In recent months, significant changes from the Federal Reserve have greatly impacted financial markets. Over the past 18 months, the Fed has decreased its balance sheet by nearly $1 trillion. This reduction in Fed credit necessitates a rise in market interest rates, which in turn pressures asset prices—namely stocks, bonds, and real estate—downward.
Understanding these dynamics is crucial; without this awareness, one risks making decisions they may later regret, leading to long-lasting consequences.
At the Economic Prism, we hold an implicit policy of not dwelling on past regrets. Regret can breed bitterness as we age, and living with such negativity is not a fulfilling way to spend one’s later years.
While we do not wish to close off the past, as it offers invaluable lessons on successes and failures, it is paramount to recognize that the future may unfold differently. What worked previously may not necessarily hold true going forward.
However, we believe that failing to learn from past errors can lead to repeated mistakes in the future.
Take, for example, the decision to invest in Cisco in April 2000. The company’s stock had surged over 1,100 percent in the preceding three years, a classic sign of market hysteria.
Now, more than 23 years later, those who invested in Cisco back in April 2000 are still down by 23 percent. When factoring in opportunity cost, those losses become even more pronounced.
Similarly, purchasing bitcoin in October 2021 was equally misguided. The craze for cryptocurrency had reached unsustainable heights, leading to the inevitability of a downturn.
Currently, bitcoin has plummeted over 58 percent from its peak. Will it remain down for two decades, like Cisco? Or is it only a matter of time before it experiences another rally? Only time will reveal the answer.
This brings us to a vital distinction…
Speculating vs. Investing
Predicting stock market movements is a game best left to speculators rather than genuine investors.
So far this year, the S&P 500 has risen approximately 16 percent, recovering from a 19.44 percent loss in 2022.
Will the S&P 500 climb another 4 percent in the last quarter of this year, achieving a total return of 20 percent for 2023? Or are we on the brink of a long-term downturn? Nobody can say for sure.
While speculators often convince themselves they can forecast market movements, investors focus on buying shares of reliable companies with strong cash flows and reasonable valuations. Long-term prospects for increasing dividends and capital gains based on anticipated cash flow are what guide investors’ decisions.
In essence, investors concentrate on the fundamentals of businesses, while speculators are fixated on price movements. Speculating in itself isn’t inherently wrong, but clarity about one’s approach is essential.
To gauge the overall value of the stock market, several valuation metrics offer insights into its current standing. Is it overvalued or undervalued?
One such measure is the Buffett Indicator, as described by Warren Buffett himself. He termed it, “probably the best single measure of where valuations stand at any given moment.”
As it stands, the Buffett Indicator presently indicates a ratio of total market capitalization to gross domestic product exceeding 167 percent. On Wednesday’s close, the Total Market Index, as calculated by the Wilshire 5000, stood at $44.85 trillion, which is more than 167 percent of the most recent U.S. GDP figure, approximately $26.79 trillion.
Significantly Overvalued
A fairly valued market is characterized by a ratio of total market capitalization to GDP ranging from 75 to 90 percent. Anything above 115 percent is deemed significantly overvalued.
To put this into context, the Buffett Indicator reached 148 percent in March 2000 right before the S&P 500 fell by 49 percent. Similarly, the indicator registered only 110 percent in September 2007 before a 56 percent decline.
More recently, it reached an alarming 211 percent in December 2021—coinciding with the peak of the S&P 500, which then dropped roughly 24 percent in the following nine months.
Another crucial metric for assessing stock market value is Shiller’s cyclically adjusted price-to-earnings (CAPE) ratio, which uses inflation-adjusted earnings over the past decade. Currently, the CAPE ratio exceeds 30, well above its historical median of 15.94.
This CAPE ratio mirrors levels seen at the market peak in 1929, prior to the Great Depression, with only two other periods—December 1999 during the dot-com bubble and late 2021—recording higher values.
The future remains uncertain. The Buffett Indicator may yet again approach 200 percent, or the CAPE ratio may surpass the 1999 peak of 44.19.
The critical point remains: the stock market is significantly overvalued, and at some juncture, prices must adjust to reflect actual earnings.
Importantly, a market crash is not necessarily on the immediate horizon. Nevertheless, the reality is that a substantial decline appears likely.
In other words, the risk-reward equation for betting on further market capitalization growth is less appealing now, especially when 6-month Treasury bills are yielding over 5 percent.
Understanding valuation metrics is essential for avoiding repeated mistakes and minimizing regrets. Ignoring past errors can lead to severe consequences.
Flying on a Wing and a Prayer
Franz Reichelt, known as the Flying Tailor, had a revolutionary concept: a wearable parachute for aviators.
In 1910, he began experimenting by tossing dummies from his fifth-story apartment. Initially, these experiments were successful, with the dummies—equipped with foldable silk wings—making soft landings.
However, when he attempted to scale up his design for personal use, the outcomes were not as favorable. After jumping from a height of 30 feet, instead of gliding down gently, he plunged downwards like a sack of cement, only saved from injury by a pile of straw. On another occasion, he broke his leg after jumping from 26 feet.
Surprisingly, Reichelt failed to learn valuable lessons from these experiences. Instead of improving his design, he mistakenly believed that higher jumps would lead to better results.
On February 4, 1912, at 7:00 a.m., Reichelt ascended the Eiffel Tower clad in his parachute suit. The cold morning air, with temperatures below freezing and a brisk wind, didn’t deter him.
Upon reaching the tower’s first deck, approximately 187 feet above ground, he positioned himself on a stool atop a restaurant table adjacent to the guardrail. After making adjustments to his suit and checking the wind direction with a piece of paper, he placed one foot on the guardrail and hesitated for about forty seconds.
Then, on a wing and a prayer, Reichelt executed a flawless Eiffel Tower death jump. Almost instantaneously, his parachute collapsed around him, and he fell several seconds before hitting the frozen ground below.
When Reichelt’s head struck the earth, it didn’t break open like a watermelon, but his brain was undoubtedly damaged beyond repair.
Le Petit Parisien reported that he suffered severe injuries including a crushed right leg and arm, broken skull and spine, along with bleeding from his mouth, nose, and ears. Witnesses noted a crater roughly six inches deep from his impact.
Blinded by hope and optimism, Reichelt completely overlooked the warnings his past experiments had provided, leading to his tragic end.
For those looking to build wealth through investments, it’s critical to heed the warnings of inflated valuations amidst rising interest rates. The fall from these heights could be devastating.
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Sincerely,
MN Gordon
for Economic Prism
