Executive Summary

The stock market moves in bull and bear cycles. Investors tend to be the most enthusiastic at the top of the bull cycle when valuations are stretched to the limit. This phenomenon is exacerbated by the “cheerleaders” on financial media rooting for a “new market high.” Rarely do they examine if a “new high” is justified. After every bull market comes a bear market, often eliminating years of prior gains. A brief review of historical cycles illuminates a clear picture of the extreme swings in stock price overvaluation experienced since the 1990’s. As the Federal Reserve, and its global counterparts, have become more active in attempting to “control” the economy and the stock market, irrational over-pricing of stocks has led to serial bubbles. Again, history shows that bubbles always pop. Based upon a study of market history and current valuations, it is reasonable to state that a correction on the order of 50% or more is required to bring stock prices back to their long-term historical mean. This is purely math. The bottom line is that investors holding the broad stock market today are what Benjamin Graham would classify as speculators. History has not been kind to speculators. Please see The Details below to grasp the importance of understanding the Full Market Cycle.

The Details

Those who do not understand market cycles can find themselves in a similar situation as those who leave a football game at the start of the fourth quarter because their team is winning, only to discover to the sound of roars from the parking lot; the game wasn’t over. The stock market moves in bull and bear cycles. Investors tend to be the most enthusiastic at the top of the bull cycle when valuations are stretched to the limit. This phenomenon is exacerbated by the “cheerleaders” on financial media rooting for a “new market high.” Rarely do they examine if a “new high” is justified.

Bull markets are merely one leg of the cycle. After every bull market comes a bear market, often eliminating years of prior gains. As the bear progresses, investors who only months ago were feeling as though they “won” because their portfolios were up, find themselves staring blankly trying to understand how years of gains disappeared, and why no one explained that could happen.

The fact is, once stock prices achieve levels of significant overvaluation relative to revenue and earnings, investors become speculators. Speculators, sometimes called gamblers, cheer for stock prices to continue soaring. Whether price gains are justified by fundamentals is no longer important, only that they continue their ascent. Many attempt to rationalize the moves using broad generic phrases such as “the economy is booming” or “the unemployment rate is low” without any true data to support such phraseology.

Benjamin Graham, Warren Buffett’s mentor, once stated “Speculators often prosper through ignorance; it is a cliché that in a roaring bull market knowledge is superfluous and experience is a handicap. But the typical experience of the speculator is one of temporary profit and ultimate loss.”

A brief review of historical cycles illuminates a clear picture of the extreme swings in stock price overvaluation experienced since the 1990’s. As the Federal Reserve, and its global counterparts, have become more active in attempting to “control” the economy and the stock market, irrational over-pricing of stocks has led to serial bubbles. Again, history shows that bubbles always pop. The greater the overvaluation, the greater the plunge in the subsequent bear market. Economist John Hussman wrote, “Attempting to squeeze the last bit out of a vulnerable, hypervalued market is what value investor Howard Marks describes as ‘getting cute.'”

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I continue to believe that the process of the market turning from bull to bear began at the end of the third quarter last year. Since then, the Russell 2000 Index (2,000 stocks) remains about 10% below its peak, the New York Stock Exchange Composite Index is about at the level of its September 2018 peak, and the S&P 500 Index is a mere 2.8% above its 2018 high. As John Hussman wrote in his recent Market Comment entitled “They’re Running Toward the Fire”, “The price-insensitive exodus toward passive investing has favored hypervalued, large-cap S&P 500 index components and ‘glamour stocks’ over any disciplined stock selection approach. That’s not terribly unusual for late-stage bull market advances. Still, recognize that the market has been in a broadening top formation since market internals deteriorated in early 2018.”

Hussman’s study of market history and current conditions led him to state, “Given a hypervalued market with still-unfavorable internals, history suggests that a ‘trap door’ is already open here, which is permissive of abrupt and potentially vertical declines. […]

What’s notable is that we observed this ‘Bubble’ syndrome [as explained in his article here ] again last week, this time in the context of negative market internals and a relatively flat yield curve (where ‘relatively’ flat here means a 10-year Treasury bond yield less than 1% above the 3-month Treasury bill yield). From my perspective, that’s a combination worth noting, because the only time we’ve observed it in weekly data was at the exact market high of March 2000, the exact market high of October 2007, the pre-correction market high of September 2018, and today. Restrict the criteria to a yield spread of 0.5% or less, and last week’s signal joins only two other ones, which precisely identify the bull market peaks of 2000 and 2007.” Both of which resulted in a broad market plummet of around 50%.

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Why is it that when financial analysts throw out the possibility of a market correction in the neighborhood of 50%, most media pundits and many individual investors look at them as if they have a third eye in the middle of their forehead? It’s not as if it hasn’t occurred in history, including twice in the past 20 years. Based upon a study of market history and current valuations, it is reasonable to state that a correction on the order of 50% or more is required to bring stock prices back to their long-term historical mean. This is purely math.

So, why the looks? Because the current breed of pundits has been brain-washed into believing the Fed and its counterparts can continue implementing absurd monetary policy and prop markets up forever. Hussman states, “The current market highs are dominated by a single concept: the idea that the Federal Reserve is likely to shift to an easing mode in the months ahead, most likely at its July 27-28 meeting. I don’t doubt that prospect at all. The problem, as I observed in my regular July comment, is that with the exceptions of 1967 and 1996, every initial Fed easing (ultimately amounting to a cumulative cut of 0.5% or more, following a period of tightening in excess of 0.5%), has been associated with a U.S. economic recession.” Additionally, memory seems to fail many regarding the fact that the Fed eased monetary policy, dropping interest rates, during both of the previous two bear markets…to no avail.

Hussman’s MAPE or margin-adjusted price-to-earnings (p/e) ratio is calculated by adjusting the Shiller P/E (S&P 500 price divided by 10-year inflation-adjusted earnings) for fluctuations in profit margins. Of the many variants used to determine valuation, this is one of the most correlated (-0.89) with subsequent 12-year total returns. This is a fancy way to say it is more accurate in determining valuation levels than most methods. Using this methodology, the current price of the S&P 500 Index is more overvalued than at any time prior to 2018 in the history of the stock market. One would be wise not to ignore this data.

The bottom line is that investors holding the broad stock market today are what Benjamin Graham would classify as speculators. History has not been kind to speculators. While it is true the Fed has been able to delay the next leg of the market cycle longer than most value investors thought possible, conditions today are reminiscent of previous bubble peaks. And yes, even more extraordinary monetary policy could delay the bear market further, those holding broad stock indexes at current valuations are gambling the Fed can work their magic a little longer. With corporate earnings expected to fall, economic indicators near recession levels, and stocks priced for perfection, it might actually take magic to forestall the next leg of the cycle.

Charles Dow once said, “An investor who will study values and market conditions, and then exercise enough patience for six men will likely make money in stocks.” Granted, with today’s central banks it might take 10 men. But understand, the cycle will complete.

The S&P 500 Index closed at 3,014, up 0.78% for the week. The yield on the 10-year Treasury increased to 2.11%. Oil prices rose to $60 per barrel, and the national average price of gasoline according to AAA increased to $2.79 per gallon.

At Prudent Financial, portfolios are developed to take into account the state of the economy, market cycle and valuation, and relative strength. Our goal is long-term growth with limited downside potential. If you need assistance with your portfolio, please give me a call. I would be happy to review your situation and explain how we can help you work towards achieving your goals.

© 2019. This material was prepared by Bob Cremerius, CPA/PFS, of Prudent Financial, and does not necessarily represent the views of other presenting parties, nor their affiliates. This information should not be construed as investment, tax or legal advice. Past performance is not indicative of future performance. An index is unmanaged and one cannot invest directly in an index. Actual results, performance or achievements may differ materially from those expressed or implied. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy.

Securities offered through First Heartland Capital, Inc., Member FINRA & SIPC. | Advisory Services offered through First Heartland Consultants, Inc. Prudent Financial is not affiliated with First Heartland Capital, Inc.

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