Tuesday, 28 September 2021 — Albert Park

By Vern Gowdie Editor, The Rum Rebellion

[4 min read]

• Answer one simple question
• The 20^th century guides to help you

‘In the absence of the ability to see the future, how can we position our portfolios for what lies ahead?

‘Much of the answer lies in understanding where the market stands in its cycle and what that implies for its future movements.’

Howard Marks, Co-Chairman,
Oaktree Capital Management

What’s Evergrande doing? Will it be thrown a lifeline or not? What’s happening with the commodity market? What’s the future of Bitcoin [BTC] after China did a rug pull? Is this good for gold?

Lots of questions, with an even greater number of answers.

Divining the future is really difficult. There are so many variables…and even if you think all the options are covered, along comes a left-field event.

So today, let’s keep it really, really simple and take Howard Mark’s advice…‘understand where the market stands in its cycle.’

If we do that, then we’ll know ‘what that implies for its future movements.’

The market Marks refers to is the one on Wall Street.

And as luck would have it, 21^st century investors have 19^th and 20^th century cycle patterns to guide them on their quest of understanding.

Not that many seem to use them (but ignorance of history is a topic for another day).

Whether we like it or not, the US market is THE main game in town.

Remember when the Shanghai Index (the share market of the world’s second-largest economy) tanked 30% in July 2015?

Wall Street hardly broke a sweat. However, when the Dow nosedived in March 2020, the rest of the world followed.

In the orchestra of world bourses, Wall Street is the conductor.

For the average investor — one with the majority of their investment capital in an industry-balanced fund — their only concern should be ‘where does the US market stand in the current cycle?’. Answer that question and you can decide whether to maintain a risk-on position or adopt a more risk-off one. Simple.

The 20^th century guides to help you

To help you pinpoint where we might be in the cycle, I’ve put together a selection of charts.

The first one is the Buffett Indicator, so-called because of an interview Warren Buffett did with Fortune magazine in December 2001.

In the interview, Buffett said market cap-to-GNP ‘is probably the best single measure of where valuations stand at any given moment.’

The current reading is within a whisker of four — yes, FOUR — standard deviations (4SD) away from the 70-year MEAN. If you’re not familiar with the mathematical significance of this, in plain language, it’s as rare as rocking horse poop.

The last time the US market got even close to 3SD was at the peak of the dotcom boom…and that did not end well:

John Hussman produces a valuation model titled MAPE — Margin-Adjusted PE.

He uses this methodology to forecast 10-year returns from the S&P 500 Index.

MAPE — blue line to an inverted right-hand scale — is at its highest reading EVER. Even higher than it was at the peak in 1929.

The red line — the subsequent 10-year return — has an uncanny knack of following the blue line…most of the time.

For example, at the peak in 1929, the blue line was forecasting a rather dire decade ahead…MINUS 5% per annum. And the red line shows that’s exactly what happened.

The times when the two lines part ways are temporary periods, when the market pushes the extremities of valuation and belief.

However, suspended animation eventually gives way to mathematical reality and the two reconnect.

At present, the blue line is forecasting another decade of pain ahead…with a MINUS 6% per annum prediction:

Hussman’s valuation model is not the only one sounding a warning of what lies ahead.

The Ned Davis Research dashboard — of 16 different valuation metrics — is flashing red. Every single indicator is registering in the ‘Extremely Overvalued’ range.

This too is a very rare occurrence:

Yet, in spite of these historical signposts warning of danger ahead, modern-day investors are bravely (or stupidly) going where others have gone before…gearing up into an over-overvalued market.

You gotta love human nature…it’s one of THE best guides on where we sit in a cycle.

The next chart shows the level of investor credit balances in margin lending accounts.

When the balances are red it means debt levels are greater than the cash levels…say, debt of $100k and cash of $20k.

Conversely, when the balances are green, it’s the reverse…debt of $20k and cash of $100k.

The chart shows investors BORROW to their eyeballs, the market moves towards its peak, and then they cash up AFTER it has fallen.

Really dumb, but also really predictable.

The current negative credit balance reading dwarfs the two previous bubbles.

Imagine what’s going to happen to all those algorithmic investing models when overleveraged investors panic and start cashing up…like they did in previous busts?

The reason why this bubble is slightly different to previous ones is the twin pillars of support provided by the Fed.

Low interest rates and QE.

This next chart illustrates the increasing intensity of these dynamics:

More and more and more is needed to maintain the illusion.

What happens next time? Even more? Probably.

But if history is a guide, the Fed is ultimately fighting a losing battle. Market forces eventually prevail.

All the signs are indicating we’re in the late and highly-dangerous stage of the cycle. Are we at five minutes to midnight or is there still more time left on the clock?

I don’t know.

What I do know is those final few percent that might be on offer are the first to go when the market decides to show the Fed who’s really boss.

Is it possible these past indicators are no longer relevant? Yes, it is a possibility.

We wouldn’t be the first (and won’t be the last) generation of investors to think we’re special and will be the ones to rewrite history.

My advice is don’t try to second-guess this market. Sooner or later, it’s headed for a fall of some historical significance.

I can tell you from experience, being a year early is far better than being a day late.

Regards,

Vern Gowdie,
Editor, The Rum Rebellion

Vern is also the Editor of The Gowdie Letter and The Gowdie Advisory — investment services designed to help everyday Australians avoid the financial pitfalls of a volatile economy and make informed decisions to grow their wealth for generations to come.