked in the third quarter of 2007. We are now approaching this peak again.
- The not-exactly-choleric Bank for International Settlements recently warned that “euphoric” markets were out of step with the ongoing post-crisis economic malaise.
- Thanks in large part to regulatory reform, liquidity in many market sectors has all but disappeared. If a crunch comes, we may find that we live in a world devoid of buyers.
- The largest banks’ “living wills” (required by Dodd-Frank) turn out to be a joke. “In a sweeping rebuke to Wall Street, U.S. regulators said 11 of the nation’s biggest banks haven’t demonstrated they can collapse without causing broad, damaging economic repercussions” says the Wall Street Journal.
And so on. Maybe we should be afraid.
Next up: What Are We Thinking?
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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.
