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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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It is the same with the exponential growth in technology; near us in time it doesn’t look like much is happening, but not long from now it will increase dramatically. For a hint of that, look at all of the stories that hit Ray Kurzweil’s website every day, or try to remember what it was like to use dial up internet just twenty years ago or no internet thirty years ago. The gains in technology from 1900 to 1930 were substantial, but they pale in comparison with the gains from 1984 to 2014.

(Update 7-15-15: On last night’s MLB All-Star Game broadcast Fox referenced the record number of players who were under age 25 with a vignette showing those players holding up “ancient” technology that they had never seen or used before such as VCR players and rotary dial phones. It was pretty funny.)

Here, Ray Kurzweil talks about the rapid development of our brains in a TED Talk and explains that soon our brains will be connected directly to the internet. Can you imagine that? Like curved earth, it is difficult to imagine, but not impossible, especially when we are armed with information. It is likely to happen in the next thirty years.

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I usually have a negative knee-jerk reaction to anyone who says “it’s different this time” and true to form, I disagree with Sufi’s argument that capital can replace labor completely. His is a Luddite argument that has been made since the industrial revolution and never materialized. Capital can only replace labor when (if?) we reach the Singularity and machines can reproduce themselves. (By machines, I mean both mechanical and electronic.) Until then, back-breaking labor will be replaced by machines that, in order to propagate, will need engineers and programmers and maintenance workers and chip makers, and entrepreneurs who can employ machines in purposeful activity, etc.  That reminds me; I also added Ray Kurzweil’s website to the blogroll.

http://blogs.cfainstitute.org/investor/2014/07/23/debt-and-secular-stagnation-amir-sufi-discusses-the-us-recovery-video/

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The difference between Warren Buffett and most investors has more to do with discipline than just about any other quality. There are plenty of smart investors, and most of them failed to deliver results that compare with Buffett (I will soon write another blog post that summarizes Howard Marks’s forward to this third edition in which Marks identifies ten qualities that make Warren, Warren).

I last read TWBW around 2003 when I picked up the paperback printing of the first edition. The third edition is a worthy update. Every time I read the quote below I am reminded that it is discipline that makes the difference in investing, as in most things in life:

“In 1969, Buffett decided to end the investment partnership. He found the market highly speculative and worthwhile values increasingly scarce. By the late 1960s, the stock market was dominated by highly priced growth stocks. The Nifty Fifty were on the tip of every investor’s tongue. Stocks like Avon, Polaroid, and Xerox were trading at fifty to one hundred times earnings. Buffett mailed a letter to his partners confessing that he was out of step with the current market environment.

‘On one point, however, I am clear…I will not abandon a previous approach whose logic I understand, although I find it difficult to apply, even though it may mean foregoing large and apparently easy profits, to embrace an approach which I don’t fully understand, have not practiced successfully and which possibly could lead to substantial permanent loss of capital.’”

Warren was finding it difficult to find any businesses that were trading with a Margin of Safety. Rather than stretch his logic or his principles, he closed his hedge fund. Of course, he replaced his hedge fund with an insurance holding company in which he also had a decided funding advantage.

As a hedge fund manager, Buffett had to promise the lion’s share of returns to his limited partners in order to entice them to deliver capital for him to invest. As an insurance company, he did no such thing. Instead, he raised his capital for “free.” Buffett invested the float–the premium collected today for insurance claims that did not have to be paid for a long time.

As long as he maintained underwriting discipline (that word again), he could pay claims plus operating expenses that were equal to the premium he received. The ratio of the former to the latter is known as a “combined ratio,” and as long as that figure is 100% or less, Buffett got his investment capital for free. Investing free capital with discipline over several decades is how one becomes one of the richest people in the world.

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The authors ran additional experiments using a paradigm called loss aversion, another case where emotion can influence decision making. People are reluctant to accept bets that involve a chance of losing money, even if the odds are in the favor of winning, such as a 50 percent chance of winning $12 vs. losing $10. Keysar and colleagues found that, regardless of whether the bilinguals played with hypothetical money or real cash that could be kept after the experiment ended, bilinguals accepted the positive bets more often when they played using their foreign language and more often resisted betting when using their native language. This confirmed the finding of…reasoning more logically when using a foreign language.

http://www.scientificamerican.com/article.cfm?id=foreign-language-improve-decisions

And to that end, here is a limited time offer to get a 35% discount on Rosetta Stone (I get nothing for this promotion by the way):

http://www.rosettastone.com/lp/qb50/?cid=sm-fb-3offvday13

My wife and I plan to become fluent in Spanish.

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A lot of truth here.

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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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Guess what I “predict” for 2012? Years highlighted in orange relate to the Great Depression; blue relates to the credit crunch. Notice that there were many more extreme years during the Great Depression than recently.

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