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Ben Archer

Time to be bearish on stocks...

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With things heating up in the economy, I think it's wise to tighten up your stop loses if you're in the market right now. I think there could be a 50% rout in valuations by the end of next year. There's plenty of technical reasons showing huge lack of support, and extreme valuations, but also fundamental reasons, too. I'm personally raising cash and  moving everything out of stocks and into other securities and physical assets by the end of the year (same thing I did in 2008/2009).

Edited by Ben Archer

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QE was not a normal tool. So, very specifically, "tapering" really does not have much history to go by. Of course we do have the other types of "tightening".

Over the last two cycles, the "Feds Funds Rate" was the main tool, but that is now ineffective. Nevertheless, if one takes the Feds Funds rate as a proxy for tightening over the last two cycles, one does not see the stock market shifting downward in a hurry. The data is limited, but using the little there is, the pattern is like this: tightening is a reaction. The Fed reacts after the stock market has bottomed and has then risen for a couple of years. The stock-market does not top off after the tightening, but goes on...sometimes for another two years. Again, the data is limited, but that's what it says for what its worth.

 

We did see a tantrum around June, when the Fed said they would taper. The Fed panicked -- in the professorial, stoic way in which it panics -- and backed off even though most players had taken some tapering for granted. The taper was going to be quantitatively small, and actually not even a reduction if one computes it as a percentage of government bonds being issued. However, market players often watch for turning points (the way a significant change in price expectations leads to a seemingly disproportionate repricing of long-term assets). The Fed's reassurances notwithstanding, the market figured that it's a turning point for rates, and long terms rates rose and have stayed high. However, the Fed's assurances on short-term rates have also sent a message that there won't be any good place for "risk-free" cash to hide. So, the stock market is still the only game in town if one wants to dance as long as the music is playing (as Charles Prince tried).

 

That's not to say I think you're wrong about the stock-market. Far from it. Though I wouldn't warrant a guess as to whether it will correct in 2014, 2015 or 2016, the market boom is growing a bit old, so it is wise to treat it at least as if it is somewhere between the mid-point of the upturn and the top, and to act accordingly.

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QE was not a normal tool. So, very specifically, "tapering" really does not have much history to go by. Of course we do have the other types of "tightening".

 

Well to be fair, tapering does have some history. There's been three times (four if you consider the Twist) the fed has tried to wane itself off priming the pump, and the economy contracted each time:

 

image4.1.png

(from http://futuremoneytrends.com/blog/?p=11797)

 

So it's clear the market sells off indiscriminately whenever there's tapering. The period lasts 12 weeks on average and the market falls around 16% each time. 

 

However, the Fed's assurances on short-term rates have also sent a message that there won't be any good place for "risk-free" cash to hide.

if you imagine that there is gonna be a continuation of the bubble that you saw in 2000, it’s still safe to buy stocks. If you imagine that we are in the process of returning to normal levels of stock valuation—particularly if you imagine that interest rates are likely to go higher—then there’s no way we’re gonna get to positive returns buying stocks at these prices, on average, over the next ten years.

 

The way I see it is based on shiller p/e ratios. Stocks go up when interest rates go down and valuations go up. Stocks go down when interest rates go up and valuations go down. It's a lock. And I think you’re gonna see valuations fall by around 50 percent. So I think the Shiller P/E, let’s say it ends the year around 24, 25, you’re gonna see it next year between, say, 12 or 14. And this will be great for people who have a lot of cash on the sidelines.

Edited by Ben Archer

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I agree. I was thinking about history prior to the current "great recession".

Right...that's more important actually, for context...because if you compare it to that last 15 years you're just looking at a "bubble period."

 

Currently, the Shiller P/E ratio today is around 23. And that is about roughly half of its peak – P/E in 2000 – bubble. And a lot of people, in their minds, they say, “Oh, then that means it’s pretty cheap because it’s nowhere near the top of the market in 2000.”  But the problem with that is, if you look historically, the Shiller P/E has generally always been range-bound between around 20 and around 10. That’s where most of the Shiller P/E levels have been during the market history. There are several notable exceptions to that. Stocks were incredibly expensive prior to the Great Depression, so you look in ’29, the Shiller P/E is over 30. And stocks were incredibly expensive in the big bubble of 2000, where the Shiller P/E was over 45.

Edited by Ben Archer

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Currently, the Shiller P/E ratio today is around 23. And that is about roughly half of its peak – P/E in 2000 – bubble. And a lot of people, in their minds, they say, “Oh, then that means it’s pretty cheap because it’s nowhere near the top of the market in 2000.”

True, but other than comparing to the last peak, people also give weight to current P/E and other such current metrics (as opposed to slightly longer averages / normalized metrics). Momentum seems to rule, between major turning points. People do realize that business profitability is higher than its historical averages because businesses cut back cost more than their drop in revenues. However, businesses can still do more of that as long as a sense of optimism does not take over.

I think the biggest driver of stocks has been the "only game in town" notion. For a while now, the bulk of investors have thought that interest rates have bottomed, making bonds a poor bet. "Cash" returns nearly nothing, in nominal terms. Foreign economies seem more precarious than the U.S.  Talking to colleagues who simply put money in 401-Ks and forget it, I get the sense that people are still cautious about stocks -- so maybe the last little bears have not folded yet. If their bond funds drop, will they increase the money they put into stocks? At the same time, margin-debt is extremely high -- which would indicate that the more trigger-happy money is heading to stocks. Some vocal bears have folded recently (e.g. the always entertaining Hugh Hendry).

Anyhow, I basically agree with you on the essentials. The stock market has all characteristics of a boom and one must be cautious about stocks.  Yet, the Fed has shown that it watches and reacts to the stock-market. And, Janet Yellen has spoken longingly about negative interest rates. Even if Yellen does not want to walk back the tapering, she could walk back tightening in other ways. She could even ponder the idea of having the Fed buy stocks, as the Japanese did, and testify that enabling legislation would be welcome. Unfortunately, this has many elements of figuring out the machinations of a criminal mind, not just of some relatively rule-driven, framework-constrained business process. So, while I would not be surprised if the market drops 50% in 2014, I think it could well go higher still  for a few more years (though I'm not betting on it).

 

John Hussman could well be right, the market might be right near the top, ready to crash within months, before hitting S&P 2000. Or, Jeremy Grantham of GMO could be right, that even though the market is over-valued there's a good chance we get to S&P 2300 over a couple of years of extra Fed reaction, before it truly loses plausibility. (Both those guys are always thoughtful reads.)

 

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Currently, the Shiller P/E ratio today is around 23. And that is about roughly half of its peak – P/E in 2000 – bubble.  ...   ...

John Hussman could well be right, the market might be right near the top, ready to crash within months, before hitting S&P 2000. Or, Jeremy Grantham of GMO could be right, that even though the market is over-valued there's a good chance we get to S&P 2300 over a couple of years of extra Fed reaction, before it truly loses plausibility. (Both those guys are always thoughtful reads.)

It's a more than a year later, and the S&P was up about 17% and is still up over 10%. Now, with China's slowing confirmed, and with the Fed claiming they are going to raise rates by a token amount this year, and with the market flattening ...  the market slowdown seems real. 

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According to Peter Schiff, the housing bubble was primarily caused by the lowering of the Federal Funds Rate to around 1 percent between 2002 and 2004 and the continued low, but gradually raising rates over the next two years. He says that now that interest rates have been at 0 percent over the last five years, plus QE, even bigger bubbles have been inflated, which when they pop, will lead to an even bigger collapse than in 2008. This is my understanding of his view and it's quite compelling to me.

I've been looking at the historic Fed Funds Rate since 1954 (as far back as I can find) but it seems that these interest rate levels are pretty unprecedented with the exception of three short periods in 1954, 1958 and 1961. I'm wondering if these periods of lower rate were associated with any significant bubbles? If not, is that explained by the shortness of the periods of low rates? What about other factors that may have made low rates appropriate for the current economy? Also, is there anything in history like the period of 1% rates between 2002 and 2004? 

Edited by oso

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The attached chart shows the Fed Funds rate with NBER-defined recessions marked as grey bars. The best source is the FRED database. If one looks at the top part (the Fed chart) lower Fed rates tend to come right after recessions. No surprise of course: when the Fed thinks a recession is under way, they cut rate and keep them down until they judge things are better. 

The second chart is one is for the DOW stock index. The Y-axis is logarithmic (which is a good thing in this case). Falls in the stock market occurs around the same time as NBER-defined recessions. 

However, if one steps back from the pair of charts, and look at them across all 50 years, the picture that evolves is: interest rates rose from very low to very high, and are now back to being very low. Meanwhile, stocks have risen. The steepest rise in stocks are in the decades that saw interest rates come from their highs to the current lows. 

None of this is analysis, of course. Just putting down some history for the record.

fed_fund_rate.png

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