Why I'm hoarding cash and praying for the crash

Reflection

Why I’m hoarding cash and praying for the crash

October 13, 2017

This post is also available in: Dansk

Abstract

  • With a Shiller P/E (or CAPE) of 31.13, the S&P500 is now at levels only surpassed by the dot-com bubble. This indicates that prices have appreciated far more than the businesses’ underlying earnings power, i.e. the market is likely overvalued. The P/S and P/BV levels too are above the 20 year mean, hence substantiating the claim of a heated market.
  • The Danish C20 index is the most expensive in the whole world with an average P/E of 25.90, P/BV of 6.67 and a P/S of 5.47.
  • In my opinion, interest rates is the central component of the current bull market. The Fed failed to raise rates in 2010-2011 when they should have according to “the credit cycle textbook”. As a result of the seemingly eternal low interest rates, and thus low returns on deposits and bonds, investors have flocked to stocks in the hopes of any returns. Hence, my theory is that the stock markets’ high levels are artificial, since the price appreciation of stocks have been led by market participants’ buying behavior rather than real, fundamental increases in underlying business value.
  • For these reasons, I’m hoarding cash and praying for a forthcoming crash so I am ready to strike once the truly great businesses such as Coca-Cola, Mastercard, P&G and J&J come on sale. However, I won’t let the markets’ high levels refrain me from exploiting Mr. Market’s bargain offers, since I have no clue as to when the collapse will take place.

In practically all situations of life, a decrease in price means an increase in attractiveness. Say the car you’ve been drooling over for the past few months suddenly becomes the local car dealer’s hot bargain of the month. This would surely grab your attention, since you can now acquire this asset at a discount relative to your assessment of its worth.

The stock markets appear to be the only sphere where said law doesn’t apply. The many observers keep a keen eye on the ever-increasing needle of e.g. the S&P500’s index. They see that it’s up 10%, then 20%, heading towards 30% within a relatively short time frame. Now, the crowd hurries to jump on the bandwagon not to “miss out” on further increases. Better late than never, right? Well, that’s another rule of thumb that doesn’t seem to apply in the world of finance. Remember, in The Most Important Thing, Howard Marks warns us that the maxim ‘wisdom of the crowd’ is a paradox. That, which seems obvious in everyone’s eyes, often turns out to be a false truth. Well, where has the crowd led us lately?

Record highs, that’s where
Just yesterday, the S&P500 flirted with a price point of 2,555 – that’s an all-time high; a record, if you will. This should be somewhat alarming, since all market highs come to an end eventually. Another red flag, which is more significant than the price itself in my view, is the huge gap between the index’ companies’ underlying earnings power relative to their prices. As you may remember from Irrational Exuberance, this relationship is captured in CAPE (Cyclically Adjusted Price Earnings), or Shiller P/E. This metric applies a 10-year earnings average relative to price, and is thus a more accurate picture of true earnings power (rather than simply the current year’s earnings). We’re currently holding a second place in the Shiller P/E discipline, only ‘outmatched’ by the outright absurd dot-com bubble, cf. the graph below.

Historically, the Shiller P/E has been a quite reliable tool to identify market tops and subsequent crashes. For instance, take a look at how consistently the market has tanked once the needle moves far above the mean of 16 (the average Shiller P/E between 1880-2017).

The price-to-sales (P/S) and price-to-book (P/BV) metrics are currently far above the mean as well. The last 20 years’ P/S mean of 1.46 is ‘beaten’ with a current level of 2.18. Likewise, the P/BV is currently 3.25 compared to a 20-year average of 2.76. If you’re a chart fanatic and interested in additional graphs that signal the market’s overvaluation, check out this article from The Motley Fool.

Denmark: The world’s most expensive market
Now, we know that the American index, S&P500, is pricey measured on fundamental metrics. However, let’s double-click on the most expensive index in the world: the Danish C20. Conveniently, Denmark is my home country, and since a decent amount of this blog’s readers are Danish, I hope the below is an eye-opener. The C20 index lists the 20 largest listed companies in the country. It’s obvious from below table that Danish stocks are indeed highly valued with an average P/E of 25.90, P/BV of 6.67 and P/S of 5.47.

Company/stock P/E P/BV P/S
A. P. Møller – Mærsk A N/A 1.25 1.09
A. P. Møller – Mærsk B N/A 1.25 1.09
Carlsberg B 21.96 2.15 1.73
Chr. Hansen Holding 46.54 13.12 10.16
Coloplast B 36.06 22.71 7.33
Danske Bank 11.57 1.54 2.52
DONG Energy 15.54 3.11 2.84
DSV 35.10 6.49 1.32
FLSmidth & Co 30.34 2.42 1.17
Genmab 65.16 17.73 47.82
GN Store Nord 26.53 5.36 3.53
ISS 16.93 3.40 0.60
Jyske Bank 9.39 0.99 2.62
Lundbeck 38.92 7.98 4.99
Nordea Bank 12.75 1.44 4.35
Novo Nordisk B 19.80 17.08 5.42
Novozymes 32.41 8.42 5.89
Pandora 11.67 10.36 3.49
TDC 18.92 1.25 1.45
Vestas Wind System 16.75 5.18 1.63
Average 25.90 6.67 5.47

How did we get here?
To recap, we’re in the longest credit cycle expansion in recorded history. The Shiller P/E is above that of 1929 – the spark of the Great Depression. Other fundamental metrics, e.g. the P/BV and P/S, should induce caution in investors as well – especially if you’re a Dane suffering from home country bias.

That’s where we’re at. How did we get here? In Irrational Exuberancewe learned that each bubble is driven by a “new era” narrative, a zeitgeist. In 1901, people were convinced that railroads, light bulbs and radios would change the world and companies would prosper on this account. In 1920, the public was seduced by a narrative of eternal economic prosperity. Fast forward, then came the 1960s’ “new capitalism” bull market, the nifty fifties of the 1970s and the 1990s’ manic adoration of Internet and tech stocks. All these narratives proved to be fallacies. So, what’s the narrative this time?

In my view, there hasn’t been such a clearly defined and recurring narrative this time around. However, I believe a central component of the last decade’s narrative is interest rates. Usually, the economy is quite predictable. We go through ups and downs (or expansions and tightenings, as it’s termed). These swings are mainly controlled by the central banks through the increase or decrease of interest rates (I’ll strongly recommend watching Ray Dalio’s video “How the Economic Machine Works” at the end of this post to get a better understanding of this dynamic). Anyhow, in essentially all credit crises, the central banks (with Fed leading the way) have been able to lower interest rates, thus facilitating borrowing, which spurs spending (of credit!), hence driving the economy forward based on the maxim “one man’s spending is another man’s income”.

Back in 2010-2011, the then Chairman of Fed, Ben Bernanke, should have increased rates according to this template of economic history. However, he didn’t. He skipped this entire cycle in order to pursue “wacky experiments” such as quantitative easing according to economist Jim Rickards (listen to this great podcast episode). Now, as mentioned, Ben should have increased rates when the economy could bare it. According to Jim, the now Chairwoman of Fed, Janet Yellen, has to play catch-up in order to get the interest rates to 3.5% before the next recession, since 300-400 basis points is the (historical, at least) necessary percentage central banks must decrease the interest rates with in order to ignite borrowing and thus spending to get us out of the hole and into the expansion phase of the next credit cycle. This assumption may explain why Janet Yellen tried to ‘buy time’ with this laughable comment: “We will not see another financial crisis in our lifetime.”

With rates this low and huge amounts of credit in the system, I believe, investors have felt ‘forced’ to buy stocks due to a lack of alternatives, since deposits and bonds’ inflation-adjusted returns have been almost non-existing. Then throw e.g. the large influx of ETF money, governments’ buying frenzies, quantitative easing and Trump’s bizarre pro-business policy intentions into the mix, and you have (in my opinion!) the recipe for the current artificial high stock market valuations. Artificial, because the price appreciation of stocks have been led by market participants’ buying behavior rather than real, fundamental increases in underlying business value.

But, hey, what do I know. This is but my thesis, and you may be falling off your chair laughing as to how superficial my ‘analysis’ is. I’m by no means a macro expert (very far from it), I simply know three things regardless of whether my assumption as to how the markets got so inflated hold water: 1) The markets (at least most, and surely the US and Danish ones) are overvalued, no question about it; 2) I have no clue as to how long they’ll stay at these levels (3 months, 1 year, 3 year?); and 3) because I have no clue, I continue to invest, but cautiously so.

What should the cautious investor do?
In length, I am but an aspiring value investor with no extraordinary information or insights to when (not if) the financial markets go belly up next time. Will the Fed succeed in reaching 3.5%, which according to Jim Rickards will happen in 2019, before the next recession? My guess is as good as a toddler’s. Based on this embarrassing self-assessment, I chose to stay invested – and continue to invest – in strong businesses I deem attractively priced. I do not, however, push funds into ETFs or market indexes, as the Shiller P/E indicates a 10-year return of just 3%. Furthermore, I stay 50% in cash to make sure I have capital to deploy once the truly great businesses such as Coca-Cola, Mastercard, P&G and J&J come on sale when we experience the next meltdown.

Be aware of the pendulum’s swing, Howard Marks advises in The Most Important Thing. Don’t let an overheated market keep you from exploiting Mr. Market when he offers you bargains. However, don’t go all in either. Be aware of the pendulum, and remember this golden quote from the very same super-investor: “Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.”

This post is also available in: Dansk

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