Animal Spirits Podcast - The Melt-Up (EP.12)

Episode Date: January 10, 2018

On this week's show, we discuss the prospects for a melt-up in the stock market, look back at the long history of bubbles in stocks, try to figure out the best investment you can make in 2018 and more. Find complete shownotes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Like us on Facebook And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation.   Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Animal Spirits, the podcast that takes a completely different look at markets and investing. I hate the people who talk about it all the time, so I didn't want to be one of those people. From two guys who study the markets as a passion. Can I count on you to talk me off the ledge partner? Yes, and that's what this podcast is for. And trade for all the right reasons. That's my due diligence. I'm in. Dude, if you're in, I'm in.

A line of thinking is the higher the volatility on an asset, the higher the volatility on the opinions. so I feel like you have crazies on both sides. Here's your host of Animal Spirits, Michael Batnik. I can say that I was never driven by money. So you were trading three times leveraged ETFs for the love of the game. Exactly, man. I'm a purist. But anyway, and Ben Carlson.

This is true. I do not drink coffee. I've never been on Facebook. I've never done fantasy football. Oh, one last thing. Michael Batnik and Ben Carlson work for Ritt Holtz wealth management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritthold's wealth management.

This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Rithold's wealth management may maintain positions in the securities discussed in this podcast. Now, today's show. Welcome to Animal Spirits with Michael and Ben. On this week's show, Ben is sick. I guess he caught the cold that I had last week had traveled through the airwaves and over the Great Lakes and to Grand Rapids, Michigan.

So last week, Ben, you mentioned that. There was a 30 to 40% chance of a meltup, and that number was pulled directly out of your butt. But apparently, Jeremy Grantham is a listener off the podcast because he put out something this week's saying basically the exact same thing. Yes, I was front-running his story, apparently. So he put out a piece for, and Jeremy Grantham is one of the founders of GMO, which is this huge money management shop that's based in Boston, I believe. And he said, bracing yourself for a possible near-term melt-up. and Grantham is kind of a historian of bubbles and looked back and basically he's laying out the case for over the next 9 to 18 months that we could see something like a 60% price rise. He thinks that's possible if this follows the historical pattern of previous bubbles.

So I don't know if he's called meltups in the past, but he has a pretty darn good track record when it comes to calling for crashes. I believe that he got the Japan bubble right in 1989. and he got the dot-com bubble in the late 90s, which crashed in March of 2000, and he also got the great financial crisis. So it was raising a few eyebrows across the internet this week that he was calling not for a crash, but for the opposite of meltup. Yeah, and he actually also, pretty much to the week, said it's time to really invest hand over fist in March of 2009 at the bottom, too. So he's got a pretty good track record. He's been relatively bearish, but I don't think he's called.

for a crash for the past, I don't know, five or six years, but I think he's been pretty open-minded about it. So it's interesting because he even says, you know, I think he's, he's kind of learning some of his lessons, which is kind of interesting for a guy who's probably in his, I don't know, 70s or 80s maybe. I think he's actually 80. Because he talks about the fact that, you know, in the past they would look at their models and it would just be price alone would be used to figure out what a bubble is, but now he's saying it's not, you can't just look at price, you have to look at sentiment too. And I think that's kind of the one piece that's been missing this whole time is just this idea of euphoria. And that was my thoughts last week is

if we get that euphoria, then that meltup is going to come and it's going to could get crazy. So that's kind of what he's predicting here that it's going to finally happen. Speaking of the psychology, Grantham said, quote, we know we're not there yet, but we can perhaps see some early movement, increasing vindictiveness to the bears for costing investors money, end quote. And sure, we do see some of that. But I think that GMO is incredibly transparent about their worldviews. So for their investors, and obviously we don't know what their investors are saying, to be mad at them for missing a run-up seems sort of ridiculous because, obviously, I guess

it's human nature, but you know exactly what you're getting from them. You're hiring a company that is an independent thinker that will stick to their guns right or wrong. So to turn nasty to them seems sort of silly. Obviously, you know, on Twitter you see bear bashing all the time, which is, I guess, what you get in this type of a market environment. And with such a large asset base, they, I think, they may have. lost mass this now, but I know at one point they were over $100 billion.

They're mostly institutional funds, which is kind of funny because these funds are the ones that really probably, for the most part, have missed out on a lot of this. So they saw what GMO did during the last crash, and they probably said, let's get in there and figure out for the next one. And of course, that means they missed this uptrend because I think GMO has been more defensive. So it's kind of interesting to see who's in that group. I'm sure there's conversations all across the country. Should we pull out of GMO? Oh, but if we do now, that's going to be the top. and I'm sure that's happening quite a bit.

Right, which, yeah, which gets to the point of understanding what you own and why you own it. So if you go into these guys, you have to understand that you're always going to be early. He even says that. As a value investor, you're always going to be early, and that's kind of the way that they've run their business for since the 70s when they started it. So putting some numbers on this, he said, quote, a range of 9 to 18 months from today and a price rise to around 3,400 to 3,700 on the S&P 500, which showed the same 60% gain over 21 months as the least of the other classic bubble events, end quote.

So I took those numbers and I split the difference between nine and 18 months, and I just use 12 months. So if the S&P 500 ends the year at 3,700, which would be a annual gain of 37%, or thereabouts, I'm sorry, I think I actually did the calculation room, but it's close enough. Then it would put the 10-year returns compounded at 17%, which is in the 87th percentile. So 10-year numbers would look damn good, and it still would not do that much to longer-term numbers because we've had two 50% crashes in the last 20 years. So 20-year rolling returns would be at 7.4%, which is actually just the 14th percentile. The crazy thing is, if this did happen, I think it could even go further than he says so

because we haven't had that euphoria to this point. So if we did see a melt-up, I think we could see more people pile in. And so I think it would even go higher than he's predicting. but then he also says, obviously, if this happens, you have the other side where we, what does he give a 90% probability of a 50% crash from there? And so the crazy thing is, I did the little back of the envelope math on that. So he said if we get up to 3,700 on the S&P 500 and we crashed 50%, that would take us down to, what, 1850, which is kind of funny because that would take us back to, you know,

February of 2016, just about, which at that time didn't seem, you know, the stocks had fallen 15%. didn't seem like the end of the world, but obviously, psychologically, that would be hugely scarring because investors anchor to that max value. So if you, right, exactly. If you told somebody in February 2016 that after a 250% run up in the S&P 500 over the previous six years or whatever that number is, that in three years you'll be right back to where you started, I don't think people would be too upset with that. But if the path of that was a bubble and then a 50% crash, holy shit.

that would be, uh, that would, that would hurt. Right. Yeah. So I, I think if we did see this meltup situation where investors once again got sucked in and believed that the future is going to be all roses and everything's fine. And then we had a crash again. I think that would just scar investors, many investors for their lifetime because that'd be three within 20 to 25 years. And that would just be so psychologically damaging, I think, even if the end result isn't the worst case scenario, I don't think. I wonder how much the 1999, situation plays into our psychology today that we think that that's going to repeat. But these bouts of massive public euphoria in public stocks is pretty rare. And it doesn't necessarily

have to look like 1999. We could go our entire lives without seeing another 1999. Right. The fact that people use that as their baseline, it seems, I mean, that's the ultimate extreme where valuations got as high as they've ever been. Yeah, I think so, too, that that's why I think the higher probability is that we don't see that. I think it's possible, but I think you have to, you know, view the extremes that they don't happen all the time, obviously. Otherwise, they wouldn't be extremes. Ben, make up your mind.

Are we melting up or are we not? I wish I could tell you. I have no idea. That's my, that's where I fall on. I know. That's my timestamp. So in Grantham's piece, he actually mentioned something that I read, I think a year ago, which is really good, called Bubbles for Phama.

And there's some really great data that I pulled on that. piece, and the author said that of the 40 bubbles that they identified since 1928, only 21 crashed, implying that, obviously, 19 did not. And the authors defined a bubble as a 100% increase over a two-year period, and then a crash as a 40% decline in a two-year period. So a few more statistics that they gave out and Ben and interrupt me whenever. When they do pop, they typically do so quickly. So in 17 of the 21 episodes in which there is a crash, the industry experienced a single month return of 20% or worse during the drawdown period. So crashes don't have to happen, but when they do, they're pretty damn fast. Yeah, this is interesting. So this is our present to the readers.

We look at these papers from the National Bureau of Economic Research for you. So this was like a 50 or 60 page academic paper. And it was interesting because the bubbles that they identified since the late 20s were all in industries. So they looked at what they say, 40 different bubbles. But yeah, it's interesting the fact that they don't all crash. So if you're expecting, that something happens, that there's nothing in the markets that if A happens, then B will follow. It's never that easy. Yeah, so to your point, if shares in an industry increased by 50%, the probability of a crash over the next two years is only 20%. And a 100% return increased the odds of a crash only to 53%. So even if something doubled in a two-year period, then it only crashed 53% of the time.

So, yeah, these things are certainly not black and white. Does that mean that Bitcoin has a 10,000% chance of crashing with its price gain? Yeah, okay. No time stamp on that one. Michael's shaking us ahead of me. The other one, the other interesting part of this one that they show, which I think this guy probably gets too much praise for when things crash and not in too much derision when things don't is Robert Schiller.

So they said he initially said that stocks were in a bubble in 1996 and prices double. from there. And then when stocks hit their low in 2003 after that long bear market, prices were still higher than when he first called it a bubble. So the whole idea of this paper is that, yes, we can kind of put these price parameters on what a bubble is, but figuring out how far will go and when it'll stop and when it'll crash is basically impossible. I wonder if Schiller makes any adjustments to its portfolio is based on valuations, like his personal portfolio. I highly doubt. He talked a little bit about his personal portfolio when he was on Barry's podcast. And I think he said he keeps it pretty simple, but he, I know every once in a while

he'll talk about how he invests in these low Cape countries in Europe and stuff, but that's a good question. I don't know. I think, and he's more, he gives more context than people put around the headlines around him, but it's interesting that he's used as sort of a scapegoat, you know, for almost everything. Yeah, for everything. But yeah, I guess that that comes with the territory when you actually invent something like this. So speaking of all the high valuations and stuff and people are worried about, you know, what happens when markets get to these levels. There was a good piece by Jonathan Clements at the Humble Dollar, and he talked about what his favorite investment option is for 2018. And he basically laid out three cases for the reason that paying down

mortgage debt is the best investment option you have. And he said, basically part of it is tax reform because we now have higher standard deductions, meaning itemizing your mortgage interest won't have as big of an impact going forward. We have high valuations in the stock market, and then We're going into the, you know, ninth or tenth year of the economic expansion. And so preparing for a recession. So he basically said paying down debt could be one of the smartest moves you make in 2018 because it gives you this known return, whereas everything else is completely unknown. And he specified mortgage debt.

Yes. Yeah. So what say you on this? My knee-jerk reaction is, I don't know why you necessarily do that because if there is a recession and if you were to, say, sell your home over the next few years, then why would you put more money into an asset that is going to fall along with everything else, obsessively, if there is a recession? Yeah, or it's a liquid. I think his audience maybe is more of the retirement community, so maybe it's the idea of

if you're going into retirement, paying down your debt is a good idea so you don't have that obligation. And I guess it's also just a lack of other options. Yeah, so if it's between stocks and your house, maybe paying down debt helps because stocks could fall more in value, but if it's between cash in your house, then obviously cash is more liquid. So I guess it depends on, yeah, what your opportunity set is. Yeah, I think that makes sense. Yeah, especially, again, for older people, I think maybe this is going against the personal finance golden rules. But I think for young people like us, I think in 20 or 30 years, we're going to

look back at the interest rates now and think we should have taken on more debt, which obviously doesn't always make sense for people who can't handle it. But rates are so low now. I don't see the reason to, you know, and I think I've changed my views on this over time, and I'm not, you know, advocating for people to take out more debt. But I think, you know, if you can use it correctly, I think actually, you know, low interest rate debt that we're seeing now, like when my parents bought their first home in the 80s, they were paying double digits on their mortgage. I'm paying three and a quarter or something. It's pretty ridiculous. Yeah, I think that the best investment in 2018 might actually be a variable annuity. Okay. Time stamp on that one. So another piece we read this

week that was speaking of the cape ratio, which we've talked about a little bit, you got a little publicity from Rob Arnaut and some of his colleagues at research affiliates. And this was a great quote. I think this is one of the better quotes you've had. And so Arnaut talked about the cape ratio, which is just this long-term valuation ratio of stocks. And there's always a ton of arguments about it because people can't figure out whether it's the greatest thing ever or it's the worst thing ever. And you were actually used to take the other side of the argument. He was saying it's still valid. And he used a quote from you who said, Comparing the CAPE ratio from 1960 to today is like comparing Oscar Roberts into Russell Westbrook.

Same game, but things have changed. Michael Batnick, C.I.O. Ritholtz wealth management. Yeah, so first of all, thank you for the promotion, Mr. R. Nott. I am not the CIO, Barry Ritholz is. But I would also say, before I get into the details, that I was truly humbled by this. I am a pimple on the pimple of their ass. So to see my name quoted as a naysayer of the cape ratio was really humbling. Yes, that was good. And it's also kind of funny because I think a lot of what gets lost in these arguments is the audience, like who you're trying to reach. And I'm trying to help people that need help, retail investors

who are overwhelmed and bombarded with tons of information and tons of misinformation and research affiliates is talking to institutional clients who manage billions of dollars. So it's really apples to desk chairs. Yeah. So I wrote a piece this week, just saying like 10 things you can expect from that investors can expect in 2018. And I said one of them is the fact that there's going to be 99% of the investment, the geeky investment arguments out there this year are going to be worthless to most people. And I mean, these are the things that we do, but most people can safely ignore them. Having said that, let's now go into this geeky argument and break it down a little bit. Yeah, I mean, I agree with a lot of what they said. I hardly think that valuations

don't matter. The more you pay, the less you should expect to get over the long term. And it's, I It's not, I would never say that higher valuations lead to higher returns, although that's what it seems like these days, but of course, that's ridiculous. So a few of the quotes that I pulled from them, quote, Schiller's research showed that the Cape ratios do not protect future growth rates. He found that some of the strongest mean reversion in the capital markets is between past and future earnings growth rates. We do not think this time will be different. And quote, to that, I would say, neither do I. Another quote, most of the explanations we have discussed for the rise in the Cape ratio are inherently temporary and are subject to the risk of mean reversion. end quote. Again, I agree. And then lastly, the Cape naysayers tend to focus on the reasons why a high cap ratio can support a high return, end quote, no, I do not. So I agree with much of what they say. I guess we would just draw different conclusions. In other words, what I would suggest to most people or the people that I'm trying to talk to is that don't be afraid of the Cape ratio. Don't let it dictate all in or all that decisions. If you think that U.S. stocks are expensive and you feel like holding a long.

little bit more cash or you want to hold a little bit more international stocks. Fine. But do not, for goodness sakes, make these all in all out decisions. And these all in all out decisions are what's usually reported in the headlines. So that's what I'm trying to convey. So I totally agree with research affiliates. And thank you for the shout out. Yes. You heard it here, folks. Michael Batnik setting the record straight for Rob Arnott. So there was another chart going around that I thought was one of the better shorter term performance charts I've seen in a while. and this was from Mark Halbert at the market watch and basically people are trying to figure out what last year means. So last year stocks were up 20 plus percent. You know, what does that mean?

Does that mean stocks this year have to tank? Does that mean stocks this year are going to rise because of momentum? And basically, so he looked at the Dow going back to 1897. And so they looked at, he looked at four different categories. One was all year since 1897. One was the year before the previous market rose. One was whenever the market fell the previous year. and one was whenever the market was up the previous year, at least 20%, which was last year. And basically, if you look at this chart, which I'll post in the show notes, the probability of seeing a gain the following year after any of these situations is almost identical. It's like 65 to 70%.

So basically, the takeaway is whatever happened in 2017, basically has no bearing on what's going to happen in 2018. It's kind of a wash. Basically, stocks are up three out of every four years on average over the long term, and that's about your baseline expectations. Yeah, I guess the tricky thing with this for investors is that we don't live year to year, calendar, year to calendar year, year to calendar, we live week to week month and in some cases day to day, in terms of surviving portfolio returns and such. Yes, exactly, right. And so just a changing of the calendar doesn't really change much, you know, of anything. It's just, it's just a different date. Okay, so speaking of the Dow, last week, the Dow top 25,000, and the Wall Street Journal had a really long article.

as Dow tops 25,000 individual investors sit out. And I thought that there was a lot of weird anecdotes in there. So one of the quotes that I pulled was, as baby boomers near retirement age, many are pairing back positions in riskier equity funds in favor of more stable holdings such as bonds following the advice of most financial planners. I don't really know where, end quote, I don't really know where they pulled that from because I'm not sure that that's, you know, obviously speak to your financial advisor about this. It's different for everybody.

but as people are living longer, you can expect a lot of these people to have a 30-year retirement and bonds are not going to get it done. If you need your money to grow, there's risk whatever you do. You cannot eliminate risk. So you either eliminate volatility in the short term by holding more bonds, which will put you at a much greater risk of running out of money, or you take a little risk, your portfolio fluctuating more, and you being able to potentially pay the bills over the the course of your retirement. Right. It's, it's when do you want to feel comfortable now or later? And like you said, there's risks either way. But the unfortunate predicament that we're in right now is the fact that to earn returns over the inflation rate, you're going to have to

accept some volatility. And that means for retirees as well, you can't just put it in a five or six percent treasury like you could in the 80s and 90s, and you'd been fine. That doesn't exist today. But these pieces are always kind of funny to me because there seem to be based on anecdotal data surveys. And so it's always really hard because people really want to blame mom and pop investor for everything. You know, the retail investors are the idiots driving this market higher. And then in the same breath, we see another article that says the retail investors have set this out. So it's always kind of difficult to figure out exactly, you know, how much people are invested in and whatnot, because it's impossible. But you can't blame a group like this because

institutional capital, they're the ones who push the markets around, not little mom and pop retail investor. They're on the margin these days. there's another anecdote in there, same line of thinking. Quote, I'm 10 years from retirement, so I'm being more cautious, said Jeffrey Lee Shant, a 58-year-old architect in Boston, who has put what he considers to be his nest egg into, quote, very conservative investments, including fixed income funds, end quote. Again, they, you know, they found a person to quote, but this, I don't know if this is necessarily representative for everybody, and this person is potentially in for a rude awakening when he sees it. He's getting two to three percent nominal on his

bonds. This is like the people that try to gauge sentiment from social media. Again, that's impossible because your sample size is so small. So whatever you see, you're going to extrapolate. And there's just so many different investors out there these days, especially since markets are global. It's impossible to gauge what's going on based on a few stories and sentiment indicators. It just doesn't work like that anymore. Yeah. And then Bloomberg had an article, maybe two days later, showing that retail investors are all in. And that was pointed out by our friend DeConomic on Twitter. So, yeah, I think to use these anecdotes and sort of to gain an edge is just beyond absurd. It's really hard to know how much retail investor is or is not invested.

And I don't think people should be worrying about that. Yeah. So the other thing people can do that are really worried about the markets and people are talking about getting conservative or going along the markets, you know, the biggest thing that we always talk about is just you're probably going to have to save more money. And so there was an article in Market Watch. And this was done by a guy named Derek Tharp who works with Michael Kitts. and they basically looked at is it going to be enough and there's obviously a lot of different

parameters you have to use for this but they try to figure out is saving 10% of your salary enough to save for retirement based on you know if everyone keeps their lifestyle the same and it's because it's easy for people to just pick a double digit rate and say save this much and you should be fine and obviously depends on your lifestyle but they actually found that saving just 10% alone for retirement every year probably would not get the job done and so basically they decided the way it works with the tournament calculators is you put a stat in and it assumes you grow your salary by the inflation rate every year. But the problem is most of your salary upticks come early in your career and by the end it kind of plateaus. So you're not getting

those big kick-ins at the end. And that's when it really matters the most for how much you save because that's when you make the most. So anyway, it's kind of interesting. Basically, their advice was, you know, you have to ratchet up your savings rate a little bit every year to keep up with inflation and maybe even beat inflation. So that was kind of interesting. It's not as easy as just picking a percentage and everything's going to be fine. All right, so let's move on to the end of the show. I assume that you were pretty light on watching reading, listening this week because you were in bed with the flu. Yeah.

By the way, I found out this. I think by my estimation, the flu shot this year has a negative 26% effective rate. That's what I'm giving it anyway. So since I didn't really watch much, I was in bed, I do have a new form of consuming entertainment. though so for christmas i got a pair of air pods those are the wireless apple pot apple headphones and they're not very fashionable i will say that but they are pretty sweet and so i listen to a lot of podcasts and the ability to use them in the car so listening to a podcast and i drive i get to work i can pop those in continue listening while i come into my office and get things ready and put them in

while i work out they actually don't fall out because i'm the guy at the gym who spends 10 minutes every time detangling headphones. So just that, even though they look kind of weird and futuristic, I highly recommend those. Those are one of the coolest little technologies that I've gotten in a long time. Okay. Interesting. Yeah, so I watched, this weekend, I watched Mudbound on Netflix, and it was a movie about post-World War II and racism in Mississippi, and it was definitely slow at first,

and it was really hard to watch parts of it, like the Ku Klux Klan and all the shit that was going on down there. It was very powerful and moving, and I'm not sure that I, like, highly recommend because, like I said, it was sort of tough to get through because it was slow in the beginning and then just... Any big actors in that or actresses? Mary J. Blige was actually really, really good. Oh, interesting.

And the dude from Zero Dark 30, who was also in The Last Terminator, I forget his name. Oh, yeah, yeah, yep. Oh, and Mike from Breaking Bad was the racist father, and he was a vile character, but great acting. Yeah, I always have a hard time watching those things, but I know we have to, but it's...

The crazy thing to me is, like, that wasn't that long ago, right? that the fact that this stuff happened and it was not that long ago, it's, it kind of boggles a mind. Yeah, there's a piece where it's just like, I can't even believe that these are people. Right. Yeah, it's disgusting. Yeah.

So then I also, I binge read the book that you recommended, the Stephen Johnson, how we got to now six innovations that made the modern world. And I didn't recognize that name. I'm not sure why. But I read a book of his a year ago that Josh recommended, the invention of air. Did you read that one? No, I haven't. I don't have to put it on the list because I do like him.

Yeah, that was pretty. good, but this one was way better. This book was amazing. Definitely one of the better books I've read in a long time. And there was just so much amazing stuff in there. Like, they talked about how they would lift buildings in Chicago, like literally lift buildings to put sewers underneath. Oh, yeah, I forgot about that. That was pretty sweet. And the story about how this one guy would ship ice from New England to the tropical continents, and he thought he was going to make a killing. And then when he got there, the natives were like, what do we do with this? Right. Yeah, they didn't know what ice was. Right. And then, uh, in terms of like how light changed the world, I

I had no idea that sperm whales had 500 gallons of oil in their brains, and people would literally dive inside their brains and pick it out so that people could light candles and not get smoke all over their faces. Yeah, and I'm sure those people smelled really good, too. Yeah. So, anyway, cannot recommend that book enough. Really, really great. So thank you for listening. We will catch you next week. Thank you.