Guest Post: “Sell American. I am.”

By Ben Michaud, Private Investor (originally posted on Zero Sum)

To borrow from Buffett’s 2008 op-ed, “Buy American. I Am.”, the title of my presentation is….

SELL AMERICAN. I AM.

In summary, the bullish case for stocks as peddled by David Tepper earlier this year is as follows:

1. Stocks are cheap relative to bonds with 2014 operating earnings yield of 7.5% versus a 1.93% 10-Year US Treasury yield
2. Central banks have removed tail risk from the system – most specifically with Draghi’s “Whatever it takes” commentary in July 2012
3. The Fed’s current QE program puts a floor under equity markets – i.e. a free put, akin to the “Greenspan Put”

Just like many value investors on this forum, I’m a valuation guy – in the long-run, little else matters. At a recent price level of 1,557, the S&P 500 is projected to return 3.87% per annum over the following ten years. If we subtract the 10-year treasury yield of 1.93%, we get the so-called “market risk premium”, which is 1.94% at present. I’m going to go out on a limb and say the bull case as outlined above is currently priced into stocks.

Compare the current MRP of 1.94% to the MRP at 10/15/08, the night before Buffett penned his “Buy American. I Am.” op-ed in the New York Times…..5.89%. That was with a 4.04% 10-year treasury yield. The current MRP is with a 1.93% yield!!!! To say the least, I am VERY fearful right now with so much greed in the market.

History is fraught examples of why valuation metrics are not great “timing” metrics – look no further than GMO and Baupost sitting out a massive bull run from 1996 through 2000 (off the top of my head). If so, why do I think NOW is the “time” to short the market? Well in addition to being a valuation guy, I’m also a market guy – I’ve tried, but I am unable to plug my nose and ignore two facts: the market moves in long secular valuation cycles and the crowd is ALWAYS wrong at extremes. Thus, I like to view the risk-reward of the market with a multi-faceted approach, and not JUST valuation. So in summary conclusion, I believe the market at current levels presents an attractive asymetric short opportunity for the following reasons:

1. S&P 500 approximately 49% overvalued
2. U.S. secular bear market likely still in progress
3. Extreme optimism among fund managers with long exposure at multi-year highs

The trade has a 3.85 year duration and a projected IRR of 15.5% per annum from a recent SPX level of 1,557.
Please refer to the attached presentation for a detailed outline of the thesis.

***A note on market timing – When I say “timing”, it is not in the typical derogatory way that “market timing” critics use it – rather, I mean timing of the risk-reward equation. In other words, one can never know precisely when the market will decline, BUT one can determine the “time” the risk-reward equation is as such that the market does not sustainably rise above a particular level. For example, the market never fell back to its 1996 level of between 600 and 700 in the 2000-2002 bear market – so if you were bearish in 1996, your short position never even broke even in the decline you were ultimately looking for.***

See the full presentation here.  

Guest

This story is authored by a guest and its content is not necessarily endorsed by Pragmatic Capitalism nor are its views representative of other authors on this site.

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  • perpetual neophyte

    Can someone help me with the math of the market risk premium? How are we coming to the conclusion that the SPX 10-year projected return is 3.87% annualized?

  • John Wilkins

    I don’t know the assumptions made but the 3.87% must come (I guess) from an assumption of earnings growth and P/E assumptions and perhaps a constant P/E. It is probably nominal growth so if you add say 2+% inflation, you get a roughly “normal” expected return of about 6%.

  • InvestorX

    Hussman does a similar analysis. He comes with 3.5% p.a. Check his site. He assumes 6.3% p.a. nominal GDP (and profits) growth over 10 years.

  • Tom Clown

    Is anyone else seeing a jacked-up website today? Everything is basically in reverse on pragcap.

  • Steve W

    The S&P 500 is approximately 49% overvalued? I gather he believes the MRP metric is superior to other measures, such as the good old P/E ratio.

    I suppose I should see the full presentation before posting any other questions. Having said that, we shouldn’t be surprised if the US equity markets pull back a bit. Earnings growth is slowing, the recovery is fragile.

  • drewf

    GMO & Hussman both use Schiller’s P/E I believe which puts long term returns in the same category. They may be right, but it has to be frustrating for them to be “wrong” for so long.

  • http://wellsfargomustdie.blogspot.com Wells Fargo Must Die

    The downturn will not come until the Fed has taken its eye off the ball. Right now, Bernanke is sitting on it like Reggie Jackson on a hanging Charlie Hough knuckleball. Any and all downturns will be met with maximum force. That promise eliminates all but market fluctuation.

    Once QE has been removed, Europe has been resolved and the coast is clear, there may be a chance of a sizable downturn as the fraudulent numbers collapse of their own weight and the Fed is caught off guard. Until then, the perculation will continue and the pot will be reheated as the coffee cools.

  • Adrian

    I am bearish from February on US market for short term because of high magnitude of PMI indicators regarding new orders/productions/prices relative to historical values. I am more worried about US on the long term because the money pumping can’t continue forever and US is already at a high level of indebtedness. So the market or the dollar will suffer. Either way you lose.

  • pas

    PE of 15 is not extreme, quite average really. S&P averaging 3.8% is not great but that is if you buy today. That forecast changes every day. When it gets to zero like 1999 then we are at an etreme. You Ivory tower people would rather be right than make money. Tha’s why Hussman’s reurns are MINUS 8.75 1 year, MINUS 5.72 three year, MINUS 4.5 5 year.

  • Skateman

    And NGDP growth is likely to be a whole lot worse than that.

  • Skateman

    It’s extreme within the context of all time high profit margins.

  • perpetual neophyte

    It’s worth reading through all of the slides. He makes what I feel is an “in paradigm” point about QE and the Bernanke / Fed Put. I’m not speaking to its accuracy one way or the other, but I do think the rationale is within the MR framework.

    My main criticism of the groundwork for the bear case presented is that it relies too heavily on data points from an incredibly small sample set to make very precise calls. Averages are often made up of wild outliers. If you look at the *annual* returns (NOT annualized) of the DJIA, you will see a lot of data points well above and well below the long-term average.

    Specifically, the work regarding average cyclical bull and bears within a secular bear and the references to average duration of secular bears and using that for predictive purposes.

    Likewise, the asymmetry of the upside/downside is based on those relatively low anticipated rates of return. I’d like to see the same data from Jan 2012. “The market can stay irrational longer than you can stay liquid.”

  • bfuruta

    Michaud’s strategy is stated on slide 17: It is not about timing, not about picking the high in the market. It is about asymmetrical risk. Was Buffett wrong because he bought in October 2008 instead of March 2009? Michaud: “ Isn’t this what value investing is all about? Nobody knows when a 50-cent dollar bill will re-value to 100 cents, but rather that the risk-reward is heavily skewed in one’s favor.”

  • hangemhi

    Can someone interpret this sentence?
    “The trade has a 3.85 year duration and a projected IRR of 15.5% per annum from a recent SPX level of 1,557.”

    Is he saying that if you short now, that over the next 3.85 years you can expect a 15.5% avg annual return? If so, then I presume he is predicting the S&P will get to the low 800′s. Right?

  • perpetual neophyte

    743 per slide 23
    “Based on historical precedent, SPX likely to fall to around 743 in less than 4 years.”

  • perpetual neophyte

    See my post above yours. This concept of asymmetrical risk is based on his assumptions, several of which seem to be grounded on shaky metrics. Would his analysis also have predicted a sub 4% rate of return for 2012? He cites GMO and Hussman for some of his data and I don’t remember them pounding the table for US equities last year.

    That also brings up the point of sequence of returns and the arithmetic of loss. A bear that bought the SH short S&P 500 ETF on Jan 3 2012 would have lost about 22% through today’s close. Now they need to make almost 30% just to break even.

    I’m not saying his analysis is wrong, but I think some of the assumptions are shaky at best (such as the precise time frames listed based on a tiny data set) and that the “asymmetric risk” may only be present given those assumptions.

  • Alberto

    Maybe not forever but the money can continue for many years more, it’s completely in the FED hands. The dollar sooner or later will not be the reserve currency and this is how all this ends. US production was 40% of world GDP in 1960, now is 20% and it will be 10% in 20 years. You cannot have a reserve currency with such a little weight on the world economy.

  • Ilya

    While I agree with overvaluation statement , true downside is ignored. If corporate margins don’t come off in a hurry we can get a multiple expansion to say 20

  • http://pragcap Michael Schofield

    Please make it stop. How many more of these misguided missles will I have to tolerate before one of them finally gets a lucky hit? For four years now the investing public has been exposed to a constant and monotonous screed that the end is near, the fear mongers need to just STFU until it actually ends. Of course that won’t happen because most of these learned gentleman are selling snake oil to those less savvy….this is not the top. Stay in until there is clear evidence. Go short some yen or something, the CB’s are still giving away money.