Investing in the Tails

Investing in the Tails

With U.S. stocks up about 6% in January, everyone is talking about the stock market melt-up. And turning to Google to find out exactly what that is (we aren’t pointing fingers; we didn’t know either). Also, despite the prospects of debt service costs rising with interest rates, few appear interested in cash flow anymore, based on this very unscientific analysis.


What is a melt-up? At an event in Chicago last week, well-known value investor and market historian, Jeremy Grantham, provided this loose definition: a price acceleration of 60% (not all have been that large) over a period of 9-18 months. These melt ups, if coupled with high valuations and extremes in investor euphoria, tend to mark the top of bubbles. We care about that because those bubbles are always met with significant price declines that take years to recoup losses. History is unforgiving on this point.


Grantham first discussed the prospects of a melt-up in a commentary published earlier this month, although the letter was written last Fall but took months to get through compliance (his firm, GMO, is a “value” shop so his view was no doubt unpopular).


Using his definition, we looked at how often significant price accelerations occur in broad U.S. stocks. Looking at rolling 18-month periods shows that +60% moves have occurred about 2% of the time since 1928 and 0.7% of the time since 1950. They are rare. By contrast, moves larger than 30% happen quite frequently (22% of observations). 

What is a melt-up? 



If we widen the sample to include the more common price accelerations of at least 30%, but isolate just those days where valuations have been excessive, we get the chart below. We define excessive valuations as Shiller P/Es greater than 30x. 30x is an arbitrary round number, but it represents the 5th percentile of historical valuations so it will do fine.



For the broad U.S. stock market we only have two historical examples that allow us to see how things played out. One of them was nearly 90 years ago when the U.S. stock market was far more U.S.-centric and dominated by large industrial companies like U.S. Steel, Standard Oil and Bethlehem Steel. The other was more recent, but concentrated in just one or two sectors (technology and telecommunications companies). As far as U.S. stocks are concerned, that is all we have to work with.


Which brings us to the chart of the week: Investing in the tails.


The chart below compares the forward one-year returns of the S&P 500 Index for every day in the last 89 years (teal bars) to a subset of days that are similar to today – where the market was (1) historically expensive and (2) in a strong year-over-year up-trend of greater than 30% (orange bars). While the underlying data is gleaned from just 2 periods (1929 and 1998-99), other similar cases across multiple countries and markets corroborate this finding: if history is a guide, U.S. stocks have significantly higher chances of both above- and below-average returns over the next year, but far less odds of something in the middle.


So investors should expect volatility, currently at historic lows, to increase. Dramatically.


It is worth noting that the chart below does not deal with the prospects for longer-term returns, which are consistently lower than average when starting valuations are excessive.


What is the most appropriate way to invest when valuations are high and rising and you have far higher odds of poor outcomes in the short term (and longer term), but possibly higher prospects of unusually good outcomes in the short term?


In a word: carefully.


Yet that is not how investors are responding. According to reports from U.S. brokerages, the last few months have seen more retail participation in the stock market, especially among younger investors, than in at least 5 years. Cash balances are at record lows at Schwab while TD Ameritrade claims their clients are now “up to their chests” in stocks. Margin debt, too, is at an all-time high.


We do not know what the future holds, but our process is designed to reduce risk as the forward return prospects for assets dims (and vice versa). We believe that process works over the long term. A lot of what we are seeing today appears to be doing the exact opposite.


As a closing thought on this topic, here is an excerpt from Howard Marks’ (Oaktree) most recent missive that we think frames the issue well:

For one thing, I’m convinced the easy money has been made. For example, the S&P 500 has roughly quadrupled, including income, from its low in 2009. It was certainly easier for the p/e ratio to go from the low teens in 2011-12 to 25 today than it would be for it to double again from here. Thus the one thing we can say for sure is that the current prospects for making money in U.S. equities aren’t what they were half a dozen years ago. And if that’s the case, isn’t it appropriate to take less risk in equities than one took six years ago?


Prospective returns are well below normal for virtually every asset class. Thus I don’t see a reason to be aggressive. Some investors may adopt an aggressive stance to be in the riskiest (and thus hopefully the highest-returning) assets; to squeeze out the last drop of return as the markets continue to rise (under the assumption they’ll be able to get out at the top, something that’s present in every strongly rising market)…






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