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The dust still hasn’t settled on the shock and outrage that followed Bill “let them eat deflationary iPads” Dudley’s oped in which he suggested that the Fed could crash Trump’s reelection chances by sinking the economy into a recession, when today the former NYFed president and Goldman Sachs economist and current Bloomberg op-ed writer decided to lend some support to his colleague Neel Kashkari by writing yet another op-ed titled “Fed’s Repo Response Isn’t Fueling the Stock Market” in which Dudley “explains” that “equities are being driven by low rates and a healthy economy, not central bank T-bill purchases.“

As a reminder, two weeks ago, Neel Kashkari sparked a vocal  response among Fed watchers when he urged “QE conspiracists” to show him how the Fed is moving stock prices. And while we did just that, using none other than a recent BIS article to explain to Kashkari precisely how the Fed is “moving stock prices”, Neel probably did not anticipate that one of his own FOMC colleagues, Dallas Fed president (and another former Goldmanite), Robert Kaplan, would join the ranks of “QE conspiracists” when he told Bloomberg that what the Fed is doing now is “a derivative of QE when we buy bills and we inject more liquidity; it affects risk assets” adding that “growth in the balance sheet is not free. There is a cost to it.”

Kashkari certainly did not expect Trump’s top economic advisor, Larry Kudlow, and Morgan Stanley CEO James Gorman to also admit that the Fed’s balance sheet expansion is quantitative easing, as more and more establishment luminaries joined the ranks of “QE conspiracists.”

So with Neel suddenly feeling all alone in his lack of understanding of monetary policy, Bill Dudley decided to join the fray, and ignoring all the recent statements from Kaplan, Kudlow and Gorman, trumpeted today that he is “skeptical that the Fed’s balance-sheet expansion is having a major effect on U.S. stock prices.”

Dudley is of course referring to the fact that ever since the start of the repo “bailout” by the Fed in September, when Powell launched hundreds of billions in overnight and term repos and especially with the start of “Not QE” on October 11, stocks soared, something we have shown virtually every week since October when we demonstrated the uncanny correlation between the rise in the Fed’s balance sheet and the S&P. This is how Dudley framed this:

During the past few months, the U.S. stock market has surged as the the Federal Reserve bought hundreds of billions dollars of Treasury bills to add reserves to the banking system and calm the repo market.

To Dudley none of this matters because “of course, correlation isn’t the same as causation. Just because two things are moving together doesn’t mean that one causes the other” which would be a great argument if one were to exclude, for example, the fact that global central bank liquidity and the market’s performance ever since the Fed’s infamous pivot, have moved tick for tick. In other words, according to Dudley the chart below is pure coincidence:

Second, and more importantly, Dudley continues, “the notion that the Fed’s actions are fueling a stock market bubble isn’t supported by how the Fed’s T-bill purchases are affecting short-term interest rates or how the Fed’s actions are increasing liquidity in the financial system.”

As Dudley then “explains”, the “Fed’s T-bill purchases substitute a bank reserve (essentially equivalent to a one-day T-bill) for a slightly longer risk-free asset (a T-bill) that the Fed now holds in its portfolio. But that’s it. There are no funds created to purchase equities.”

This is great, and if correct would certainly validate Kashkari’s skepticism… if it were true. Unfortunately it isn’t. As a reminder, none other than the BIS explained how generous commercial bank leverage was necessary and sufficient to allow hedge funds to engage in massively-levered, repo funded Treasury pair trades, and that without this liquidity – which the Fed directly enabled – hedge funds would be forced to unwind trillions in trades, resulting in a liquidation cascade. But don’t take our word for it, this is what Claudio Borio, head of the monetary and economic department at the BIS, said to explain the dramatic surge in funding needs among commercial banks which was to meet…

… high demand for secured (repo) funding from non-bank financial institutions, such as hedge funds heavily engaged in leveraging up relative value trades

In short: whereas both Kashkari and Dudley only look at the supply side of the newly injected reserves into the US commercial banking system, they both ignore the demand side, i.e., all those funds whose very existence is dependent on there being a generous excess of liquidity in the US financial system, or else all those “free” pair trades that boost returns would collapse overnight. What happens then? See LTCM.

Dudley’s third, and final point is the most laughable: “there is a more obvious explanation behind the stock market’s rise: the prospect of a sustained economic expansion and a Fed that is likely to stay on the sidelines and not raise its federal funds rate target in 2020.”

We have no idea what is going on here: maybe Dudley was  busy eating iPads last Monday when the IMF cut its global economic forecast for a 6th consecutive time, including slashing its US GDP forecast for 2020. Or maybe he has not pulled up the Citi US econ surprise index, which after – ironically – surging into the September repocalypse, has since drifted lower and has been hugging the flatline for the past 5 months?

So three specious, if not outright fallacious, arguments down, what is the real purpose behind Dudley’s screed? It’s simple: as Dudley himself says, the answer is important whether the Fed’s balance sheet expansion is pushing stocks higher “because the Fed’s large T-bill purchases will end soon. If the central bank’s balance-sheet expansion is truly lifting stocks, then the market is vulnerable when these purchases cease.“

And it is here, where Dudley’s op-ed shifts from facts to hope:

The Fed’s expansion of its balance sheet and the increase in bank reserves have stabilized U.S. money markets. As a result, the Fed is likely to gradually taper its repo-market interventions and significantly slow its T-bill purchases after the April tax season. The end of this aggressive provision of bank reserves, however, is unlikely to create major problems for the U.S. equity market.

And there you have it: all Dudley hopes to do by siding with his Minneapolise Fed colleague is preparing the market for what comes next, namely the tapering of QE4 and the tremendous growth of the Fed’s balance sheet, which as most sellside strategists expect to start slowing sometime in late Q1 and certainly Q2. It explains why at the very end of his op-ed the former NY Fed president has nothing more to offer his read than a hope that “the end of this aggressive provision of bank reserves, however, is unlikely to create major problems for the U.S. equity market.”

In other words, nothing more than his own, biased opinion; the opinion of a man who outraged even his former employer when he suggested the Fed should prevent Trump’s reelection.

Well, Bill, you know what they say about opinions and anal sphincters. As for Dudley’s emotion appeal, we have a simple counterargument, the same one we offered Neel Kashkari: announce today that QE4, pardon “NOT QE” is ending and surprise the market. Let’s see what the reaction will be.

Of course, that won’t happen for the simple reason that markets would instantly crash, and instead the Fed will make such an announcement in the coming weeks, giving markets plenty of advance notice of what is coming. It is then that all future debate on whether this was or wasn’t QE will finally, mercifully end, as the market’s reaction will give us all the answers we need, and it is then that we will see if Dudley’s conclusion that “it is unlikely to create major problems for US equity markets” is correct.

Sen. Joe Manchin (D-WV) said on Wednesday that Hunter Biden would be a “relevant witness” in President Trump’s impeachment trial over withholding aid to Ukraine while pushing for an investigation into allegations of Biden corruption.

“I think so — I really do,” Manchin told MSNBC‘s “Morning Joe,” adding “I don’t have a problem there because this is why we are where we are.“

“Now, I think that he [can] clear himself — what I know and what I’ve heard … But being afraid to put anybody that might have pertinent is wrong, no matter if you’re a Democrat or Republican.”

Sen. Manchin (D): Hunter Biden is a relevant witness.

“This is why we are where we are”

pic.twitter.com/Uc4vlLDHRD

— Benny (@bennyjohnson) January 29, 2020

Manchin expounded after his appearance:

Sen. Joe Manchin: “The whole process is hypocrisy… They’ve all reversed themselves, Schumer and McConnell both.” pic.twitter.com/pP8ks3Ktd0

— The Hill (@thehill) January 29, 2020

During this week’s impeachment arguments, President Trump’s defense walked the Senate through Hunter Biden’s ‘nepotistic at best, nefarious at worst’ board seat at Ukrainian gas giant Burisma. Joe Biden, meanwhile, bragged in 2018 about withholding $1 billion in US loans to Ukraine if they didn’t fire their top prosecutor who had been investigating Burisma.

“All we are saying is that there was a basis to talk about this, to raise this issue, and that is enough,” said Bondi, who noted that Hunter Biden was paid over $83,000 per month to sit on Burisma’s board even though he had zero experience in natural gas or Ukrainian relations while his father was Vice President and in charge of Ukraine policy for the United States.

Pam Bondi explains the Bidens’ connection to the corrupt Ukrainian gas company Burisma https://t.co/SpmArCYbb7 pic.twitter.com/aKNqQKo8cl

— RNC Research (@RNCResearch) January 27, 2020

Other top Democrats have categorically ruled out testimony from the Bidens, with Senate Minority Leader Chuck Schumer claiming that Hunter wouldn’t be able to offer relevant testimony about Trump’s interactions with Ukraine, and that his appearance would be a distraction.

Republicans have threatened to subpoena Hunter, 49, if Democrats succeed in securing testimony from former White House National Security Adviser John Bolton, who claims in a leaked manuscript of his book that President Trump explicitly tied Ukraine aid to investigations into the Bidens.

Democratic strategists haunted by damaging right-wing attacks on past nominees Hillary Clinton and John Kerry say the specter of Hunter Biden getting publicly grilled by Senate Republicans would inject uncertainty into a still-fluid primary race.

…

Trump’s allies vow that if Bolton is called, they’ll subpoena Hunter Biden, and perhaps the former vice president.

“If you call John Bolton, we’re going to call everybody,” South Carolina Senator Lindsey Graham, one of Trump’s most vocal defenders, said Tuesday. He made clear that means the Bidens. –Bloomberg

“Biden can expect Trump and outside groups to deliver the same experience that wrecked Clinton’s and Kerry’s campaigns,” said Trump’s former chief strategist, Steve Bannon, adding “Isolate and amplify the most damaging charge against the strongest Democratic candidate and hammer into voters’ minds until Election Day.”

Meanwhile, in ‘please clap’ news, Joe Biden’s 2020 campaign is now begging his supporters to defend him against online attacks from Bernie Sanders supporters, according to Bloomberg.

With less than a week before the Iowa caucuses, the Biden campaign expressed concern on a call to its supporters that Sanders people were “getting ugly” and it had to “step up its game” defending the vice president. The message was confirmed by campaign national press secretary TJ Ducklo. –Bloomberg

And last but not least, Joe Biden put his hands on an Iowa voter Tuesday, telling him to “go vote for someone else” after he was asked not to support the construction of new pipelines. The man replied that he would support Biden in the general election against Trump, but that he supports billionaire Tom Steyer for the primaries.

A man in Iowa asks Joe Biden to stop supporting the building of new pipelines. Joe Biden tells him to go vote for someone else and then starts accusing him of voting for Bernie Sanders. Actually, the man says, he’s voting for Tom Steyer. Very awkward. pic.twitter.com/OOuGiypED8

— Zaid Jilani (@ZaidJilani) January 28, 2020

Oil prices surged overnight after API’s surprise draw and headlines about a Houthi missile attack on Aramco facilities, but after tagging unchanged from Friday’s close (erasing the post-virus drop), comments that all missiles were intercepted sent prices lower and refocused traders’ attention on the potential for an imminent demand crisis due to the ‘Devil’-Virus spreading across the world.

Refinery utilization rates have been sluggish for this time of year, says Bob Iaccino, market strategist at Path Trading Partners:

“If refineries are not operating at capacity, it’s because they don’t have the demand, a lower draw or a build could make the demand fear worse”

So all eyes once again revert to inventories..

API

• Crude -4.27mm (+500k exp)

• Cushing +1.02mm (-870k exp)

• Gasoline +3.27mm (+1.3mm exp)

• Distillates -141k (-1.1mm exp)

DOE

• Crude +3.548mm (+500k exp)

• Cushing +758k (-870k exp)

• Gasoline +1.203mm (+1.3mm exp)

• Distillates -1.289mm (-1.1mm exp)

A big surprise crude draw from API was not enough to trump china demand fears but the official data from DOE shows a much bigger than expected 3.548mm crude build

Source: Bloomberg

As Bloomberg warns, the world is swimming in refined products. Gasoline stockpiles hit a seasonal high in data going back 29 years in last week’s report. Demand is likely to be soft, especially if we see a big slowdown in exports to Asia as fears persist about the coronavirus.

US Crude production remains at a record high, as forward-looking rig-counts begin to stabilize after their collapse…

Source: Bloomberg

WTI had dropped back to just above $43 before the DOE data – close the levels before API’s surprise draw was reported.

Finally, as Bloomberg Intelligence Senior Energy Analyst Vince Piazza explains, measured against the 2002-2003 SARS outbreak, the coronavirus situation in China will have a larger absolute effect but about the same effect on a relative basis.

Daily demand may be curtailed by more than 200,000 barrels vs 100,000 in the earlier incident, but China now accounts for 15% of global use vs 7% in 2003.

U.S. exports and therefore inventories may show a more marked effect, however, as China is now more integrated into the global economic system.

Yemen’s Houthis claimed Wednesday its Shia militants targeted Saudi Aramco facilities with a missile strike in Jizan on the Red Sea in the kingdom’s south, which caused a brief surge in oil, jumping above $54 a barrel in New York, before it slipped back down to a nearly 3-month low on reports that no missiles reached their intended targets, leading to skepticism about the Houthi statement. 

An hour after the announcement briefly rattled oil markets, a Saudi oil official indicated that all missiles were intercepted by Saudi defenses — though details still remain unclear and unconfirmed, especially the timeline of when the attack allegedly happened.

It marks the first such Houthi attack on Aramco facilities since the major Sept.14 drone and missile strikes which severely damaged two facilities deep inside Saudi Arabia, knocking all the country’s production offline for at least a day.

Reuters reports: “Houthi military spokesman Yahya Saria did not give a timeframe for the assault.” State oil giant Aramco itself has not issued confirmation or denial.

And further, the Houthi military statement indicated “the group that has been battling a Saudi-led military coalition for nearly five years had also targeted non-energy Saudi facilities near the border with Yemen,” according to Reuters.

Typically either the Saudis or Houthis themselves release some level of video evidence for such major rocket attacks. In past rocket attacks from Yemen onto Saudi soil, Riyadh has released images of missile debris which fell short of the intended target. The Saudis have yet to provide proof that an “intercept” did in fact take place. 

The Jazan facility, while not a crude oil production or major export site, is home to a 400,000 barrel-a-day Aramco refinery, which is further expected to operate at full capacity by the end of 2020.

Blain’s Morning Porridge, submitted by Bill Blain

Stock markets shrugged of the Coronavirus yesterday, and staged a buy-the-dip rally. Are they right to discount the threat? It’s not about infection rates or mortality – the economic damage is already very real.

I am concerned Wuhan flu should not be lightly discounted. The numbers appear to show its spreading faster than anything previous like SARs, it shows few signs of topping, and the mortality rate seems to be rising faster than in previous China originated epidemics. That could be because it was given an opportunity to become more widely established – its now known local Wuhan authorities first knew about it in December, but did little for nearly 6 weeks. It’s now erupting in clusters away from China – like in Germany – spread by single travelers unaware they were carriers. 

Now governments are playing catch-up. However, many investors suspect the recent market stumble was due to Government over-reaction than any real contagion threat. They’re looking to buy the market cheap to the fears triggered by over-reactive policy to contain the outbreak. 

Maybe, the virus is more serious than the market hopes. Hope is never a good strategy. It could well be dismissing 2019-nCoV as not particularly relevant, and no more dangerous than SARS is the right call, but maybe not. But, there are two threats; the virus itself, and policy consequences. If the virus is already widely established, continues to balloon in numbers of infections, then it’s likely to trigger further government action – for instance there were rumours of US China flight ban yesterday. BA have cancelled their flights to China this morning. Economic effects will escalate and seriously impact business. There is a serious threat of China slowdown translating into a global event. 

That is what markets should be pricing – the economic slowdown caused by the virus. If it gets worse, the consequences will be so much more painful. 

It’s clear any business connected with China is going to suffer some form of Q1 hit from the impact in China. We still don’t know how much more economic damage may be inflicted from policy responses to the virus.  Firms like Honda are shuttering China factories. Plans to evacuate foreign nationals from China are being put in place – will they all be put in quarantine? 

Don’t discount Coronavirus. It is not over yet. 

An Apple a day keeps my Pension OK

Apple results certainly distracted markers in a positive way – beating estimates with a $91.83 bln revenue post. 

Here is great statistic, courtesy of the FT: Apple’s Market cap is $1.354 trillion. The Market Cap of the Entire DAX 30 German stock market is.. $1.350 trillion. (Well worth a read: FT – The Apple Effect: Germany fears being left behind by Big Tech)

Today I’d keep a close eye on Boeing and Tesla for the action. I can’t see anything good for Boeing – its increasingly a question of just how badly Boeing’s Management have screwed up over the years. Tesla will be a moment: if it beats, then whoopee… If it misses.. then hold on to your hats. (And probably worth noting how many Tesla Bulls are hyping the new Shanghai factory to drive the firm into sustainable profit – let’s see how that plays out in Q1 if China goes into virus lockdown.) 

Let’s focus on Apple. Back in the early 20-teens, I went mildly bearish on Apple. For a company that had innovated wonderful new tech like the iPod and iPad, I wondered where the next must have bright shinny thing would be. As the years passed I continued to wonder where the companies design and innovatory mojo had gone. Fortunately, I didn’t dump my stock. 

Looking round my home office this morning I can understand why Apple is such a screaming success. I’ll be replacing my i-Phone later this year. I’m writing this on the new iMAC I bought in December (with go-faster solid state hard drives and a massively pixelated screen). My Mac-Pro I use to write the porridge on the train is charging beside me. My i-Watch is charging on the other side. At least 2 i-Pads are elsewhere in the house, while another is on the boat – my main navigational aid these days. I might play some music later – on Apple Music, and tonight we’ll be watch “For All Mankind” on Apple TV. (It’s an interesting thesis, imagining the Russians got to the Moon first, and how that would galvanise the American exploration of space.) In the last 10-years I’ve owned at least 5 iPhones, bought 3 iMAC’s, 3 Mac Books plus bought the kids iPads and Mac Airs for university and travel. Even when the product is crap – I bought it. There is an Airpod in the Kitchen with a resentful Siri inside that’s never asked for anything…  Despite my first iWatch falling apart, I bought another. (I don’t use the apple ear thingys.. I got much nicer ear-buds.) 

I am a therefore an Apple retail sucker. Just like the other 100 million Bright Shiny Thing Addicts who keep buying over-priced Apple ecosystem stuff we don’t really need. It’s a very sustainable business. It doesn’t rely on a small number of business buyers, but a massive pool of discreet retail fans. And, that’s why I hold Apple Stock PA. 

Apple have cracked it – for the time being. 

After  a surge in existing home sales and a 3rd monthly decline in new home sales, pending home sales for December were expected to break the tie over the state of US housing with a continued rebound. However, they very much did not, with sales crashing 4.9% MoM, the biggest monthly drop since May 2010.

Source: Bloomberg

All regional indices were down in December.

• The Northeast PHSI slipped 4.0% to 92.4 in December, 0.1% lower than a year ago.

• In the Midwest, the index dropped 3.6% to 98.8 last month, 1.3% higher than in December 2018.

• In the South decreased 5.5% to an index of 118.1 in December, a 7.4% increase from December 2018.

• The index in the West fell 5.4% in December 2019 to 93.1, an increase of 7.0% from a year ago.

While December crashed, pending home sales still surged 6.8% YoY (with mortgage rates down over 1%), but fell to the lowest SAAR since February 2019…

Source: Bloomberg

“Mortgage rates are expected to hold under 4% for most of 2020, while net job creation will likely exceed two million,” said Lawrence Yun, NAR’s chief economist.

While he noted that these factors are promising for the housing market, Yun cautioned that low inventory remains a significant longer-term concern.

“Due to the shortage of affordable homes, home sales growth will only rise by around 3%,” Yun predicted.

“Still, national median home price growth is in no danger of falling due to inventory shortages and will rise by 4%. The new home construction market also looks brighter, with housing starts and new home sales set to rise 6% and 10%, respectively.”

“The state of housing in 2020 will depend on whether home builders bring more affordable homes to the market,” Yun said.

“Home prices and even rents are increasing too rapidly, and more inventory would help correct the problem and slow price gains.”

This is the worst December drop for pending home sales on record…

Source: Bloomberg

We’re gonna need more lower-er rates to keep this train going!

CNN host Don Lemon offered an on-air apology after he mocked Trump supporters alongside guests Rick Wilson and Wajahat Ali on Saturday – suggesting they’re illiterate rednecks while imitating southern accents.

The arrogance, the dismissiveness, the smug cackling, the accents.

If Donald Trump wins re-election this year, I’ll remember this brief CNN segment late one Saturday night in January as the perfect encapsulation for why it happened. pic.twitter.com/8kQ6zN9AZV

— Steve Krakauer (@SteveKrak) January 28, 2020

The segment went largely unnoticed – being CNN and all, until President Trump tweeted it on Monday, writing “Don Lemon, the dumbest man on television (with terrible ratings!)”

In response to the backlash, Lemon ‘apologized’ Tuesday… by claiming he didn’t hear all the jokes.

#BREAKING: @DonLemon addressing the now-viral Saturday @CNNTonight segment mocking and showing such venom toward Trump supporters. Not surprisingly, Lemon deflected: “I don’t believe in belittling people….In the moment…I didn’t catch everything that was said.” pic.twitter.com/oI4eNz7rkR

— Curtis Houck (@CurtisHouck) January 29, 2020

Wajahat Ali, a New York Times Op-Ed writer, turned himself into the victim, saying that his friends and family now fear for his safety.

Are your national tv appearances supposed to be kept secret?

The desire to be a victim in 2020 is incredible

— SETH WEATHERS (@sethweathers) January 28, 2020

Amazing hypocrisy.

Lemon vs Lemon pic.twitter.com/fuUSOiMxJf

— The Daily Wire (@realDailyWire) January 29, 2020

Authored by Lance Roberts via RealInvestmentAdvice.com,

“Stock prices have reached what looks like a permanently high plateau” – Irving Fisher, New York Times September 3, 1929

One of the more infamous quotes from the roaring ‘20s came within two months of a market peak, which would not be surpassed again until the 1950s. Between 1920 and September 1929, the Dow Jones Industrial Average rose over 18% on an annualized basis.  Economist Irving Fisher essentially declared that such outsized gains were the norm. As he discovered a couple of months later, that time was not different.

Today, with valuations as stretched as they were in 1929 and 1999, the calls for a lengthy continuation of the current bull market are growing to a crescendo. The sentiment is so extreme that some outlandish predictions on individual stocks and indexes are treated as gospel as opposed to the warnings they likely are.  

Despite the high likelihood of poor returns over the coming decade, more and more stock analysts are telling us this time is different. One particular article caught our attention and is worth discussing to show how data can be used to support nearly any view.

4x by 2030

The Investor’s Fallacy by Nick Magguilli, states the following:

“And the crazy part is that the red star represents “only” a doubling over the next decade.  If history were to repeat itself in some meaningful way, the S&P 500 would be 4x higher by 2030 than where it is today.” 

Magguilli’s bold statement is based on an analysis comparing prior returns to forward returns. Correctly, he assumes that periods of lower than average returns are typically followed by a period of higher returns. We wholeheartedly agree; however, one must first understand that this method of forecasting returns is heavily reliant on the dates one assigns to prior and forward periods.

The article shows several charts using different periods. The intention is to show that 20 year prior returns have a stronger correlation with ten year forward returns than other date ranges. The graph below from the article highlights his findings.

Below the graph Magguilli states the following:

“Think about how insane this would be relative to history.  If you are expecting anything less than a doubling of the S&P 500 by 2030, then you are suggesting that the red star above will be even lower on the y-axis than where I already placed it.  If this were to occur, it would be unlike anything we have ever seen before in terms of growth over such a long time period.

And the crazy part is that the red star represents “only” a doubling over the next decade.  If history were to repeat itself in some meaningful way, the S&P 500 would be 4x higher by 2030 than where it is today. 

This statement seems crazy right now, but that’s what has happened historically.  I understand that there is no law forcing U.S. markets to follow this trend indefinitely.  However, if you are forecasting an awful coming decade for U.S. stocks, I have some bad news for you—the evidence is heavily against you.

We repeat- the evidence is heavily against you. We find not only the forecast crazy but his assertion that anyone bracing for a period of weak returns is an outlier.”

With that ringing endorsement to quadruple your money in the next ten years, it is worth highlighting two significant flaws in the analysis.

Flaw #1

One of the reasons that his forecast for the 2020s is so high is that the preceding 20-year period started in 2000 at the peak of a ten-year bull market and what was clearly an equity market bubble. The total annualized return (dividends included) from that peak to today is 5.30%, as shown below. If instead he had used 17 years as his backward-looking period, the start date would have coincided with the bottom of the dot com crash, and the total annualized returns over the past period would have been significantly higher.

Recall, from his graph, the higher the prior period return, the lower the forecasted return and vice versa. The graph below shows how a relatively small change in the start date makes a big difference in the analytical conclusion.

Data Courtesy Shiller

As we will detail below, when one uses a 17-year prior period starting at the market trough, the expected annualized return is only 10% as opposed to Magguilli’s approximated 16% return using a 20-year time frame. This is certainly not the end of the world, as 10% is still an above-average return. To put the two returns in context, the 6% annualized difference on a $100,000 portfolio results in a $182,000 difference in returns over the ten-year period.

Most analysts, ourselves included, like to use even numbers when conducting long term analysis. In this case, an even 20 years coincides with an important market peak. The lesson from the first flaw is that the start and end dates and associated index values are very important.

Flaw #2

“And though my process is limited by the amount of data that I have, I know that it’s not unreasonable.”

Despite Magguilli’s attestation, the amount of data he used could have been more robust. The second flaw in the article relates to the span of data used to assess correlation. We believe he is using approximately 60 years of data. While 60 years encompasses a lot of data, more data is readily available to make the analysis better. If we include data back to 1900, as shown below, the chart tells us something different about the future.

Data Shiller

The first thing to notice is that R2, or measure of correlation, drops significantly from .83 to .33. It appears a primary reason for the loss of correlation is the performance from the depression era, as shown with orange dots.   

The following graph uses prior 17-year returns from 1900 forward. The red line highlights the current prior 17 years annualized return of 9.47%.

Data Shiller

The expected total annualized return for the next decade is approximately 10%, denoted on the chart above where the red line crosses the dotted regression line. More importantly, the range of possible returns is much larger than what Nick’s graph shows.  Annualized returns could be as high as 18% but may also be as low as negative 3%. As it should, the risk-adjustment considering dispersion, or range of possible returns, raises a variety of other questions and concerns, among them, certitude in the original analysis.

Your guess is as good as ours on where returns will fall over the next ten years. However, consider that in 1929 valuations were similar to where levels stand today across a wide variety of metrics. Many valuation-based forecasts predict returns of plus or minus a few percent annualized over the next ten years.  The graph below, for example, shows that returns could easily be below zero for the next ten years.

For further perspective on valuations, the following table contrasts current valuations versus prior periods.

Additionally, the more rigorous and detailed analysis of Jeremy Grantham of GMO show 7-year projected returns which are not encouraging.

Summary

Maggiulli humbly states that he doesn’t know what the future holds, but the substance of the article suggests that you, dear investor, would be a fool not to buy and hold stocks for the next decade.

Although you cannot predict the future, you can prepare for it. What we do know is that we are well into a historically long bull market and valuations are in record territory. We believe that at this stage of the cycle investors should focus less on the potential rewards and much more on the risks. The primary reason is that market reversals are often sudden and vicious, especially from points of extreme valuation. As one example, after peaking on March 10, 2000, the NASDAQ composite wiped out 29% of its value in only three weeks and 37% in less than five weeks. Having been conditioned to “buy-the-dip” over the previous months and years, investors could not envision a lasting selloff despite the radical dislocation between market prices and fundamentals.  

For those who have enjoyed the benefits of the surging equity market over the past several quarters, congratulations on a race well run, but do not forget the importance of risk management. Those who fail to heed signs of caution or are blinded by false confidence tend to lose what they gained. Remember, the objective is compounding wealth over the long haul and not keeping up with the S&P 500 index.

We hope this article encourages you to think about current circumstances and develop plans to hedge and/or reduce exposure if and when you deem appropriate.

That “high plateau” Irving Fisher thought we had achieved in September 1929 cost him his reputation and his net worth. The cost of being prudent is not that expensive and, in part, depends on one questioning both bullish and bearish arguments.