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in**@mc******.com
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
What Does Your 401k Own? The Ignorant Bliss of Passive Investing
December 16, 2020
“We’ve never seen these kinds of volumes in the history of U.S. equities markets or global equities markets and derivatives markets. The bottom line is really this – overpaying for assets. That’s the norm today. It is the greater fool theory, not in theory, but in practice. And the bottom line, I think, is captured by an old bit of wisdom – The fool and his money are quickly parted.”
– David McAlvany
Kevin: David. While we’re thinking about it, let’s go ahead and ask our listeners for questions for the shows coming up over the next few weeks. Every year we’ve made the comment that we get better and better questions. We’re just amazed at the quality of the listeners to the McAlvany Weekly Commentary.
David: If you send them to
in**@mc******.com
and just make mention that it is questions for the Weekly Commentary, we will circle back around in a few weeks and do our very best to provide some insight, and, if not, we will sufficiently punt.
Kevin: I was watching Monday Night Football, Browns/Ravens, and they were showing pictures of the vaccines coming out of the warehouse. And one of the sports commentators said, “Oh, I saw that this morning, and finally, finally, there’s hope.” I thought, “Gosh, that sounds a little bit overstated right now for a vaccine that really hasn’t had any time to be tested. When you see the pictures of the vaccines rolling out of the warehouse, did you breathe your first sigh of relief in nine or ten months, Dave?
David: I can understand if somebody has a significant health issue how this is definitely a day to celebrate. Reuters reported that there are five genes linked to severe Covid-19 cases. When I see those pictures, what I’m reminded of is, when we look at age, when we look at comorbidity, when we look at the testing for those five genes, we can pretty well narrow the scope of who is at risk. I think we ought to be engaging with those facts and plan accordingly. For those most at risk, again, I’m glad we have a solution. In fact, we’ve got three to choose from here in a short while.
David: That gene research was interesting too, because you have such a wide range of reactions to Covid. Some people barely know they have it, other people end up dying from it, and they’re finding that it can be genetically identified.
David: Yes, there has to be a more intelligent solution than to vaccinate the global population outside of those high-risk categories, because we’re dealing with materials that up to this point have never been used on human subjects.
Kevin: You don’t buy the shotgun theory where you just start shooting into the air and everybody gets it.
David: No. The reality is we’ve got very little science to quantify the risks that recipients face into the future. So if I’m 85 years old, if I’m 90 years old, I’m not really thinking about what the long-term implications for my health are. I’m just wanting a solution that takes care of this problem right now. But to roll out a vaccine without double blind studies with no historical data of effects, that just doesn’t exist yet.
I am reminded quite frequently as I’m listening to a drug advertisement, either on the radio or television, they give you this long list of things that can go wrong, and it’s not like mild headaches or cold sweats, it’s nasty. It’s a whole list of things, including death. And I just think, okay they’ve disclosed, you’ve chosen it. In this case, there’s nothing to disclose. The liability to the companies, I don’t think it’s going to be there.
And I don’t know that there is going to be any accountability if there are vaccine health-related issues in the future. Kind of a total free pass, and in that sense, all of the risk is on you. So what do you want to know? You want to know your comorbidities, you want to know if you have one of those five genes, you want to know if your blood type is particularly susceptible, and then you have to weigh the risks. And to me, I think there’s reason for pause. There’s always a reason for reasonable engagement.
Kevin: I remember in high school I learned my first Latin words. I’m not like your kids who learned Latin early. Caveat emptor was buyer beware, and I think probably what you’re saying is just before you use a blanket recommendation, do a little bit of research on your own.
Dave, before we started recording, we were talking about just the amazing amount of bailout money that’s come over especially this last year. But really, if we look almost the last decade, the three major central banks have purchased so much. And the European Central Bank, as we’ve talked about over the last few weeks, is literally buying everything. And what we were talking about is, as long as you’ve got a currency that you can create out of thin air and it still has value, no matter how much you create, you can you can literally go in and buy everything. I’m thinking of the ECB and what they’re doing right now.
David: Yes, and of course, that deals with confidence in that currency and the perception of stability. The ECB last week expanded their monetary stimulus program another 500 billion euros, and that’s of QE, quantitative easing, and that’s on top of the $2.2 trillion stimulus package backed by joint debt. And that’s not cannabis debt, by the way, but that’s mutually issued.
Kevin: Joint debt, not cannabis debt, okay.
David: No, no, no. Mutually issued, although it is a little wacky, all those countries kind of finding this sort of fiscal unity.
Kevin: Well, we’re going to jump in too, right? The Fed’s going to get involved. We’re going to find out what that looks like next week.
David: We may have something as soon as this Wednesday. And we may have one more reason for the markets to get very excited. We’ve already had risk-on. Again, think about it. If we are past the worst of Covid, how is it that we continue to, again, in the case of the ECB, another 500 billion, another 2.2 trillion? All of this towards would end? There’s really no end in sight, which, frankly, I think the markets kind of like.
Kevin: Oftentimes, Dave, because we’ve watched the market so long in our lives, we think of the markets as independent actors, and the independent actors in the markets, people making decisions, whether to buy stocks, sell stocks, what have you. But really, the paradigm has shifted over this last few years from active investing, which would be independent investors making their own decisions, to passive investing. One of the things I appreciate about you, Dave, is you save me work, because last night we were having our Talisker and just talking, and you said, “I’ve got a 35-page report from the Boston Federal Reserve Bank and I think I might read that tonight.” I was thinking, “I’m glad you like to read 35-page reports from the Boston Federal Reserve Bank.” But it really was focused on this shift from active to passive investing and the risks involved. And you did read it. And I’d like to talk about that today.
David: If I had more interest in the Browns and Ravens, that’s probably how I would have spent my evening.
Kevin: It was a pretty good game, by the way.
David: I haven’t watched the Browns play a game in probably 15 years.
Kevin: They’re back. The Browns are back. And I’m not going to act like I’m a Browns fan, but it’s nice to see this team sometimes.
David: Is there a team still called the Cincinnati Bengals?
Kevin: There is a team still called the Cincinnati Bengals. You’re scaring me, though. You’re scaring me a little bit. Yes, the team still exists, you just don’t see any fans in the stands anymore.
David: Well, the things that don’t change in the marketplace are that the market is driven by sentiment and psychology, so when we talk about monetary policy and fiscal policy, you’re really talking about the aspects that get into people’s heads. Go back to confidence, go back to perception, go back to what emboldens. In the investor world, there’s really not a lot of difference between the average investor and the average college student. Liquid courage, in the markets, comes from the central bank. Liquid courage for your incoming freshman comes from a keg. What we have seen is a shift away from full engagement in the process of determining what you invest in. And now it’s just buy the average, buy the index. So the shift from active to passive investing, it’s worth noting that the Federal Reserve is mindful. They know that there are implications to this, and it’s not just costing someone a franchise. In fact, there are implications in terms of financial stability.
Kevin: Well, they can intervene in the market, but they can’t intervene always, all the time, and buy everything. We joke about that, but they were leaning that this was decidedly negative, right?
David: What the paper implies, if you step back from it, they lay out various aspects of risks to financial stability because of this shift from active management where a mutual fund or an individual investor is choosing an individual stock, shifting that allocation throughout the year, as opposed to passive, where you’re just buying an index and letting it sit, invest passively either in mutual funds or exchange traded funds.
But what the paper implied is that the changes to financial market stability are decidedly negative and will ultimately invite fed interventions and legal accommodations in the passive and in the ETF universe, just is the Bank of Japan has done previously. So ultimately, will the Fed increase its direct purchases of ETFs, which is an indirect purchase of stocks.
Kevin: Yes, you’re not buying the real thing. When you’re buying an index, you’re buying an index of the real thing. You’re once removed.
David: Yes, you’re buying shares of a basket. And the paper highlights four negative transformations in the shift toward passive investing. Again, by passive investing we mean either mutual fund or ETF investments where an investment theme is not actively managed but passively or statically reflects the index. The first thing they mentioned is that pro-cyclical investor flows tend to reduce liquidity. Pro-cyclical means just sort of exaggerates the trend. On the way up there is an exaggeration of the up-trend, on the way down there is an exaggeration of the downtrend. And particularly when you’re talking about a liquidation cycle, that pro-cyclicality means that you make it to the point where there’s not a lot of liquidity, nobody there to buy the asset when investors want to sell.
Kevin: Is that what happened in March when Covid looked like it was going to be a real close-down for U.S. business? We had the market drop from 30,000 down to about 20,000. It was pretty quick.
David: It’s the nature of any fast market selloff, which is essentially a buyer strike. The second thing that the paper highlighted was that this move to passive investing tends to amplify volatility. The third was that it concentrates asset management within the industry, and you can see that with the big players – BlackRock, Vanguard, State Street, etc.
The last thing that they mentioned, which was very important, was that it changes the nature of an asset’s returns through inclusion in the index. So if you’re the Golden Child chosen to be put into an index, for instance, Salesforce got put into the Dow, and Exxon Mobil got taken out. It’s generally positive if you’re getting put in, generally negative for a stock performance if you’re getting taken out. So that last point, again, is that it changes the nature of performance and returns through the inclusion in the index.
You go back to point number one, the pro-cyclical investor flows reducing liquidity, and the paper said this: “Cash redemptions may create first mover advantages for redeeming investors, which in turn could lead to destabilizing redemptions and fire sales by the funds.
Kevin: So, okay from the start, but the further down you go, the longer you’re in that particular investment, the more it could be volatile for you. You want to be the first out because, first out would be the guy who gets the benefit. But the buyer of last resort has seemed to be, over this last decade, always the central banks. Wouldn’t the Fed be the buyer of last resort to stabilize the index?
David: Sometimes we think about how we account for buys and sells, and on an accounting basis, how we are going to pay our taxes? I love the first in, first out. If we can borrow that for the value investor, you’re early, first in, and you’re early again, first out. You’re not late, and late. You’re early, and early.
Kevin: So FIFO helps you if you just use it as an investment strategy, not just an accounting strategy.
David: Exactly. In our opinion, this is where the implications of concentrated positions with individual institutions, with a loss of liquidity, with amplified volatility, this is where you get an expanded list of assets that are purchasable by the Federal Reserve. This is where it comes from. They become the buyer of last resort.
We witnessed earlier this year, this is exactly what the Fed did in the fixed income markets when investment-grade exchange-traded funds were selling off and high-yield, that great acronym, we’ve always known it as junk bonds, when they were in freefall, the underlying assets could not be sold in orderly manner. So you began to see a major price difference between the shares of those exchange-traded funds and the underlying assets. And ultimately, the Fed had to step in and influence the market, purchasing those fixed income ETFs. Now we’re talking about a number that is fast approaching $10 billion in ETF purchases, and almost all of that is concentrated in the biggest firms.
We’re not talking about firms that were struggling to stay afloat, we’re talking about products in their stable of offerings that got a direct Fed bailout. BlackRock, trillions and trillions of dollars in assets under management. Were they under duress? No. Did they get the bailout? Yes. Vanguard. Were they under duress? No. Did they get the bailout dollars? Yes. How about State Street? This is back to point three. Passive investing has concentrated assets in a few big, largely passive shops. And when the structural deficiencies of those funds are on display, whose risk is it? Is it BlackRock? Is it the institution?
Kevin: They’re too big to fail.
David: Well, that’s right.
Kevin: We’ve seen that back … 12 years ago. Too big to fail.
David: And when that happens, when the too big to fail is revealed, you’ve got the superheroes. In this case, it’s Mnuchin and Powell coming in with their capes. The 2020 capers are coming in to rescue, fix, and ultimately pass on the expense to the taxpayer. So it’s a little bit of a déjà vu – privatized gains, socialized losses. We’ve been here before. This marks part of 2020 and the fixed income markets, and because of the structure of passive investing, likely to see it in the equity markets, as well.
Kevin: 500 years ago there was a system where the monarchy would support just a few large industries or trading companies like the East India Trading Company. It was called Mercantilism. It’s another form of monopoly. It’s almost like an endorsed monopoly. Mussolini said that when government and large corporations come together what you have is fascism.
We can we can name it different things, but when you’re talking about these large, too big to fail, like BlackRock, Vanguard, State Street, one of my concerns about free market economics – I love free market economics, I love reading Ludwig von Mises. But what I don’t love about free market economics is when it bonds to the point of monopoly.
What we have at this point is monopoly in the financial markets, probably for the first time in world history, don’t we? At this point what we’re seeing is passive investing, baskets of stocks. People aren’t buying their own stocks, they’re just basically saying, “Hey, I’m going to retire in 2032 so I’m going to press the button for 2032 and they’re just going to buy me either BlackRock or Vanguard or State Street or Schwab. They’re just going to buy me what it takes to be in a basket for me to retire in 2032. That sounds to me like a monopoly. Is it financial fascism, or am I overstating the case?
David: I think one of the other issues that is discussed in the paper is something that has nothing to do with the structural weaknesses of a particular product, but rather the weakness to the system of having concentrated near-monopoly status.
Just take a theoretical, hypothetical example. Let’s say there is a security breach, some sort of a hack of the system at BlackRock or Vanguard, and you have a confidence-breaking event through no fault of their own. All of a sudden, people don’t want their money in those funds. You have such a concentration of assets in those funds that now you do have major liquidity issues. Now you do have the indiscriminate selling, not on the basis of market concerns, but on the basis of institutional concerns, through no fault of their own.
This is the age we live in. We live in an age of cyber insecurity, and that was one of the factors that went in this paper. In an age of cyber insecurity, is it smart to have everything concentrated in that way?
Kevin: So let’s say too many people are asking for their cash all at once out of these baskets. Do they have to always redeem in cash? Is there another alternative or are there rule changes that could occur that could actually trap an investor in the market at that time?
David: It’s interesting because the mutual funds we tend to think of as carrying a larger cash cushion and there not being as much of a forced liquidation of the underlying assets to meet at least small doses of redemptions. That probably was the case 5, 10, 15 years ago. The trend has been to eliminate cash balances or get down to the nubs.
And so, to some degree, there are sort of cash settlement issues with mutual funds. These large firms, when it comes to ETFs are constantly creating and making a market in baskets of tradable securities. So you take, let’s say, five companies, put it into a basket and now you’re selling shares of the basket which has those five companies in it. You’ve created a basket of tradable securities.
Interestingly, over 90% of those baskets do not have to be redeemed in cash but can be redeemed with the underlying securities instead. There’s a critical distinction here, not that this happens, but it can happen. Investors operate, we operate, in the secondary market. We’re dealing with the tradable baskets already created. And that’s a market where we assume that cash is one mouse click away. So we assume that liquidity is there. Doug Noland often refers to this market belief, if you will, and it’s a belief in liquidity, as the moneyness of an asset.
Kevin : In 2008, remember when you thought your liquidity was a mouse click away – I won’t name the firm because we can’t, but it was a major one, and you wanted to get some stock out when the stock market was falling. And it wasn’t a mouse click away, was it?
David: No, it wasn’t. That was that was a structural issue with the company.
Kevin: That was personal funds, too. This was not managed funds.
David: Correct. And now we’re talking about structural issues with the products themselves. In the primary market, again, this is where the baskets of securities are created and traded by the big firms mentioned, they are also known as authorized participants, there is no forced sale of securities. The assets in the baskets are sufficient to meet liquidity demands. But the primary market participants are then on the hook to make a market in those underlying assets.
And, of course, if they’re going to do that, if I am forced to take in this deluge of selling, and now I own the underlying assets of all these baskets that I previously created, I need to hedge those positions. So I’ll step into the options market or futures market to hedge my price risk. We’re now diving into the expanded use of derivatives to accommodate what is an implicit risk for the primary or other authorized participants in the ETF scheme.
Kevin: So we’re talking about this paper that you read from the Boston Fed on passive versus active investing, and the dangers of this massive increase in passive investments. We know that the Federal Reserve is just sort of expected to stabilize prices. But there’s another issue, and you brought it up earlier and I’d like to unpack that a little bit. If necessary, they can distribute the shares to the individual investors and then the individual investors can trade on their own. How does that affect the index?
David: That’s a worst case scenario. I think the biggest risk for these firms, and really it’s the first place that the Fed has, as we’ve seen with fixed income, and will be invited – as we look at the equities markets – will be invited to stabilize prices, is with assets in the passive investment vehicles where they’re dealing with inherently illiquid underlying assets.
So not all assets are created equal. If you’re thinking about large cap blue chip companies, there’s a lot more liquidity there than there is small cap stocks or emerging market stocks or fixed income, particularly as you as you move down the food chain and get into the lower quality credit, there is just not a lot that trades there.
And in that case, the price divergence between the ETF share, which trades like a stock, the divergence between that and the underlying assets, the basket of securities, which could be stocks, bonds, derivatives, represented by the passive investment vehicle, they can diverge, and neither the investor nor the authorized participant need to worry.
Kevin: Isn’t that interesting? What you’re saying is the index of these assets, and the assets themselves, could be radically different in price.
David: Yes, and if they’re radically impaired, the reason I say they don’t need to worry, and I say that somewhat tongue in cheek, is because we have to assume the price divergence is great enough to invite bailout dollars. How do we learn this? This is sort of the Pavlovian pattern already. Sell-offs begin, you’ve got a fear of systematic destabilization which is triggered, and then any and all means necessary are employed to restore calm to the markets.
Kevin: And the Fed is Daddy Warbucks. The Fed just has the big wallet.
David: Right. So again, totally tongue in cheek, but investors believe in the dedication and commitment of the Treasury Department and the Federal Reserve, and therefore you don’t need to worry. Those are the operative choices we’re seeing on display in the marketplace today. What we’re saying is that in many instances, passive investing is successful in part because of implicit moral hazard. Buying begets buying with downside protection in place.
Kevin: As I was saying, I do love that you read these papers. I don’t necessarily read them unless you tell me, “Hey, I’ve read this. This is a good one to read.” It reminds me of a couple of years ago, I think it was April of 2019, you read a paper that talked about how the central banks and how the banking industry as a whole would have to get their head around negative interest rates and how to sell that to the public. And so it was like we were looking at something that was ahead of the curve. I’m wondering, Dave, about the timing on this paper. Why are they putting it out now? Are they concerned?
David: The paper you mentioned is one that dealt with deeply negative rates, not just negative rates, but how you could orchestrate deeply negative rates. And that was another research piece by the Federal Reserve. It’s not as if they’re going to do the things that they talk about, but they certainly explore, and I appreciate their curiosity and doing so. If we’re put in the position where we have to, what are the implications?
And I think that is, because of the structure of the market today, a very reasonable conclusion to come to as you look at this move toward passive investing. Frankly, not all ETFs invest in illiquid assets, so the degree of moral hazard differs from product to product. But in the next major market sell-off, it’s not as if the Treasury and Fed haven’t run the traps on what they need to do. They take the playbook right off the shelf and when they begin to feel the pinch, and in all likelihood get pressure from the CEOs – Larry Fink at BlackRock, Tim Buckley at Vanguard, Ronald Hanley at State Street – when they’re getting calls of concern, the assets will flow to these three behemoths, and so, too, I think, will the bailout dollars.
Here’s another issue as it relates to these products, product proliferation. There was somewhat of a stay in 2010 where the SEC stepped in and said, “We’re not going to do any more leveraged ETFs. They’re just not a good idea. The SEC is now in the process of lifting that 2010 moratorium on leveraged ETFs, and it’s the leveraged ETFs which are really squirrely. It’s a smaller niche, but it also accommodates a lot of speculation, and it’s likely to increase volatility in the marketplace quite significantly.
Kevin: The timing reminds me of Glass Steagall. Remember when they backed away from Glass Steagall? We’d had Glass Steagall since the 1930s and it was to keep 1929 from happening again. I think we had the tech stock bubble pop right after that, didn’t we? I think it was just within two years.
David: Yes, so keep in mind when we talk about derivatives in use in a leveraged ETF, that is so that you can add a double or triple exposure to the reference asset. On the other hand, you’ve got the folks who are buying and selling the baskets, creating the baskets, who have to hedge their market exposure. So derivatives are both a hedge and a speculation. And the proliferation of derivative use, both as a hedge and a speculation, everyone assumes that it’s a very reliable market to go to, either as a hedge or a speculation, and yet there are times when they simply don’t work.
Kevin: One of the vulnerabilities we have as investors, though, is just regulation changes, rules. They can change the rules in the middle of the game. It’s like a commodity contract. If you own a contract, let’s say, of wheat, and it can’t be delivered in the final product, they can just deliver it in currency. So rule changes, like with this, if we were to have a major market correction, are the things that they could do that would actually, I have mentioned it before, trap you in the market or change the nature of the investment as a whole.
David: One of the solutions the Fed paper discussed is where you have the scenario of a drop in the passive vehicle’s underlying assets, again, where NAV, or Net Asset Value, diverges from the share price too much and you just suspend the primary market activity. In other words, the folks who put those baskets together are no longer responsible for buying or selling anything. You convert the exchange-traded fund to a closed-in fund, and now you can have a fund sell at a discount, and you have to decide if you want to take the hit and liquidate or wait for it to return to fair value.
But I guess that serves as a reminder that investors operate off a variety of assumptions, and there is a baseline belief in liquid and continuous markets. We talked about that just a second ago in the derivatives market, but even in exchange-traded funds, you assume that you’re playing according to a certain set of rules, unaware that rules are frequently changed in the middle of the game.
I’ll just end with this point on the Fed’s fourth discussion point. The change of behavior when a security is included in an index, this is something to note, I think there are two dimensions to consider. First is that you can see an increased capital flowing either toward or away from the asset right? So it’s more money that’s either going to inflate the value of that stock or bond or more money leaving that asset, and it will exaggerate the trend in either way. So you get performance exaggeration, positive or negative.
Every dollar into an index gets split proportionally. And I would also remind you, blindly to the constituent parts. Look at the S&P 500 capitalization weighted index, it’s really interesting here, leading us to a second issue, the price earnings multiple. The PE, price compared to earnings, assigned to an index is not cap weighted. And thus, in this case, you look at the PE of the S&P 500, and in some instances you’re going to find that it’s, in fact, very understated. We’ll get to that in a minute.
Kevin: You talk about price earnings often, and we talked about Tesla. If you were really just trying to make back your money on the price of the stock based on price earnings, you’d be at 1,000 years right now. Tesla is 1,000 times earnings.
David: That’s what we mentioned last week.
Kevin: But you’re saying it’s not cap-weighted, so you wouldn’t actually even see that in the index because it’s not cap weighted.
David: Well, the fascinating thing, we mentioned it being expensive, their market cap is now above that of Berkshire Hathaway.
Kevin: Bigger than Buffett.
David: And to be honest, I’m having to rethink the value of carbon credits because I’m thinking, just in terms of a new business model, if I could sell carbon credits instead of making things, I could have a business like Enron. I could have a business like Tesla. This is fascinating.
Kevin: Now, can we store those carbon credits a little like we do gold in Zurich or Toronto? Can they deliver the carbon credits? I’m wondering, is this the new career, Dave?
David: Yes, are carbon credits the next best thing? Maybe we could tie carbon credits to block chain. Now we’re talking about something that sizzles. We’ve got something going here.
Tesla joins the S& 500 index this month, and that’s important. Currently the S&P 500 price earnings ratio is 29.
Kevin: Which is already high, but you said that Tesla’s not cap-weighted, so they come in with 1,000–to-1, that’s going to affect that index.
David: Well, it’s not that Tesla is not cap-weighted, it’s that the index doesn’t show the PE on a cap-weighted basis.
Kevin: That’s what I meant. But still, anything over about 14-20 is high.
David: Yes, if your average through time, if a reasonable value is 9 and 16, then getting to 29, it’s a little high. And this is what they basically do for the S&P 500’s PE ratio, they take the sum of all market values and divide by all earnings. And it does not account for the capitalization weighting. If you factor in the disproportional size of, say, Apple, Amazon, Microsoft, Facebook, Alphabet (the old Google), and we’re talking about this month, soon to be Tesla, your cap-weighted price earnings ratio is different if it jumps to 38 from 29.
Kevin: So if you add Microsoft, Facebook, Alphabet to that and you cap-weight it, it takes it from 29 to 38. Now, is that including Tesla?
David: No. My appreciation to Grants’ Interest Rate Observer for exploring this, then you include Tesla and your P/E ratio for the index, again, is skewed higher by the 1000+ P/E. With Tesla’s capitalization, as it gets factored into the index, it’s going to make up about 1.8% of the entire S&P 500 index. And so now the PE for the index jumps 18 points again to 56.4. Not 29, which is historically high, and accounting for cap weighting, not 38. But we’re going to levels that are extremely high, over 56.
So valuations are rich, right? Have we said that before? Why does anyone insist on playing in the stock market now? I suppose if you choose your allocations wisely, that’s fine. We’ve talked about there being pockets of value. That’s fine. But if you’re not hunting for value, if you are, in fact, one of those passive investors (laughs)…
Kevin: If you follow your emotion, we’ve talked about it before, right now, it’s very, very comfortable to be a bull. It’s comfortable because we’ve seen the Federal Reserve step in, and for people who don’t watch, last week you talked about Tobin’s Q. That’s been a very, very accurate index as to when a market is too high, the price earnings ratio. If I remember right, 14 or 15 is the norm average of what it should be. Now what you’re saying it’s 56.4, if you add Tesla.
David: Tesla is included. But it feels more comfortable to be a bull, we talked about this last week, because everybody else is, if you want to be part of the crowd, which lots of people do. If you’re going to be a contrarian investor you’re always going to be unpopular and lonely, like I said last week.
David: The liberal arts school here in town, four-year state college, I’m on the investment advisory committee for the foundation. Last week we gathered, and one of the things that I ended with was, it’s better to be fearful when others are greedy, and greedy when others are fearful. And the reality is, you look at the professional view of the market today, and it’s no different than the retail view of the market today.
Bloomberg covered the latest survey of professional asset allocators. These are professional investors. And the opinions that they gathered, I think, are very telling. They have a record high, this is very bullish, and this is how they record it. A record high for the survey’s “composite optimism indicator.” So very bullish.
Internally, we look at the Investors Intelligence survey of Bulls versus Bears, which over the last two weeks has had a difference of over 40 points in favor of the bulls, and by the way, anytime that differential between bulls and bears on the AAII measure gets above 40, you’re near market reversal. It’s a contrary indicator. The better people feel, the closer they are to something quite severe happening on the downside. Nevertheless, bullish record high for the survey’s composite optimism indicator. Bullish record probability of a stronger business cycle. That is the belief today, that we’re heading into an even stronger business cycle.
Again, from my vantage point, you’d say, “Well, what about the shutdowns, what about the real economy remaining disconnected from financial markets? What you really have is not a measure of the business cycle, but a measure of easy money flowing to Wall Street.
The third thing on this professional asset Allocator opinion survey was an optimistic record-low probability that US unemployment will be higher. So not expecting an increase in unemployment, we’re moving lower on the rates. That’s good. Record probability that investment grade credit is going to be a bigger winner as an investment strategy in treasuries. In other words, risk-on, risk-on. Record probability that high-yield, that is junk bonds, will beat investment-grade credit, again, an indication of risk-on, let the bulls run. Record probability that emerging market hard currency bonds will beat high -ield. This is this is like it’s green lights.
Kevin: It’s all risk-on
David: Right. Record probability that global equities will be higher. Record probability that global earnings will be higher. Bullish record probability of a 20% drawdown in U.S. equities, bullish record low probability.
Kevin: They’re saying hardly anybody believes that it could drop 20% down.
David: Yes, you just go through all of the things that they have, and it’s risk-on, risk-on, risk-on. We’ve got nothing but blue skies.
Kevin: There was one thing in that list, though, that you agree with because the one way you pay for all that risk-on is by creating currency out of thin air, and they do believe the dollar will go down. You would agree with that?
David Yes, exactly. There is a probability – they would say it this way, a, low probability – that the U.S. dollar will appreciate, which is a kind way, a very diplomatic way of saying, a high probability that the U.S dollar will depreciate. With that we agree. But heading to this sort of gross bullish sentiment, and I mean gross as in the large, not disgusting, but gross bullish sentiment, BofA says we’ve got the greatest call-buying frenzy since the dot.com bubble.
Kevin: Right. And buying a call was basically saying, “We are betting that the market’s going higher.” Dave, when I learned to fly, actually, even before I learned to fly, growing up in an aviation household, there was a saying, “There are old pilots and there are bold pilots, but there are no old bold pilots. Now, unfortunately, that’s not just a funny little saying. Unfortunately, I know of some people who were bold pilots who aren’t with us anymore. And I also know old pilots who take twice as long as they actually should to do their preflight checkout because they’ve done it so many times, yet they’re going to do it again.
David: There are options traders, and there are traders. Let me put it in the same syllogism that you had. There are traders with money, and there are options traders, but there are not options traders with money.
Kevin: (laughs) In the long run.
David: Well, I think about 96% of options expire worthless. So I suppose if you are the writer of options, you’re the winner. But if you are the buyer of options, 96% of the time you lose.
Kevin: No, no, you didn’t download the video package for $49.95. It teaches you how to become wealthy trading options.
David: Oh, I see. Well, if you’re in the 4% of winners and you can account for it not being dumb luck, then great. But there is a great stake for you.
Kevin: You get to be an old, bold pilot.
David: Bank of America, says it’s the greatest call-buying frenzy since the dot.com bubble. We’ve got call-option buying that’s hitting levels we’ve never seen before. In 2010 there was a little bit of fervor there, and we’ve taken out the volumes in terms of call-option buying that we had even back in 2010, and any other measure, just again, it’s worth keeping in mind, when you compare the various measures of market valuation and bullish sentiment and this intrigue with options trading, these are predominately short-dated call options, expiring within one week or 10 days.
There’s one analyst that I read who was commenting, I think he was sort of dripping with irony, that the stock market has become a derivative of the options market. Speaking of the post-election action, Chris Cole had this to say. “The market being up has nothing to do with who won the Presidency, who won the Senate. It has everything to do with the fact that you had a massive amount of short-dated put exposure that suddenly rolled off after the election and had reset to a lower volatility level.”
So, Kevin, if you look at a chart of the VIX, the Volatility Index, it was trading between 36 and 40 in the early days of November leading up to the election, dropped to as low in the last 30 days to as low as 20, again early December.
Kevin: Just a reminder, when people are buying call options, you have to have somebody who’s out there who’s going to fill that, or buying put options, which is betting the other direction. Somebody has to go buy those stocks so that you will have a rally if … these are these short-dated, you said.
David: That’s precisely what Cole said, is that dealers were forced to hedge that by buying the market. It had nothing to do with fundamentals, everything to do with a massive amount of short-dated optionality. And now we have something almost the exact opposite. Now it’s not puts and people expecting that they needed to hedge the election outcome, it’s calls exuberantly expressing the view that we’re headed even higher, there are no limits to growth in a post-Covid world.
Kevin: And this is why you have the reputation on that college board of sort of being – I don’t want to call you a chicken little – but you’re going to be somebody who’s going to be fearful when maybe they’re overly bullish?
David: I would say that we’re here because of money-printing. The valuations that we have are not on the merits of economic activity, commerce, revenue sales. It’s strictly on the basis of money-printing. So on last week’s call with the Local College Foundation, the idea was presented that valuations were understandably, justifiably higher because interest rates were lower. In other words, the risk-free rate goes down, and valuations, it’s normal for them to move up. And that’s okay. But where I beg to differ, I gave them Tobin’s Q and the Schiller PE and said, “Just so you know, this is how it is stacked up.” I guess I could have also referenced the S&P 500’s aggregate price earnings ratio, which is in the 98th percentile.
Kevin: And that was before Tesla was added.
David: If we count the cap-weight adjustment, we’re in the 100th percentile.
Kevin: So we’ve never been here before?
David: You can’t get higher than the 100th percentile. So I could have referenced the price-to-tangible book value. That’s also in the 100th percentile. I could have referenced enterprise value-to-EBIDTA, also in the 100th percentile. I could have referenced enterprise value-to-sales, price-to-sales, price-to-book, U.S. market cap-to-GDP. All of these are in the 100th percentile. That last one, again, U.S. market cap-to-GDP, that’s what we often refer to as the Buffet ratio. They’re all in 100th percentile.
Kevin: It reminds me of the smoke alarms in our house. One alarm goes off, and then another, and then another, and then they’re all going off at same time. It seems like every indicator right now is on the 100th percentile.
David: There are at least three or four that are between the 91st and 98th percentile, and we’ll see them catch up. But I think you’re right. Are we waiting for the last smoke alarm to send the message? If one goes off, you can reasonably ask the question, is there something wrong with the battery? Let’s go change the battery. If three are going off, the odds of three batteries going dead at once are slim to none. When you start getting this chorus of cacophonous voices from your fire alarms, what is it telling you?
We said this last week. We’ll say it again. Get out. It shouldn’t be that difficult. Somebody is going to say, yes, but you’re going to time the market wrong. You’re right. Valuations like this are not market timing mechanisms. They don’t help with that. The question is, are you comfortable being early rather than late?
When the market decides to move lower, it doesn’t usually give you much notice, and it takes it back a lot faster than it put it on. So if you’ve got a 20-30% gain in whatever period of time, you could lose that in a fraction of the amount of time it took to gain that amount. So crisis compresses time in many respects, and in this respect you have to be careful, and it’s always advisable to be a little early rather than a little late.
Kevin: The argument is that if we have risk-free low rates, then we’re going to have a higher market. That may be accurate, but it’s just very, very dangerous if you’re wrong.
David: I understand in theory how, if you adjust the risk-free rate lower, that it justifies higher valuations. I think what it neglects is a few practical realities because not all other things are equal. You have to say, if you lower the risk-free rate and all of the things remain equal, then you can see higher valuations. But we’re talking about business and commerce that needs to happen. We’re talking about sales and revenue that need to be generated.
Kevin: It’s just general business.
David: Right. So financial engineering cannot be the alpha and omega of investor returns. We return to the sobering reality that at the end of a cycle, psychology turns radically speculative and you enter with these new justifications of a paradigm shift and whatever argument it is to fortify more and more risk-taking. We talked about options, derivatives, leveraged products.
Kevin: Let me ask a question, though, because everything we’ve been talking about is an assumption of either low rates staying low or going lower. Doesn’t this work the opposite direction, if we’re possibly going to see higher rates?
David: Well, ask yourself a question. You’re sitting at Goldman-Sachs Investor Day last week, and Jamie Diamond, J.P. Morgan CEO, amongst half a dozen comments about the market and the economy and whatnot. He says that he wouldn’t touch treasuries at these rates with a 10 ft. pole. Why would that be? You’re running one of the largest banks in the world, and you know that your business is related to interest rates. You have to have some pretty solid views about where they’re at and where they’re going.
I guess it brings us to this. Remember this. Rates are not shackled to some imaginary floor. If you want to justify higher valuations and equities on the basis of lower and lower rates, you need to be willing to apply the same logic in a rising rate environment where valuations must come down and prices must come down.
So we come back around to these issues of inflation, currency pressures. What do we see unfolding in 2021 and 2022? One thing leads to another. If Diamond’s comment at the Goldman Investor Day last week is relevant, won’t touch treasuries that these rates with a 10 ft. pole.
Kevin: Could that possibly be an old pilot who’s not being bold?
David: Yes, are we talking about the end of a rate cycle? Are we talking about inflation or stagflation looming? And yet, you look at the broader market, and it’s the lemmings parade continuing in equities, and it’s growing as the lemmings parade. Everybody wants to trade options.
We’ve never seen these kinds of volumes in the history of U.S. equities markets or global equities markets and derivatives markets. Now we’re moving to the end of the month, now we’re moving to the end of the quarter. This Friday is quadruple witching, where you get expiration. Lots of interesting things could develop this week within the options market.
The bottom line is really this. Over-paying for assets – that’s the norm today. It is the greater fool theory, not in theory, but in practice. And the bottom line, I think, is captured by an old bit of wisdom – the fool and his money are quickly parted.
