Date: 4th May, 2015
Updated 14 August, 2015
S&P Current Price: 2115
Horizon: 1.5 year
A word of caution, or rather, a general principle in trading I try to hold myself to: Keep your leverage below 20x, ideally 10x. Even if the trade seems absolutely golden (like this one is), you don’t want to get caught on some 3-4% move against you resulting in margin call.
In September 2007, the S&P was trading at 1540, nothing seemed to be able to stop it. The subprime crisis was becoming apparent, but somehow the bulls charged on. Even in the face of what in hindsight were obvious warning signs, stocks continued to go up.
By late 2008, the market was bottoming in the crash. Since then we have been in an almost 7-year bull market, rising from a low of 665 to a high of 2120, an over 200% return. Look at this chart nice and hard. In 2 years you will look back and see how obvious it was in hindsight, but this has been essentially a monotonic rise in prices, year after year, under dubious monetary and macroeconomic circumstances.
Historically, if you exclude the “Great Moderation” of the 80s to the .com Bubble, bull markets don’t last more than 5-6 years. In fact, the current bull market is the THIRD LONGEST bull market (2,270 days by August 14) in US history. This is after the post-WWII boom and the internet boom of the 90s.
Historically, Central bank interest rates have been positive and move with inflation and are affected by growth. We are currently in an unprecedented period where interest rates in most developed economies have been around 0%. This has been a new occurrance as a response to the 2007-2008 Financial Crisis. There are even countries (Denmark and Switzerland) with negative interest rates. This is a strong indication of DEFLATION in the world economy. When coupled with falling commodity prices (see oil and gold) the case becomes even stronger. Deflation is negative for economic growth, and economic growth drives the earnings and confidence which drive stock prices.
Another historical correlation is how transport stocks are a leading indicator of a down market, see the chart below for an illustration:
Note that we are teeting on a decline, which in recent downturns has been a nice indicator of recession and market drop.
Part of the reason why this bull market has been so persistent has been Federal Reserve easy monetary policy. QE1, QE2, QE3 – trillions of dollars worth of reserve balances created in exchange for various government debt mortgage derivatives, and other assets. The direct effects of QE are hotly debated, but there is strong suspicion that by removing this high-risk debt from private sector balance sheets, it has caused investors to move funds into the stock market. Claudio Borio, Chief Economist at the Bank of International Settlements(BIS) said in 2014: "there has a disappointing element of deja-vu in all this". By the end of 2014, Quantitative Easing in the United States is no longer (as Mario Draghi at the ECB is just beginning…).
And what have companies done to earn such all-time high stock prices? They’re stockpiling cash at record levels, engaging in high levels of stock buybacks (pw), and don’t seem to have any projects to invest in that would yield the growth that is implied by their market value. The only bull market longer than this one, that went from 1987-2000, was due to unprecedented levels of globalization, the privatization of the internet, and explosive technological development. What do we have now? Secular stagnation, a crisis that Europe and the US never quite recovered from. Gloom is the new normal.
And here we are now, at the end of line. No more QE will be coming to save the market. It's Spring 2015, the FOMC voting members have been debating when to raise rates. Yellen says this year, Evans says 2016 would be more prudent. Despite no sign of accelerating inflation, despite terrible GDP numbers, the open policy discussion not about if, but WHEN to raise short-term interest rates. The inevitably of tighter money, combined with a Eurozone in perpetual crisis and a slowing Chinese economy, it fosters an environment that is less conducive to a continuing bull market, thus contributing to the extreme downward pressure on risk-assets like the S&P 500 Index.
Prominent asset managers have started to come out with grim outlooks on not just the stock market, but the bond market and the US (and global) economy as a whole: Bill Gross, billionaire fund manager, has issued dire warnings about the state of Western asset markets. . Additionally, Warren Buffett has similar words of caution And finally, Janet Yellen recently came out and said “stock valuations are quite high” . When the most powerful economic actor on earth tells you market valuations in an asset class seem high, you RUN, not walk to the exit.
Finally, for the fundamental case, nothing is more important than Earnings. The path of earnings growth is turning down, and fast. Additionally, revisions to forward guidance are showing a much more bearish outlook by publicly traded companies. If the troubling macroeconomic environment is not convincing enough, then the cash flows and earnings of the companies is the cherry on top. No matter what is going on with fiscal or monetary policy, if the stocks composing the index are losing money, investors will no longer wish to own them. Unlike commodities or cryptocurrencies, stocks values derive heavily from the underlying earnings the ownership entails. The trend in the chart above is simple. And when we are still just 2% from All Time Highs, the decline in earnings growth can only continue without a change to stock prices for so long until it breaks.
Robert Shiller, recent Nobel Prize winner in Economics, has spent a good part of his career studying bubbles and trying to understand the psychology behind asset market price movements. One of his most important contributions has been an alternative measure of Price to Earnings ratio (PE) called the Shiller PE. It takes a 10-year rolling average of inflation-adjusted earnings, to account for momentum and adjust for big changes rather than overreacting to the short-term. You can think of this as a crude but effective “bubble warning meter”. In 2007, this ratio was 27.21. We are now at 26.84.
Another useful metric to determine how overvalued the market is is Tobin's Q. Historically one can see that values above 1 indicate it is overbought.
Historically, technically, fundamentally, cyclically – the S&P 500 is going to be going down. Stock markets have always fluctuated with the business cycle, and this US economy is not immune to the Minsky financial forces. The correction that is coming is not a bug, but a feature of the system. The cracks in the foundation are already showing, and the pressure is getting to be too much for investors to handle.
The reversal of trend and drop in prices may be long and slow, or it may tumble fast. What is nearly certain though is that a reasonably leveraged short against S&P is a medium-term investment that will pay off.