Bipolar disorder is a serious illness.
It not only affects the person but their close relatives as well.
A few years ago I had a heart-to-heart conversation with a fellow whose wife suffered from bipolar disorder.
For more than 20 years he had been a co-passenger on his wife’s emotional rollercoaster.
He said: ‘You cannot imagine the extremes she can go to. The highest of highs followed by the lowest of lows.’
In his book Atlas of Bipolar Disorders, author Edward H Taylor provided this graphic on the emotional range bipolar sufferers can experience:
Source: Atlas of Bipolar Disorders
[Click to enlarge]
The graphic illustrates the ‘wild and irrational’ behaviour he described to me.
The volatility displayed in this graph is eerily similar to the valuation range experienced by markets.
The Shiller PE 10 — the price-to-earnings ratio based on the annual earnings of S&P 500 companies over the past 10 years — displays the emotional state of investors dating back to 1880.
Source: Guru Focus
[Click to enlarge]
The Shiller PE 10 ‘mean’ is the emotional equivalent of ‘normal mood’ in Taylor’s chart.
As you can see, the market spends very little time being ‘normal’.
A high PE reading relates to mania. A low reading equates to severe depression.
The market’s highest PE ratios — 1929, 2000 and today — have all been at the peak of investor euphoria.
The psychology driving investors to pay higher and higher multiples is one of ‘tomorrow is going to be much better than today’ and ‘the party is never going to end’.
On the other hand, the lowest PE ratios have been during the 1921 Depression, The Great Depression, and the severe recession of 1980/81, when US GDP suffered an 8% contraction.
[Click to open in new window]
Social mood is affected by economic conditions. When people are losing their jobs and homes and others are wondering if they’re next, investors are much more pessimistic in their outlook for the future.
Doubts creep in.
Perhaps things will never get better?
When you cannot see any improvement on the horizon, there’s no way that you’re going to pay a multiple of 30-times for one year of earnings.
Which is why the PE multiple shrinks to a low of 5-times…
Five years in advance is about the limit of your vision.
Emotional terminology is used at these extremities — you’re ‘crazy’ for not getting in on the boom and missing out on the easy money on offer OR you’re ‘mad’ if you buy into a depressed market and risk losing more money.
Markets are emotionally-driven…they suffer from a form of bipolar disorder.
Like all things market related, this is not some new discovery (emphasis mine):
‘I can calculate the motions of heavenly bodies, but not the madness of people.’ — Sir Isaac Newton (after losing his fortune in the South Sea Bubble of 1720–21).
‘Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.’ — Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds, 1852.
‘…sad to say, the poor fellow [the US share market] has incurable emotional problems. At times he falls euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price, because he fears that you will snap up his interest and rob him of imminent gains. At other times, he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions, he will name a very low price, since he is terrified that you will unload your interest on him… Under these conditions, the more manic depressive his behavior, the better for you.’
Warren Buffett, 1997
The Shiller PE 10 is a measure of investor mood swings: manic depressive…to rational…-to euphoric.
What’s interesting is that the US share market since the 1990s has spent most of its time above the ‘normal mood’ level.
Why is this?
The good doctors at the Fed have gradually increased the market’s medication — low interest rates and QE (quantitative easing).
Whenever the market has started experiencing a negative mood swing, the Fed prescribes an increased dosage of ‘happy’ pills.
The latest Shiller PE 10 reading of 32-times indicates a market that’s awfully close to the ‘mania’ stage.
In the short term, the market’s behaviour is unpredictable. It could go much higher before there is an abrupt and violent change in mood.
In the longer term we know the high will be followed by a low.
In the past, the Fed has been able to stabilise market mood relatively quickly, albeit with a greater quantity of ‘drugs’ to turn things around.
But can they do it again?
Has the market developed a resistance to the Fed’s drugs?
How low will interest rates need to go and how much money will need to be printed to prevent a spiral into depression?
The numbers are unknown. But it’s not unreasonable to suggest that it’ll need to be much, much more than the last (and unprecedented) dose.
I’m guessing the Fed is going to be unable to stop a violent mood swing.
Based on the graphic by Edward H Taylor, mania is going to be followed by severe depression.
Should this eventuate, how bad will the losses be?
At present, euphoric investors are prepared to pay 32-times for $1 of earnings.
In the depths of previous depressions, cautious investors have paid 5-times for the same dollar in earnings…representing a fall of 84% in value.
Even if this downside scenario is only half right, then, in my opinion, investors who remain in this market are certifiably crazy.
If you want to know how to keep your head, while others are losing theirs, please go here.
Editor, The Gowdie Letter