Going into a stock market bubble

[giofranchi]

Agree!

 

Not only: I think cash might be useful even in a rising market, at least for a portfolio as concentrated as mine. Given the fact I hold just a few companies, the volatility of my portfolio can often be much greater than the one of the general market. And cash helps me take advantage of opportunities that might arise irrespective of what the general market is doing. ;)

 

My problem today is rising cash level, I simply cant find anything that meets my criterias.

 

And don’t you think the fact you are experiencing difficulties in finding investments that meet your criteria and the fact the Shiller PE of the S&P500 is approaching 29-30 might be somehow correlated?

 

Another thing I would point out about the markets from 1996 to 2000 is that, as Hussman has often said, the average stock today is already more pricy than it was in 2000. In other words, those who keep saying the Shiller PE of the S&P500 was over 40 in 2000, keep missing the fact that internet and technology stocks substantially distorted the picture back then.

 

Gio

 

[anders]

You still want to be 100% invested when the Shiller PE of the S&P500 gets above 30? Well, as I have already said, then you will always find some rationale to be fully invested, and you will never hold cash. Period. Maybe you’ll do fine… But it is just not my style!

 

- I have never argued being 100% fully invested

 

And don’t you think the fact you are experiencing difficulties in finding investments that meet your criteria and the fact the Shiller PE of the S&P500 is approaching 29-30 might be somehow correlated?

 

- Im not stupid

 

------

 

What im saying is that I strongly disagree with the notion of making a strategic decision on portfolio allocation based on level on CAPE, the notion that we might go into bubble territory.

IMO The level of cash should be correlated on finding great ideas regardless of level of CAPE or the market, which evidently gets more difficult with higher premiums in the market.

 

Regards,

 

[petec]

 

What im saying is that I strongly disagree with the notion of making a strategic decision on portfolio allocation based on level on CAPE, the notion that we might go into bubble territory.

IMO The level of cash should be correlated on finding great ideas regardless of level of CAPE or the market, which evidently gets more difficult with higher premiums in the market.

 

Regards,

 

Agreed, although we all seem to agree that the two will be correlated.  Going back to the November 1996 example, I wonder how many clear opportunities there were then?  The ensuing bubble (and it was a bubble!) took KO to 40x and bid a lot of worthless internet companies up to 8,000x eyeballs per page or whatever the trendy metric was at the time.  So it's quite possible that an investor looking for good, undervalued businesses would have moved to cash.  Gio's point is that CAPE suggests we are at a similar point now, where further moves up will be into bubble territory.  You seem to agree using a different metric (the difficulty of finding things).  I agree with both of you, because both, while they are useless timing tools, are quite good predictors of long run future returns.

[giofranchi]

- Im not stupid

 

Sorry!... Didn’t want to sound sarcastic… My fault!

 

IMO The level of cash should be correlated on finding great ideas regardless of level of CAPE or the market, which evidently gets more difficult with higher premiums in the market.

 

In theory I agree. But in practice there is no way escaping the fact we are investing in the stock market, and what the general market does is like enjoying tailwind or suffering headwind for all our investment ideas. That’s why Mark’s concept of “the pendulum” is and will stay highly relevant.

 

Let me give you two examples: BH selling at BVPS and LMCA selling below NAV are imo incredibly cheap today… Yet, I wouldn’t be surprised at all if in a market crash they both decline faster than the general market… And, though I do believe 10 years from now they will turn out to be great investments, I know I will have to wait a long time, before my thesis is finally validated. It will be far easier to wait, if in the meantime I am able to average down… So, the question is: I have 3 ideas that I think are very good businesses which could be purchased at fair/good prices today… Why am I only 70% invested in them, instead of 100%? Your answer might be: because you are wrong! Another answer might be: because of Mark’s pendulum… ;)

 

Cheers,

 

Gio

 

[anders]

+1 Gio,

 

As always, I appreciate all your thoughts and this boards ability to spin matters in different directions,

[moody202]

What do you see in IBM that makes the future bright? Just curious as I'm not able to come up with the same conclusion!

 

 

 

My problem today is rising cash level, I simply cant find anything that meets my criterias. (Except maybe IBM  :) reading the AR,s, I think I finally start to understand why WB is bought it after 50 years of waiting, its a wonderful company with a bright future ahead)

[original mungerville]

essentially the take-away is don't use it.

 

original mungerville,

 

This is what Hussman had to say in his latest weekly commentary:

 

As a side note, the reason I emphasize that the effect of QE is psychological is that one can calculate the impact that a given period of zero interest rates should have on the discounted value of future cash flows. I’ll say this again – if historically normal equity valuations and prospective returns are associated with short-term rates averaging, say, 4%, one can show with straightforward discounting arithmetic that the expectation of zero interest rates for 3-4 years will result in a justified 12-16% increase in valuations over and above historical norms. On valuation measures that are best correlated with actual subsequent S&P 500 total returns (and many popular measures are quite weak on that record), we presently estimate that the S&P 500 is about 115% above historical valuation norms.

 

Put another way, we estimate nominal total returns of less than 1.4% annually for the S&P 500 over the coming decade, with negative total returns over the next 8 years. So if one believes that zero interest rates are likely to persist for another 8 years, and that stocks should be priced with zero return or premium for risk, stocks are probably fairly valued. If one believes that zero interest rates are likely to persist for another three decades, but stocks should be priced with normal historical risk premiums over and above risk-free rates, stocks are also probably fairly valued. In every other universe, stocks are about double historically normal valuations, even adjusting for the likelihood of several more years of zero short-term rates.

 

Which is basically what the Shiller PE of the S&P500 is telling us right now.

 

Of course you might answer Hussman is not a good investor, he has not made any money for his shareholders in a while, etc. … And I might even agree with you … This doesn’t change the fact than when it comes to general market valuation no one that I know of, and I repeat: no one!, has done a more accurate, thoroughly researched, and convincing work than Hussman. Period. Anyone who doesn’t read his weekly commentary should start doing so.

 

If the Shiller PE of the S&P500 truly gets to 30, valuations will be even more stretched!

 

Furthermore, just look at the ups and downs of the markets in the 20s’ and 30s’: those were two decades of unbelievable booms and busts! And, although the Shiller PE might not have been very useful in the midst of those booms and busts, surely it acquired meaningfulness at the extremes! It never got lower than 6… and it never got higher than 30! If it approaches 30 again, I strongly believe you should take notice.

 

I simply repeat this: In 1929 the Shiller PE of the S&P500 reached 30… a market crash of more than 80% followed… If the Shiller PE of the S&P500 gets to 30 again, and you don’t become defensive… you will never be.

 

Gio

 

Gio,

 

Look, I agree with you completely. The market is high on multiple measures - not just the CAPE. Hussman uses about 5 measures and all of them are at records including the CAPE. My point was not to disagree with you but to point out that that guy on that blog has some really important points and other articles, that's all.

 

Actually the article I was referring to might even imply that the US CAPE of 30, when adjusted appropriately, may be 33 or 35 or something. So actually the article I was pointing out only supports your view. What the article was saying is that Greece has a low single digit CAPE and the Irish CAPE is 8 or something which implies both are cheap, but he clearly argues that the Irish stock market is in no way cheap. So, let me make my final quote more specific (after reading that article):

 

"If the CAPE is low for a country index, do not use only the low CAPE as a justification for investing in the index as that CAPE, in a period following a long-tail dislocation like we had in 2008/9, may not be representative due to the fact that the earnings pre-dislocation are not from the same companies whose prices we are using post-dislocation (think banks which failed whose earnings are still in the CAPE calculation from 2004 to 2008, but then those banks are no longer in the index in 2014 and have been replaced by other manufacturing or services businesses). The CAPE works best to smooth the regular business cycle over a 10-year period, and does not work as well in a post 1932 period or post 2009 period - as it may underestimate valuations due to the above dynamic."

 

[original mungerville]

Further Gio, I just stated earlier that I agree with a very conservative allocation to stocks at this point like 10% precious metals, 20% stocks, 70% cash/bonds. With the latter too high and the fact we could wait forever for a market crash, combined with my view that FFH can be viewed somewhat as cash-like for portfolio allocation purposes, I fully agree with your 30% cash, 35% FFH position for a total of 65% which is pretty damn close to where I am.

 

The only reason I would agree with 65-70% in cash-like investments is because I think the market is very very high on a long-term basis. The FFH piece is important because it gives you staying power with high single digit maybe double digit returns as you wait this out.

 

We are in total agreement but I do urge you to read that guys blog and other articles because they are just great - and very relevant, you will enjoy them and they may change some of your views to a minor degree which can be helpful.

 

[petec]

The CAPE article is really interesting, both in that it exposes serious flaws but also in that it doesn't say the idea is bad, just that there are errors in the calculations used at certain key points in time.

 

That said, it's not a timing tool but a returns-forecasting tool.

 

I'm not sure I agree with him on energy though - he's basically arguing that past earnings have no predictive value but that's the case for many companies, and where it is extreme the PE is just lower (as for energy) so CAPE vs CAPE history still makes some sense.

[giofranchi]

We are in total agreement but I do urge you to read that guys blog and other articles because they are just great - and very relevant, you will enjoy them and they may change some of your views to a minor degree which can be helpful.

 

I will do. But let me tell you right away what I think from the quote you have posted: imo they are trying to be much too precise… Because I consider the following of the pendulum to be more a “feeling” than something precise… In other words, what might be truly misleading surely is not to be interested and vaguely aware of where the pendulum is at any given time, but to think you could know its precise position! ;)

 

Gio

 

[vinod1]

Further Gio, I just stated earlier that I agree with a very conservative allocation to stocks at this point like 10% precious metals, 20% stocks, 70% cash/bonds. With the latter too high and the fact we could wait forever for a market crash, combined with my view that FFH can be viewed somewhat as cash-like for portfolio allocation purposes, I fully agree with your 30% cash, 35% FFH position for a total of 65% which is pretty damn close to where I am.

 

The only reason I would agree with 65-70% in cash-like investments is because I think the market is very very high on a long-term basis. The FFH piece is important because it gives you staying power with high single digit maybe double digit returns as you wait this out.

We are in total agreement but I do urge you to read that guys blog and other articles because they are just great - and very relevant, you will enjoy them and they may change some of your views to a minor degree which can be helpful.

 

+1

 

Gio,

 

What you state makes a lot of sense and I agree with you.

 

That said, as original mungerville mentioned above, reading the blog might, just might make you a bit less certain about Hussman's research. There is an article where he exposes the limitations of Hussman's graphs - especially how the visual illustration makes them look more reliable then they really are.

 

Hussman makes two assumptions basically in his conclusions (1) profit margins reliably mean revert around 6% (2) normal stock market returns should be 10%. Both these might change as economic conditions change.

 

Vinod

[Liberty]

Hussman makes two assumptions basically in his conclusions (1) profit margins reliably mean revert around 6% (2) normal stock market returns should be 10%. Both these might change as economic conditions change.

 

Vinod

 

On profit margins, this is worth reading:

 

http://www.philosophicaleconomics.com/2014/05/profit-margins-dont-matter/

 

Businesses optimize for ROE, not for profit margins.

[vinod1]

Hussman makes two assumptions basically in his conclusions (1) profit margins reliably mean revert around 6% (2) normal stock market returns should be 10%. Both these might change as economic conditions change.

 

Vinod

 

On profit margins, this is worth reading:

 

http://www.philosophicaleconomics.com/2014/05/profit-margins-dont-matter/

 

Businesses optimize for ROE, not for profit margins.

 

I did read that and it was an eye opener for me. The blog is an absolute gem.

 

Vinod

[wbr]

A couple of things:

 

First of all I agree that the US market might continue to rise and end up in bubble territory. Low interest rates, lower unemployment, lower oil prices etc lead to a steadily improving economy which will improve confidence and drive equity markets.

 

But I also think timing the market is foolish. When you say that you have a high allocation in cash and deliberately limit your investments I think you are doing just that. In my opinion it is ok to hold cash and sometimes lots of cash, but it shouldn't be a *decision* that is based on

 

1.) a ratio

2.) media coverage

3.) Hussman

4.) the length of the bull market

5.) anything macroeconomic

6.) sentiment

7.) technical analysis

8.) or in general your "view of the world and the markets"

 

It should be the *result* of your usual bottom-up investment activity: Depending on the available opportunities your cash allocation goes up or down.

[giofranchi]

There is an article where he exposes the limitations of Hussman's graphs - especially how the visual illustration makes them look more reliable then they really are.

 

Hussman not only prints graphs about stock market predictions and subsequent actual returns, he also give a numerical correlation. Does the blog point that out? If it doesn’t, I am already suspicious…  ;)

 

Gio

[giofranchi]

It should be the *result* of your usual bottom-up investment activity: Depending on the available opportunities your cash allocation goes up or down.

 

Then, please, answer the question I asked anders just a few posts ago...

 

Gio

[Liberty]

There is an article where he exposes the limitations of Hussman's graphs - especially how the visual illustration makes them look more reliable then they really are.

 

Hussman not only prints graphs about stock market predictions and subsequent actual returns, he also give a numerical correlation. Does the blog point that out? If it doesn’t, I am already suspicious…  ;)

 

Gio

 

Why not just read a few of his articles and find out? The primary source is easily available. I think you'll be pleasantly surprised.

 

Here's a few to get you started:

 

http://www.philosophicaleconomics.com/2014/06/critique/

 

http://www.philosophicaleconomics.com/2013/12/shiller/

 

http://www.philosophicaleconomics.com/2014/01/cape/

 

http://www.philosophicaleconomics.com/2014/05/profit-margins-dont-matter/

[yadayada]

Good blog but sort of disagree with him here though. Not sure if I like his logic and his example there. I think it is a bit too abstract and he is jumping to conclusions:

http://www.philosophicaleconomics.com/hard-money-deflation-or-economic-stagnation/

 

Thoughts?

[vinod1]

There is an article where he exposes the limitations of Hussman's graphs - especially how the visual illustration makes them look more reliable then they really are.

 

Hussman not only prints graphs about stock market predictions and subsequent actual returns, he also give a numerical correlation. Does the blog point that out? If it doesn’t, I am already suspicious…  ;)

 

Gio

 

Yes! He digs deep into the data, to point out the flaws.

 

As I pointed out nearly everything written by Hussman is based on two things (1) profit margins mean revert to 6% (2) stocks normal  returns are 10%. He thinks these are pretty much as certain as Planck's constant. He is 100% certain that these would hold true in future. If these do not hold in future, neither does any of his estimates.

 

Vinod

 

[frommi]

Was there the same amount of bubble talk in 1999 and 2007 in here?

After reading the book "The great crash - 1929" i really doubt that we are in a similar situation, even if the bear inside of me tells me other stories.

 

 

[wbr]

It should be the *result* of your usual bottom-up investment activity: Depending on the available opportunities your cash allocation goes up or down.

 

Then, please, answer the question I asked anders just a few posts ago...

 

Gio

 

The answer is obvious and he already gave it to you. The point is that your initial post and how it's written suggests that you positioned yourself for a crash by having a high cash allocation and limiting your spectrum of investments as opposed to allocating cash "naturally".

I would argue that I have no idea whether we are in 1996 or 1999. For all I know the market could start a 30% slide tomorrow because [reasons that will be apparent only after the fact] or keep going for years. As long as there are compelling opportunities you should seize them and avoid forming a strong opinion about the market (à la Hussman) which can put a big part of your capital on the sidelines for a long time.

[original mungerville]

There is an article where he exposes the limitations of Hussman's graphs - especially how the visual illustration makes them look more reliable then they really are.

 

Hussman not only prints graphs about stock market predictions and subsequent actual returns, he also give a numerical correlation. Does the blog point that out? If it doesn’t, I am already suspicious…  ;)

 

Gio

 

Why not just read a few of his articles and find out? The primary source is easily available. I think you'll be pleasantly surprised.

 

Here's a few to get you started:

 

http://www.philosophicaleconomics.com/2014/06/critique/

 

http://www.philosophicaleconomics.com/2013/12/shiller/

 

http://www.philosophicaleconomics.com/2014/01/cape/

 

http://www.philosophicaleconomics.com/2014/05/profit-margins-dont-matter/

 

Gio, its worth your time to read these articles. All they will do is help you better interpret Hussman's stuff and CAPE - I don't think they change the fact the market is overvalued right now but it may change your outlook on 1) how long it could take to mean revert on the "E" in the P/E (ie longer than in the past potentially), and also 2) some slight adjustments to interpreting CAPE/Shiller p/e. Its just helpful - one level more detailed - stuff to interpret Hussman etc, and (maybe?) understand why Marks, Buffett and Munger are not quite at the point where they want to call this a bubble (whereas Hussman is, and Grantham with another 10% rise in the S&P from here will be).

[racemize]

It should be the *result* of your usual bottom-up investment activity: Depending on the available opportunities your cash allocation goes up or down.

 

Then, please, answer the question I asked anders just a few posts ago...

 

Gio

 

The answer is obvious and he already gave it to you. The point is that your initial post and how it's written suggests that you positioned yourself for a crash by having a high cash allocation and limiting your spectrum of investments as opposed to allocating cash "naturally".

I would argue that I have no idea whether we are in 1996 or 1999. For all I know the market could start a 30% slide tomorrow because [reasons that will be apparent only after the fact] or keep going for years. As long as there are compelling opportunities you should seize them and avoid forming a strong opinion about the market (à la Hussman) which can put a big part of your capital on the sidelines for a long time.

 

Agree completely.

[frommi]

I feel really bearish about the market but at the same time very bullish on my stock picks. Perhaps its just a good idea to avoid cyclicals where the cycle is not at the bottom, banks near fair value, commodity stocks or stocks where you feel that their margins are stretched. I can sleep very well with FFH as a deflation protection. And that is probably the most important thing, that you can sleep well with your portfolio even when the stock market closes for a year or two.

[vinod1]

It should be the *result* of your usual bottom-up investment activity: Depending on the available opportunities your cash allocation goes up or down.

 

Then, please, answer the question I asked anders just a few posts ago...

 

Gio

 

The answer is obvious and he already gave it to you. The point is that your initial post and how it's written suggests that you positioned yourself for a crash by having a high cash allocation and limiting your spectrum of investments as opposed to allocating cash "naturally".

I would argue that I have no idea whether we are in 1996 or 1999. For all I know the market could start a 30% slide tomorrow because [reasons that will be apparent only after the fact] or keep going for years. As long as there are compelling opportunities you should seize them and avoid forming a strong opinion about the market (à la Hussman) which can put a big part of your capital on the sidelines for a long time.

 

I think there is a difference between having a strong view on market direction (like Hussman) and knowing where we are in the cycle (pendulum in Mark's words) and trying to adjust our portfolio accordingly. When valuations are unambiguously high, you might want to be a little bit more careful - avoiding marginal investments, selling closer to 90% of IV, invest in opportunities that benefit from a negative shocks, etc.

 

If someone is a truly great investor, I am sure they would still find investments selling at 50% of IV even when the market is richly priced. If I can find opportunities like that, I would be buying all day long regardless of market valuations. But IMO, those kinds of opportunities are a mirage for most investors, they are most likely overlooking some risks, if they think they found deeply undervalued securities when market is very richly priced. For most, slightly better than average investor (hopefully), it is much easier to find opportunities when there is some dislocation or market is cheap overall.

 

I would differentiate the above from holding off on making investments when the market is richly priced hoping for a crash.

 

Vinod