November 3, 2023
By Steve Blumenthal
“Only a few market events in an investor’s career really matter, and among the most important of all are superbubbles. These superbubbles are events unlike any others: while there are only a few in history for investors to study, they have clear features in common.”
– Jeremy Grantham
Last week, we looked at Jeremy Grantham’s piece titled “Entering The Superbubble’s Final Act,” Most of the time, markets behave normally. But about 12% of the time, they behave irrationally, and about 3% of the time, they panic. As much as we would like to believe, there is no way of removing human emotion (fear and greed) from the equation.
How do you know you are in one? Grantham watches for something he calls a 2.5 sigma valuation event. In English, it simply means near-record extreme overvaluation. When the condition exists, Grantham then looks to see if investors are behaving rationally. He argues that excess speculation, such as meme stocks short squeezes and IPO frenzies, proved they were acting irrationally. When these conditions collide, you find yourself in a rare superbubble event.
All prior super bubble events ended in the stock market down more than 50%. That would put the S&P 500 Index around 2,400. Let that sink in. If you are thirty years old, what a coming opportunity. If you are in your 60s or older, it is a disaster—the reality of mother time.
A Superbubble in a Picture
There is an excellent way to see what a superbubble looks like. One of my favorite valuation charts comes from Ned Davis Research, which compares the value of the stock market to gross domestic income. I’ve shared this with you in past letters. Let’s look at the most recent chart, but this time, seeing within the context of a superbubble.
Here’s how to read the chart (red mark-up are mine):
- The data compares the U.S. Stock Market Capitalization (total value of publically traded stocks – outstanding shares times current price calculated at month end) to the U.S. Nominal Gross Domestic Income (the total of the U.S. economy’s income).
- The orange line in the middle section plots the price level of the total market (stock market capitalization) as a percentage of nominal gross domestic income and then compares it to an upward-sloping trendline. This is actually a more conservative way of parsing the data.
- I’ve put in red date boxes and red arrows to mark prior valuation extremes. Prior superbubbles.
- You can see that the orange line moves above and below the blue dotted trend line over time.
- You can also see that human behavior gets out of hand at market tops and bottoms. I don’t think that will ever change.
- An important takeaway from this analysis is captured in the data box in the upper left-hand corner. NDR calculated the subsequent return performance of the S&P 500 Index 1, 3, 5, 7, 9, and 11 years based on whether valuations were extremely overvalued (top quintile or top 20% of all valuation readings dating back to 1925) or extremely undervalued (bottom quintile).
- Bottom line: The average percentage change in the S&P 500 index was negative 11 years later. At 10-31-23 month end, we continue to find ourselves in the “Top Quintile” extremely overvalued red zone. Expect a wild down-up-down-up investment return ride over the coming years, where $1 million invested in the S&P 500 is worth $983,600 11 years from now. I’m 62 years old. I’ll be 73 then. The future return probabilities are not yet in our favor.
This process can help you create a game plan. For example, it is better to overweight equities when valuations are at or below the blue dotted trend line (center section in the prior chart). We are not yet there. Superbubble conditions remain.
Grab that coffee and find your favorite chair. We’ll take a look at the Buffett Indicator. It is said to be Warren’s favorite valuation metric, and it too is back in a 2.5 Sigman overvaluation extreme). Finally, I conclude this week’s post with a nice story in the personal section below, along with a few pictures. Thanks for reading!
Here are the sections in this week’s On My Radar:
- Valuations- The Buffett Indicator
- Random Tweets
- Personal Note: Family on Three!
- Trade Signals: Weekly Update, November 2, 2023 – Sell the Rallies
(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)
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Valuations – The Buffett Indicator
“The Buffett Indicator, also known as Market Capitalization to GDP Ratio, is a long-term valuation indicator for stocks that has become popular in recent years, thanks to Warren Buffett. Back in 2001, he remarked in a Fortune Magazine interview that “it is probably the best single measure of where valuations stand at any given moment.” It is a measure of the total market value of all publicly traded stocks in a country divided by the country’s GDP and can be used as a way to assess whether the country’s stock market is undervalued, fair-valued, or overvalued.” Source: AdvisorPerspectives
Jeremy Grantham talked about a 2.5 Sigma event. That’s geek talk for a 2.5 standard deviation event, which is more geek talk that means such levels of extreme almost never occur. But when they do, be on guard. This next chart plots what that looks like. +SD stands for 1 Standard Deviation. +2SD is 2, and I’ve estimated where +2.5 sits (yellow circle with red line). We are back above 2.5SD at the end of October 2023. Just look at the history, and you can see that by Buffett’s favorite indicator, we remain widely overvalued.
Not a recommendation to buy or sell any securities. Opinions expressed may change at any time.
Stanley Druckenmiller (click on photo to link to the article)
Liz Ann Sounders (click on photo to link to the tweet)
Follow me on X (formerly Twitter) @SBlumenthalCMG
Not a recommendation to buy or sell any security. For discussion purposes only. Current viewpoints are subject to change.
Personal Note: Family on Three!
The best moments happen. Unexpected, out of nowhere. And then, a fantastic pang to the heart!
This one was needed.
Coach Sue’s Malvern Prep high school boys’ soccer team sits in last place in its division with an overall season record of six wins, eleven losses, and one tie. It hits Coach hard. Regular readers know I’m helping my wife, Susan, during games.
The state playoffs began this week, and due to our record, the team was seeded at the top of the second division of the playoffs. Game one was yesterday afternoon against the lowest-seeded team in the tournament, a Philadelphia high school team called Girard College. It isn’t apparent, but it is a high school, not a college, and is located near the Philadelphia Art Museum.
Leading 10-0 at halftime, Coach Sue asked the Girard College head coach if he would consider conceding the game and turning the second half into a friendly competition by combining the players from both teams and splitting them into two groups. The coaches consulted the officials; the new teams were formed, and then, the moment!
Before the second half began, the boys huddled in a tight circle with one hand each raised to the sky. A boy from Girard College took the lead, “Right now we are all one family. We don’t know you and you don’t know us but that doesn’t matter, because right now we are all one family. And family sticks together! Right? Ok? FAMILY ON THREE.”
Yellow vs. Pink
What the Girard College soccer team lacked in soccer skills, they excelled in friendship, and you could see the joy expressed on their faces. It was extraordinary. If kindness and sportsmanship are the prize, this team is the champion. They won our hearts. And I think this is day we will all remember for a very long time.
Excerpts from Girard College’s website,
Girard College was formed by an unprecedented act of philanthropy shown by French immigrant and merchant Stephen Girard. At the time of his death in 1831, Stephen Girard was the richest man in America, and his endowment for Girard College was, up to that point, the largest private charitable donation in American history.
Inspired by the institutions around him, Stephen Girard sought to address the challenge of educating young Americans for the future. He directed the city of Philadelphia to use his money to build a boarding school for poor, orphan (interpreted as “fatherless”) white boys so that they might be prepared for the trades and professions of their era. Girard College opened on January 1, 1848.
Of course, the world has evolved since then, and the school is now multi-racial and co-ed.
There is one boy on Coach Sue’s team who has an especially kind way. With the mixed teams formed, just before he ran back onto the field, he said to me, “I going to do everything I can to help my guys win. I want to see them win.” And they did!
It was a joy to watch the Girard College boys play. It was a joy to watch how gracefully they handled defeat. It was a joy to watch everyone come together as one team, as one family.
Arms in the air… Family on Three!
Some golf is in the weekend plans. Looks like it will be sunny in the high 50s on Sunday. I had an enjoyable client event at Stonewall this week. Dinner on Monday night and golf on the Old Course on Tuesday. Pictured is the approach to the 18th green. The leaves were past peak and falling, and there was a chill in the air—beautiful nonetheless.
Ben, Scott, Steve, and Dennis
Have a great week.
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Trade Signals: Weekly Update, November 1, 2023 – Sell the Rallies
“Extreme patience combined with extreme decisiveness. You may call that our investment process. Yes, it’s that simple.”
– Charlie Munger
Notable this week:
Sixteen Months and Counting
The yield curve matters:
- Inverted yield curves and recessions:
- Inversion happens when the 6-month Treasury Bill yield exceeds the 10-year Treasury Note yield. Many follow the 2-year vs. 10-year Treasury (same idea – when short-term rates are higher than long-term rates, something is not well in the system.
- Historically, inversions have resulted in a recession within 6 months to 18 months. Source: Commonwealth Financial Network.
- Among bear markets since 1946, the average decline with a recession was 35.8% versus 27.9% on average without a recession. Source
- An inverted yield curve has preceded every recession since 1958, with a “median lead time” of 11 months before the recession started, according to Ned Davis Research (chart E641).
- Since recessions are only known in hindsight, it is important to assess the probability of a recession in advance.
- Why? All the bad stuff happens in recessions. The average S&P 500 Index drop is approximately 38%. Several exceeded –50%.
- I’m highlighting it this week, noting the depth and duration of the current inversion: lower section, red line, bottom right-hand section of the chart.
- Median Lead Time for Recessions (after the first inversion) equals 11 months. (Red arrow). We are now at 16-months.
- It’s when the degree of inversion moves back towards 0% that recession soon follows. That is now happening:
- It peaked at -1.90% on June 30, 2023, was –1.61% at August 2023 month end, –1.37% at the end of September 2023, and –1.01% at the end of October.
Several key equity market indicators moved to sell signals this week. The dashboard of indicators and the stock, bond, developed, and emerging market charts, along with the dollar and gold charts, are updated each week. We monitor inflation and recession as well. If you are not a subscriber and would like a sample, reply to this email, and we’ll send you a sample.
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Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
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