November 17, 2024
The Shiller P/E—also called the 10-year P/E or the cyclically adjusted P/E (CAPE)—recently exceeded 38. This is in the top 0.5% of history. The CAPE has only been higher one time—December 1999, when it reached 44.
However, according to John Hussman’s most reliable P/E ratio, the S&P 500 index today is at its most overvalued level ever, including December 1999. John Hussman writes:
MarketCap/GVA is the ratio of the market capitalization of nonfinancial companies to gross value-added, including our estimate of foreign revenues, and is our most reliable gauge of market valuation (based on correlation with actual, subsequent 10-12 year S&P 500 total returns in market cycles across history). The current level of 3.3 is the highest extreme in history, eclipsing both the 1929 and 2000 bubble peaks.
See: https://www.hussmanfunds.com/comment/mc240923/
The long-term average CAPE for the S&P 500 index is 17. But even if we assume that the CAPE should be 20, that is still 47% lower than today’s CAPE of 38.
So the CAPE is likely to decline to somewhere in the range of 20 to 22. This means that the S&P 500 index is likely to decline 40% to 50% over the next 3 to 5 years.
Warren Buffett, arguably the greatest investor of all time, has raised $325 billion in cash at Berkshire Hathaway. So Buffett clearly thinks that market is overvalued. In fact, Buffett says that total market cap to GNP is “probably the best single measure of where valuations stand at any given moment.” Currently, the total market cap to GNP is 201%, one of its highest levels in history, comparable to December 1999.
When did Buffett last have so much cash as a percentage of Berkshire’s portfolio?
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- 2007 before the Great Financial Crisis
- 1999-2000 before the internet bubble popped
INFLATION MAY PICK UP AGAIN
The consumer price index (CPI), which measures price growth across a basket of goods, ticked up to an annual pace of 2.6% in October – from 2.4% in September, which had been the slowest rate in more than three years.
Importantly, the 10-year treasury yield has increased from a recent September low of 3.649% to 4.445%. The great macro investor Stanley Druckenmiller said just recently he trusts market prices more than he trusts professors. The 10-year treasury is predicting that inflation will start increasing again, forcing the Fed to stop lowering rates and possibly to start raising rates.
If, in fact, inflation keeps increasing and the Fed has to keep rates high, that would probably be a catalyst for the S&P 500 index to start a 40% to 50% decline over the next 3 to 5 years.
That said, the catalyst for a bear market could be any number of things, including inflation inceasing, a possible recession, or something else the market is not currently considering.
BUBBLE HISTORIAN JEREMY GRANTHAM
As bubble historian Jeremy Grantham notes, there has never been a sustained rally starting from a 38 Shiller P/E. The only bull markets that continued up from levels like this were the last 18 months in Japan 1989 and the U.S. tech bubble of 1998 and 1999. Both of those great bubbles broke spectacularly. Separately, there has also never been a sustained rally starting from full employment.
What happened to the 2021 bubble? It appeared to be bursting conventionally in 2022—in the first half of 2022 the S&P declined more than any first half since 1939 when Europe was entering World War II. As Grantham points out, previously in 2021, the market displayed all the classic signs of a bubble peaking: extreme investor euphoria; a rush to IPO and SPAC; and highly volatile speculative leaders beginning to fall in early 2021, even as blue chips rose enough to carry the whole market higher—a feature unique to the late-stage major bubbles of 1929, 1972, 2000, and now 2021. Grantham writes:
But this historically familiar pattern was interrupted in December 2022 by the launch of ChatGPT and consequent public awareness of a new transformative technology—AI, which seems likely to be every bit as powerful and world-changing as the internet, and quite possibly much more so.
See: https://www.gmo.com/americas/research-library/the-great-paradox-of-the-u.s.-market_viewpoints
Grantham continues:
But every technological revolution like this—going back from the internet to telephones, railroads, or canals—has been accompanied by early massive hype and a stock market bubble as investors focus on the ultimate possibilities of the technology, pricing most of the very long-term potential immediately into current market prices. And many such revolutions are in the end often as transformative as those early investors could see and sometimes even more so—but only after a substantial period of disappointment during which the initial bubble bursts. Thus, as the most remarkable example of the tech bubble, Amazon led the speculative market, rising 21 times from the beginning of 1998 to its 1999 peak, only to decline by an almost inconceivable 92% from 2000 to 2002, before inheriting half the retail world!
So it is likely to be with the current AI bubble. But a new bubble within a bubble like this, even one limited to a handful of stocks, is totally unprecedented, so looking at history books may have its limits. But even though, I admit, there is no clear historical analogy to this strange new beast, the best guess is still that this second investment bubble—in AI—will at least temporarily deflate and probably facilitate a more normal ending to the original bubble, which we paused in December 2022 to admire the AI stocks. It also seems likely that the after-effects of interest rate rises and the ridiculous speculation of 2020-2021 and now (November 2023 through today) will eventually end in a recession.
Grantham says to beware of FOMO (fear of missing out), which comes along at the end of every great bubble. It’s incredibly seductive and hard to resist.
This bubble has crossed off all the boxes. It’s done all the things that a super bubble typically does.
We had a 11-year bull market (2009 to 2020), the longest in history.
It requires crazy behavior—we’ve had some of the great crazy behavior of all time.
It needs to accelerate at something like 3x the average rate of the bull market. It has done so.
At the end of every super bubble, the speculative stocks start to peel off and go down (even if the broad market goes up). This has happened. 40% of all NASDAQ stocks are down over 50%. This is the beginning of the end of the bubble: speculative stocks go down even as the market goes up. It’s a very rare condition that only previously happened in 1929, 1972, 2000.
Grantham concludes by asserting:
It is likely that we are at the beginning of a crash.
It would be unlikely that the market would not come down 50% from its peak.
And it would be unusual if the speculative stocks did not do worse than that.
CONCLUSION
Benjamin Graham and David Dodd, in Security Analysis (1934), wrote:
The ‘new era’ doctrine – that ‘good’ stocks were sound investments regardless of how high the price paid for them – was at bottom only a means of rationalizing under the title of ‘investment’ the well-nigh universal capitulation to the gambling fever. The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-era theory led directly to this thesis… An alluring corollary of this principle was that making money in the stock market was now the easiest thing in the world. It was only necessary to buy ‘good’ stocks, regardless of price, and then to let nature take her upward course. The results of such a doctrine could not fail to be tragic.
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.
The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.