Warren Buffett has a problem, one that not many, either as individuals or companies are likely to experience or even view as a problem.
He has too much money.
According to the latest filings, Berkshire Hathaway has just under $100bn in cash sat on its balance sheet (a record high), money that Buffett clearly feels under pressure to deploy as evidenced by the following comment he made at the recent shareholder meeting when questioned about his approach.
“[T]he burden of proof really shifts back to us, big time.”
As one of the most famous value investors in the world, this growing cash pile is indicative of, at least from his perspective, a lack of fundamentally attractive investment opportunities. Even a cursory glance at Shiller’s CAPE ratio – see exhibit below – suggests that he is not alone among value investors in perceiving there to be a dearth of buying opportunities.
Exhibit 1: Case-Shiller CAPE Ratio
After recent gains, Shiller’s widely watched valuation metric stands at 29.48 – levels that have only been exceeded twice before in the 130-year history of the series. First, in 1929 just prior to the great Wall Street crash, when stocks dropped 85% in nominal terms over the next year or so, taking the ratio down to near record lows. Second, in 1997 as the dot.com bubble was forming. The bubble eventually burst a couple of years later, but not before even “old economy” heavy indices like the S&P500 rallied a further 75% taking the ratio to an as yet unmatched high of 44.19.
Same starting point – two very different outcomes.
Perhaps there is no clearer illustration of the inadequacy of valuation as a market-timing tool than these two highly divergent episodes.
To Wait or Not to Wait?
Given stock markets did eventually correct in the early 2000s, one potential approach for value investors is to move to the sidelines and wait it out. However, with active managers across the globe experiencing a continuing outflow of funds under management in favour of passive strategies, this is hardly a risk-free approach. Indeed, this pressure to be invested in the market is exactly the point Buffett is alluding to in the aforementioned quote.
What elevated valuations do tell us is that future long-run returns will almost certainly be lower than one has become accustomed to during the bull market, but this is not necessarily mean a market crash is imminent. First, there is nothing to stop them becoming more expensive over a shorter time-frame (as occurred in the late 1990s). Second, a rally could also end in a whimper, with equities trading sideways for a prolonged period of time and gradually improving valuations, rather than with a bang.
That said, high valuations are not the only factor that has attracted the attention of the bears. Further fuelling such speculation is the remarkable decline in market volatility, with the VIX index this week having week dropped to levels that have only previously been exceeded on the downside in late December (a notoriously quiet trading seasonal period) 1993. As everyone knows, implied volatility is mean-reverting over time, hence the rationale goes: what goes down must come up – something which would typically be associated with a falling equity market.
Markets vs Governments
Many investors will recall that in the first half of 1994 stock markets were negatively impacted by the turmoil in government bond markets triggered by a surprise Fed rate hike on February 4, 1994. The Fed tightened raised short-term interest rates by a cumulative 300bp over a 12-month period triggering a 150bp back-up in longer-dated US Treasury yields, which dragged down other major bond markets across the developed world.
The logic of using low implied volatility as a contrarian market signal seems to be compelling doesn’t it?
Yet, if one actually goes back and looks at the impact the back-up in government bond yields had on the US stock market one may be surprised to find that it was actually rather modest. It was less than 10 percentage points peak-to-trough, a decline that is hardly noteworthy in the grand scheme of things and veritably dwarfed by the subsequent gains as the bull market progressed.
Exhibit 2: SP500 December 1993 – December 1996
The VIX index is often labelled the stock market’s fear gauge. This is erroneous as implied volatility is very much the residual of the options market and can be influenced by many, often unrelated, factors. After all, consider the following exhibit (overleaf) which plots crowd-sourced Fear sentiment towards the SP500 in both mainstream and social media.
Fear and the VIX
Crowd-sourced Fear sentiment and the VIX are reasonably well-correlated over time. At the current juncture, one might, therefore, expect the crowd-sourced Fear sentiment to be, like the VIX, near record lows. However, although Fear sentiment in social media, which one takes to be more reflective of the retail mindset, is low from a historical perspective for mainstream media it remains rather elevated – albeit having declined markedly. Such readings are not suggestive of over-complacency as many financial commentators looking solely at the level of VIX index have concluded.
Exhibit 3: Crowd-sourced Fear Sentiment – S&P 500
Furthermore, looking at historic asset price bubble bursts, one reliable tell – borrowing the language of poker players – is excessive crowd optimism, or as former Fed Chairman Greenspan put it “irrational exuberance”.
Looking at the aggregated mainstream and social media crowd-sourced sentiment indicators for equity market around the globe, aside from India one sees scant evidence of such crowd mood. Even when one looks just at social media, there are still very few sentiment hot spots (in addition to India, one has high sentiment readings in Japan and the UK – see exhibit overleaf).
Are We in a Bubble?
So, if it does turn out that this is a stock market bubble, something that can only be validated ex post by a major price decline, then it will have been one of the most unusual as a typical ingredient – crowd overconfidence – is missing.
Exhibit 4: Social Media Global Heat Map– Major Equity Indices
Some investors argue “this time is different” – three of the most dangerous words in finance – because of the unprecedented degree of monetary accommodation that has been injected into global asset markets by central banks who have struggled to achieve their inflation mandates given the disinflationary undertow from the Great Recession.
There is some merit in this argument. Central bankers have clearly driven down nominal interest rates to levels that are without precedent in modern times, and the lack of yield has forced investors into riskier assets (not just equities). Indeed, this was the very goal that such policies were designed to generate – recall the portfolio balance channel effect. What’s more, it is becoming increasing clear that the monetary policy liquidity tap is being turned off – or at least threatened to be turned off.
Central Banks, Centre Stage
The latest central bank to drop hints in this direction has been the ECB. Governing council member Mersch, in the first speech by an ECB policymaker following Macron’s confirmation as the next French president, made it clear that with political risks having diminished (a Le Pen victory would have constituted an existential crisis for the single currency warranting further monetary policy support), and with the growth outlook for the region becoming less skewed to the downside, the ECB could soon consider beginning to normalize its policy stance. First, by curtailing its asset purchase programme followed later on by raising interest rates (or more factually correct, making them less negative).
While Mersch was clearly cautious in his comments, and added the standard “there are still risks” caveat, the conditions for the ECB shifting to a less accommodative monetary stance may well be coming sooner than many investors consider. Taking a look at the Eurozone crowd-sourced sentiment indicators, even though public perceptions of economic growth and inflation in the region are relatively stable there has been a sharp rise in consumer confidence recently and this was one of the key positive economic growth feedback loops cited by Mersch in his speech.
Exhibit 5: Crowd-sourced Consumer Sentiment – Eurozone
So, is this shift – or promised shift – in monetary policy stances in major developed economies something which, contrary to earlier arguments, means that the world, in fact, on the cusp of a great bear market?
Even though central banks are either turning off – or planning to turn off – the liquidity tap, they are doing so in a manner that is market-friendly. Unlike 1994, but fully in keeping with the forward rate guidance framework, changes in monetary policy are clearly flagged in advance. Additionally, and importantly, there are no signs that underlying inflation pressures are building up significantly. Such pressures would almost certainly be associated with increased public perceptions of rising inflation (so-called second-round effects) – a trend one does not observe in the crowd sentiment data – see exhibit below.
Exhibit 6: Global Heat Map – Future Inflation Sentiment
Moreover, and especially so with an absence of high private sector inflation expectations, if reining in monetary policy accommodation did trigger a correction in global asset markets, especially one broad-based encompassing stocks and bonds, then one thing one can be sure of is that the central banks will not only reverse direction, but could do something much bolder (revisit the article about last fall’s BOJ decision to adopt a yield target).
At the danger of sounding like a cautious central banker, we would not rule out the possibility of a modest stock market correction – only a fool would do such a thing – especially given the grounds for caution noted in the previous article. Yet, based on the current thinking of the crowd, both sentiment and fear, and the behaviour of central banks, we do not share concerns that we are on the precipice of a major bear market in global equity markets.
Indeed, if a correction were to occur in many ways it would be the ideal scenario for Buffett and other value investors, as lower market prices could generate buying opportunities that they have been so far unable to identify. Add in the potential for policy capitulation by central banks and the current absence of crowd bullishness and this could provide the foundation for a powerful market rally, at which point we would – finally – have all the ingredients of a classic stock market bubble.