Market declines take time. They also offer a ton of chances to lose money. Investors have the chance to buy higher in order to later sell lower with each bounce.
In the fall of 2022, the main U.S. stock market indices reached what is probably an interim bottom. They have since sprang back with amazing vigor. Investors now feel more confident than ever thanks to the rally, which may have come at the worst possible time.
The bear market rally, often known as a sucker’s rally, has been misinterpreted by many intelligent individuals as the start of a new bull market. Calls for a bull market have spread far and wide in the wake of January’s excellent performance to kick off the new year.
These bull market predictions might be accurate. Perhaps this week’s stock market decline was just a period of consolidation. Also, the main stock market indices will shortly surpass their record highs from more than a year ago. We’re not certain.
Billionaire investor Jeremy Grantham, and co-founder of the Boston-based money manager GMO, recently provided a well-reasoned assessment of where the stock market, as measured by the S&P 500, is headed. In his 2023 outlook letter, After a Timeout, Back to the Meat Grinder!, which was published on January 24, Grantham noted:
“While the most extreme froth has been wiped off the market, valuations are still nowhere near their long-term averages. My calculations of trendline value of the S&P 500, adjusted upwards for trendline growth and for expected inflation, is about 3,200 by the end of 2023. I believe it is likely (3 to 1) to reach that trend and spend at least some time below it this year or next.”
As of Thursday’s close, the S&P 500 was at about 4,012. Thus, to hit 3,200, the S&P 500 would have to fall 20 percent. What to make of it?
Reversion to the Mean
It’s possible that the S&P 500 is not as absurdly overvalued as it was 16 months ago. But according to historical standards, it is still massively overvalued. The current value of the cyclically adjusted price-to-earnings (CAPE) ratio used by Shiller is 29.14, which is much higher than the 17-year average.
The stock market, as measured by the S&P 500, still has a long way to fall unless something has changed and the historical averages are no longer relevant. It is highly possible that the fall will be accompanied by some kind of financial panic that causes people to flee the area. In fact, Grantham pointed out that a 50% reduction is entirely feasible.
“Even the direst case of a 50 percent decline from here would leave us at just under 2,000 on the S&P, or about 37 percent cheap. To put this in perspective, it would still be a far smaller percent deviation from trendline value than the overpricing we had at the end of 2021 of over 70 percent. So you shouldn’t be tempted to think it absolutely cannot happen.”
If you aren’t familiar with Grantham’s writing, he has successfully predicted multiple bubbles throughout the course of his extensive career. He accurately foresaw the late 1980s boom in the Japanese Nikkei stock market, the dot com bubble in 2000, and the mid-2000s housing bubble.
The outlook of Grantham is quite practical. Reversion to the mean, a fundamental financial concept, is where he focuses.
This is a statement on how all market segments and asset classes will return to mean historical levels following highs and lows. However, according to Grantham, the decrease in 2022 was insufficient to bring the S&P 500’s prices back into line with their historical mean.
Observe Again
The stock market freefall that took place on Tuesday [February 21], dropped the Dow Jones Industrial Average (DJIA), the S&P 500, and the NASDAQ by 2.06 percent, 2.00 percent, and 2.50 percent, respectively. This may not be much in the grand scheme of things. But it was a good reminder that there is still plenty of danger imbedded in today’s prices.
In addition, when you factor in rising treasury yields, and the newfound allure of holding bonds, stocks become especially dangerous. A 12-month treasury note, for example, is yielding over 5 percent. Will the S&P 500 increase by 5 percent over the next 12 months?
Certainly, it could. It may even rise more. But, based on Grantham’s analysis, it could also lose 20 percent – or even 50 percent.
At what point does the risk of stocks become outweighed by the reward of bonds?
That’s up to each individual to decide, given their time horizon and appetite for risk. Nonetheless, for many people, accepting a 5 percent yield – which is still below the rate of consumer price inflation – beats rolling the dice for a potential 20 percent loss.
And as yields rise higher, in the face of an overvalued stock market, the reward of bonds becomes more enticing. At some point, investors will transfer more and more of their portfolios from stocks to bonds. This drain of capital from the stock market will pull the indexes down.
This is all a very natural occurrence. The relationship between interest rates and stock market or other asset prices isn’t complicated. Tight credit generally produces lower asset prices. Loose credit generally produces higher asset prices.
After two decades of artificially low interest rates, courtesy of the Federal Reserve, a massive stock market bubble was inflated. If you think the decline of the major stock market indexes that took place from roughly January 2022 to October 2022 is all that was needed to expunge the prior excesses, you should think again.
Here’s why…
Fear and Greed with a Roll of the Dice
Warren Buffett, in the 1986 Berkshire Hathaway shareholder letter, offered the following insight:
“[O]ccasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
This remark is a classic contrarian view on stock markets and the, sometimes, wild price swings that are experienced. The observation relates to market psychology. Investors, as a group, are compelled by emotions of fear and greed.
Rising markets attract emotions of greed, as investors bid up prices in the hopes of even higher prices. When the bubble inevitably pops and the market falls, fear takes over, and investors sell just as the market bottoms. Buffett’s advice is to do the opposite of the herd.
This all sounds well and good. But it is easier said than done. Clearly, the U.S. stock market indexes were overtaken by greed in 2021. Smart investors sold prior to the market’s peak and sat out the decline.
But did they buy back in at the stock market’s interim bottom in October 2022? Some did. However, others didn’t. Moreover, how does an investor know when the stock market’s consumed by fear and when it’s consumed by greed?
For what it’s worth, and it may not be worth much, CNN Business provides a Fear & Greed Index. The index compiles seven different indicators, including: market momentum, stock price strength, stock price breadth, put and call options, junk bond demand, market volatility, and safe haven demand.
The index gives each indicator equal weighting in calculating a score from 0 to 100, with 100 representing maximum greediness and 0 signaling maximum fear. Currently, the index is at 63, which is firmly in the greed range.
In summary, according to Grantham, the stock market has further to fall to revert to its historical mean. The reward of treasuries is starting to outweigh the risk of stocks. Buffett says you should be fearful when others are greedy. The Fear & Greed Index is standing firmly in the greed range.
What to do?
You could always roll the dice, buy shares of Tesla, and hope for the best. You’d certainly be in good company. As of last week, retail investors had poured $9.7 billion into Tesla so far this year.
But by our rough assessment, lightening up on equity positions and going fishing for a few months is the better option.
[Editor’s note: No investing strategy is complete without considering geopolitical factors. For this reason, I just put the finishing touches on a unique Special Report. It’s called “War in the Strait of Taiwan? How to Exploit the Trend of Escalating Conflict.” You can access a copy here for less than a penny.]
Sincerely,
MN Gordon
for Economic Prism
Return from Fear and Greed with a Roll of the Dice to Economic Prism
Source: Economic Prisim Rephrased By: InfoArmed