Monday, 8 December 2014

Keen on Downside Risk? Buy U.S. Stocks Now!

A few weeks ago I published a chart depicting the relationship, or lack of relationship rather, between the ECRI's U.S. Weekly Leading Index and the Wilshire 4500 stock market index. The ECRI index is a composite leading index that anticipates cyclical turning points in U.S. economic activity by 2-3 quarters. Comparing stock market prices to this index therefore gives us an indication to what extent stock market performance is related to the overall economy. As the stock market is in itself a leading economic indicator (as it is supposed to discount all future earnings, or at least so we were all taught at university) one would perhaps reasonably expect at least a modest relationship between the two. Not so. 

That the two don't move in tandem at all times is nothing new. What is new however, is the current extent of dislocation between the two. During the last twelve months, the Wilshire 4500 index is up some 10.3% while the ECRI index is up a meagre 0.2%. This has helped propel the ratio between the two to unprecedented levels with a current reading more than 76% higher than the previous peak from 12 October 2007. And no, I did not forget to enter a comma, the correct number is 76%. Furthermore, the ECRI year on year growth rate has slowed significantly during the last few months, falling from 3.5% at the end of July to the current 0.2%. Perhaps even worse, the current y/y growth rate is 450 basis points lower than it was at this stage last year. 

Yes, the dollar has strengthened in recent weeks providing a source of income for those with a different reporting currency than the dollar. But the readings in recent months as depicted in the chart, and especially today, indicates that this is a stock market bubble of great proportions. Of course, making such a statement based on one chart is folly. But I'm not, I'm basing it on many charts, all of whom have one thing in common: they're at new peaks similar to those in 2000 and 2007 and many are much, much higher than previous peaks. 

But surely, stock market investors can't be this stupid, can they? Well, they can, as proven again and again throughout history (even the "financial wizards" Merton and Scholes that we learned to cherish got it wrong - remember LTCM). 

But surely there must be good reasons to be in the stock market? Yes, and one such good reason is the low interest rates received on bank savings and government bonds. But you can't make a living out of a mediocre spread (that between earnings yield and interest rates) forever. With everyone desperately chasing yields, this can only ultimately end one way: badly. But does the current low spread, currently about 141 basis points*, compensate for the significant risk that the stock market can plummet at any time? No, it does not in my opinion, not even close. Just as U.S. government bonds have offered return-free risk for some time, the same now most certainly applies to the U.S. stock market: Downside risk dwarfs upside potential.

Or perhaps stock market investors (long positions) are simply taking it for granted that the Fed will commence QE4 soon? Well, there are good chances it will and the Fed probably will have to implement it at some stage to protect their owners (the banks) and to accommodate the faulty economic preaching so abundant these days (that the issuance of more fiat money is the solution to all economic evils). My advice: act according to what the Fed actually does, and not what you think it might do (unless you're a gambler in which case there is no good reason whatsoever for you reading this article). 

Please note that I am short U.S. mid-caps.

*Based on the earnings yield of the S&P 500 stock market index, calculated as CPI adjusted average earnings during the last 10 years divided by the current price, minus current yield on 10-year treasuries: 3.73% minus 2.32% = 1.41% (141 basis points).