As the stock market closed last week we were left rubbing our chins and asking ourselves, "What the Heck" as markets continue to move effortlessly to new highs.
We are starting to sense another bubble in U.S. stocks, but like many bubbles, this one may grow significantly larger before it pops.
In the meantime here are some of the things that make us ask "What the heck?"
The 12 month forward earning Price to Earnings ratio (P/E) for the S&P 500 is 17. That is well above the 5 year average of 14.7 and the 10 year average of 14.3.
The ratio of total market capitalization for U.S. stocks vs U.S. Gross Domestic Product (GDP) is 122.4%. The only time it has been higher was just before the Dot.com stock market bust in the year 2000.
The Shiller P/E for the S&P 500 is 27.2. That is a higher value than September 2007, just before U.S. stocks started to roll over. A value of 27.2 has been exceeded only twice. Once was at the peak of the market in 1929. The other time was at the peak of the market in 2000.
The "Q Ratio" is a measure of market valuation which is the total price of the stock market divided by the replacement cost of all of its companies. It has exceeded a value of 1.06 only 5 times from 1900 to present day. Shortly after each previous time a significant correction took place. It was recently at 1.10.
On April 14, 2016 Bank of America Merrill Lynch reported that going back to 1964 the S&P 500's total market capitalization has averaged 57% of annual US GDP. If the "tech bubble" years are excluded the number falls to 53%. As of the end of March 2016 the ratio was 99%. That is more than 70% above the historic average level--and the market has gone up more since then!
U.S. stocks are clearly back in the stratosphere as far as we are concerned. But it is quite possible that they will continue to move higher for the foreseeable future.
In fact from a purely technical perspective that is the odds on case.
One question we keep asking ourselves is why there is such a "bull market" in complacency about the stock market? No one seems overly concerned about these extreme valuations. But then, few seemed concerned in 2000 or 2007 either.
Conditions are very different now and we are not predicting collapses of the magnitude that happened back then. Yet we are quite concerned that valuations are very stretched.
The "VIX" is an index that measures stock market volatility. When the VIX is high that means volatility in the market is high. When it is low that means that volatility in the market is low.
Since 1990 the "VIX" has oscillated between a low of 9.31 in late 1993 and a high of 89.53 as the market was falling apart in 2008. It closed Friday at 11.26. That is not far from the all time low in 1993.
The answer to why there is a "bull market" in complacency is in plain sight. Central banks around the world seem to be working in unison again. Monetary policy is easy everywhere. Most central banks are still adding multiple stimulus packages to their national economies.
The U.S. Fed had diverged from the others in late 2015 by raising interest rates for the first time in eight years. They were threatening up to four more increases in 2016.
It now appears that they may raise once in 2016, if at all. They have really backed off their more hawkish stance and are among the "doves" again, or so it seems.
Since "BREXIT" the Bank of England (BOE) and the European Central Bank have both gotten more dovish. Short term interest rates in Britain have been cut in half and the BOE announced several other measures to stimulate and shore up the British economy.
The Bank of Japan (BOJ) is not only stimulating their economy through negative interest rates and other forms of easy monetary policy. They are actually buying stocks in the open market.
Bloomberg reports that the BOJ is now a top 10 shareholder in about 90% of the companies listed on the Nikkei 225 Stock Average. That makes the BOJ a bigger shareholder than the likes of BlackRock, Inc. or Vanguard.
Bloomberg also recently reported that US companies have issued approximately $937 Billion in new corporate bonds from January 2016 through July 2016. They are on track to far exceed over $1 Trillion of new issuance this year; just as they did in 2015.
Much of that money is finding its way directly into the stock market in the form of share buyback plans. The biggest buyers of the U.S. stock market in 2016 are the companies that make up the market!
According to the Securities Industry and Financial Markets Association (SIFMA) total outstanding U.S. corporate debt was approximately $4.6 Trillion at the end of 2005. As of the end of Q1 2016 it was approximately $8.4 Trillion. Does anyone else ask "What the Heck" when they see data like that?
The bottom line for U.S. and Japanese stocks is that the path of least resistance is upward. This is probably true of other markets as well, including Emerging Markets. They will suffer if the U.S. Dollar starts to appreciate significantly. But that is not likely to happen if U.S. interest rates stay lower for longer, which now appears more likely.
When 5TQ entered 2016 our base case for U.S. stocks was that they were likely to churn in a broad trading range and that volatility would increase significantly.
We believed that investors would benefit from betting on high volatility rather than making a directional bet on stocks actually going up or down.
We believed that monetary policy was about to diverge among the major central banks. The U.S. Fed was obviously signaling its intention to raise rates multiple times and stop quantitative easing (QE). All other central banks were still in full throttle QE. We expected that this divergence in policy would lead to increased volatility in U.S. stocks, and potentially around the world.
Divergent monetary policy went completely out the window with the surprising result of the "BREXIT" vote in Great Britain. Central banks are now all on deflation, recession watch again and ready to stimulate on a moments notice.
Stock markets are saying to themselves that "The Fed's got my back" and are ready to rise! That is happening everywhere that there is a really active central bank.
We believe that US stocks are now quite overvalued. We also suspect that they are about to get even more overvalued. We have lived and worked with these markets long enough to know that bubbles get bigger and bigger right up to the moment that they pop.
That moment is not likely at hand with all the current central bank stimulation and corporate bond activity. It is all simply supplying much more liquidity to drive markets higher.
But we have read this book before and we know how it ends. We intend to be ready.
All the best,
GOVINDA QUISH, PAUL KRSEK, JEFF ROUSH,
THE INVESTMENT POLICY COMMITTEE
5TQ CAPITAL, LLC
595 Coombs Street, Napa, Ca, 94559
(707) 603-2672 Office
(707) 486-7333 Cell
Disclosure and Disclaimer - Updated last on July 17, 2016, 2016 by Paul Krsek:
ELLUMINATION is the proprietary newsletter written for clients, friends, and affiliates of 5TQ CAPITAL, LLC .
FROM JUNE 1998 to January 1, 2016 Paul Krsek was the sole author of ELLUMINATION. While the views and representations found in the newsletter generally reflect the attitudes and opinions of the 5TQ CAPITAL, LLC members and staff, Krsek wrote without editing was therefore is solely responsible for the content and opinions contained in ELLUMINATION.
AS OF JANUARY 2016 ELLUMINATION IS NOW A COLLABORATIVE EFFORT OF THE INVESTMENT POLICY COMMITTEE OF 5TQ CAPITAL, LLC, LLC. THAT COMMITTEE IS CURRENTLY COMPRISED OF GOVINDA QUISH, PAUL KRSEK, JEFFREY ROUSH AND PHILLIP LAMPE.
ELLUMINATION does not represent the opinions of Fidelity, Fidelity Institutional Brokerage Group, NFS or anyone employed by Fidelity in any capacity. Neither Fidelity, Fidelity Institutional Brokerage Group, nor NFS, nor anyone employed by Fidelity in any capacity has participated in the creation of ELLUMINATION and they are not responsible for the contents or distribution of ELLUMINATION.
ELLUMINATION is written to provide general information to clients, friends, and affiliates. The contents of ELLUMINATION are not to be taken as individual investment advice. No investment decisions should be made based on the opinions or information offered in ELLUMINATION.
5TQ CAPITAL, LLC does not represent that the information in ELLUMINATION is accurate or complete and it should not be relied upon as such. Opinions expressed herein are subject to change or modification without notice.
The investment portfolio models or management services mentioned in ELLUMINATION may or may not be available in some states, and they may not be suitable for all types of investors.
5TQ CAPITAL, LLC manages accounts with various histories and investment objectives. Various accounts may be managed differently from time to time.
On July 1, 2016 Govinda Quish took over as Chief Investment Officer of 5TQ Capital, LLC. Quish and Krsek are currently collaborating, along with the other members of the Investment Policy Committee on investment strategy and portfolio construction.
Not all accounts managed by 5TQ CAPITAL, LLC are "modeled" accounts. We strongly urge our clients to understand which model or strategy, if any, are being used to manage their accounts.
From time to time 5TQ CAPITAL, LLC receives requests from clients to purchase securities that are not included in the model portfolios or strategies to which they are assigned. Effective May 24, 2006, 5TQ CAPITAL, LLC has encouraged clients to hold such securities in a separate account for the client. Because 5TQ CAPITAL, LLC is a "fee only" registered investment advisor" it charges its normal management fee for monitoring such securities in the separate accounts in which they are held.
5TQ CAPITAL, LLC makes every effort to exclude securities that are 'requested by the client' from the modeled portfolio accounts.
The investment objectives of various accounts and models may be substantially different from one another. Therefore topics or investments mentioned in E-Ellumination may or may not apply to specific managed accounts and/or models.
Trades or adjustments to accounts mentioned in ELLUMINATION may or may not happen in every account managed by portfolio managers at 5TQ CAPITAL, LLC.
If you are not satisfied with the investment results in your account it is your responsibility to inform Krsek or Quish to discuss possible changes that can be made to the account to accommodate and satisfy your needs.
The assets held in managed accounts at 5TQ CAPITAL, LLC may include stocks, bonds, cash, commodities, foreign exchange, mutual funds, exchange traded funds (ETF's), money market accounts or limited partnership interests that represent the same. They are subject to market fluctuation and the potential for losses. The assets are not insured. The value and income produced by these investment products may fluctuate, so that an investor may get back less than they initially invested.
The portfolio managers at 5TQ CAPITAL, LLC do not guarantee results.
Past performance should not be considered an indicator of potential future performance. If you do not consider yourself suitable, either emotionally or financially, to experience volatility and/or losses in financial markets, you should not invest.
From time to time the authors of Ellumination list the simple annual returns of model accounts mentioned in this newsletter. These accounts are "models" and do not represent the actual results accruing to individual accounts. Simple annual return does not represent "time weighted return" as reported individually to clients. 5TQ CAPITAL, LLC, LLC no longer provides composite performance reporting for "model" groups. Individual clients should request performance reporting on their specific accounts. 5T uses Orion Advisors to prepare those reports.
This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy any securities or other instruments mentioned in it.