How Will the Speculators Fare?

Executive Summary

Benjamin Graham (Warren Buffett’s mentor) and David Dodd authored the book Security Analysis, in which they define investment as: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” The second graph below shows current P/E ratios at 192% above the long-term mean (almost a statistical anomaly described below). Bear markets such as the Great Depression did not fully recover until the 1950’s – over 20 years later. The Great Financial Crisis of 2008 wiped out gains back to 1996 – 12 years. Speculators today should be adequately hedged, and/or have a detailed plan for how they will exit with their winnings – otherwise they could depart with far less.

Please proceed to read The Details below for more information.

“The only real mistake is the one from which we learn nothing.”
–Henry Ford

The Details

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” This definition of an “investment” was written by Benjamin Graham (Warren Buffett’s mentor) and David Dodd in their infamous book, Security Analysis. The problem for those with funds to deploy is that markets do not remain at levels considered reasonably valued for investment purposes. In fact, it was William Hamilton, the successor to Charles Dow as the editor of The Wall Street Journal, who said, the reason bull and bear trends are inevitable “…lies in human nature itself. Prosperity will drive men to excess, and repentance for the consequence of these excesses will produce a corresponding depression.”

Investing money involves purchasing shares of stock, or a fund of stocks, which are priced at levels that should provide safety of principal and provide earnings which can be distributed as dividends to shareholders. When stock prices rise above these reasonable levels, investors turn into speculators as now they are “betting” that the stock price will continue to rise, even if it makes no sense fundamentally. As witnessed over the past 12 years, the periods of speculation can trend for a long time.

A chart of these long-term bull and bear cycles, along with the corresponding Shiller P/E Ratio (or PE10) is shown in the chart below from Crestmont Research.

Long-term or secular bear markets are periods where the excesses built into prices as shown by the high PE 10 ratios are burned-off resulting in average or below average price-to -earnings ratios. The current Crestmont P/E ratio (a derivation of the PE10) is shown below from VettaFi.

Once prices relative to earnings and revenue become excessive, investors morph into speculators. Many investors are unaware they have turned into gamblers, betting on even higher prices despite the relatively low level of revenue and earnings. The exuberance grows as do the stories of lucky individuals achieving unheard of winnings from skyrocketing stock prices. Family, friends and colleagues swap stories of their “investment successes.” The FOMO (Fear of Missing Out) becomes too great for even the staunchest fundamental investor. The feeling of falling behind one’s speculator peers becomes too great and eventually lures in the last hold outs. As more and more retail speculators join the party, stock prices become even more detached from reality.

Notice in the graph above, the P/E is 192% above the long-term average. The level is just shy of the “4 standard deviations” line. What does that mean? In a normal distribution, the probability of an event occurring 4 standard deviations from the mean is 0.006%. In other words, this level of overvaluation almost never happens.

To bring the level of prices down to the mean would require a drop of about 67%. However, notice above, after peaking, the following correction often takes the level of valuation below the mean. The bear markets ending in the early 1920’s, 1930’s, 1940’s and 1980’s took valuations to levels around 50% below the mean. This type of correction would entail a market drop of about 75%.

Speculators do not give much thought about this happening…until it is too late. With every dip, speculators assure themselves that markets will soon return to an ever increasing state. Oftentimes, the dips are used to “double-down.” The thing that many speculators don’t realize is that EVERY bubble has eventually burst. The higher the overvaluation, the greater the eventual loss.

Suffice it to say that today, those with money in funds tracking the major indices are currently speculators. Most people don’t care. As long as the market goes up, they are happy. It is important to realize that the markets are truly a casino now, with gamblers betting prices will continue to rise. There are all kinds of justifications, whether technologically, politically or geo-politically based. It might help to go back and re-read the first line in this newsletter. Those who are okay betting on more exuberance must come to terms with the ultimate outcome of these cycles. The downturn during the Great Depression did not fully recover until the mid-1950’s. The Financial Crisis ending in 2009 wiped away all prior bubble gains from 1996 forward. This bubble being even greater means the outcome could be similar or worse than these prior cycles.

Those who have been to the casino and won know the thrill it can bring. But how often does that happen consistently? How many people leave the casino with more money than when they arrived?

Speculators today should be adequately hedged, and/or have a detailed plan for how they will exit with their winnings. Sadly, most will depart with far less. There is a big difference between investment and speculation.

The S&P 500 Index closed at 5,969, up 1.7% for the week. The yield on the 10-year Treasury Note fell to 4.41%. Oil prices increased to $71 per barrel, and the national average price of gasoline according to AAA fell to $3.06 per gallon.