Pushing Your Luck

One can go some distance in a mine field without anything blowing up – it’s just that the overall odds aren’t good. For now, market action remains unfavorable, which suggests that the enthusiasm of investors is not yet robust, and further skittishness is possible. But again, there is no particularly strong reason to expect one direction over another over the very short term. In any event, conditions remain poor from a valuation standpoint. Stocks are emphatically not ‘cheap.’

It’s particularly interesting that the forward operating earnings crowd has advanced the notion that stocks are as cheap as they were in 1990. Aside from the problems with forward operating earnings that I’ve previously detailed, this particular argument rests on overlooking the state of profit margins, which were quite depressed in 1990 and are at record highs currently. Think about that for a moment and you’ll see what’s going on. A forward P/E multiple on depressed profit margin assumptions provides at least some margin for error. The same forward P/E based on assumptions of the highest profit margins in history contains no such margin.

– John P. Hussman, Ph.D., August 27, 2007, shortly before the global financial crisis

The problem with speculation is that there’s usually a gap between the underlying risk and the inevitable outcome. The gap is most dangerous when there are potential rewards for pushing your luck.

In July 2007, Chuck Prince, the CEO of Citigroup, famously pushed his luck saying “When the music stops, in terms of liquidity, things will get complicated. But as long as the music is still playing, you’ve got to get up and dance.” The deterioration that would shortly unfold into a global financial crisis was already underway. After years of Fed-induced yield-seeking speculation in mortgage securities, aided by demand from yield-starved investors, and abetted by Wall Street institutions that were all too ready to supply new “product,” the inevitable implosion would produce a 55% loss in the S&P 500, and a 98% loss in the value of Citigroup.

Unfortunately, the rewarding gap between underlying risk and inevitable outcomes can encourage people to persist in reckless behavior. In 2007, the tragic results of that behavior were already baked in the cake. Only the timing was uncertain. As I wrote at the time, one can go some distance in a mine field without anything blowing up – it’s just that the overall odds aren’t good.