The Investor’s Dilemma Part II
“Think of the tulip bubble. It’s very easy to look back at that episode and throw stones: ‘How could anyone in their right mind ever consider paying almost one million dollars for a single tuber?’ one might ask even as he lives in a glass house represented by his trading portfolio made up of shitcoins or memestocks worth, in aggregate, tens of billions of dollars despite zero fundamental value. What at first seems absurd becomes commonplace when it is validated by general acceptance. ” Jesse Felder of the Felder Report
The dilemma is that conservative investors who used to make some decent money in bank deposits, money market funds, and bonds, can’t find a real yield that is positive above inflation and at this point in the business cycle they are taking increasing risks with default and adverse moves upward in interest rates.
For most investors, that leaves two other choices – real estate and the stock market. There are more possibilities like gold, which we personally like, (especially after this last decline in price) but gold is considered a “hedge” by most money managers, not a primary investment. It is regarded as a means to diversify holdings in mainstream investments like stocks, bonds, and real estate.
But our dilemma continues to widen. Both real estate and the stock market have done extremely well and are now in the ionosphere of historic value. That of course does not mean these markets are about to reverse course, but it is likely one would be buying quite late in the game after a lot of appreciation has already occurred. Clearly, the later you are to the game, the greater the risk of buying near a top and suffering the consequences.
Those of you who follow the column of Wolf Richter in The Prickly Pear have seen his charts on the housing bubble. If not, look them up by pushing the ARCHIVES button at the top of the page or search at FIND GREAT CONTENT at the bottom of the homepage.
There are other sectors in real estate other than single-family homes such as multi-family, self-storage, industrial, office, and retail. We can’t get into each sector in detail but there are likely opportunities for the expert. But housing seems to wag the entire real estate dog. When it goes, likely because of the leverage (the amount of debt used to underpin prices), it can cause difficulties in the entire sector.
And these other sectors have their own problems. How does office space look now that many have learned to work from home? How does retail look in a slump and if we have another lockdown? Will online shopping continue to kill brick-and-mortar retail? How does industrial property look if we have a recession?
Many people felt owning rental properties would be the key to the kingdom. However, when the CDC can invoke an unconstitutional edict creating a moratorium on paying rent, and the President of the United States continues it in spite of what a Federal Court has ruled, you have to wonder how secure your property rights are. Without secure property rights, what do you own?
In short, real estate has its own set of dilemmas, especially in a questionable recovery.
This leaves the stock market as one of the better places to be. Unlike real estate, it is a liquid market that is easy to get in and out of. Prices are transparent. This and other factors have created what some call TINA, or “there is no alternative”.
As a result, very positive investor flows continue into stocks and their performance has been good, perhaps too good.
Traditional metrics such as price to book value, price to sales, market cap relative to GDP, Tobin’s Q ratio, and quite a few others, are registering historically high values. Bulls argue that these historic indicators are no longer valid because we live in a new era of government stimulation and rapid technological change. Perhaps they are right. However, it is worth noting that “new era thinking” has been present in all past bubbles, and they all ended the same way…in disaster.
The market is priced pretty much to perfection. Maybe perfection is what we will get, and everything will be great but that seems unlikely. Biden wants to raise taxes substantially and is running very inflationary policies. Rising interest rates would also be negative for stocks.
The economy has been on life support for some time, elevated by extraordinary, dare we say unprecedented, fiscal and monetary stimulation from the government. There is so much distortion in the system with zero interest rates and liquidity flowing like wine, that it is hard to make sense of it. There is such a departure from historic values that the more history you know, the less money you would have made.
Those with more experience actually have been at a disadvantage. They have felt reticent to chase a market this expensive, but newcomers, not knowing much history to calibrate their expectations, have done better.
That itself is a problem. A market that has a high degree of borrowed money with record-high margin debt and undisclosed amounts of loans against the value of stocks (so-called security-based lending), could be vulnerable if stocks were to have a bear market, which is normal and frequent in history. If the collateral value of stocks were to decline enough to endanger the loans, this could cause forced selling, which tends to have a cascading effect as one investor’s need for cash causes another person to receive a margin call.
Recently, we have seen the entrance of large numbers of new investors, apparently flush with stimulus money and bored with being kept at home during the lockdown. We are not talking about a small increase either.
James Stack, an independent money manager in Montana, who also writes an investment advisory called Investech, notes that heavy public participation has always been a hallmark of speculative frenzies. As just one example, Reddit forum members have been involved in some recent sharp movements in particular stocks. He notes just one year ago, there were about 1.3 million members. Today, there are 11 million members.
He notes as well that members of the Robinhood platform which caters to new, smaller investors (and just went public), have grown from virtually zero in 2018 to now about 18 million members.
Individual factors that make up each stock cycle can change but there have always been underlying factors to consider. The standard factors have been tax policy, regulatory policy, the rate of economic growth, the level of interest rates, corporate earnings, and inflation levels.
Looking at each of these, not all of the trends look that great, but you must make your own evaluation.
Clearly, the entrance of the government into the job of manipulating interest rates and new tools to drive liquidity have been new and powerful factors in the landscape since 2000. How long can we keep up massive FED buying of debt, the suppression of interest rates to near zero and record government deficits?
Besides the problems of extreme mass psychology, financial leverage, and overvaluation, the market is now suffering what some call divergences. It means that stocks within a given index, are no longer moving together. Often divergences are the first signals that something may be going on with the momentum of the market. It is not obvious in the index itself, it is rather an internal deterioration of momentum.
We don’t have room for a detailed discussion but the broader average, the NYSE, shows that only about 40% of stocks within the average are above their 50-day moving average. Just back in June, over 75% of stocks were above the 50-day average. So fewer and fewer stocks are participating, all the while the market is going to new highs. That basically tells us that a handful of mega-cap stars are holding the market afloat while a clear majority of stocks in the index are in trouble. This concentration is itself a problem with an estimated $10 trillion now in just seven big-tech stocks, with the rest of the S&P 500 coming in at $36 trillion.
Besides the divergences, the domination of the index by so few reduces the “diversification” of the index, undermining the very purpose to be indexing.
This divergence may well clear up, but with valuations so high, and psychology so distorted, that deteriorating momentum could become a problem.
Bulls argue that liquidity is plentiful, the investment choices are few, thus TINA reigns supreme and markets will just keep climbing. Indeed, that is what they have been doing.
Bears suggest that serious divergences are forming, unhealthy concentration is present, momentum is flagging, overvaluation is extreme with the liquidity spigots already wide open. It is hard to imagine rates lower, and fiscal and monetary stimulus any more liberal than they are today.
So, the dilemma for stock buyers seems to be this: stocks have been working well, but are very expensive by historic standards, and there are clear signs of public mania and signs that divergences are forming.
This recalls the statement made by Charles Prince, Chairman of Citigroup in front of a Congressional committee investigating the crash of 2008. The chairman was questioned as to why the bank suffered such losses. He said, “as long as the music is playing, you’ve got to get up and dance.” Unfortunately, Citi danced so long, they could not find a chair when the music stopped and required another taxpayer bailout.
Who will bail us out? Who will bail out the government?
There is pressure on money managers, and individuals, to stay heavily in markets that are working because of the lack of alternatives elsewhere. Desperation to find a real return above inflation is driving investors to take risks they otherwise would not consider.
Indeed, the investor’s dilemma is that there are no easy solutions, just tradeoffs that you must weigh and consider.
For the FED, their dilemma is to keep liquidity growing and risk inflation or begin to raise interest rates and reduce liquidity and risk bursting the bubble they have assiduously blown.
Increase your situational awareness. Be aware we are now in a range, in a variety of markets, where overvaluation and a high degree of public speculation are present. Consult at least quarterly with your financial adviser.
It is said that history repeats itself. That seems true. What is more remarkably repetitive, is that people fail to learn from history and that failure to learn is what seems repeated.
As we move through 2023 and into the next election cycle, The Prickly Pear will resume Take Action recommendations and information.