Speculators are playing with fire; investors, don’t get burnt!

Chris Leithner

Leithner & Company Ltd

Earlier this month, a columnist at another Australian website encapsulated the exuberance that’s currently gripping stocks – and the incredulity that somebody mightn’t share it: “It’s difficult to be anything other than bullish on the prospects for equity markets next year. I know I am. I mean, what exactly is the bear case? Is there even one?” This article summarises mine. For how long can central banks and governments – and the speculators they subsidise – deny and defy reality? THIS question, it seems to me, and NOT the availability and effectiveness of COVID-19 vaccines, the extent and timing of additional “stimulus,” etc., is the key risk for investors in 2021.  

Poor and Deteriorating Fundamentals

During 2020, the world’s central banks and governments committed one of their biggest blunders of the past century. Their panicked reaction to COVID-19, in the form of an estimated $25-30 trillion of fiscal and monetary “stimulus” (more is sure to come in 2021), has created a colossal disconnect – even bigger than the one which had previously prevailed – between prices of financial assets on the one hand and underlying reality on the other. On 5 June, Jeremy Grantham wrote that America’s stock market and economy have seldom been more disjointed:

The current PE ratio on the U.S. market is in the top [5%] of its history ... The U.S. economy in contrast is in its worst 10%, perhaps even the worst 1% … This is … one of the most impressive mismatches in history … the current market seems lost in one-sided optimism.

In an interview on CNBC (17 June), Grantham upped his ante:

My confidence is rising quite rapidly that this is, in fact, becoming the fourth “real McCoy” bubble of my investment career. The great bubbles can go on a long time and inflict a lot of pain, but at least I think we know now that we’re in one.

Central banks’ and governments’ latest mega-mistake is merely the most recent in a long series. Since the mid-1990s, they haven’t been able to admit the truth – namely that booms (which their interventions ignite) eventually cause busts. Instead, they’ve moved heaven and earth to prevent recessions. They fail to understand – or, at least, refuse publicly to acknowledge – that occasional and moderate downturns are to industries and regions what “cool” bushfires are to local ecosystems: necessary stages of the cycle of renewal and growth. Unfortunately, and like the councils and state governments that prohibit controlled burning, central banks and governments have encouraged huge quantities of economic and financial tinder to accumulate; as a result, they’ve repeatedly caused much bigger conflagrations – and blamed others for their misdeeds! This year, they’ve painted themselves into a corner. As Mohammed El-Erian told Bloomberg on18 October, “they are increasingly on what I call a no-exit paradigm.”

Since the mid-1990s, the mainstream’s hyper-interventionism hasn’t just deranged the business cycle: it’s also corrupted markets, induced them to emit false signals – and, worst of all, encouraged societies as a whole to consume their seed corn. It’s enriching a small minority and impoverishing a larger one. Short-term consumption without regard to consequences (“sugar-hits”) has disguised economies’ long-term deterioration, but signs are obvious:

  1. the survival of ever more households and businesses requires constant “hits” of fiscal and monetary “stimulus;”
  2. the rising tide of “stimulus” generates progressively smaller increases of GDP;
  3. debt is rising at an accelerating pace (which cannot relent, for that would derail the “recovery” and collapse the “prosperity”!); and
  4. the earnings of ASX-listed firms have collapsed to all-time (CPI-adjusted) lows.

Consequently but less perceptibly, some assets’ values have also sagged; yet since March their nominal prices have mostly risen smartly, and a few have skyrocketed. Even if profits subsequently rise significantly – which is hardly a foregone conclusion; indeed, it’s a highly questionable assertion – can this extreme disconnect between prices and values continue? 

The Stock Market Isn’t the Economy

The existence of a disjuncture between stock market and economy (as opposed to its current extreme magnitude) is hardly unusual; indeed, it occurs much of the time. The aphorism is true: Wall Street isn’t Main Street. In other words, the market and the economy don’t, as a rule, move in tandem. Over the years a decent number of academic studies have rigorously affirmed this fundamental conclusion. The analysis of Nir Kaissar, a columnist at Bloomberg, is far simpler but his conclusion is much the same – and much more readable. In his words, he recently

compared the historical growth of the market, as measured by the S&P 500 Index, with the economy, as measured by gross domestic product, net of inflation and over various periods [since 1930]. I found no correlation. Some readers objected that adjusting for inflation needlessly adds another variable to the analysis and that a handful of companies dominate the S&P 500, both of which obscure the underlying relationship between the market and the economy. So I ran the numbers again … The result is the same … Then I ran the numbers using the S&P 500 Equal Weight Index … The result was the same again … (“I Ran the Numbers Again. Stocks Are not the Economy.” Bloomberg, 27 October 2020).

Certainly since 1930 in the U.S., and probably well before, a rise of the S&P 500 hasn’t reliably foretold an upswing of GDP growth; and an acceleration of GDP growth hasn’t consistently preceded an increase of the S&P 500. This is bad news for today’s bulls: history says that their expectation of an economic “recovery” cannot logically – as opposed to emotionally – underpin their exuberance about stocks. Equally, it also means that fear of a relapse towards economic reality cannot reasonably support sceptics’ bearishness.

Today’s High Multiple, Tomorrow’s Low Returns

On what ground, then, can today’s conservative-contrarian investors solidly stand? What, in my view, repudiates speculators’ blind optimism – or should, at the very least, give them pause? The short answer is “history.” Since August, and as I’ve detailed in previous Livewire posts, the All Ordinaries Index (AOI) has entered uncharted waters. Its PE ratio has zoomed to an unprecedented extreme (more than 40) in large part because its earnings have slumped to an all-time (CPI-adjusted) low; and practically all market participants have discounted or ignored the “earnings recession” (which has now become a depression) that’s afflicted Australian equities since the GFC.

The GFC crushed earnings: from peak (October 2008) to trough (December 2012), they plunged 41% (nominally) and 46% (CPI-adjusted). For the next seven years, they fluctuated without trend. The Global Viral Crisis (GVC) has slammed them further: during the past 12 months they’ve plummeted 60%. As a result, in September they revisited the nominal level first reached in 1999. Adjusted for the CPI, they haven’t merely matched the depths they reached during the recession of the early-1990s: they’ve plumbed a new all-time low. Finally, the GFC’s full impact upon earnings took four years to appear. Will the GVC’s take longer than six months? If so, then in 2021 and beyond they’ll sag further. I’m therefore sceptical that they’ll soon recover from the GVC’s – never mind the GFC’s – hammerings.

Why does this matter? First, the AOI’s level is the product of its earnings and PE ratio. Second, the market’s current earnings multiple strongly influences the market’s subsequent return. For each month since January 1974 (the earliest for which reliable estimates of the Index’s earnings exist), I computed the AOI’s return during the next six months, 12 months and five years. (Accordingly, after June 2020 we don’t have subsequent six-month returns; after January 2020, there are no 12-month returns and after January 2015 we don’t have 5-year returns.) I then rank-ordered these data by the All Ordinaries Index’s PE ratio; divided them into five subsets (“quintiles”) containing approximately equal (net of rounding) numbers of observations; and in each quintile computed the AOI’s average return during the next six months, 12 months and 60 months.

Table 1 summarises the results. The higher is the AOI’s PE at a given point in time, the lower is its subsequent average short-term (up to 12 months hence) and medium-term (five years hence) return. Ratios in the lowest quintile of observations generate double-digit returns. The last few months of 2008 and the first few of 2009, which marked the low point of the GFC, are the most recent observations in this quintile. Conversely, PEs in the highest quintile are associated with meagre (less than 3% annualised) short-term and below-average medium-term returns. 

Table 1:All Ordinaries’ PE Ratio and Subsequent Annualised Returns, January 1974-September 2020

Why is today’s PE ratio (more than 40) so significant? It’s literally off the chart: the highest observation in the dataset has a PE ratio of 23.9. In a subset of the highest quintile’s observations, those whose PE ratio exceeds 20, the market’s short-term returns are negative. Today’s consensus about 2021 is very bullish. It’s possible that next year’s results will meet the bulls’ expectation; but intelligent investment is a matter of odds, and Table 1 tells us that, from the bulls’ point of view, the odds aren’t good.

“Never mind history: it’s different this time!” the bulls retort. And in important respects they’re right. The magnitude of this year’s fiscal and monetary “stimulus,” for example, has no counterpart in the past. As a result, deficits and debt have exploded to hitherto-unimaginable levels – and show every sign that in 2021 they’ll balloon further. But does today’s extraordinary earnings multiple – which is more than six standard deviations above its historical mean – annul history’s pattern? The problem for the bulls is two-fold. First, as I’ve detailed previously, “stimulus” is actually poison. It hasn’t rescued markets and economies: it’s merely created more “zombie” firms and households that require constant “stimulus” to remain afloat. Secondly, and as Sir John Templeton famously quipped, “the four most dangerous words in investing are ‘this time it’s different.’” Hitherto, historical data have provided a more reliable guide to the future than today’s emotions and unsubstantiated assertions.

 Irrational Exuberance Revisited: Speculators Are Again Sledging Warren Buffett

During the Dot Com Bubble, speculators who mistakenly thought they were investors took pot-shots at Warren Buffett. On 27 December 1999, for example, the cover of Barron’s proclaimed: “What’s Wrong, Warren?” The accompanying article almost gloated:

After more than 30 years of unrivalled investment success, … Buffett may be losing his magic touch. Shares in … Berkshire Hathaway are set to experience their first annual decline since 1990 and their second-worst year of performance, relative to the Standard & Poor’s 500 Index, since Buffett took control of what had been a struggling New England textile maker in 1965.

Barron’s disparaged Buffett by comparing the price of Berkshire Hathaway’s “A” shares to the Index and two major corporations (American International Group and General Electric) that had “outperformed” Berkshire during the previous five years – and whose futures, it strongly implied, were much brighter than Berkshire’s (Figure 1).

Figure 1:Barron’s Bags Buffett (27 December 1999)

In 1999, Barron’s was rather unkind to Buffett; since then, fortune has been considerate to Berkshire – and cruel to AIG and GE. Since 2000, Berkshire hasn’t merely outpaced the others; it’s done so almost continuously. Figure 2 plots the courses since January 2000 (taking into account dividends, issues and buybacks of shares) of four investments of $US1,000. Almost 21 years later, the market value of the investment in Berkshire Hathaway’s Class A shares (BRK) was $6,827. That’s a compound rate of growth of 9.6% per year, which handily outpaced the S&P 500 Index. An investment of $1,000 in January 2000 in a hypothetical portfolio that perfectly mimicked the Index was worth $2,601 in January 2021; that’s a compound return of 4.6% per year. 

Figure 2: Market Value of $1,000 Invested in AIG, BRK, GE and the S&P 500 in January 2000

Since 2000, BRK and the S&P have left AIG and GE in the dust. From the late-19th until the late-20th century, General Electric was a pillar of American – and hence of global – technological innovation and industrial might. During the past two decades, in contrast, others have overtaken it; as a result, it’s become a has-been and also-ran. The market value of $1,000 invested in GE’s shares in January 2000 was thus just $400 in December 2020. That’s a total loss of 60% and a compound rate of return of -4.2% per year.

If the causes of GE’s trials and tribulations were many and complex, the source of AIG’s near-demise was single and simple: without realising it, during the years preceding the GFC it bet colossally that the price of residential real estate in the U.S. would rise indefinitely. It lost comprehensively; indeed, without a mammoth (ca. $150 billion) bailout from the U.S. Government, the GFC would have slain what had for decades ranked among the world’s biggest insurers. Even with the rescue, most of AIG’s shareholders suffered an all-but-total loss. The market value of an outlay of $1,000 in January 2000 fell as low as $6 in February 2009 (a loss of 99.5%); since then it has rebounded as high as $63 on a couple of occasions (most recently in January 2018). In January 2020, its market value was $42 – a seven-fold rise from its all-time low, but nonetheless a loss of almost 96% over the 21-year period. Memo to bulls: what were world-beaters in 1999 subsequently became road-kill. Is it possible that today’s market-darlings will suffer the same fate? 

What’s a tell-tale sign that market participants have repudiated prudence and embraced recklessness? As they did in 2000, so they’ve begun to do this year: unknowns and wannabees are ignoring Buffett’s stellar 65-year track record and belittling his comparatively modest short-term results. According to Market Insider (9 June),

 Warren Buffett has been a popular punching bag in recent weeks … One [little-known speculator] suggested the 89-year-old’s age might explain why he didn’t go on a buying spree during the coronavirus sell-off. ”Time to reinvent yourself, Warren,” [another] said, [asserting] that Buffett had an “outdated view” of how far the stock market would fall. David Portnoy, the Barstool Sports founder and celebrity trader, tweeted that Buffett was “washed up” and had “lost his fastball.”

Buffett’s current crop of critics should study Berkshire’s Annual Report (2000):

Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behaviour akin to that of Cinderella at the ball … They know that overstaying the festivities – that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future – will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.

Today’s stampeding herd of high-spirited speculators would also do well to acknowledge that what occurred during the Dot Com Bubble is, broadly speaking, recurring today:  

  1. unprecedented doses of funny-money, conjured out of thin air by reckless central banks and borrowed by profligate governments, as well as seemingly-rapid technological change, encourage people in all walks of life to abandon established standards of value;
  2. speculation (which obsesses about what speculators believe the next person will shortly pay for today’s “hot stock”) has largely displaced investment (which concentrates upon companies that produce essential goods and services, their operations and results and justifiable estimates of their long-term values);
  3. unexpected short-term events – such as the fastest-ever escape from the quickest-ever bear market – embolden speculators to mock successful long-term investors.

The risk, it seems to me, is high and rising that today’s herd of speculators (who, like their forebears 20 years ago, erroneously think they’re investors) will, like their ancestors, pay a dear price for their folly.

What Says the “Buffett Indicator”?

In Fortune magazine on 10 December 2001 – that is, towards the peak of the Dot Com Bubble – Buffett stated that the ratio of a country’s stocks’ total market capitalisation to its total output (measured by Gross Domestic Product) “is probably the best single measure of where [stocks’] valuations stand at any given moment.” Since then, research by academics and others has corroborated this conjecture, and this ratio has become known as the “Buffett Indicator.” If the total capitalisation of a country’s publicly-traded stocks equals its GDP, then the Buffett Indicator = 1 (or 100%). The less is total “market cap” relative to GDP, the further the indicator falls below 100% – and, by implication, the more undervalued are that country’s stocks. The higher the indicator rises above 100%, the more overvalued stocks become.

Figure 3: Ratio of Total U.S. Market Cap to GDP, U.S., Q1-1947 to Q3-2020

Using quarterly data compiled by the Federal Reserve Bank of St Louis, Figure 3 plots the “Buffett Indicator” since 1947. Its mean is 74%. From the late-1940s until the mid-1990s – a key inflection point – it remained at or well below this average: indeed, during the bear markets of the 1970s and 1980s it slumped to approximately one-half of its long-term average. From the mid-1990s to the early-2000s, however, it skyrocketed: indeed, it doubled from ca. 80% to almost 160%. In 1999, when Grantham and Buffett declined to participate in the Dot Com Bubble, the Buffett Indicator exceeded 150% – which, at that time, was uncharted territory. During the bust of the early-2000s it halved to its long-term average. Between then and the onset of the GFC it rose smartly (i.e., from ca. 80% to almost 120%); and during the GFC it again collapsed to its long-term average. Since then it’s risen inexorably, and in the wake of the GVC has skyrocketed to an all-time high of almost 200%.

Buffett’s comments to Fortune almost 20 years ago are highly pertinent today:

For investors to gain … at a rate that exceeds the growth of U.S. business, the … line on the chart must keep going up and up. If GDP is going to grow 5% a year and you want market values to go up 10%, then you need to have the line go straight off the top of the chart. That won’t happen. For me, the message of that chart is this: If the percentage … falls [below 70%], buying stocks is likely to work very well for you. [But] if the ratio approaches 200% … you are playing with fire.


“Logic,” noted James Grant in Bagehot: The Life and Times of the Greatest Victorian (W. W. Norton & Company, 2019), “makes as poor an argument against a boom as it does against a love affair.” My case will convince few or none of today’s bulls to restrain their emotions and engage their brains. No matter: I’m not trying to change speculators’ minds; I’m trying to stiffen investors’ spines – and remind them that in order to generate robust long-term returns you must avoid crippling short-term losses. 

When so many people, including prominent and seemingly authoritative people, speak and act similarly – that is, like speculators – it behoves investors worthy of the name to think clearly and explore alternatives. Remember how confident – and flatly wrong! – so many “experts” (including “strategists” at major financial institutions and heads of central banks!) were before the Dot Com Bust? The GFC? The greater is its confidence, it seems, the more often the mainstream treads on the same old rakes. If you’ve not already done so, then do it now: consciously ignore today’s stampeding herd – and your own emotions. Instead, collect valid and reliable data, conduct your own analyses, draw your own conclusions – and act rationally in the midst of folly. 

This blog contains general information and does not take into account your personal objectives, financial situation, needs, etc. Past performance is not an indication of future performance. In other words, Chris Leithner (Managing Director of Leithner & Company Pty Ltd, AFSL 259094, who presents his analyses sincerely and on an “as is” basis) probably doesn’t know you from Adam. Moreover, and whether you know it and like it or not, you’re an adult. So if you rely upon Chris’ analyses, then that’s your choice. And if you then lose or fail to make money, then that’s your choice’s consequence. So don’t complain (least of all to him). If you want somebody to blame, look in the mirror.

Chris Leithner
Managing Director
Leithner & Company Ltd

After concluding an academic career, Chris founded Leithner & Co. in 1999. He is also the author of The Bourgeois Manifesto: The Robinson Crusoe Ethic versus the Distemper of Our Times (2017); The Evil Princes of Martin Place: The Reserve Bank of...

I would like to

Only to be used for sending genuine email enquiries to the Contributor. Livewire Markets Pty Ltd reserves its right to take any legal or other appropriate action in relation to misuse of this service.

Personal Information Collection Statement
Your personal information will be passed to the Contributor and/or its authorised service provider to assist the Contributor to contact you about your investment enquiry. They are required not to use your information for any other purpose. Our privacy policy explains how we store personal information and how you may access, correct or complain about the handling of personal information.