It should and will come as no surprise that fundamentals like valuation basics and sane credit levels have left the building (and securities markets) for some time.
Global stocks, as per the MCI Global Stock Index, are trading at 31 PE multiples and bonds are so overbought across the world that over $18 trillion of them are offering negative yields.
In short, they are technically defaulting…
Today’s investors have effectively given up on managing risk.
Instead, they are at record-low cash buffers and objectively all-in as markets reach new highs on the tailwinds of unprecedented fiscal ($3.8T) and monetary ($3.6 T) support (i.e. fake money and deficit expansion) from 2020 and helluva lot more for 2021.
But that’s what happens when a central bank produces fiat money like this…
That is, gobs and gobs of printed dollars (of which the FOMC has promised more 2021) keep banks artificially liquid, bond prices artificially bought/high, yields artificially repressed and thus rates (i.e. the cost of borrowing) stapled to the floor of history.
But as the Austrian School reminds, cheap debt leads to debt binging, and debt binging leads to very scary things…
Cheap Debt = Crappy Bonds & Zombie Enterprises
Smelling cheap rates, U.S. companies will borrow (i.e. binge) like this…
Companies chase cheap debt almost as much as college kids seek discounted beer, and use it just as dangerously—i.e. to buy-back their own shares or issue dividends with borrowed dollars, make no profits and then call themselves “recovered” as their stock prices fly, literally, on borrowed wings.
Many, in fact 15%, of these debt-drunk enterprises are walking dead “zombies” who borrow at advantaged rates just to pay yesterday’s interest and have no chance at all of ever repaying the principal.
These zombies, however, are just one member of an over-all embarrassing club of U.S. corporate bond issuers, 67% of which are rated junk, a “pinch” above high yield or levered loans—namely the bottom of the credit barrel, as we’ve reminded before.
From Bad Bonds to Inflated Stocks: Just Do the Math
But when not issuing IOU’s to stay alive, many of those same enterprises are passively riding a stock market wave above jagged rocks of broken balance sheets hidden just beneath the waterline.
And as for modern corporate balance sheets–do they or any other rule of math and common sense even matter anymore in this new, Market Fantasy Zone?
Toward that end, I’m thinking of those pesky items of the ancient past like earnings, profits, cash flow, book value etc.
As Doug Cass recently reminded, nearly every traditional and once-respected measure of sound S&P stock valuation—i.e., PE ratios (27.9), Cyclically Adjusted PE multiples (32.9), Price to Earnings ratios (27.9), Price to Sales (3.0) or even the classic Total Market Cap to GDP (170%)—are all at record highs today.
And yet buyers are crowding in for more, buying at (and chasing) frothy tops like sheep following a mad herdsman.
Speaking of mad crowds and their even madder herdsman, Citigroup is forecasting an S&P at 3800 for 2021 while JP Morgan and Kantor Fitzgerald are anticipating 20% surges from current stock valuations for the new year–pandemics, recessions and unemployment levels be damned.
Price to What?
But let’s pause and consider (for the sake of brevity) just one of the many 100th percentile metrics of market overvaluation—the infamous price to operating earnings ratio.
It’s worth noting that current PE ratios for the S&P are now where they were just before the infamous bubble-popping of 2001 and even higher than where the stood before the great rise of 2008 made history as the Great Financial Crisis of that same year:
Look a little scary to you?
Now look even closer.
What’s particularly eerie is just how fast those ratios (i.e. metrics of gross over-payment) have climbed since the market tanked in March.
Folks, it’s not as if earnings were rising by double digits because valuation was rising.
In fact, they weren’t rising at all—just the pricing was.
If we look at actual earnings per share data, they confirm that earnings today are where they stood in 2018 when the market was valued much lower.
This means today’s (and tomorrow’s) investors are literally riding such an optimistic high that they are openly (and likely unknowingly) paying 35% higher prices for the same companies whose earnings have not risen for the same period.
So, what gives? What’s going on?
Mania and Market Psychology
In simple terms, we are witnessing a mania, and manias, like viruses, can last for a long time.
Mania’s moreover, have less to do with valuations and math—i.e. PE ratios and bond yields—and more to do with psychology, a topic absent from most Wall Street (and even Main Street) reading lists.
Looking at past manias and bubbles (listed below), we know that investors pile in together on the buy-side, ignoring valuation sobriety until they are forced to—i.e. when it’s too late.
We also know that market manias often have no correlation to underlying economic conditions, and thus markets can thrive while economies (as now) are literally gasping for air.
In fact, manias typically gain speed rather than tire out as markets pierce resistance levels and reach new, record-highs, seemingly, with each weekly headline.
Confidence follows headlines, and headlines create crowds, and crowds follow each other and the sell-side—right up to, and then eventually, right over a market cliff.
Overestimating Skill While Underestimating Humility
Psychologists, for example, would remind that a cognitive bias often occurs in bull markets wherein individuals of a low ability at a given skill begin to overestimate their abilities due simply to an “inability to face their inability.”
This often takes place when investors are enjoying a trend (or mania) rather than genius.
The fancy lads call this psychological phenomenon the Dunning-Kruger affect, and I’d contend that many Fed Chairs and wealth advisors, as well as many investors, are suffering from it now as they passively enjoy (and take credit for) a maniacal market rise.
This disease of false confidence spurred by false (i.e. artificial markets) is particularly the case for Janet Yellen, who is now heading from the Fed to the Treasury with much applause.
Ah, how the ironies do abound. When it comes to monetary discipline, Yellen at the Treasury makes as much sense as Madoff at the SEC.
And no, this time is not different. It’s worse.
The level of current mania (Tesla to Bitcoin) surpasses prior bubbles, and the depth of debt and economic (as well as political) weakness beneath it is now greater than prior recessions.
With global debt now at $280T and combined corporate, household and consumer debt in the U.S. now at $80T, this in no time for losing one’s mind (and portfolio) to the buzz of yet another Fed-driven mania.
In short, this Market Fantasy Zone is colliding with a Perfect Storm (psychological, financial, social, political).
Mean Reversion—The Great Humbler
All markets revert to the mean. It’s a law of markets as real and natural as gravity is to the laws of physics.
And math, as well as natural market forces, like the laws of physics, still matter.
Together, these forces stand in the background rubbing their hands as maniacal investors go all-in to chase a market top that would make the Matterhorn blush.
By example, math reminds us that the median PE ratio for the S&P is 17. Today, that PE ratio is a jaw-dropping 30.
Once (not if) this market reverts to its mean (as all markets do), this would place the S&P closer to 2,000, where the real value investors can start buying the falling bottoms rather than these dangerous tops, now poised to needle further before they tank.
More Fiat Dope, More Addiction & More Debased Currencies
But as we also know, and after years of addiction to Fed “accommodation,” whenever and however markets begin their next implosion (typically on some headline scandal or event), the Fed will crank out the money printers and deliver more fiat dope to markets suffering “the needle chill.”
Global money supply, increased by greater than $14T in 2020, and is only going to shoot higher, as central banks shoot more steroids into a system which they helped corrupt, debasing currencies with blind elan as markets inflate on the backs of fiat dollars and unpayable, rotten debt.
As always, all rivers and informed market conversations eventually turn toward physical gold, often castigated as a “barbarous relic” in times of mania and then no longer available/affordable when desperately needed in times of pain.
In short, those who were chasing tops in times of mania suddenly find themselves looking for a safe and precious place to land when there’s nowhere left to hide in times of pain.
Currencies, in short, are being debased by the second, and although Bitcoin may get you rich (or tank), it is not the best hedge or alternative currency for those seeking to protect their wealth, for any asset that climbs by 5X or loses 85% in a year, is not about to be the next currency insurance.
Instead, it’s a speculators front run, and trust me, Druckenmiller, Saylor and Paul Tudor Jones know this, and will know when to make a ton a cash, as well as when to cash out…
Their headline-making and confidence-boosting (as well as mania-abetting) purchases literally acted as “market makers” and by sheer volume alone insured a price spike (98% of all Bitcoin is held by 2% of the accounts).
Three Little Piggies & The Big Bad Wolf
Such cycles remind us of the tale of the three little piggies and the big, bad wolf.
Two piggies, enjoying all the blissful ignorance of the Dunning-Kruger effect, are too busy playing (i.e. speculating) to worry about a big, bad wolf around the corner.
Thus, they build their huts of straw or mud while the third little piggy, all too aware of that big, bad wolf, diligently builds his home of bricks.
When the wolf comes, guess which hut is left standing?
Of course, the same is true of weak and strong portfolios and the big, bad market wolves of debt, over-valuation and risk asset bubbles: Some investors are prepared, but most are gamblers sitting on straw and mud.
When risk assets are slaughtered by the wolf’s fangs of needle-sharp debt, gross equity over-valuation and fatal currency debasing policies like “unlimited QE,” only those investors who built their portfolios on a foundation of risk management rather than risk chasing are left standing.
Here at Signals Matter, we know that markets supported by a central bank can rip while economies collapse, and we can be both bearish and bullish, as we have been so many times depending on the Fed’s moves and the market’s reactions.
But as we head deeper and deeper into the Market Fantasy Zone, now, more than ever, is a time to build portfolios able to catch tailwinds but respect headwinds, including a hurricane.
We look for and provide portfolio solutions not market (or marketing) fantasies.
What we are seeing both at the policy level and technical level (revealed in more detail for our paid subscribers) suggests many changes ahead in 2021.
This means informed investors, rather than fantasy investors, are getting well prepared.
Be safe, be informed.
Matt & Tom