Erik: Joining me next on the program is Francesco Filia from Fasanara Capital in London. Francesco, I’m really excited to get you on the program, because, as an engineer, I think in terms of things like feedback loops, and I know that you look at finance and some terminology that’s very familiar to me.
You’ve sent us a wonderful slide deck that I strongly encourage our listeners to refer to. Registered users, you’ll find the download link in your Research Roundup email. If you’re not yet registered, just go to macrovoices.com and look for the red button above Francesco’s picture that says Looking for the Download. And you’ll get instructions to get registered and get the download.
Let’s go ahead and jump right into your presentation. Why don’t we start with Page 3 here? You’re talking about an equity bubble, very much something that’s near and dear to my heart. And, just so you know, we’ve tried to position – we had a guest last week who was saying don’t worry about the bubble, don’t worry about valuations. We wanted to bring you in to give the contrasting view.
So tell us about the equity bubble and what you see on the horizon.
Francesco: Thank you, Erik. I think the equity bubble is quite uncontroversial, is quite unambiguous. There are a lot of different valuation metrics for those that care to look into them. They’ve been valid for over a hundred years of modern financial markets. And this time is no different in that respect.
There are the usual metrics that the valuation guys are looking at, like financial assets to disposable income that shows that this market is way more expensive than at any point in history including the big dot com bubble and the Lehman moment in 2007-2008.
But there are other metrics like the Buffett Indicator (market cap on GDP), the median debt on total assets, the corporate debt to GDP, the price on sales, the price to book, enterprise value on sales, enterprise value on EBITDA – there are a number of different metrics. They all convene that this is a market bubble that has not been seen before in history.
The only one metric that makes it a little bit less acceptable and tolerable is the comparison to bonds, which, unfortunately, are themselves into a bubble. And so they don’t provide much help in this respect. We will go through that in a moment.
But we at Fasanara, we developed our own indicator just to try to add something to what was available already. And we started with one of the most famous of all the indicators in this respect, which is the Shiller adjusted PE ratio, or the CAPE ratio. This is the most famous of them. Professor Shiller got a Nobel Prize in 2013 for it. And for his studies on market inefficiencies and for the ability to infer future expected returns from valuation metrics such as the Shiller PE.
And, based on the Shiller PE, what it does is simply to compare current prices to not spot earnings of foreign earnings, but a more reliable measure of the average of the last ten years and adjusted for inflation. So the average of the last ten years of real earnings. And on the basis of this index, we find out that the market is as expensive and just a little bit less expensive than it was in 1929 during the Great Depression, the peak of the market before the biggest collapse in equity prices ever seen, and the year 2000. So just slightly cheaper than the year 2000.
From that point onward – you know, that index itself has got a few critics. They say, yes, but wait a minute. Because of the great financial crisis in 2007-2008, what you have, you have the distorting effect of those low earnings. So if you do the average, the average is impacted by those low earnings.
So what other people like John Hussman very famously came out with – what they do is they adjusted this PE ratio for peak earnings instead of average earnings. To diffuse the most common criticism of the Shiller adjusted ratio. On the basis of the Hussman ratio (if you want to call it that), the market has never been so expensive except in the year 2000. So on the basis of the Hussman ratio, the market is more expensive than 1929 but is not as expensive as in the year 2000 (as yet).
Then Hussman also looks at the adjusted ratio for profit margins and finds out that this market is yet more expensive than the year 2000. But, on the basis of his indicator based on peak earnings, you could still argue that this market is not as expensive as in the year 2000.
What we do is an evolution of the Hussman PE ratio (which is taken from the Shiller ratio) which is to compare – kind of putting all in the basket. So we put the peak earnings as opposed to average earnings, and for peak earnings we really mean the peak. We take the two top quarters over the last 40 quarters. So we cannot really be seen as being any more generous to the current markets, we take the two peak quarters of the last 40 quarters. And then what we do is we compare these peak earnings to potential growth, or trend growth.
Because the point here is that what you pay in terms of stocks, should compare, not just to the past or the earnings of proposition, but also to the overall economy generally. Because if the overall economy has a lower potential growth you should be expecting to be able to pay less in terms of multiples than otherwise. The overall economy has a big correlation to earnings and to profit margins, so you should expect the potential growth rate of the economy to be quite relevant when it comes to PE multiples.
Keith, last time we had you on the program everybody and his brother was screaming, hey, the top is in, this is it, stock market’s about to roll over, get out, get out, get out! And you very boldly and confidently told us, look, it’s expensive. And expensive things get more expensive. That’s just how it works. And you were very bullish.
And, of course, you’ve been proven right to date. It’s so timely: As we speak again, on Wednesday morning, we’ve got the equity market down a few percent. And, of course, once again, the chorus is all over the internet: The crash has begun, it’s all over, the end is nigh, it’s all coming. What are we down? Three–four percent? And the world’s coming to an end.
Where are you at now? Is it time to join the chorus of bears? Or are you still on the bullish side of this camp?
Keith: Well, thanks for the lovely introduction. It’s always good to be, I guess, a bull when most people doubt the bullish narrative. What’s interesting, and actually the S&P 500 – it depends on where it finishes today – but, as you know, the correction was literally 60 basis points from its all-time closing high. Not just year-to-date high, or some kind of a trending high – I mean from the all-time. Which I continue to remind people is a very long time.
And if you go all the way back – and I’m sure we’ll review this – all the way back in market history, you’ll learn that, provided that profits and growth are accelerating, what happens to an “expensive market” (and I argued that it wasn’t expensive enough) is that they get more expensive.
So at this stage I think it’s less easy, obviously, that an epic move to the upside. The 60 basis point corrections clearly aren’t corrections. The ramp – and particularly in growth stocks – if you look at the returns associated with either growth as a style factor or just being long in the Nasdaq, they have been equally epic.
So it begs the question as to what happens next. I mean, a couple of the river cards that I was looking for fundamentally were 3% GDP, back-to-back quarters, which we got in both Q2 and Q3. It’s unlikely that we get a third here in the fourth quarter – our predictive tracking algorithm on GDP is currently tracking around 2.5 to 2.6 – so it’s marginally less great. And on the margin I think that might matter.
The other thing is that, clearly, earnings, in terms of the easy comparisons of earnings, which was really our call for the last 12 months, they get harder because of the acceleration. And I know that that might be a little quirky or geeky to call out. But that’s a big concern of mine, as we go more so into 2018, is that the massive acceleration that we saw in both S&P and tech earnings really has a massive comparison in the first quarter.
Of course, that’s not reported until April of 2018. So, between now and then, it is Mr. Market’s debate on what does and does not matter. And, frankly, I think that there’s – not that I wouldn’t be frank – but there are a lot of different macro tourist ideas out there on why the market should have always gone down, so I expect to hear and see a lot of those things. It’ll be fun to risk manage it or to trade it.
Please note this was transcribed to best of the ability of the transcriber and may have minor errors. Please refer to the podcast itself to clarify anything.
Jeff: Again, we want to keep in mind that over time this behavior evolved more and more at the margins. And originally, you’re right, the role of banking in society is to manage savings. And, throughout this evolution of the Eurodollar system, that role, or that intention, became eroded and replaced by what really is a bastardization of the entire idea of not just banking but money itself.
And so, you know, that stuff still went on. Banks were still lending to companies so that they could invest in their vital operations and do productive things with it. But the whole concept of savings itself was obliterated and replaced with what is essentially a system unto itself.
In fact, I think, in the housing mania portion of the middle-2000s, it came to that kind of an extreme where this financial system just – for no other reason than just expansion for the sake of expansion.
Your point about regulators and regulatory review is well taken. But by their own standards these banks were behaving according to regulatory standards. Nothing we see here is illegal. That’s an important point to stress as well. This is not illegal. It’s just a very poorly-designed system where the flaws apparent in it – that are very apparent today – weren’t readily anticipated at the time.
Erik: Now, Jeff, in the last series of slides that we’ve been through we’re talking about Bank A, Bank B, Bank C -- obviously these are fictional entities. Let’s try to pull this together in a real-world example. How real actual financial entities have manipulated balance sheets and -- give us an example. I think that’s what you’re coming to on Slide 45.
Erik: Joining me next is the one and only Grant Williams, the author, of course, of “Things That Make You Go Hmmm,” probably one of the most interesting and well-known newsletters in the business. Grant, thanks so much for joining us again.
I want to start, as we always do, with the US dollar, because everything else is priced in that. I know your partner Raoul Pal has been a secular dollar bull, but I think last time we talked to you, you had a different view.
What’s your current outlook for the US dollar? It seems like maybe we’re seeing the Raoul scenario play out, where the secular bull market is going to continue. Certainly the chart’s been looking pretty good for the last couple of weeks.
What do you think?
Grant: Hi, Erik. Great to speak to you again. Yeah, Raoul and I have differed in the last, I guess, year or so about this. We were very much aligned and I kind of – I went to the dark side and figured that the dollar had run its course, and became, not a bear as such, but I figured we’d seen the highs, and the likely future path was down. Not any kind of crash, but it was going to move lower over time.
And I based that on the fact that (A) it was in everybody’s interest – I mean, everybody’s interest for it to work lower – and (B) I figured that the US finances would actually start to matter at some point. That last point certainly doesn’t seem to be the case.
But in the last few months there certainly have been signs that perhaps the bull market is going to take one more try at going higher. The Fed seems determined to hike. And, as always happens, I think the vast majority of recessions post-1980 have been – sorry, post the US Civil War, according to a chart I saw recently – have all occurred due to one interest hike too many.
So I understand that in the short term the dollar could go higher, and I can see how that could happen. But I still think that over time the dollar is going to move lower, perhaps significantly so. But I don’t expect any kind of crash any time soon.
Erik: Joining me next on the program is Convexity Maven founder Harley Bassman. Harley, I think some of our listeners may not be completely aware of your very extensive background in the industry. You were one of the principle designers and creators of the MOVE index, which is essentially the VIX for the bond market, and held some senior roles at Merrill Lynch and PIMCO.
So why don’t we start with a little bit on your background. And particularly how the MOVE index came about.
Harley: Thank you for your time on the show. The MOVE basically came about a year or so after the VIX. It became obvious that volatility was becoming more and more important in the bond markets. People actually thought of volatility as an asset class to some degree. It’s certainly one of the three main risk vectors. Being duration, credit, and volatility. I view myself as a convexity maven; I focus on volatility and that sort of risk.
Duration is when you get your money back. Credit is if you get your money back. And volatility convexity, how you get it back. It’s a path-dependent risk.
And so creating the MOVE was a way of basically creating a language for people to look at volatility as an index as opposed to a number. And see if it’s high or low relative to where it’s been historically.