The main essence, as we understand it, is that over the last 18 months the Federal Reserve has reduced its balance sheet by nearly $1 trillion. With less Fed credit available, market interest rates must go higher. As interest rates go up, asset prices (stocks, bonds, and real estate) will eventually go down.
It is important to understand this. Because if you don’t, you may end up doing something you’ll regret. The consequences of which you’ll have to live with.
Here at the Economic Prism, as an implicit policy, we do not regret the past. For regrets can lead to bitterness in old age. And living with bitterness is no way to spend one’s final years.
So, while we do not regret the past. We also do not wish to shut the door on it. The past provides a deep source of instruction for what has worked and what hasn’t. This resource should not be ignored or dismissed.
At the same time, there are no guarantees that what worked in the past will work in the future. The world is ever-changing. What worked in one instance may not work in another.
Still, we have some inkling that past mistakes, if uncorrected, will continue to be mistakes well into the future.
For example, buying shares of Cisco in April 2000 should have been an obvious mistake. The company’s share price had spiked over 1,100 percent during the prior 36 months. The mania for easy riches had reached an extreme.
Now, over 23 years later, Cisco speculators who bought in April 2000 are still down 23 percent. Factor in the opportunity cost of holding Cisco all these years and the losses are irrecoverable.
Similarly, buying bitcoin in October 2021 should have been an obvious mistake. Another fever had ventured well into excess. A meltdown should have been the logical expectation.
Presently, bitcoin is down over 58 percent from its all-time high. Will it still be down 20 years from now, like Cisco? Or is bitcoin but one rally away from a fresh run at a new high? Time will tell.
This brings us to an important distinction…
Speculating vs. Investing
Predicting the future movement of the stock market is a game for speculators. Not investors.
Year to date the S&P 500 is up around 16 percent. For the 2022 calendar year, it lost 19.44 percent.
Maybe the S&P 500 will run up another 4 percent in Q4 and lock in a 20 percent 2023 return. Maybe a long multi-year decline will commence. No one really knows.
Yet a speculator may think he knows what direction the stock market – or an individual stock – is going. Thus, he will place his chips accordingly.
Investors, on the other hand, are looking to buy shares of companies that deliver ample cash flows at fairly priced valuations. The opportunity for increasing dividends and the potential for capital gains over time, as justified by a business’s expected cash flow, all factor into the investment decision.
Investors focus on businesses. Speculators focus on share price movement. There is nothing wrong with speculating, per se. Though, one must be clear about what they are doing.
When it comes to determining the value of the broad stock market there are valuation metrics that provide a good indicator as to where the stock market stands. Is it expensive? Is it cheap?
One valuation metric, for example, is the Buffett Indicator. Berkshire Hathaway CEO Warren Buffett once called it, “probably the best single measure of where valuations stand at any given moment.”
Currently, the Buffett Indicator, which is the ratio of the total market capitalization over gross domestic product, is over 167 percent. Specifically, at market close on Wednesday, the Total Market Index, as measured by the Wilshire 5000, is at $44.85 trillion. This is over 167 percent of the last reported U.S. GDP of about $26.79 trillion.
Significantly Overvalued
A fairly valued market is a ratio of total market capitalization over GDP of somewhere between 75 and 90 percent. Anything above 115 percent is considered significantly overvalued.
For perspective, in March 2000, the Buffett Indicator hit 148 percent just before the S&P 500 collapsed 49 percent. Before that, the Buffett Indicator registered a mere 110 percent in September 2007, in advance of the S&P 500 crashing 56 percent.
More recently, the Buffett Indicator hit a nosebleed 211 percent in December 2021. If you recall, the S&P 500 peaked out at that time and then declined by roughly 24 percent over the following nine months.
Another guide for determining the overall value of the stock market is Shiller’s cyclically adjusted price-to-earnings (CAPE) ratio. This accounts for inflation-adjusted earnings from the previous 10 years. Currently, the CAPE ratio is over 30, which is well above its historical median of 15.94.
The current CAPE ratio is about where it was when the stock market peaked in 1929, just prior to the onset of the Great Depression. The only time the CAPE ratio has been higher is at the peak of the dot com mania, in December 1999, and in late-2021.
Who knows what will happen next. Maybe the Buffett Indicator will make another run at 200 percent. Maybe the CAPE ratio will take out the 1999 high of 44.19.
The point is the stock market is significantly overvalued. At some point, its price will have to fall to where it is supported by the underlying earnings.
To be clear, a stock market crash may not be immediately imminent. Nonetheless, the reality is, the stock market is poised for a significant decline.
In other words, the risk reward proposition of betting on a higher market capitalization at this point isn’t very appealing. Not when you can buy a 6-month Treasury bill that’s yielding well over 5 percent.
Understanding valuation metrics can help keep one from repeating past mistakes and piling up regrets. When mistakes are disregarded, however, the ultimate consequences can be catastrophic.
Flying on a Wing and a Prayer
Franz Reichelt – the Flying Tailor – had an innovative idea. A wearable parachute for aviators.
In 1910, he began stitching together fabric and tossing dummies from his fifth-floor apartment. Several initial tests were successful. Dummies, equipped with foldable silk wings, made soft landings.
However, when Reichelt scaled up his design for his own use the results were less effective. One time, he jumped from a height of 30 feet. But instead of gliding down like a feather he dropped like a bag of cement. A pile of straw helped him escape injury. Another time, from a height of 26 feet, Reichelt suffered a broken leg.
Somehow, Reichelt learned the wrong lessons from his mistakes. Rather than refining his design, he focused on the jump height. He thought that jumping from a higher platform would magically make his wearable parachute work.
On Sunday, February 4, 1912, at 7:00 a.m., Reichelt arrived at the Eiffel Tower wearing his parachute suit. The weather was cold, with temperatures below 32 degrees F, and there was a stiff breeze blowing across the Champ de Mars.
After climbing the stairs to the tower’s first deck, which is about 187 feet above ground, Reichelt positioned himself – facing towards the Seine – on a stool placed on top of a restaurant table next to the guardrail. After adjusting his special flying suit and checking the wind direction by throwing a piece of paper, he put one foot on the guardrail. There he hesitated for about forty seconds.
Then, on a wing and a prayer, Reichelt executed a flawless Eiffel Tower death jump. His parachute folded around him almost immediately and he fell for a few seconds before striking the frozen soil at the foot of the tower.
When Reichelt’s head smashed into the ground it did not break open like a watermelon falling off a produce truck. His head remained intact. Yet his brain instantly transformed into the stringy goop found inside a pumpkin.
Le Petit Parisien reported that Reichelt’s right leg and arm were crushed, his skull and spine broken, and that he was bleeding from his mouth, nose and ears. Witnesses measured the depth of the crater left by his impact at approximately six inches.
Reichelt, blinded by optimism and hope, had failed to recognize what his past experiments were telling him. And he jumped to his untimely death.
Those desiring to accumulate investment wealth would be wise to consider the implications of sky-high valuations in the face of rising interest rates. It’s a long way down from here.
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Sincerely,
MN Gordon
for Economic Prism
