cycle analysis


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Yale economics professor Robert Shiller won the Nobel prize for his work on bubbles. He wrote a seminal book on speculative manias, Irrational Exuberance, a deep analysis of the dramas over the centuries when otherwise sane people drove prices for tulips, stocks, and houses to inexplicable heights.

Shiller developed some of the tools that are considered vital for taking a sober look at markets. He helped create indexes for measuring real estate prices and his stock market valuation indicator, the cyclically adjusted price-earnings ratio, or CAPE ratio, is seen as one of the best forecasting models for stock returns.

As Shiller sees it, “big things happen if someone invents the right story and promulgates it.” Quartz spoke with him about some of the frothiest assets today, from bitcoin to tech stocks. The conversation was edited and condensed for clarity.

Quartz: What are the best examples now of irrational exuberance or speculative bubbles?

Shiller: The best example right now is bitcoin. And I think that has to do with the motivating quality of the bitcoin story. And I’ve seen it in my students at Yale. You start talking about bitcoin and they’re excited! And I think, what’s so exciting? You have to think like humanities people. What is this bitcoin story?

It starts with Satoshi Nakamoto—remember him? The mysterious figure who may or may not be real. He’s never been found. That has a nice mystery quality to it. And then he has this clever idea about encryption and blockchain and public ledgers, and somehow the idea is so powerful that governments can’t even stop it. You can’t regulate this. It kind of fits in with the angst of this time in history.

If you look at the third edition of Irrational Exuberance, I’m arguing that there’s a fundamental deep angst of our digitization and computers, that people wonder what their place is in this new world. What’s it going to be like in 10, 20, or 30 years, and will I have a job? Will I have anything?

Somehow bitcoin fits into that and it gives a sense of empowerment: I understand what’s happening! I can speculate and I can be rich from understanding this! That kind of is a solution to the fundamental angst.

So I’m trying to deconstruct the bitcoin story. Big things happen if someone invents the right story and promulgates it.

So is bitcoin a bubble, or the biggest bubble?

I don’t know how to quantify that. But I have a sense that something is exciting to you. Another thing that is exciting to people now is Donald J. Trump. You may have heard of this guy.

It’s just amazing how he dominates and I think he has a genius at recognizing stories and listening to his audience and understanding what drives them.

He too is related to this fundamental angst that we have about where are we in this digitized society—international and digitized. And it’s that angst that he spoke to, and he presented a story that involves you, the voter, as a success in this new world, and that’s why the Trump story was so popular.

There really are idea epidemics.

Something you’ve written about is the role of media in speculative bubbles. In the past, you didn’t seem convinced that the internet has boosted the media’s ability to do that. Has that changed?

The big thing that happened wasn’t the internet. It was the printing press, Gutenberg in the 1400s. It didn’t really get going until the 1600s. It was then that we started seeing bubbles.

The problem with things going viral is that there has to be some transmission that’s adequate to the job. You can still go viral without newspapers, but it’s harder. There were celebrities and international stars, like Homer, who wrote the Iliad and the Odyssey. He did that by traveling from town and town and reciting his books. And it worked! He’s still going, long after he died.

Things have always gone viral, it’s the nature of civilization, but it got stronger with the printing press, much stronger. And then around the 1600s they invented the idea of weekly newspapers that told you what happened this week. And that really went like wildfire. People loved newspapers.

The internet takes it to another dimension. But I have a sense it’s not as important as the printing press.

Hasn’t the internet democratized information? Someone can promote their views widely without getting buy-in from editors or other gatekeepers? That’s what Trump has done with Twitter.

One really important thing that’s happened is that reputations don’t seem to matter as much at this point in history. Maybe it will come back. You have news media that have developed their reputation for honesty and integrity. And something that’s gone viral is a conspiracy theory that the news media, the mainstream media, are in a conspiracy, and it’s embellished in crazy ways like the Rothschilds or George Soros, or somebody, are in a conspiracy to destroy America and have bought the media and are controlling them. Those are the extreme, crazy forms of the narrative.

But there’s also a more general narrative that liberals are somehow soft and can’t handle reality. This is another narrative.

You’re asking about bubbles. These are the stories that drive the bubble. Trump speaks to these things, and he seems to be saying things that nobody else will say but maybe you’re thinking.

He also legitimizes wealth. It wasn’t that long ago that we held rich people in contempt. We have a billionaire president, and he’s kind of welcoming: You can be rich, too. The Trump story helps inflate all kinds of bubbles, not just bitcoin. I think there are aspects of a housing bubble, and a stock market bubble right now.

Are your feelings on the stock market based on the CAPE ratio?

The CAPE ratio is just one indicator I’m particularly known for. I have another indicator you can find on my website that not many people pay attention to. Since 1989 I’ve been doing questionnaire surveys of both individual and institutional investors. I’ve been doing this a long time without getting much notice for it. But I believe in it, somewhat, though I don’t think it answers everything.

I have something I call a valuation confidence index. I don’t have it really up to date because it’s only a six-month moving average based on small surveys. Maybe I should expand my size.

But valuation confidence is at the lowest it’s been since around 2000. In other words, people think the market is highly valued. They don’t have to look at CAPE. People think it. I know that. Both individual and institutional investors. We are in a time of mistrust of the market.

The only time mistrust of the market was lower since 1989 was in 2000. So around 2000, the peak of the dot-com bubble. It seems like the mindset is somewhat similar to the dot-com mindset. And that brings us to the FANGs [Facebook, Amazon, Netflix, and Google], as well. High-tech companies are probably more exciting, as they were in 2000.

The year 2000 was kind of like 1849. That was the gold rush. It really created a viral explosion of men going out west in 1849 looking for gold. Now is the time, you can’t wait until 1850! You have to do it now! It was the same thing in 1999 or thereabouts, when stories of some internet companies were coming out and people said, you know, this is the future, these guys are going to take over.

Usually these stories have an element of truth to them, but the question is how fast is it going to happen, and what’s a realistic view for investors. And they got ahead of themselves with the dot-com bubble.

We’re maybe doing that again with the FANGs.

Is low volatility a bubble, of sorts?

Well volatility is very low, both actual and projected in the VIX. So, why is that?

Some people say it’s because of central bank accommodation.

I tend to think of it as something that reflects the quality of the narrative, which is not encouraging a lot of trading activity now. I’m guessing—I can’t tell you why it’s low.

One thing I emphasized in my book Irrational Exuberance is attention is capricious. There’s a social basis for attention. We all focus our attention in the same way. Like we’re all watching Donald J. Trump. When Houston floods, well that’s got our attention. But part of the story has to be what Donald J. Trump said about it.

Somehow the attention is elsewhere than day-to-day motions of the stock market. It could suddenly change.

I remember in October 1987. That was the biggest one-day stock market drop ever. How did I hear about it? I was teaching my lecture in the morning. I noticed that one or two students were listening to transistor radios. Finally one of them raised his hand and said, “Do you know what’s going on? There’s a historic stock market crash.” That’s how you hear about it. It suddenly grabs people’s attention. And it’s just not there right now.

Monetary policy has entered a new regime. The only historical precedent for when interest rates were low for anything like this long was in the 1930s, the Great Depression, and how did that end? It ended with World War II.

It doesn’t tell you what’s going to happen now. Why are long-term interest rates so low? It’s a big thing. It’s been trending down since 1982. There’s been a downtrend around the world in long-term real interest rates.

And it’s nothing particularly to do with the financial crisis. News media like to tie things in with already popular narratives. The natural instinct of a newspaper reporter is to tie it back to that, but it’s been going on longer than that.

I don’t have any unique insight into why interest rates have gone down. But I know they’re vulnerable to changing narratives.

Have you by any chance looked at initial coin offerings?

No, what is an initial coin offering?

It’s like using a crypto token, not bitcoin itself but the blockchain architecture, and issuing these virtual encrypted tokens almost like shares, even though they say they’re not shares.

How is it different from bitcoin?

It’s somewhat like crowdfunding. Say you’ve started a bar, and you want to fund it by issuing these tokens. A token is worth one beer, but your bar will only ever serve a set number of beers. If people think it will be a really hot bar, the value of the tokens trades for up to $100 or $200. People are raising hundreds of millions of dollars this way, with pretty thin business plans.

Yeah, that’s a classic bubble. I’ll have to read about that. There are a lot of cryptocurrencies but they don’t have as good a story as bitcoin. Maybe there’s a new narrative. Maybe this is a more viral story.

You’re making me think about writing something about this. You have my thinking going.

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And he expects the indexes to keep hitting all-time highs. In fact, he looks for the S&P to reach 2650, more than a 10% gain from current levels.

But that’s where he thinks this long, unloved, but very profitable bull market will end, probably in the first half of 2018. We are entering the bull’s final, euphoric stage, he told me in a telephone interview from Montreal, where he has published his technically oriented newsletter, Phases & Cycles, for 27 years.

His analysis is based on Elliott Wave theory, which holds that markets move in “waves” — five in bull markets, three in bears.

Robert Prechter, president of Elliot Wave International, has gained notoriety for his deeply bearish — and profoundly incorrect — predictions over the last few years. But Meisels says Elliott Wave theory explains the twists and turns of this bull market very well. The chart below, which he supplied to MarketWatch, traces its history.

Ron Meisels
This chart by Ron Meisels indicates that stocks could be in the final wave of the bull market.

It began with what he calls “a major, major economic and market low” on March 9, 2009, when the S&P reached a closing low of 676.53 and the Dow hit bottom at 6547.05.

From there, the S&P nearly doubled in wave one, but then, starting in 2011, went through a major correction (the S&P lost 19.4% of its value) Meisels said was typical of wave two.

The double bottom in 2011 coincided with the end of the debt crisis in Congress, and from there the markets rallied again in wave three, which, Meisels explained, lasted until mid-2015. The bearish wave four culminated in February 2016’s lows in stocks and oil.

“If you think back to January, February 2016, a lot of newspaper writers, the market writers and commentators thought this was the beginning of a bear market,” he told me. But the market had a big surprise in store for them (or, actually, us): It started a new up leg — wave five on Meisels’ chart — that has taken the S&P from around 1800 to north of 2400.

“Leg five is definitely the last up leg of the bull market, it eventually leads to euphoria and when the taxi drivers stop to give you stock tips,” he told me.

“I don’t find that the market is at that stage yet,” he continued. “Definitely we are more frothy than we were in 2009 and 2010.”

And far more complacent. On Monday, the CBOE volatility index, or VIXVIX, +1.86%  , dubbed Wall Street’s fear gauge, closed at 9.77, its lowest level since December 1993. Also, since the election, as this column reported, conservatives and Republicans, who stayed away during the Obama administration and while the Federal Reserve was “manipulating” markets, have jumped back into stocks with both feet now that their man and party are back in charge.

Meisels, who is Canadian, studiously avoided discussing American politics. But he observed, “Maybe not just because of Trump, not just because of Democrats and Republicans, I think that people after seven years seeing the market keep going up …finally people start throwing in the towel and that leads to the euphoria you and I were talking about.”

In other words, the new administration has become a political rationale for the classic capitulation of the bears that occurs at the end of every bull market. Meisels expects to see true euphoria kick in by this fall or early next year.

“I wouldn’t be surprised … if the market slows down between now and late August, you could have a minor correction, but… I would expect the market to have another leg up starting in September, October,” he told me. “The end of leg five and the end of this whole bull market cycle … I believe most likely would be in the spring of 2018, the first half of 2018.”

No guru’s words are gospel, but Meisels does have a good track record, and his argument makes sense. Risk is rising even as complacency reigns supreme, and that’s a recipe for trouble. I wouldn’t sell everything now, but I would start gradually reducing my stock holdings on rallies.

And the true believers piling into the market after eight years’ absence are about to learn their lesson the hard way.

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Essentially these are just a copy of the Value Line charts, but, probably a lot cheaper.

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The question is being discussed broadly across blogoland and investors: can stocks rise, in a rising interest environment?

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The answer is clearly no.

However, the argument will be; yes, but that was an extraordinary time, inflation was rampant and Volcker had to push interest rates higher to tame inflation. There is no inflation to speak of currently.

Really?

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There is plenty of inflation. There always has been ever since the US went off of gold and the dollar became fully fiat. To fund any shortfall in government spending, the US simply borrowed. Very often the Federal Reserve was that purchaser.

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The result being that the money supply has increased, which is responsible for the price inflation.

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So the bottom line is this. Stocks will rise with inflation in nominal terms. Sometimes they will rise in real terms as well. Stocks are [reasonable] inflation hedges when interest rates are not rising to combat inflation, which, is pretty much never if the government have their way.

The question should really be: how bad does inflation have to get before the only answer is to let rates rise, or force them to rise?

The constant rhetoric out of the Federal Reserve is that inflation is low to non-existent. The pledge is to keep interest rates low possibly into 2016.

Inflation will remain manageable [in Fed terms] while the economy is depressed and unemployment high. Why? Because as prices rise, consumers who cannot afford, do not purchase, thus reducing demand. This reduced demand has till now resulted in a compounding inflation rate of around 2.3%. If by some miracle employment levels rise and the economy starts growing and credit expands, that 2.3% will jump.

At that point what does the Fed do? Do they allow inflation to continue higher? Or, do they try to nip it in the bud, and if so, what happens to the economy on the ‘initial rise’ in rates?

The cycles are long runs. The current highs are defined from [more or less] the highs in 2000. I know we have broken higher technically, and while rates remain low and inflation chugs merrily along, it is practical to stay long, selling down periodically to lock in profits…trading the market rather than just B&H, which, could result in losing profits gained if we get for whatever reason a market break.

The takeaway – markets do not rise into rising rates. They may not fall, but, they do not move significantly higher in nominal terms. In real terms they might even gain a little, but it isn’t flash.

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My point is this: PIMCO’s epoch, Berkshire Hathaway’s epoch, Peter Lynch’s epoch, all occurred or have occurred within an epoch of credit expansion – a period where those that reached for carry, that sold volatility, that tilted towards yield and more credit risk, or that were sheltered either structurally or reputationally from withdrawals and delevering (Buffett) that clipped competitors at just the wrong time – succeeded. Yet all of these epochs were perhaps just that – epochs.

What if an epoch changes? What if perpetual credit expansion and its fertilization of asset prices and returns are substantially altered? What if zero-bound interest rates define the end of a total return epoch that began in the 1970s, accelerated in 1981 and has come to a mathematical dead-end for bonds in 2012/2013 and commonsensically for other conjoined asset classes as well? What if a future epoch favors lower than index carry or continual bouts of 2008 Lehmanesque volatility, or encompasses a period of global geopolitical confrontation with a quest for scarce and scarcer resources such as oil, water, or simply food as suggested by Jeremy Grantham?

What if the effects of global “climate change or perhaps aging demographics,” substantially alter the rather fertile petri dish of capitalistic expansion and endorsement? What if quantitative easing policies eventually collapse instead of elevate asset prices? What if there is a future that demands that an investor – a seemingly great investor – change course, or at least learn new tricks? Ah, now, that would be a test of greatness: the ability to adapt to a new epoch. The problem with the Buffetts, the Fusses, the Granthams, the Marks, the Dalios, the Gabellis, the Coopermans, and the Grosses of the world is that they’ll likely never find out. Epochs can and likely will outlast them. But then one never knows what time has in store for each of us, or what any of us will do in the spans of time.

The meat of a quite interesting article. Have a think on it. I’ll be adding comments later.

Still, the primary way to coin money over the past 30 years has been to use money to make money. Although the price of it started in 1981 at a rather exorbitantly high yield of 15% for long-term Treasuries, 20% for the prime, and real interest rates at an almost unbelievable 7-8%, the gradual decline of yields over the past three decades has allowed P/E ratios, real estate prices and bond fund NAVs to expand on a seemingly endless virtuous timeline. Books such as “Stocks for the Long Run” or articles such as “Dow 36,000” captured the public’s imagination much like a Montana to Jerry Rice pass that always seemed to clinch a 49ers victory. Yet an instant replay of these past few decades would have shown that accelerating asset prices weren’t due to any particular wisdom on the part of academia or the investment community but an offensively minded Federal Reserve and their global counterparts who were printing money, lowering yields and bringing forward a false sense of monetary wealth that was dependent on perpetual motion. “Rinse, lather, repeat – Rinse, lather, repeat” was in effect the singular mantra of central bankers ever since the departure of Paul Volcker, but there was no sense that the shampoo bottle filled with money would ever run dry. Well, it has. Interest rates have a mathematical bottom and when they get there, the washing of the financial market’s hair produces a lot less lather when it’s wet, and a lot less body after the blow dry. At the zero bound, not only are yields rendered impotent to elevate P/E ratios and lower real estate cap rates, but they begin to poison the financial well. Low yields, instead of fostering capital gains for investors via the magic of present value discounting and lower credit spreads, begin to reduce household incomes, lower corporate profit margins and wreak havoc on historical business models connected to banking, money market funds and the pension industry. The offensively oriented investment world that we have grown so used to over the past three decades is being stonewalled by a zero bound goal line stand. Investment defense is coming of age.

PIMCO Offensive Strategy 1981 – 2011

Ready, Set, Hut 1, Hut 2 –
Recognize downward trend in interest rates and scale duration accordingly.

A. Emphasize income and capital gains. PIMCO Total Return Strategy.
B. Utilize prudent derivative structures that benefit from systemic leveraging – financial futures,
swaps (but no subprimes!)
C. Combine A and B along with careful bottom-up security selection to seek consistent alpha.

PIMCO Defensive Strategy 2012 – ?
Ready, Set, Hut, Hut, Hut –

Recognize zero bound limits and systemic debt risk in global financial markets. Accept financial repression but avoid its impact when and where possible.

A. Emphasize income we believe to be relatively reliable/safe.
B. De-emphasize derivative structures that are fully valued and potentially volatile.
C. Combine A and B along with security selection to seek consistent alpha with admittedly lower nominal returns than historical industry examples.

SVU is getting twitchy, down 7% today as I type. Why? Some possible reasons.

Put buying dominated the option activity in Supervalu yesterday as the food retailer’s shares hit the middle of their range.

SVU finished the day at $9.43, picking up 2 percent on the day. The stock in the middle of its recent range as well as its 52-week range from $7 to $12.45.

More than 23,000 August 9 puts changed hands against open interest of 946, according to optionMONSTER’s systems. Most of those contracts traded in the afternoon, with two block of 10,000 bought for $0.45 and $0.50.

There was significant stock volume in SVU around the time as blocks of 380,000 went for prices from $9.32 up to $9.4579. So it appears that the puts were hedged with the long shares.

This would create an overall strategy that is long volatility and can profit if SVU moves sharply in either direction, getting back to the highs or lows of the year.

So possibly a trade ahead of earnings, which have been estimated at:

Wall St. Earnings Expectations: The average estimate of analysts is for profit of 33 cents per share, a decline of 23.3% from the company’s actual earnings for the same quarter a year ago. The average estimate is the same as three months ago. Between one and three months ago, the average estimate moved up, but has dropped from 34 cents during the last month. For the year, analysts are projecting net income of $1.23 per share, a decline of 11.5% from last year.

Past Earnings Performance: The company beat estimates last quarter after falling short in the prior two. In the fourth quarter of the last fiscal year, the company reported profit of 44 cents per share versus a mean estimate of net income of 34 cents per share. In the third quarter of the last fiscal year, the company missed estimates by 7 cents.

Revenue has fallen in the past four quarters. Revenue declined 5.9% to $8.66 billion in fourth quarter of the last fiscal year. The figure fell 5.9% in the third quarter of the last fiscal year from the year earlier, dropped 8.5% in second quarter of the last fiscal year from the year-ago quarter and 9.2% in the first quarter of the last fiscal year.

SUPERVALU’s profit in the latest quarter follows losses in the previous two quarters. The company reported a profit of $95 million in the fourth quarter of the last fiscal year, a loss of $202 million in the third quarter of the last fiscal year and a loss of $1.47 billion in the second quarter of the last fiscal year.

Competitors to Watch: Safeway Inc. , The Kroger Co. , Whole Foods Market, Inc. , Winn-Dixie Stores, Inc. , Ingles Markets, Inc. , Nash-Finch Company , AMCON Distributing Co. , Spartan Stores, Inc. , Wal-Mart , Target and Weis Markets, Inc. .

Safeway (SWY) shares fell 8.6% in afternoon trading after the company posted weak same store sales and declining margins, although its results were helped by higher fuel sales and cost cuts.

The supermarket chain posted 41 cents of EPS, 2 cents better than expectations. revenue came in at $10.2 billion, against expectations for $9.92 billion. sames store sales rose just 0.5% and gross margin declined to 27% from 28.55%.

“This decline was largely the result of some delay in recovering cost increases and increased LIFO expense, partly offset by improved shrink and higher gross margin dollars from Blackhawk,” the company said.

Well, if they miss, it looks as if volatility will be high in the stock. If they get hammered, I’ll definitely be a buyer. It will be ugly for the portfolio in the short term, no doubt, but that can be mitigated over a longer holding period. This of course has one major assumption, that they don’t go bankrupt…again.

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