Stop Making Sense

Posted on Posted in Newsletters

Another day, another crazy market. We’ve had moves of plus or minus 3% on 7 of the last 11 trading days. This doesn’t happen very often; in fact, we’ve only seen this about a dozen times in the past 100 years. So you’re not imagining it: the stock market has been unusually volatile recently.

What does this mean for the future? Obviously, history never repeats exactly, but after prior periods of extremely high volatility, the markets have typically calmed down gradually as they seek a bottom. After that, stocks have always resumed climbing, often very strongly. We saw this after the panic of 2008, after the correction of 1998, after the crash of 1987, etc.

In a few cases, it took 2 to 4 months for the market to turn decisively upward; at other times, it took only a couple of weeks. Sometimes, the low was put in during the panic phase; at other times, the low occurred several weeks later. But in every previous panic the decline came to an end and prices rebounded. And in only 1/3 of cases did we have a recession following the decline. In 2008, the panic occurred halfway through a recession; in both 1998 and 1987, there was no recession for at least 3 more years.

“Panic” is a good descriptor of what’s happening now, at least during the big down days. Market prices are being driven by perception rather than reality. What could possibly have happened in just 24 hours to make the world’s companies worth $2 trillion less today than yesterday?  But that’s the nature of panics: people sell first and ask questions later (while trying to justify their selling with every doomsday scenario they can think of).

Panics spell opportunity as assets become dramatically mispriced. I’ve give you a couple of examples of how asset values have stopped making sense. Today, the 10-year US Treasury bond yields 2.06%, and was briefly below 2% for the first time in history. Even at the depths of the Great Depression, long-term Treasury yields were over 3%. And at that time, we had annual deflation of 5.5%; today we have inflation of over 3% per year.

So In 1932, you were getting a real yield (after inflation but before taxes) of about 9%; today, the real yield will be -1.5% if inflation stays constant. Yes, investors are willing to lock in a loss of 1.5% per year for the next 10 years (more after taxes). Why? Because who cares about the next 10 years when you’re scared to death of the next 10 minutes? Make sense? Of course not.

Meanwhile, the earnings yield on stocks (the reciprocal of the price/earnings ratio) is 8.0%, nearly 6% higher than 10-year Treasuries. And unlike Treasuries, this yield should increase at least at the rate of inflation, even if the economy never grew again. So that’s a real (after inflation) yield of 8%, vs. -1.5%. That 9.5% spread is the widest it’s been since the stock market bottom of 1974!

Either Treasuries are wildly overpriced, stocks are wildly underpriced, or both. I don’t know about you, but I prefer to buy cheap and sell dear, even if I have to wait a while for the world to start making sense again.