The author of that post suggests that the CAPE is useless for comparisons since FAS 157 changed accounting for fair value. A review of other posts recently made by the author indicate that he is fairly bullish on not just the market, but also the economy.

I am a rational optimist and I would like to be as optimistic as “valueplays”, but he is wrong to assume that the reason for the concern about market valuation is merely because of the level of the CAPE. As I have written in more detail before, and even indicated in that last post, it is the other statistics that consistently corroborate the CAPE that indicate there is not something fundamentally different about this period compared with prior periods.

Consider, for example, Tobin’s Q ratio, which measures the market’s price relative to the replacement cost of the assets for all of the companies in the market. It is higher than at any time in history bar the dot com bubble when investor psyche went overboard on “it’s different this time” thinking.

Notice that Tobin’s Q is not a straight measure of corporate book value, for which it is possible that one component–retained earnings–could be distorted by FAS 157. Tobin’s Q is an estimate of the cost to replace the assets that are already in productive use. It may not be perfect, but it corroborates the implications of the CAPE.

Consider, also,  Warren Buffett’s favorite indicator of market valuation known as Buffett’s P/E given by the following ratio:

(Market capitalization) / (Nominal GDP)

Notice FAS 157 would have little influence on nominal GDP. Buffett’s P/E is more than two standard deviations higher than it’s average since 1950. Again, the only time it has been higher was during the ridiculous dot com bubble.

I have also written that the recovery has been weak based on my favorite employment statistic. But, earlier this month ”valueplays” saw “Positive Signs Everywhere“. I certainly hope he is correct, but this market looks to me like it is one misstep away from a long fall based on the above statistics and:

1. Total debt is higher than at any time in history (there was no de-leveraging);
2. Interest rates are lower and the Federal Reserve Balance Sheet is higher than any time in history. The Fed is practically out of bullets; and
3. Corporate profits–the most mean-reverting statistic in finance according to Jeremy Grantham at GMO–are as high as they have been in history;

Invest accordingly.

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The first statistic is a macroeconomic indicator called the Employment-to-Population Ratio (E/Pop, to distinguish it from E/P or earnings yield). I prefer E/Pop to all other employment-health indicators because, unlike the unemployment and labor force participation rates, it takes the least amount of manipulation to calculate it.

E/Pop is simply the number of adults (16+ YO) employed in the US divided by the number of people 16+ living in the US who are not in institutions (jail, mental health facilities, etc.) or in the military. No one has to guess whether these people are “looking” for work or really “participating”. It measures the  number of people truly working relative to the number of us relying on those who are working to pay our collective bills. After all, the money that pays our bills can only come from people who produce; it is not created from thin air.

If there is a weakness in this indicator, it is that it overestimates economic strength by including in the numerator those who work part time, especially now when the proportion of part time workers is elevated.

http://www.advisorperspectives.com/dshort/updates/Full-Time-vs-Part-Time-Employment.php

Robust economic conditions are indicated by relatively high E/Pop ratios and weak conditions by relatively low E/Pop ratios.

The E/Pop has indicated that the economy is weak and that this “recovery” since 2007 could easily be labeled “stagnation”. The E/Pop plummeted in the housing crisis and despite unprecedented fiscal and monetary stimulus, it has barely gotten off the mat since. May’s reading announced today is 59.4%. The last time (before the current stagnation) that it was this low was in April 1984 when the economy was still digesting Paul Volcker’s attempt to choke off the inflation debacle of the late 1970s.

The second statistic–one that continues to worry me about the stock market–is Robert Shiller’s Cyclically Adjusted PE (CAPE) ratio. The latest reading shows that the stock market’s price equals 27.38 times its trailing ten-year earnings. The last time it was this high was July 2007, almost to the day that the housing crisis began and about one year before the stock market plummeted in response. It was higher only twice before in history, just before two of history’s most terrifying market crashes.

I write about these “macro” themes because, as Howard Marks says, it’s important for “intelligent investors” to know where the economy and market stand as they go about their business of evaluating businesses one-by-one and determining whether they can purchase those businesses at prices that deliver a Margin of Safety. Since 2011, the level of the CAPE helps explains why investors have found so few opportunities that possess a Margin of Safety. Invest appropriately.

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If it is easy for corporations to borrow in public debt markets because high liquidity keeps interest rates low (in the near term), corporations that lack ideas for organic expansion at high ROI will issue debt and use the proceeds to buy back equity or go on M&A sprees. Those purchases raise the price of equities regardless of underlying fundamentals.

If it is easy to borrow from a bank or in public debt markets to buy a residence for occupancy or investment (see, e.g. Blackstone’s residential investment fund http://www.blackstone.com/businesses/aam/real-estate), consumers and investors will borrow and push up house prices. There is evidence from the structured finance industry that the market that has been least resistant to secondary financing has been the auto loan ABS market, especially in sub prime loans. It’s no surprise, then, that auto prices have held up better than home prices as borrowers find easier access to auto credit than mortgage loan credit.

http://www.standardandpoors.com/spf/swf/auto_abs/index.html#/54

Finally, the least resistant path for liquidity may be in the art world as wealthy investors need to “do something” with their cash that is earning next to nothing in the fixed income market. Doing nothing can be very difficult.

In the year from July 2013, sales of contemporary art at public auctions reached $2.046 billion dollars, up 40 percent on the previous year, Artprice’s annual report said.

http://news.yahoo.com/record-breaking-contemporary-art-103321463.html

Howard Marks has a great maxim for this behavior:

What the wise man does in the beginning, the fool does in the end.

We are in unchartered territory with respect to Quantitative Easing, but as Herb Stein has said, “If something cannot go on forever, it will stop.” The Fed will have to stop providing liquidity eventually. When the Fed stops, many will be caught by surprise and they will suffer. Don’t be one of those people.

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http://www.blackrockblog.com/2014/08/07/great-deleveraging-happened-debt-problem/

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“…around 50% of our assets are in cash, and that’s a very high absolute number, now around $14 billion and rising…”–Seth Klarman

I recently came across this quote from Seth Klarman of the Baupost Group, which he said during a speech that he gave at James Grant’s Investment Conference in October 2013 (http://www.grantspub.com/mygrants/viewarticle.cfm?aid=4995).

If anything, Seth has less capital employed now than he did then.

If I had to pick one investor with whom I felt closest philosophically (and operationally), it would be Seth. PAR is currently sitting on cash equal to 55% of client capital because our bottom-up process has revealed few bargains and PAR has just about enough invested in the bargains PAR has uncovered.

As readers of PAR’s holiday card may have noted, I now view cash the way Buffett’s biographer believes Buffett views it: Cash is an option on thousands of companies and each option has no strike price, no expiration date, and no premium cost other than the lost purchasing power due to inflation. At current inflation rates, the premium is low.

This is the strongest argument to the oft-asked question: Why should I pay [Investment Manager] to hold cash? The answer, of course, is that they are paying [Investment Manager] to have the discipline to buy perpetual options on companies that will one day provide a margin of safety. [Investment Manager] “finds” these perpetual options by selling positions that become fully valued in inflated markets. It takes discipline to sell at or near full value when markets have been rising. Clients who believe that they could do the same as [Investment Manager] need to be introspective and seriously question (and answer honestly) whether they held significant amounts of cash in 2007 and employed it fully in 2009.

Coming into 2014, the market in general was overvalued as evidenced by the CAPE, Tobin’s Q, profit margins, etc., but patient investors will get their opportunities. Those with dry powder, who have been sitting on a perpetual option on every company–i.e. sitting on cash–will be the ones who exploit those opportunities.

My friend Chris Cannon attended Grant’s conference last fall and took some notes from Klarman’s speech that day that I have condensed. Enjoy:

“Seth is a great worrier.  He worries top down but invests bottom up.  He says top down analysis is a lot like sports talk radio – lots of talk and opinions…

Most investors/portfolio managers feel a gun to their head to get fully invested.  This is a weakness…

…if (Baupost) thought the world was going to collapse tomorrow then they wouldn’t return the cash. So he can’t figure out the timing.  But if it does collapse he will ask his investors for more cash…

His biggest concern is that his investors take the cash he returns them and place it with a manager putting up big numbers over the past few years, especially the last two. “This is a recipe for disaster.”  He’s encouraging them to protect it…

Nobody in the White House or the Fed has any practical business experience and handing the reigns to another academic seems totally nuts to him…

He thinks big cap companies (like Jeremy Grantham’s high quality) aren’t mispriced enough for him to do anything interesting with them…

(Because of LBO recaps and refinancings, Y)ou don’t need an economic downturn for a crack up (in high yield), just slightly higher yields… So a crackup in high yield is very, very, likely…

It’s embarrassing that after a crisis that nobody saw, government policy continues pouring on more gas to fuel more speculation to get things (stocks, real estate, debt) back to the same place we were, or maybe even worse now…

It took him at least 15 years of repeating his ideas so clients can see them really work and then they sink in.”

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“For decades, the name of the game for investors has been to make as much money as possible. From now on, Mr. LeBaron thinks, the prime directive will be to “lose as little money as possible…

In Mr. LeBaron’s view, the easy-money policies of central banks, including the Fed, have created what he calls ‘administrative markets’–in which prices are set at least partly by government policy rather than by market forces.

But, he worries, that can’t last forever. ‘In complex systems, the dynamics are predictable but the timing isn’t,’ he says. ‘It’s like adding a grain of sand one at a time to a pile: You can’t tell when it will collapse, but you know it will.’”

Dean offers great advice: “Look for the questions that are not being asked?” I try to think of these at least once per day.

http://blogs.wsj.com/moneybeat/2014/01/17/new-warnings-from-an-investing-pioneer/

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As Michael Mauboussin says, when understanding an investment idea, we should try take an outsider’s big-picture view in addition to our own expert view of the minutiae of the idea. I first came across the equity market return histogram a few years ago and I believe it offers perspective on the feasibility of return expectations.

The ranges at the bottom are the ranges of returns for each annual period. The years highlighted in blue are the years involving the recent Great Recession and those in orange involve the Great Depression. As you can see, there were many more outliers during the Great Depression. The Great Recession looks rather normal in comparison.

My opinion of expected returns is based on data obtained in the Graham-Shiller CAPE index and from Tobin’s Q ratio (plus several other metrics), so I expect low, single-digit equity market returns over the next eight- to ten-years. The CAPE, which measures long-term Price/Earnings ratios, and the Q, which measures Price/Replacement-Cost ratios for the market, are 39.1% and  40.6% higher, respectively, than their long-term averages.

But, if we believe past is prologue, then there is a 75.5% chance that returns this year will fall outside of the range of 0% to +10%. I believe I am rationally pessimistic for the near term (but a long-term rational optimist), but historically there is only a 13.9% chance that an investor will lose more than 10% of their capital in any year in the market. This kind of outsider’s perspective helps me temper my pessimism, but the best way to temper it is to invest with a MARGIN OF SAFETY. Unfortunately, few investments offer a Margin of Safety these days.

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The best way to describe the current market, then, is to say that there is “an unusually large herd of grey swans” about. It refers to an outcome–a single impactful event–that is quite possible and therefore should be anticipated but it is not because too much attention is focused on the low probability of each separate event occurring instead of the collective likelihood of any one event occurring. I guess it is another way of saying that we miss the forest for the trees. As the number of grey swans in the herd increase, the likelihood of an impactful event increases.

The conditions that make this market a herd of grey swans are as follows: The market is priced for perfection as the Graham-Shiller CAPE and Tobin’s Q ratio are near all-time highs, by which we can infer that investors are sensitive to momentum and are ignoring risk and values. At the same time, the number of low-probability events that could cause a major correction also seems to be high. This environment is different from one described by the adage that “rising markets climb a wall of worry” because those environments start at low prices relative to fundamentals. That is, there is always more worry immediately after a correction–such as in the first quarter of 2009–than after a significant rebound, which is where we stand right now (2/25/12) with the S&P 500 just 15.4% from its all-time high.

The large number of grey swans include (not in any particular order):

1. a sovereign debt default (either legally or de facto) by any one of Italy, Spain, Portugal, Japan, France, Ireland, or some other country not yet on the radar in addition to the default that has already occurred in Greece;
2. austerity throughout Europe and the US in order to pay the bills for previous overspending (US and Europe) and low productivity (Europe);
3. a collapse of the European Union or the Euro
4. a surge in inflation around the globe;
5. a war with Iran and its supporters or instability due to Iran’s development of a nuclear weapon (the collective probability of this must be close to 100%);
6. a Chinese economic implosion as inordinate government command of the economy cannot be sustained;
7. a collapse of the Russian banking system;
8. unrest in the US as a significant amount of promised public-sector post-retirement pension and health benefits must be cut or eliminated in order to balance state and local budgets;
9. significant instability in the Muslim world (excluding Iran) for many reasons, but particularly as US influence declines with US military withdrawals;
10. something unexpected from North Korea;
11. a less-than-peaceful transition of political power in the US in November; and
12. a large natural disaster–earthquakes, tsunamis, droughts, volcanic eruptions–(for example, see Nova’s excellent and recent “Deadliest Volcanoes.”  A preview:  http://www.youtube.com/watch?v=CEjnIPRuhvk)

Separately, these events are not black swans; they are grey swans–low probability events but not rare ones like black swans. Together they are a herd of grey swans where only one event need occur to cause major problems; imagine if two occur. On the surface most appear to be independent events, but what is to stop North Korea from doing something stupid if China is focused on a war in the middle east or its own economic collapse? What would happen to economic activity and political stability if lingering ash from volcanic eruptions caused a significant reduction in food production? If we add a black swan event that no one is even thinking about, the outcome could make us nostalgic for 2008-2009.

In the very long run, I am a rational optimist. In the near term, I am a rational zoologist. If you can buy cheap insurance, do so. On that note:

http://finance.fortune.cnn.com/2012/02/16/is-japan-next/

While the Japanese debt bomb isn’t expected to go off tomorrow, Japanese CDS is now 50% higher than where it was a year ago. Wall Street involvement in the Japanese debt market has grown in the last few years, which could bring increased pressure on the government to try and solve its debt dilemma. Eventually, though, the Wall Street bond vigilantes could drag Japanese bond yields up to levels that could cripple the government’s  ability to pay off its debts, setting the stage for one of the most prolific sovereign debt defaults in history.

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http://www.voxeu.org/

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The extraordinary events we’ve seen these past months are now threatening the euro project, and calls for its dismissal, which were laughable a year ago, are becoming more mainstream. Risk aversion has increased dramatically and we are arguably in as bad a shape as in 2008/2009. Peripheral bond yields are now much higher than they were back then, as are all sovereign CDS. The low yields of the safe haven bonds (Bunds and US Treasuries) also highlight the sharp risk aversion in the markets and while the tensions in the money markets are not as bad as they were back then, they remain at extreme levels.

Kyle Bass on CNBC today essentially said the following:

“Europe is trying to fix a solvency crisis with liquidity. Liquidity is not the problem. No one is saying the payments system will fail; it did not fail in the US when Lehman went under, either. However, bills are coming due in Europe that no one can pay.”

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