Midsummer Reflections on the Stock Market

As we’re all getting ready for the Independence Day weekend, it’s a good time to pause and reflect on how the first half of the year has been going. Many developments have arrived and passed in the news which have caused various actions and reactions. One day it seems nagging, complex issues are about to be resolved just when other more vexing problems take their place. The only constant, as the cliché goes, is the constant of change.

That is except in the stock market. It’s less than 1% above where it opened the year and has been moving basically sideways in that time. From speculation about the Fed raising rates to languidly growing economy to Greek debt dramas, the market seems to be carelessly bobbing along, flotsam-like, awaiting some direction.

Asking, ‘how did we get here’, is easy. When you shoot for mediocrity as a country and society, sometimes that’s what you get (or worse). Now might be a good time to ask, where do we go from here?

Today’s jobs report doesn’t give us much of a clue. The unemployment rate has dropped to 5.3%, close to a level which in the past used to be described as full employment. On the other hand, labor force participation is the lowest it’s been since the 1970s, a time before women were fully entering the workforce and life expectancy for men was below 70 years of age.

Those that dropped out of the labor force aren’t counted in the unemployment rate, and they aren’t eligible for unemployment benefits. However, they haven’t just disappeared off the face of the earth. Many have passed from a temporary welfare program to the more permanent one of social security disability. Well, more permanent until the program runs out of funds as soon as next year.

But that’s old news. The complacent collective market sees what it wants to see and has chosen to see the government’s version of economic reality.

We can look at ways of fundamentally gauging the valuation of the stock market such as price to earnings ratio or the so-called Warren Buffet Indicator of total market cap to GDP ratio. I like to look at the Q ratio which is a simple comparison of the total price of the stock market to the replacement costs of all companies listed. This is the favored metric of billionaire black swan investor Mark Spitznagel, who by the way wrote a most excellent book, The Dao of Capital, about Boydian investment strategies.

  • Q ratio – Pricey but is it dicey?

  • By this measure, the market looks to be at a pricey level compared to other points in time. 1907, 1929, 1937, and 1968 were all years when the stock market peaked and saw a significant decline. The problem is it’s also at the same level as 1997, which had a small pause before marking the half way point in a multi-year rally. We generally have seen regression to the mean in the past, but that doesn’t necessarily suggest it has to ever happen again. We could be waiting a long time for a sanity check to take hold, especially if the definition of sanity has changed.

    A shorter term answer possibly comes from the world’s best econometrics blog Political Calculations. They believe, convincingly in my opinion, that expectations for future dividends drive stock prices in the near future, absent any surprising shocks to upset the apple cart. Those of us who used to watch Larry Kudlow on CNBC (since his show was cancelled there hasn’t been any reason to watch that silly network anymore) remember he used to say ‘earnings are the mother’s milk of stocks’. Well if that’s true than dividends are your father’s pemmican.

    What they do is take values of dividend futures traded on the Chicago Board Options Exchange and apply a multiple (and some other math) to convert them to expected stock prices. Their calculations show a possible slide in prices for the next few weeks to few months. It has worked reasonably well in the past with a few caveats.

    There are different instruments traded for different times in the future. Prices can and do take leaps from one trajectory to the other. It usually happens when someone from the FED talks about raising rates, and then the financial press speculates what specific month or quarter it can happen. In this way, stock prices behave similar to quantum particles bouncing from one energy level to another. It’s not a good way to pin down exactly where stocks are going but just gives a range.

    The other caveat is this measurement only works when the market is in a state of relative order, and not buoyed or rattled by some overly cheery or dreary news. While at a smaller level the market seems to obey quantum mechanics, at the macro level it acts like a natural system, following mathematical probabilities such as those observed in predators hunting or even groups of people foraging. The market moves from more easily observable and predictable periods until the forageables (earnings and dividends) run out, in which case it moves into chaos and unpredictability until new expectations are established.

    What will trigger rapid moves in either direction and out of the current financial horse latitudes is anybody’s guess. There’s a big vote in Greece this weekend, but how many times has that situation reached a cliffhanger? Perhaps too many to matter anymore. As unsatisfactory as it sounds, what usually occurs is something we weren’t expecting, not an event that seems to replay itself over and over again. The best we can really predict is that we won’t be drifting forever, and the time will come when the stock market will move far away from this level. The key is to stay ready for it when it finally does.

    [Jonathan adds: If the right side of the included graphic is hidden on your screen — the date scale should go to 2020 — try right-clicking on the graphic and opening it in a new tab.]

    13 thoughts on “Midsummer Reflections on the Stock Market”

    1. 1907, 1929, 1937, 1968, 2000. What else do they have in common? The Fed is engaging in shenanigans that have artificially elevated stock prices for the last 7 years. They have helped return banks’ balance sheets to a semblance of order. But you can never do only one thing. There will be consequences and they will be ugly. Just as the debacle in Greece will probably have geopolitical consequences far in excess of the economic.

      Interesting times.

    2. The market will never crash as long as Obama is President. The Fed has spent 15 trillion dollars to prevent crashes and has another 100 trillion in reserve.

      Nothing but lies are reported by the Wall Street Journal and New York Times — modern equivalents of the Soviet Tass and Pravda. The networks are controlled by DHS and NSA.

      Inflation is at 15% and climbing to hyper levels, unemployment is so bad (25% and rising) that entire middle-class white families prowl the streets hoping to rob a tourist or a CNN anchor.

    3. I think the bigger puzzle is in the long term debt markets. I think the stock market will be jolted if long term bonds ever go back to where they were before the Panic of 08.

      But, markets can stay irrational longer than you can stay solvent.

    4. We learned the wrong lessons from 1907. The crisis was kicked off by excessive railroad regulation. The solution was even more financial regulation.

      The Mises Institute has argued that J P Morgan’s role in saving the country has been overstated. What really restored liquidity was exchanges and markets ability to operate outside of the banking clearinghouse system which were collapsing. They could bypass the diseased banks and exchange payment in gold directly. In addition, markets were much freer then, so American railroad bonds were being traded in different exchanges all over the world. When the New York Stock Exchange dried up, capital flowed like water from London and Frankfurt to fill the void.

      The free markets were self-correcting, all while bankers were bailing themselves out and engineering a takeover of the system.

    5. grey bear Says:
      July 2nd, 2015 at 10:16 pm

      I’m not going to disagree with your last two paragraphs at all. They are gospel truth.

      I would qualify your first paragraph though. Yes, the Fed and the Regime can outwait any individual or institutional investor. But there are a lot of bubbles all over the world. China has had its markets fall over 20% after a bubble that doubled their value over the last year or so. Margin calls can bring down the whole house of cards.

      Europe has not only the Greeks to worry about, but the Spanish and Portuguese are not far behind. The EU cannot take that much stress, and the Federal Reserve is entangled in the Euro via Credit Default Swaps. We have guaranteed the freaking Euro.

      A sufficient military shock anywhere in the world, or domestically is going to put pressure on economies. An unanswered military/terrorist strike against the US [which may be hours away, if DHS is to be believed (and they rarely can be believed on most things, I grant)] could start a financial panic.

      Countries have been trying to repatriate the gold they own that is stored here. And the US has been stalling. Not a confidence builder.

      I’m just saying that there are a host of events that could and probably will swamp the Ponzi Game that is the US economy. The $15 Trillion may not be enough.

      I especially agree with what you said about the statistics released being totally fake. Here’s another one. There is a statutory ceiling on how much debt that can be accumulated before going back to Congress for an increase in the debt ceiling. We have been deficit spending, both with and without appropriations from Congress, at an ever increasing rate for years.

      According to the figures released by the US government, the official national debt has not moved a dollar [even granting that this does not include the shadow debt] for 15 weeks.


      Not freaking possible.

    6. The Fed is able to prevent a market collapse by buying stocks and bonds with freshly created dollars -trillions of them. Countries around the world buyt these freshly created dollars and hoard the dollars as a reserve currency to back their own currencies.

      Now China is printing Renminbi to buy Chinese stocks to prevent a Chinese market crash. Some of the BRICS nations are using renminbi as a reserve curreny.

      The day may come tomorrow when everybody realizes that there are too many dollars and too many renminbi circulating and hyperinflation will occur everywhere in the world except Russia and Texas (both back their curency with gold). It will be worse than the famous German hyperinflation after WWI.

    7. Ironman from Political Calculations responded to this post with some further details about their forecasting method

      They wanted to clarify that their model does perform well in chaotic conditions, which was the case in 2008 for example, but it doesn’t do so well during periods of panics and manias that distort the fundamentals such as in the late 90s. Looking at that Q ratio chart, things really were way out of whack back then.

      I suppose the analogy to the natural world would be a stampede? We’ll have to stay tuned to see if they tackle that next.

    8. Congrats Gurray. BTW, Ironman is, afaik, an individual named Craig Eyermann. You can check his page at Linkedin.com.

    9. Thanks Robert, I give his blog my highest recommendation.

      I never knew who was behind it but suspected there were a few people behind the scenes because of the breadth of the topics. This checks out when I do a google search of his name. He comes up on a few guest appearances on Doug Short’s blog with links back to Political Calculations.

      Doug Short has another good site. He’s a retired English professor who made a second career out of financial trends and analysis.

    10. ” entire middle-class white families prowl the streets hoping to rob a tourist or a CNN anchor.”

      I think you got the color wrong and the class wrong, but otherwise not a bad analysis.

      The 1907 Panic followed the 1906 San Francisco earthquake which created huge insurance losses. I think that was also a major factor.

    11. >>What will trigger rapid moves in either direction and out of the current financial horse latitudes is anybody’s guess. There’s a big vote in Greece this weekend, but how many times has that situation reached a cliffhanger?

      As I read the signs, the question isn’t whether Greece is leaving the EU, it’s how to ease them out smoothly and what sort of help to offer them afterward. I think it’s a fair bet the money they owe will never be repaid.

      I agree that money printing and debt are out of control, but…

      >>Inflation is at 15% and climbing to hyper levels, unemployment is so bad (25% and rising) that entire middle-class white families prowl the streets hoping to rob a tourist or a CNN anchor.

      Really Grey Bear, you’re ‘talent’ is wasted here. You belong with your Russian cohorts on YouTube, writing anti-American/pro-Russian propaganda and disseminating disinformation. I take it you’re an old hand at this from back in the glory days of the CCCP. I hear North Korea is looking for a few people with your skills.

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