“I’ve sat for years at a time with $10 million to $12 million in treasuries. Just waiting, waiting. A lot of people can’t stand to wait. It takes character to sit there with all that cash and do nothing.” – Charlie Munger, Vice Chairman of Berkshire Hathaway
The phrase “greed is good” was popularized by the 1987 movie Wall Street, specifically in a speech given by movie star Michael Douglas as stereotyped sleazy Wall Street character Gordon Gecko, where the term “greed” is used to describe a driving force for good. Gecko characterizes “greed” as a supposed force that brings about positive change as persons (investors in this case) act in their own best interest to create efficiency and growth through the drive for more. In reality, and as the movie later shows, greed is not simply the desire for more, it is an obsession with getting more. This obsession often manifests in imprudent behavior and decision making, resulting in damage to ourselves and/or others. It is somewhat ironic that this movie about Wall Street was released just a couple of months after Black Monday, October 19, 1987, the single worst day in stock market history, where the Dow Jones Industrial Average fell -22.61% just after hitting a new all-time greed-driven high point the Friday before. Like a rubber band when it becomes overstretched, markets have a tendency to snap back quickly from extremes.
Investor greed is frequently driven by the fear of missing out (or FOMO as it has been popularly named), a particularly pernicious human behavior, especially when it comes to decisions about money. Investor FOMO most often occurs after some asset starts quickly gaining in value, garnering media attention, and eventually hot money investors start chasing what seems like easy money (see Bitcoin as the latest example). The longer this goes on, the more other investors start to become less concerned with whether their portfolios are providing the returns they need and more about whether their assets are “keeping up” with these other potential investments. This typically leads to the temptation to chase performance and recency bias (the cognitive fallacy that tricks people into believing that was has just happened will keep happening) sets in. If given into, this temptation gets investors to purchase the now more expensive assets at higher (instead of lower) prices, which is of course the exact opposite of the buy low sell high formula frequently prescribed for investment success. The challenge for investors, and portfolio managers, is to identify when greed has possessed investment markets and their participants, and then be disciplined enough to resist the temptation to join the herd chasing performance.
A Twitter-Worthy Executive Summary
When it comes to long-term financial success, our own greed is often one of the biggest threats. Proper investment management requires prudent risk taking, but also prudent risk mitigation, which occasionally requires us to check our greedy temptations.
Has Investor Greed Reached Dangerous Levels?
If greed is such a dangerous force, then identifying when it is has taken control of investor behavior becomes a matter of paramount importance. In the world of Big Data, there are more and more ways to gauge just when greed has set in, the most obvious being overall market valuation, but also investor sentiment and account cash balances.
When risk taking is rewarded at imprudent levels, investors can begin to conclude that high prices aren’t a problem, which in turn leads to overly positive investor sentiment (bullishness in industry jargon) at market highs. This usually turns out to be a significant mistake eventually, after markets quickly give back years of gains in just days or weeks, but that can sometimes take an extended period of time to become evident. One gauge of investor sentiment is the weekly American Association of Individual Investors (AAII) poll. The recent poll from January 17th, 2018 shows AAII bullish (optimistic) sentiment remains well above the average level and bearishness (negative sentiment) well below the average. This suggests that individual investors may be a bit overoptimistic and perhaps also underappreciating underlying market risk.
Source: AAII Investor Sentiment Survey. (January 17, 2018). AAII.
Everyone knows that what people say and what they actually do can be completely opposite in some cases. In this case, investors are putting their money where their mouth is and they, as a group, hold more stocks relative to cash than at any time since the dot-com boom. Buying pressure (demand) is what drives up stock market valuations and when cash becomes a scarce holding for this group, one has to wonder where the continuing demand will come from.
Source: Edwards, A. (n.d.). The Bull Just Goes On and On and… Societe Generale.
Another demonstration of the abnormality of current investor demand is global money flows into risk-on stock positions, showing that greed is not just a US phenomenon. Money has been flowing into risk-on (long the market) positions for a record 167 days now, which is well above previous streaks.
Source: Sonders, L. (January 11, 2018). Global Fund Flows Have Been “risk-on” for 167 Consecutive Trading Days— A New Record. Twitter @LizAnnSonders.
For every buyer there must be a seller, which beckons the question, “if the general global public is buying, who is selling and sitting on all of the generated cash?” As an example answer, we turn to Warren Buffett. Unlike retail investors, Warren Buffett, one of the world’s greatest investors, has been quietly building a massive record high cash pile through his company, Berkshire Hathaway. Note Berkshire’s most recent SEC filing (10-Q, Q23 2017) shows the total cash value had increased by another almost $10 billion to $109 billion.1 One cannot help but be make the contrast between the general public, that is greedily buying at all-time market highs, and the Oracle of Omaha’s record high cash position. Mr. Buffett is obviously having a hard time finding opportunity and is patiently waiting for something to appear.
Source: Buhayar, N. (August 7, 2017). Buffett Nears a Milestone He Doesn't Want: $100 Billion in Cash. Bloomberg Markets.
Valuation: What Matters Most
Investor sentiment and cash levels wouldn’t be nearly so interesting/worrying if markets weren’t at ridiculous levels of valuation. A major CWM investment philosophy is, “expensive things are dangerous and buying low, lowers your risk.” The table below demonstrates the reasoning behind this philosophy, via the Shiller Price-to-Earnings Ratio (CAPE), as forward outcomes are more often highly positive/least negative for lower CAPE scores and the worst negative/lowest positive returns occur at high CAPE scores. Lower CAPE values reflect historically cheaply priced markets and this table represents CAPE scores 25 and over as expensive. It should be noted that significantly positive outcomes are still possible even at already high valuations.
Source: Carlson, B. (December 26, 2017). Stock Market Valuations Won’t Predict the Next Crash. A Wealth of Common Sense.
The current CAPE ratio is at a ridiculous 34.41 as of January 25th, 2018. This level has only been surpassed one time in the past, during the irrationally greedy time of the late the 1990s during the Dot-Com boom. At the end of February 1998, the CAPE reading was 34.712 and by five years later, at the end of February 2003, the S&P500 had lost -23.65% of its value,3 even after making some significant gains into the year 2000.
Source: Shiller PE Ratio. (January 25th, 2018). Multpl.com, Comprehensive Wealth Management.
On top of the extremely high valuations, the current market rally is now tied for the longest stretch ever without a negative annual outcome. The last time there was a streak this long was again in the 1990s and that did not end well.
Source: Gundlach, J. (January 9, 2018). Just Markets. DoublelinLine Funds.
The current rally is also the longest streak ever without at least a 5% correction. Neither this, nor any of the above guarantee that a crash or even a sharp correction is imminent, but the risks of such events are definitely elevated.
Source: Kostin, D. et. al. (January 25th, 2018). Where to Invest Now: Year 2. Goldman Sachs.
The above data makes the case that excessive investor greed coupled with extremely high market valuations has increased the risk of a negative market event, but it does not provide any potential catalyst for setting off such an occurrence. The thing we, and most other financial organizations, are watching is how global central banks reduce their balance sheets and normalize policy over the foreseeable future. Since the crisis in 2008, these banks have been exceptionally supportive of markets by directly purchasing assets with printed money, but over the next few years they are expected to reverse this process. The chart below shows the expected drawdown process through the end of 2019. This should be interpreted as decreased demand, but still net positive demand until 2019. Notably, the Fed is the only central bank expected to actually shrink its balance sheet in that timeframe, which may have a significant local effect on the US. It remains to be seen how this reduction in support will be handled by the global economy and if the central banks will pullback support as expected.
Source: Kelly, D. et. al. (Q1 2018). Guide to the Markets. J.P.Morgan.
Just because markets are expensive and just because we have gone an abnormally long-time without a negative annual year, does not mean a major crash is in the offing. We should not replace the irrational emotion of greed with fear. However, we should be mindful of the increased risks that exist when both high valuations and irrational investor greed exist in a marketplace and follow strict risk reducing disciplines.
The Current CWM PTS® Indication
“Fear of missing out (or “FOMO”) is one of the more powerful reasons for investor aggressiveness, and also one of the most dangerous.” –Howard Marks
Aggressiveness cannot be justified as the highest priority when market valuations are where they are.
While greedy emotions may tempt us all to reach for more, the wise investor recognizes that the primary goal is keeping what one already has and growing it intelligently. Fortunately, our CWM Performance Targeting System (PTS®) is designed to help us control our behaviors during times of either irrational greed or fear, ensuring we are taking proper precautions or advantage when warranted. Caution is currently called for based on the above and other evidence.
Our CWM PTS® metric currently stands at 1.81 as of 1/24/2018. This does not guarantee a market sell-off or crash is near, only that risks are now elevated for markets. At this level we can be highly confident that stocks are more likely to underperform bonds/non-correlated investable assets over the next couple of years, though nothing is ever guaranteed of course. As it stands, the current 1.81 indication suggests we should remain overweight to bonds/non-correlated assets versus stock investments.
Source: Macro PTS® Score. (January 24, 2018). Comprehensive Wealth Management.
Though there is potential for stocks to move higher still, current valuations reflect a high and rising probability of a negative outcome, a risk we are striving to mitigate for our clients. CWM PTS® models continue to be invested conservatively, as they have been for some time. Your CWM team will continue to be disciplined in our efforts to provide the best risk adjusted returns possible.
Please pass this article on to any one you know who may be interested in or might benefit from the information. We are always looking for more great clients just like you and would welcome any opportunity to assist them.
If you have questions or comments about the above subjects or other investment topics, I would love to have a conversation! Feel free to email me or if you are interested in more regular financial tidbits, follow me on Twitter.
Chief Investment Officer
P.S. It is still January and not too late to think about goals and visions for the rest of the year and beyond. When thinking about goal setting, which should be about improving life and work experience, the Japanese have an interesting concept called Ikigai.
Source: Oliver, L. (August 9, 2017). Is This Japanese Concept the Secret to a Long, Happy, meaningful Life? World Economic Forum.
1 Form 10-Q. (Q3 2017). Berkshire Hathaway.
2 Shiller, R. (n.d.). Online Data Robert Shiller. Yale University.
3 Yahoo! Finance
This article has been prepared and distributed for informational purposes only and is not a solicitation or an offer to buy any security or investment or to participate in any trading strategy. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice as individual situations will vary. For specific advice about your situation, please consult with a financial professional. Past performance is no guarantee of future results.