Twas the season of giving.
The biggest gift share investors received in 2013 was a rising market.
ASX 200 up 15%.
Dow Jones up 27%
S&P 500 up 30%.
These very impressive results (in addition to the previous three years of gains) had more than a few people in my social circle talking about shares over a cold seasonal ale.
Conversations such as, ‘My brother told me to buy xyz shares. I should have.’ And, ‘What do you think about hybrids, in particular the safe ones like bank hybrids?’
Trying to explain the inverse relationship between rising bond rates and the impact this has on hybrid capital values and the artificiality of the 2013 results was a lost cause. Admittedly I didn’t try too hard either. The festive season was hardly the time to be the ‘party pooper’.
But it did get me thinking about how the average person is turning their attention to the share market.
My seasonal straw poll indicates ‘recentism’ (the psychological term for extrapolating recent results into the future) is starting to creep back into everyday thinking.
When the herd starts to get restless it means two things may happen:
- The weight of money can take the market higher
- The smart money sells out to the herd, and then it is a case of watch out below.
But what is the herd buying?
The following chart from FRED (Federal Reserve Economic Data) compares US Corporate Profit (CP) to GDP — dating back to the late 1940s.
US Corporate profits as a percentage of GDP are the highest they have been in over 65 years. In fact they are currently 70% above the mean…and eventually everything is mean reverting.
So what is it the herd buying? The simple answer is ‘a whole lot of pain’.
Here is the Shiller P/E chart (showing the time averaged multiple applied to the inflated US Corporate earnings)
This is what the herd is buying — record corporate profits (driven by post-GFC cost cutting and the lowest interest rates in history) multiplied by one of the highest Price/Earnings (P/E) ratios in history.
This is the so-called ‘wealth effect’ the Fed has created.
The reality is when this ‘bubble of all bubbles’ bursts, the Fed will have the dubious honour of having created the ‘wealth destruction effect’.
Assuming the math principle of ‘mean reversion’ has not been made redundant by the Fed’s almighty powers, here are the numbers if the market (earnings and P/E) mean reverts.
For corporate earnings to mean revert requires a 40% fall (I know there will be those who are thinking ‘aren’t corporate profits 70% above the mean?’ Yes they are, but to revert from 170 to 100 requires a fall of 40%).
For Shiller P/E to revert to mean requires a 34.5% fall.
$ 9.9 Million
Simple mean reversion can wipe 60% of the value away. A quick look at the two graphs above shows you ‘the higher they rise, the harder they fall’ applies to the stats. Therefore it is not unreasonable to assume that simple mean reversion will not occur. The distinct possibility is ‘the mean’ may just be a station this express train of wealth destruction passes through on its way to a much lower destination.
The herd is buying a one-way ticket to poverty.
The following chart is the reason they do not know what they are actually buying.
The correlation between the US Federal Reserve’s balance sheet and the S&P 500 is uncanny.
The periods when the Fed wasn’t expanding its balance sheet (the two arrows over the flat spots in the red line) are when the S&P suffered its most significant downturns.
The QE drug has kept the market alive.
Take away the Fed’s life support and this is what Global Macro Investor (GMI) believes the S&P would look like. Flatlining.
Interestingly the GMI estimate deflates the S&P by approximately two thirds. This accords with the above ‘reversion to the mean’ calculation.
Cashed up investors may have to remain patient a little longer while the herd dive into a ‘sure thing’.
The only surety is the higher the herd drives this market up, the greater the level of downside pain to be inflicted.
This will be a not so happy 2014 for those investors.
The question is how can you ensure you’re not one of them?
Well, now that Christmas is over, I’m more than happy to be the party pooper. The answer is simple: sell everything.
That’s what I’ve done, that’s what I’m recommending my friends do…and the readers of my family wealth research letter.
But I realise ‘selling everything’ is impractical for many people. That’s why I’ve prepared a report detailing the five most urgent stocks you should sell for 2014.
The prices of these five stocks have gone up hugely over the past year.
But it won’t last.
My advice is to sell these five stocks to the herd right now, while you still can.
for The Daily Reckoning Australia