Today, rather than focus on a single topic, I’ve compiled some quick hits on the common themes. I will follow up with a more in-depth take on them in the next week or so.
One of the points I made was that the market could drop by 30 percent to 40 percent before it hits what has, historically, been fair value. Not that I am calling for such a drop. Not at all—especially in the short term—but that is what the math tells us. The Shiller price/earnings ratio, for example, is now at 30.73. The average over all time periods (from 1881 to present) is 16.79, which is 45 percent lower. The average from 1946 (after World War II) to present is 18.78, which is 40 percent lower. And from 1982 to present, the ratio is 22.49, which is about 27 percent lower. Recent data is more comparable, which gives us the 30 percent to 40 percent range.
Other metrics give us similar results—or worse. The price-to-sales ratio, which is not subject to some of the concerns around measuring earnings, is very elevated. Price-to-book, same thing. Any way you look at it, the market is quite expensive. This, as I discussed in my monthly market risk analysis, clearly puts us in risky territory.
That’s not to say that the risk is immediate or that this kind of drawdown is inevitable, any more than hurricanes as bad as Harvey and Irma are inevitable. They are, however, certainly possible, and we should be aware of that and plan for them. Arguably, fair value has increased; therefore, the gap is not nearly so large and the downside risk much smaller. That may be, but it is far from proven. Remember, we thought the same thing at other market tops, but we were wrong.
Another major worry is inflation. Some worry that it is too low and will remain that way; others worry whether it is poised to go too high. For the first time in a while, there seems to be concern that inflation and rates are about to take off. While it does appear that inflation is on the turn and poised to go higher, there is not really any sign that takeoff is immediate. When it does happen? Rates (and the Fed) are likely to respond, which could disrupt the high market valuations we discussed above.
Here, one key takeaway is that when everyone assumes the same thing—in this case, that low rates will continue indefinitely—any change in that thesis can be very disruptive. That is the foundation of the inflation worry that is starting to brew.
The final area of common concern is low volatility in the markets. When markets are this calm, it has historically been a bad sign. Hyman Minsky made his name as an economist by pointing out that calm periods encourage investors to take greater and greater risks, secure in the growing belief that markets will remain calm no matter what. But when volatility does come back, the system is stretched too far, and the consequences are worse than they would have been without that period of calm. The “Minsky moment,” a phrase coined by Paul McCulley of PIMCO, is the point at which that volatility comes back. With the combination of high valuations in financial markets, complacent investors, and a feeling that interest rates are going to stay low, you can see how a Minsky moment could be developing.
In many ways, all of these worries are centered on the same fear: that things have been too good for too long, and payback is looming. Maybe so. But as I have been saying for years, high risk is not the same as immediate risk. This is exactly why I have developed the monthly economic risk factor and market risk updates. We recognize the risks, monitor them, and are therefore better positioned to ride them out. In that respect, I think it is positive that others are starting to take that position as well.