We are in the early stages of the Greater Fool phase of the market. It’s too soon to bail out.
“Winter time is coming, the windows are filled with frost.
I tried to tell everybody, but I could not get across.
I want to be your lover, baby, I don’t want to be your boss.
Don’t say I didn’t warn you, when your train gets lost.”
~Bob Dylan – It Takes a Lot to Laugh, It Takes a Train to Cry
A couple of months ago I wrote an article wherein I argued that we were in the Greater Fool stage of this historic bull market. Today I reiterate that thesis, but I am not ready to issue a sell signal just yet.
The Greater Fools who are buying this market might be safe over the short term, maybe a year or so, but over a longer time frame I don’t see much upside until the market does what it always does – correct its over-extended valuation, with or without the help of a recession.
Here are a few of the assumptions one would have to make in order to believe that buying stocks today will provide fair compensation for taking on the attendant elevated risk, and thus becoming part of the Greater Fool cohort.
- The U.S. stock market is not overpriced, in spite of a mountain of evidence to the contrary.
- O.K. the market might be a little expensive right now, but it’s justified by low interest rates and an accommodating Fed.
- Corporate earnings will continue to rise by 10% per year for the next few years, in spite of the fact that earning estimates are coming down, rather than going up.
- The Fed will succeed in shrinking its balance sheet from $4 trillion to $2 trillion without impacting interest rates or stock prices.
- Interest rates will remain low for the next few years, justifying the high P/E ratio of the stock market.
- The Trump administration will deliver tax reform, infrastructure spending, repeal of Obamacare, and the return of high-paying factory jobs, including coal mining jobs, by renegotiating trade agreements with China, Mexico, and Canada.
- Passing a large tax cut, without offsetting spending cuts, will stimulate growth so much that it will pay for itself. Trickle down, baby.
- Kim Jong Un will eventually realize the error of his ways and agree to end his nuclear program, thus making the global community safe and secure.
- Vladimir Putin will eventually realize the futility of trying to influence American elections, and agree to stop his state sponsored cyber attacks.
- This time is different.
Pardon my skepticism, but it seems to me that the optimism among investors today is based on a shaky foundation. One could argue that the stock market today is priced for perfection, meaning that most of the assumptions I listed above are already baked in. I think it’s worth considering the counter-arguments for these assumptions, to bring expectations more in line with historical norms.
You can disagree with my argument, and you might turn out to be right. I’ve never shied away from admitting a bad call. But if you reject this type of inquiry out-of-hand, because you believe that “this time is different” or “there is no alternative” or “the Fed will be there to support the market”, you might be setting yourself up for a fall.
My official advice to clients and subscribers is to stay invested in risk assets until there is evidence of a business cycle turning point. Don’t fight the tape, in other words. And don’t get ahead of yourself by bailing out too soon.
Pick your valuation metric. P/E, P/B, P/S, P/Cash Flow, CAPE, The Buffet indicator, Gross Value Added, Tobin’s Q, or others. They all support the overvalued argument to some degree. The counter-arguments I hear from the bullish crowd are (i) unemployment, inflation and interest rates are low, (ii) the Fed won’t allow the market to crash, (iii) the economy is going to take off, (iv) earnings are going to accelerate, and so on. The problem is that even if these arguments are true, they are already reflected in the markets.
The Fed has painted itself into a corner. They have ballooned their balance sheet, and they have announced to the world that they are now starting to unwind their positions. Stock and bond market bulls assume that the Fed will be skilled enough to pull this off without causing any serious disruptions to the capital markets.
They also assume the Fed will quickly ride to the rescue if traders start to rebel, but I’m not so sure. Even if they did ride to the rescue, that would only provide temporary relief. Eventually they will have to normalize policy and start unwinding in earnest.
And now that we have a new candidate to replace Janet Yellen, all bets are off in terms of how the Fed will respond to the next fiscal, monetary, or capital market crisis.
How will the coming bear market unfold?
A few days ago, my 30 year old son asked me what I thought about the market. He’s just starting to build a retirement fund and he was wondering if he should hold off on new stock purchases for now. We talked about it and came to the conclusion that he should go ahead and put his savings to work now, rather than waiting. But I had some serious caveats. When I said that I was expecting a bear market sometime in the next 12 months, he asked me if it would all happen right away, of slowly over time. Here’s what I told him.
“I don’t think it will be an immediate dump, because people have been conditioned to “buy the dips” and they probably will again. But they can only do that a few times before it becomes apparent that the market is not going to make a new high again anytime soon.
Once the “buy the dip” crowd gets spooked, it’s Katie bar the door. Just imagine what it’s going to look like when everybody who is counting on Trump wants to sell at the same time. Add in the impact of algorithmic trading, and you have computers making the decisions to sell at any available price.
To me, this all adds up to a classic meltdown, on a scale we haven’t seen since October 1987. The tricky part is knowing how to tell the difference between a dip that will be bought, and a crack that won’t.”
Am I encouraging my son to become part of the Greater Fool cohort? I suppose you could say that. But one of my golden rules of investing is to let the data drive your decisions. Leave speculation, assumptions, and emotions out of it. If you have indicators, don’t get ahead of them. And don’t fight the tape.
Until I see some evidence of a crack in the foundation of this historic bull, I will continue to advise my clients, and my family, to stay invested.