January 2019 Data Update 1: A reminder that equities are risky, in case you forgot!

In bull markets, investors, both professional and amateur, often pay lip service to the notion of risk, but blithely ignore its relevance in both asset allocation and stock selection, convinced that every dip in stock prices is a buying opportunity, and soothed by bromides that stocks always win in the long term. It is therefore healthy, albeit painful, to be reminded that the risk in stocks is real, and that there is a reason why investors earn a premium for investing in equities, as opposed to safer investments, and that is the message that markets around the world delivered in the last quarter of 2018.

A Look Back at 2018

The stock market started 2018 on a roll, having posted nine consecutive up years, making the crisis of 2008 seem like a distant memory. True to form, stocks rose in January, led by the FAANG (Facebook, Amazon, Apple, Netflix and Google) stocks and momentum investors celebrated. The first wake up call of the year came in February, first as the market responded negatively to macroeconomic reports of higher inflation, and then as Facebook and Google stumbled from self-inflicted wounds. 

The market shook off its tech blues by the end of March and continued to rise through the summer, with the S&P 500 peaking for the year at 2931 on September 20, 2018.   For the many investors who were already counting their winnings for the year, the last quarter of 2018 was a shock, as volatility returned to the market with a vengeance. In October, the S&P 500 dropped by 6.94%, though it felt far worse because of the day-to-day and intraday price swings. In November, the S&P 500 was flat, but volatility continued unabated. In December, US equities finally succumbed to selling pressures, as a sharp selloff pushed stocks close to the "bear market" threshold, before recovering a little towards the end of the year.  

Over the course of the year, every major US equity index took a hit, but the variation across the indices was modest.

The ranking of returns, with the S&P 600 and the NASDAQ doing worse than the Dow or the SD&P 500 is what you would expect in any down market. With dividends incorporated, the return on the S&P 500 was -4.23%, the first down market in a decade, but only a modestly bad year by historical standards:

I know that this is small consolation, if you lost money last year, but looking at annual returns on stocks in the last 90 years, there have been twenty years with more negative returns. In short, it was a bad year for stocks, but it felt far worse for three reasons. First, after nine good years for the market, investors were lulled into a false sense of complacency about the capacity of stocks to keep delivering positive returns. Second,  the negative returns were all in the last quarter of the year, making the hit seem larger (from the highs of September 2018) and more immediate. Third,  the intraday and day-to-day volatility exacerbated the fear factor, and those investors who reacted by trading faced far larger losses.

The Equity Risk Premium

If you have been a reader of this blog, you know that my favorite device for disentangling the mysteries of the market is the implied equity risk premium, an estimate of the price that investors are demanding for the risk of investing in equities. I back this number out from the current market prices and expected future cash flows, an IRR for equities that is analogous to the yield to maturity on a bond:

As with any measure of the market, it requires estimates for the future (expected cash flows and growth rates), but it is not only forward looking and dynamic (changing as the market moves), but also surprisingly robust and comprehensive in its coverage of fundamentals. 

At the start of 2018, I estimated the equity risk premium, using the index at that point in time (2673.61), the 10-year treasury bond rate on that day (2.41%) and the growth rate that analysts were projecting for earnings for the index (7.05%). 

The equity risk premium on January 1, 2018 was 5.08%. As we moved through the year, I computed the equity risk premium at the start of each month, adjusting cash flows on a quarterly basis (which is about as frequently as S&P does it) and using the index level and ten-year T.Bond rate at the start of each month:

While the conventional wisdom about equity risk premiums is the they do not change much on a day to day basis in developed markets, that has not been true since 2008. In 2018, there were two periods, the first week of February and the month of October, where volatility peaked on an intraday basis, and I computed the ERP by day, during the first week of February, and all through October:

During October, for instance, the equity risk premium moved from 5.38% at the start of the month to 5.76% by the end of the month, with wide swings during the course of the month.

After a brutal December, where stocks dropped more than 9% partly on the recognition that global economic growth may slacken faster than expected, I recomputed the equity risk premium at the start of 2019:

The equity risk premium has increased to 5.96%, but a closer look at the differences between the inputs at the start and end of the year indicates how investor perspectives have shifted over the course of the year:

Going into 2019, investors are clearly less upbeat than they were in 2018 about future growth and more worried about future crises, but companies are continuing to return cash at a pace that exceeds expectations.

What now?

I know that you are looking for a bottom line here on whether the numbers are aligned for a good or a bad year for stocks, and I will disappoint you up front by admitting that I am a terrible market timer. As an intrinsic value investor, the only market-related question that I ask is whether I find the current price of risk (the implied ERP) to be an acceptable one; if it is too low for my tastes, I would shift away from stocks, and if it is too high, shift more into them. To gain perspective, I graphed the implied ERP from 1960 through 2018 below:

At its current level of 5.96%, the equity risk premium is in the top decile of historical numbers, exceeded only by the equity risk premiums in three other years, 1979, 2009 and 2011. Viewed purely on that basis, the equity market is more under valued than over valued right now.

I am fully aware of the dangers that lurk and how they could quickly change my assessment and they can show up in one or more of the inputs:

1. Recession and lower growth: While there was almost no talk about a possible recession either globally or in the US, at the start of 2018, some analysts, albeit a minority, are raising the possibility that the economy would slow down enough to push it into recession, at the start of 2019. While the lower earnings growth used in the 2019 computation already incorporates some of this worry, a recession would make even the lower number optimistic. In the table below, I have estimated the effect on the equity risk premium of lower growth, and  note that even with a compounded growth rate of -3% a year for the next five years, the ERP stays above the historical average of 4.19%.
   
2. Higher interest rates: The fear of the Fed has roiled markets for much of the last decade, and while it has played out as higher short term interest rates for the last two years, the ten-year bond rate, after a surge over 3% in 2018, is now back to 2.68%. There is the possibility that higher inflation and economic growth rate can push this number higher, but it is difficult to see how this would happen if recession fears pan out. In fact, as I noted in this post from earlier in the year, higher interest rates, if the trigger is higher real growth (and not higher inflation), could be a positive for stocks, not a negative.
3. Pullback on cash flows: US companies have been returning huge amounts of cash in the form of stock buybacks and dividends. In 2018, for instance, dividends and buybacks amounted to 92% of aggregate earnings, higher than the 84.60% paid out, on average, between 2009 and 2018, but still lower than the numbers in excess of 100% posted in 2015 and 2016. Assuming that the payout will adjust over time to 85.07%, reflecting expected long term growth, lowers the ERP to 5.55%, still well above historical levels.
4. Political and Economic Crises: The trade war and the Brexit mess will play out this year and each has the potential to scare markets enough to justify the higher ERP that we are observing. In addition, it goes without saying that there will be at least a crisis or two that are not on the radar right now that will hit markets, an unwanted side effect of globalization. 

Looking at how the equity risk premium will be affected by each of these variables, I think that the market has priced in already for shocks on at least two of these variables, in the form of lower growth and political/economic crises, and can withstand fairly significant bad news on the other two. 

Bottom Line

I have long argued that it is better to be transparently wrong than opaquely right, when making investment forecasts. In keeping with my own advice, I believe that stocks are more likely to go up in 2019, than down, given the information that I have now. That said, if I am wrong, it will be because I have under estimated how much economic growth will slow in the coming year and the magnitude of economic crises. Odds are that I will see the tell tale signs too late to protect myself fully against any resulting market corrections, but that is not my game anyway. 

YouTube Video

Datasets

1. Historical Returns on Stocks, Bonds and Bills - 1928 to 2018
2. Historical Implied Equity Risk Premiums for US - 1960 to 2018

Spreadsheets

1. Implied ERP for January 1, 2019

January 2019 Data Updates

1. Data Update 1: A Reminder that equities are risky, in case you forgot!
2. Data Update 2: The Message from Bond Markets
3. Data Update 3: Playing the Numbers Game
4. Data Update 4: The Many Faces of Risk
5. Data Update 5: Of Hurdle Rates and Funding Costs!
6. Data Update 6: Profitability and Value Creation!
7. Data Update 7: Debt, neither poison nor nectar!
8. Data Update 8: Dividends and Buybacks - Fact and Fiction!
9. Data Update 9: Playing the Pricing Game!

Is there a signal in the noise? Yield Curves, Economic Growth and Stock Prices!

The title of this post is not original and draws from Nate Silver's book on why so many predictions in politics, sports and economics fail. It reflects the skepticism with which I view many 'can't fail" predictors of economic growth or stock markets, since they tend to have horrendous track records. Over the last few weeks, as markets have gyrated, market commentators have been hard pressed to explain day-to-day swings, but that has not stopped them from trying. The explanations have shifted and morphed, often in contradictory ways, but few of them have had staying power. On Tuesday (December 4), as the Dow dropped 800 points, following a 300-point up day on Monday, the experts found a new reason for the market drop, in the yield curve, with an "inverted yield curve", or at least a portion of one, predicting an imminent recession. As with all market rules of thumb, there is some basis for the rule, but there are shades of gray that can be seen only by looking at all of the data.

Yield Curves over time

The yield curve is a simple device, plotting yields across bonds with different maturities for a given issuing entity. US treasuries, historically viewed as close to default free, provide the cleanest measure of the yield curve,  and the graph below compares the US treasury yield curve at the start of every year from 2009 to 2018, i.e., the post-crisis years:

Treasury.gov: Daily Treasury yield curve

The yield curve has been upward sloping, with yields on longer term maturities higher than yields on short term maturities, every year, but it has flattened out the last two years. On December 4, 2018, the yields on treasuries of different maturities were as follows:

Treasury.gov: Daily Treasury yield curve

The market freak out is in the highlighted portion, with 5-year rates being lower (by 0.01-0.02%) than 2-year or 3-year rates, creating an inverted portion of the yield curve. 

Yield Curves and Economic Growth: Intuition

To understand yield curves, let's start with a simple economic proposition. Embedded in every treasury rate are expectations of expected inflation and expected real real interest rates, and the latter

Interest Rate = Expected Inflation Rate + Expected Real Interest Rate

Over much of the last century, the US treasury yield curve has been upward sloping, and the standard economic rationalization for it is a simple one. In a market where expectations of inflation are similar for the short term and the long term, investors will demand a "maturity premium" (or a higher real interest rate) for buying longer term bonds, thus causing the upward tilt in the yield curve.  That said, there have been periods where the yield curve slopes downwards, and to understand why this may have a link with future economic growth, let's focus on the mechanics of yield curve inversions. Almost every single yield curve inversion historically, in the US,  has come from the short end of the curve rising significantly, not a big drop in long term rates. Digging deeper, in almost every single instance of this occurring, short term rates have risen because central banks have hit the brakes on money, either in response to higher inflation or an overheated economy. You can see this in the chart below, where the Fed Funds rate (the Fed's primary mechanism for signaling tight or loose money) is graphed with the 3 month, 2 year and 10 year rates:

Interest Rate Raw Data

As you can see in this graph, the rises in short term rates that give rise to each of the inverted yield curve episodes are accompanied by increases in the Fed Funds rate. To the extent that the Fed's monetary policy action (of raising the Fed funds rate) accomplishes its objective of slowing down growth, the yield slope metric becomes a stand-in for the Fed effect on the economy, with a more positive slope associated with easier monetary policy. You may or may not find any of these hypotheses to be convincing, but the proof is in the pudding, and the graph below, excerpted from a recent Fed study, seems to indicate that there has been a Fed effect in the US economy, and that the slope of the yield curve has operated as proxy for that effect:

Federal Reserve of San Francisco

The track record of the inverted yield curve as a predictor of recessions is impressive, since it has preceded the last eight recessions, with only only one false signal in the mid-sixties. If this graph holds, and December 4 was the opening salvo in a full fledged yield curve invasion, the US economy is headed into rough waters in the next year.

Yield Curves and Economic Growth: The Data

The fact that every inversion in the last few decades has been followed by a recession will strike fear into the hearts of investors, but is it that fool proof a predictor? Perhaps, but given that the yield curve slope metrics and economic growth are continuous, not discrete, variables, a more complete assessment of the yield curve's predictive power for the economy would require that we look at the strength of the link between the slope of the yield curve (and not just whether it is inverted or not) and the level of economic growth (and not just whether it is positive or negative).

To begin this assessment, I looked at the rates on  three-month and one-year T.Bills and the two, five and ten-year treasury bonds at the end of every quarter from 1962 through the third quarter of 2018:

Interest Rate Raw Data

Following up, I look at five yield curve metrics (1 year versus 3 month, 2 year versus 3 month, 5 year versus 2 year, 10 year versus 2 year and 10 year versus 3 month), on a quarterly basis from 1962 through 2018, with an updated number for December 4, 2018. 

Interest Rate Raw Data

For the most part, the yield curve metrics move together, albeit at different rates. I picked four measures of the spread, one short term (1 year versus 3 month), one medium term (5 year versus 2 year) and two long term (10 year versus 2 year, 10 year versus 3 month) and plotted them against GDP growth in the next quarter and the year after. 

Interest Rate Raw Data

The graph does back up what the earlier Fed study showed, i.e., that negatively sloped yield curves have preceded recessions, but even a cursory glance indicates that the relationship is weak. Not only does there seem to be no relationship between how downwardly sloped the yield curve is and the depth of the recessions that follow, but in periods where the yield curve is flat or mildly positive, subsequent economic growth is unpredictable. To get a little more precision into the analysis, I computed the correlations between the different yield curve slope metrics and GDP growth:

Taking a closer look at the data, here is what I see;

1. It is the short end that has predictive power for the economy: Over the entire time period (1962-2018), the slope of the short end of the yield curve is positively related with economic growth, with more upward sloping yield curves connected to higher economic growth in subsequent time periods. The slope at the long end of the yield curve, including the widely used differential between the 10-year and 2-year rate not only is close to uncorrelated with economic growth (the correlation is very mildly negative).
2. Even that predictive power is muted: Over the entire time period, even for the most strongly linked metric (which is the 2 year versus 1 year), the correlation is only 29%, for GDP growth over the next year, suggesting that there is significant noise in the prediction. 
3. And 2008 may have been a structural break: Looking only at the last ten years, the relationship seems to have reversed sign, with flatter yield curves, even at the short end, associated with higher real growth. This may be a hangover from the slow economic growth in the years after the crisis, but it does raise red flags about using this indicator today.

How do you reconcile these findings with both the conventional wisdom that inverted yield curves are negative indicators of future growth and the empirical evidence that almost every inversion is followed by a recession? It is possible that it is the moment of inversion that is significant, perhaps as a sign of the Fed's conviction, and that while the slope of the yield curve itself may not be predictive, that moment that the yield curve inverts remains a strong indicator. 

Yield Curves and Stock Returns

As investors, your focus is often less on the economy, and more on stock prices. After all, strong economies don't always deliver superior stock returns, and weak ones can often be accompanied by strong market performance. From that perspective, the question becomes what the slope of the yield curve and inverted yield curves tell you about future stock returns,  not economic growth. I begin the analysis by looking at yield curve metrics over time, graphed against return on US stocks in the next quarter and the next year:

Interest Rate Raw Data

If you see a pattern here, you are a much better chart reader than I am. I therefore followed up the analysis by replicating the correlation table that I reported in the economic growth section, but looking at stock returns in subsequent periods, rather than real GDP growth:

As with the economic growth numbers, if there is any predictive power in the yield curve slope, it is at the short end of the curve and not the long end. And as with the growth numbers, the post-2008 time period is a clear break from the overall numbers.

What does all of this mean for investors today? I think that we may be making two mistakes. One is to take a blip on a day (the inversion in the 2 and 5 year bonds on December 4) and read too much into it, as we are apt to do when we are confused or scared. It is true that a portion of the yield curve inverted, but if history is any guide, its predictive power for the economy is weak and for the market, even weaker. The other is that we are taking rules of thumb developed in the US in the last century and assuming that they still work in a  vastly different economic environment. 

Bottom Line

There is information in the slope of the US treasury yield curve, but I think that we need to use it with caution. In my view, the flattening of the yield curve in the last two years has been more good news than bad, an indication that we are coming out of the low growth mindset of the post-2008 crisis years. However, I also think that the stalling of the US 10-year treasury bond rate at 3% or less is sobering, a warning that investors are scaling back growth expectations for both the global and US economies, going into 2019. The key tests for stocks lie in whether they can not only sustain earnings growth, in the face of slower economic growth and without the tailwind of a tax cut (like they did last year), but also in whether they can continue to return cash at the rates that they have for the last few years.

YouTube Video


Data

1. Raw data on US treasury rates, GDP growth and Stock Returns

Interest Rates and Stock Prices: It's Complicated!

Jerome Powell, the new Fed Chair, was on Capitol Hill on February 27, and his testimony was, for the most part, predictable and uncontroversial. He told Congress that he believed that the economy had strengthened over the course of the last year and that the Fed would continue on its path of "raising rates". Analysts have spent the next few days reading the tea leaves of his testimony, to decide whether this would translate into three or four rate hikes and what this would mean for stocks. In fact, the blame for the drop in stocks over the last four trading days has been placed primarily on the Fed bogeyman, with protectionism providing an assist on the last two days. While there may be an element of truth to this, I am skeptical about any Fed-based arguments for market increases and decreases, because I disagree fundamentally with many about how much power central banks have to set interest rates, and how those interest rates affect value.

1. The Fed's power to set interest rates is limited

I have repeatedly pushed back against the notion that the Fed or any central bank somehow sets market interest rates, since it really does not have the power to do so. The only rate that the Fed sets  directly is the Fed funds rate, and while it is true that the Fed's actions on that rate send signals to markets, those signals are fuzzy and do not always have predictable consequences. In fact, it is worth noting that the Fed has been hiking the Fed Funds rate since December 2016, when Janet Yellen's Fed initiated this process, raising the Fed Funds rate by 0.25%. In the months since, the effects of the Fed Fund rate changes on long term rates is debatable, and while short term rate have gone up, it is not clear whether the Fed Funds rate is driving short term rates or whether market rates are driving the Fed.

It is true that post-2008, the Fed has been much more aggressive in buying bonds in financial markets in its quantitative easing efforts to keep rates low. While that was  started as a response to the financial crisis of 2008, it continued for much of the last decade and clearly has had an impact on interest rates. To those who would argue that it was the Fed, through its Fed Funds rate and quantitative easing policies that kept long term rates low from 2008-2017, I would beg to differ, since there are two far stronger fundamental factors at play - low or no inflation and anemic real economic growth. In the graph below, I have the treasury bond rate compared to the sum of inflation and real growth each year, with the difference being attributed to the Fed effect:

Download spreadsheet with raw data

You have seen me use this graph before, but my point is a simple one. The Fed is less rate-setter, when it comes to market interest rates, than rate-influencer, with the influence depending upon its credibility. While rates were low in the 2009-2017 time period, and the Fed did play a role (the Fed effect lowered rates by 0.77%), the primary reasons for low rates were fundamental. It is for that reason that I described the Fed Chair as the Wizard of Oz, drawing his or her power from the perception that he or she has power, rather than actual power. That said, the Fed effect at the start of 2018, as I noted in a post at the beginning of the year, is larger than it has been at any time in the last decade, perhaps setting the stage for the tumult in stock and bond markets in the last few weeks. 

To examine more closely the relationship between moves in the Fed Funds rate and treasury rates, I collected monthly data on the Fed Funds rate, the 3-month US treasury bill rate and the US 10-year treasury bond rate every month from January 1962 to February 2018. The raw data is at the link below, but I regressed the changes in both short term and long term treasuries against changes in the Fed funds rate in the same month:

Looking at these regressions, here are some interesting conclusions that emerge:

1. Short term T.Bill rates and the Fed Funds rate move together strongly: The result backs up the intuition that the Fed Funds rate and the short term treasury rate are connected strongly, with an R-squared of 56.5%; a 1% increase in the Fed Funds rate is accompanied by a 0.62% increase in the T.Bill rate, in the same month. Note, though, that this regression, by itself, tells you nothing about the direction of the effect, i.e., whether higher Fed funds rates lead to higher short term treasury rates or whether higher rates in the short term treasury bill market lead the Fed to push up the Fed Funds rate. 
2. T.Bond rates move with the Fed Funds rate, but more weakly: The link between the Fed Funds rate and the 10-year treasury bond rate is mush weaker, with an R-squared of 6.7%; a 1% increase in the Fed Funds rate is accompanied by a 0.19% increase in the 10-year treasury bond rate. 
3. T. Bill rates lead, Fed Funds rates lag: Regressing changes in Fed funds rates against changes in T.Bill rates in the following period, and then reversing direction and regressing changes in T.Bill rates against changes in the Fed Funds rate in the following period, provide clues to the direction of the relationship. At least over this time period, and using monthly changes, it is changes in T.Bill rates that lead changes in Fed Funds rates more strongly, with an R squared of 23.7%, as opposed to an R-squared of 9% for the alternate hypothesis. With treasury bond rates, there is no lagged effect of Fed funds rate changes (R squared of zero), while changes in T.Bond rates do predict changes in the Fed Funds rate in the subsequent period. The Fed is more a follower of markets, than a leader. 

The bottom line is that if you are trying to get a measure of how much treasury bond rates will change over the next year or two, you will be better served focusing more on changes in economic fundamentals and less on Jerome Powell and the Fed.

2. The relationship between interest rates and stock market value is complicated

When interest rates go up, stock prices should go down, right? Though you may believe or have been told that the answer is obvious, that higher interest rates are bad for stock prices, the answer is not straight forward. To understand why people are drawn to the notion that higher rates are bad for value, all you need to do is go back to the drivers of stock market value:

As you can see in this picture, holding all else constant, and raising long term interest rates, will increase the discount rate (cost of equity and capital), and reduce value. That assessment, though, is built on the presumption that the forces that push up interest rates have no effect on the other inputs into value - the equity risk premium, earnings growth and cash flows, a dangerous delusion, since these variables are all connected together to a macro economy.

Note that almost any macro economic change, whether it be a surge in inflation, an increase in real growth or a global crisis (political or economic) affects earnings growth, T.Bond rates and the equity risk premiums, making the impact on value indeterminate, until you have worked through the net effect. To illustrate the interconnections between earnings growth rates, equity risk premiums and macroeconomic fundamentals, I looked at data on all of the variables going back to 1961:

Download spreadsheet with raw data

The co-movement in the variables and their sensitivity to macro economic fundamentals is captured in the correlation table. Higher inflation, over this period, is accompanied by higher earnings growth but also increases equity risk premiums and suppresses real growth, making its net effect often more negative than positive. Higher real economic growth, on the other hand, by pushing up earnings growth rate and lowering equity risk premiums, has a much more positive effect on value.

3. Value has to be built around a consistent narrative

In my post from February 10, right after the last market meltdown, I offered an intrinsic valuation model for the S&P 500, with a suggestion that you fill in your inputs and come up with your own estimate of value. Some of you did take me up on my offer, came up with inputs, and entered them into a shared Google spreadsheet and, in your collective wisdom, the market was overvalued by about 3.34% in mid-February. While making assumptions about risk premiums, earnings growth and the treasury bond rate, I should have emphasized the importance of narrative, i.e., the macro and market story that lay behind your numbers, since without it, you can make assumptions that are internally inconsistent. To illustrate, here are two inconsistent story lines that I have seen in the last few weeks, from opposite sides of the spectrum (bearish and bullish).

• In the bearish version, which I call the Interest Rate Apocalypse, all of the inputs (earnings growth for the next five years and beyond, equity risk premiums) into value are held constant, while raising the treasury bond rate to 4% or 4.5%. Not surprisingly, the effect on value is calamitous, with the value dropping about 20%. While that may alarm you, it is unclear how the analysts who tell this story explain why the forces that push interest rates upwards have no effect on earnings growth, in the next 5 years or beyond, oron  equity risk premiums.
• In the bullish version, which I will term the Real Growth Fantasy, all of the inputs into value are left untouched, while higher growth in the US economy causes earnings growth rates to pop up. The effect again is unsurprising, with value increasing proportionately. 

While neither of these narratives is fully worked through, there are three separate narratives about the market that are all internally consistent, that can lead to very different judgments on value.

• More of the same: In this narrative, you can argue that, as has been so often the case in the last decade, the breakout in the US economy will be short lived and that we will revert back the low growth, low inflation environment that developed economies have been mired in since 2008. In this story, the treasury bond rate will stay low (2.5%), earnings growth will revert back to the low levels of the last decade (3.03%) after the one-time boost from lower taxes fades, and equity risk premiums will stay at post-2008 levels (5.5%). The index value that you obtain is about 2250, about 16.4% below March 2nd levels.

  

  Download spreadsheet

• The Return of Inflation: In this story line, inflation returns, though how the story plays out will depend upon how much inflation you foresee. That higher inflation rate will translate into higher earnings growth, though the effect will vary across companies, depending upon their pricing power, but it will also cause T. Bond rates to rise. If the inflation rate in the story is a high one (3% or higher), the equity risk premium may also rise, if history is any guide. With an inflation rate of 3% and an equity risk premium of 6%, the index value that you obtain is about 2133, about 20.7% below March 2nd levels.

  

  Download spreadsheet

• The Growth Engine Revs Up: In this telling, it is real growth in the US economy that surges, creating tailwinds for growth in the rest of the world. That higher real growth rate, while pushing up earnings growth for US companies (to 8% for the near term), will also increase treasury bond rates (to 3.5%), as in the inflation story, but unlike it, equity risk premiums will drift back to pre-2008 levels (closer to 4.5%). The index value that you obtain is about 3031, about 12.7% above March 2nd levels.

  

  Download spreadsheet

• A Melded Version: I believe in a melded version of these stories, where inflation returns (but stays around 2%) and real growth in the economy increases, but only moderately. That will translate into higher treasury bond rates (my guess would be 3.5%), with a proportionate increase in earnings growth (at least in steady state) and an equity risk premium of 5%, splitting the difference between pre-crisis and post-crisis periods. The index value that I obtain, with these assumptions, is about 2610, about 3.1% below March 2nd levels.

Download spreadsheet

You can see, even from this limited list of scenarios, that to assess how stock prices will move, as interest rates change, you have to also make a judgment on why interest rates are moving. An inflation-driven increase in interest rates is net negative for stocks, but a real-growth driven increase in interest rates is a net positive. In fact, the scenario where interest rates go down sees a much bigger drop in value than two of three scenarios, where interest rates rise. 

The Bottom Line

When macro economic fundamentals change, markets take time to adjust, translating into market volatility. During these adjustment periods, you will hear a great deal of market punditry and much of it will be half baked, with the advisor or analyst focusing on one piece of the valuation puzzle and holding all else constant. Thus, you will read predictions about how much the market will drop if treasury bond rates rise to 4.5% or how much it will rise if earnings growth is 10%. I hope that this post has given you tools that you can use to fill in the rest of the story, since it is possible that stocks could actually go up, even if rates go up to 4.5%, if that rate rise is precipitated by a strong economy, and that stocks could be hurt with 10% earnings growth, if that growth comes mostly from high inflation. I also hope that, after you have listened to the narratives offered by others, for what markets will or will not do, that you start developing your own narrative for the market, as the basis for your investment decisions. You've seen my narrative, but I will leave the feedback loop open, as fresh data on inflation and growth comes in, and I plan to revisit my narrative, tweaking, adjusting or even abandoning it, if the data leads me to. 

YouTube Video

Data Links

1. T.Bond Rates, Inflation and Real GDP Growth - 1954-2017
2. Fed Funds Rate and Treasury Rates - 1962-2017
3. T.Bond Rates, Earnings Growth Rates and ERP - 1961- 2017

Spreadsheet Links

1. Intrinsic Valuation Spreadsheet for S&P 500
2. More of the Same: Spreadsheet
3. The Return of Inflation: Spreadsheet
4. The Growth Engine Revs Up: Spreadsheet
5. The Melded Version: Spreadsheet

Blog Post Links

1. Testing Times: Market Turmoil and Investment Serenity

Superman and Stocks: It's not the Cape (CAPE), it's the Kryptonite(Cash flow)!

Just about a week ago, I was on a 13-hour plane trip from Tokyo to New York. I know that this will sound strange but I like long flights for two reasons. The first is that they give me extended stretches of time when I can work without interruption, no knocks on the door or email or phone calls. I readied my lecture notes for next semester and reviewed and edited a manuscript for one of my books in the first half on the trip. The second is that I can go on movie binges with my remaining time, watching movies that I would have neither the time nor the patience to watch otherwise. On this trip, however, I made the bad decision of watching Batman versus Superman, Dawn of Justice, a movie so bad that the only way that I was able to get through it was by letting my mind wander, a practice that I indulge in frequently and without apologies or guilt. I pondered whether Superman needed his suit or more importantly, his cape, to fly. After all, his powers come from his origins (that he was born in Krypton) and not from his outfit and the cape seems to be more of an aerodynamic drag than an augmentation. These deep thoughts about Superman's cape then led me to thinking about CAPE, the variant on PE ratios that Robert Shiller developed, and how many articles I have read over the last decade that have used this measure as the basis for warning me that stocks are headed for a fall. Finally, I started thinking about Kryptonite, the substance that renders Superman helpless, and what would be analogous to it in the stock market. I did tell you that I have a wandering mind and so, if you don't like Superman or stocks, consider yourself forewarned!

The Stock Market’s CAPE

As stocks hit one high after another, the stock market looks like Superman, soaring to new highs and possessed of super powers.

There are many who warn us that stocks are overheating and that a fall is imminent. Some of this worrying is natural, given the market's rise over the last few years, but there are a few who seem to have surrendered entirely to the notion that stocks are in a bubble and that there is no rational explanation for why investors would invest in them. In a post from a couple of years ago, I titled these people as  bubblers and classified them into doomsday, knee jerk, conspiratorial, righteous and rational bubblers. The last group (rational bubblers) are generally sensible people, who having fallen in love with a market metric, are unable to distance themselves from it.

One of the primary weapons that rational bubblers use to back up their case is the Cyclically Adjusted Price Earnings (CAPE), a measure developed and popularized by Robert Shiller, Nobel prize winner whose soothsaying credentials were amplified by his calls on the dot com and housing bubbles. For those who don’t quite grasp what the CAPE is, it is the conventional PE ratio for stocks, with two adjustments to the earnings. First, instead of using the most recent year’s earnings, it is computed as the average earnings over the prior ten years. Second, to allow for the effects of inflation, the earnings in prior years is adjusted for inflation.  The CAPE case against stocks is a simple one to make and it is best seen by graphing Shiller’s version of it over time.

Shiller CAPE data (from his site)

The current CAPE of 27.27 is well above the historic average of 16.06 and if you buy into the notion of mean reversion, the case makes itself, right? Not quite! As you can see, even within the CAPE story, there are holes, largely depending upon what time period you use for your averaging. Relative to the fully history, the CAPE looks high today, but relative to the last 20 years, the story is much weaker. Contrary to popular view, mean reversion is very much in the eyes of the beholder.

The CAPE’s Weakest Links

Robert Shiller has been a force in finance, forcing us to look at the consequences of investor behavior and chronicling the consequences of “irrational exuberance”. His work with Karl Case in developing a real estate index that is now widely followed has introduced discipline and accountability into real estate investing and his historical data series on stocks, which he so generously shares with us, is invaluable. You can almost see the “but” coming and I will not disappoint you. Of all of his creations, I find CAPE to be not only the least compelling but also potentially the most dangerous, in terms of how often it can lead investors astray. So, at the risk of angering those of you who are CAPE followers, here is my case against putting too much faith in this measure, with much of it representing updates of my post from two years ago.

1. The CAPE is not that informative

The notion that CAPE is a significant improvement on conventional PE is based on the two adjustments that it makes, first by replacing earnings in the most recent period with average earnings over ten years and the second by adjusting past earnings for inflation to make them comparable to current earnings. Both adjustments make intuitive sense but at least in the context of the overall market, I am not sure that either adjustment makes much of a difference. In the graph below, I show the trailing PE, normalized PE (using the average earnings over the last ten years) and CAPE for the S&P 500 from 1969 to 2016 (last twelve months). I also show Shiller's CAPE, which is based on a broader group of US stocks in the same graph.

Download spreadsheet with PE ratios

First, it is true that especially after boom periods (where earnings peak) or economic crises (where trailing earnings collapse), the CAPEs (both mine and Shiller's) yield different numbers than PE.  Second, and more important, the four measures move together most of the time, with the correlation matrix shown in the figure. Note that the correlation is close to one between the normalized PE and the CAPE, suggesting that the inflation adjustment does little or nothing in markets like the US and even the normalization makes only a marginal difference with a correlation of 0.86 between the unadjusted PE and the Shiller PE.

2. The CAPE is not that predictive

The question then becomes whether using the CAPE as a valuation metric yields judgments about stocks that are superior to those based upon just PE or normalized PE. To test this proposition, I looked at the correlation between the values of different metrics, including trailing PE, CAPE, the inverse of the dividend yield, earnings yield and the ratio of Shiller PE to the Bond PE) today and stock returns in the following year and the following five years:

There is both good news and bad news for those who use the Shiller CAPE as their stock valuation metric. The good news is that the fundamental proposition that stocks are more likely to go down in future periods, if the Shiller CAPE is high today, seems to be backed up. The bad news is two fold. First, the relationship is noisy or in investment parlance, the predictive power is low, especially with one-year returns. Second, the trailing PE actually does a better job of predicting one-year returns than the CAPE and while CAPE becomes the better predictor than trailing PE over a five-year period, it is barely better than using a dividend yield indicator.  While I have not included these in the table, I will wager that any multiple (such as EV to EBITDA) would do as good (or as bad, depending on your perspective) a job as market timing.

As a follow-up, I ran a simple test of the payoff to market timing, using the Shiller CAPE and actual stock returns from 1927 to 2016. At the start of every year, I first computed the median value of the Shiller CAPE over the previous fifty years and assumed an over priced threshold at 25% above the median (which you can change). If the actual CAPE was higher than the threshold, I assumed that you put all your money in treasury bills for the following year and that if the CAPE was lower than the threshold, that you invested all your money in equities. (You can alter these values as well). I computed how much $100 invested in the market in 1927 would have been worth in August of 2016, with and without the market timing based on the CAPE:

Download spreadsheet and change parameters

Note that as you trust CAPE more and more (using lower thresholds and adjusting your equity allocation more), you do more and more damage to the end-value of your portfolio. The bottom line is that it is tough to get a payoff from market timing, even when the pricing metric that you are using comes with impeccable credentials. 

3. Investing is relative, not absolute

Notwithstanding its weak spots, let’s take the CAPE as your measure of stock market valuation. Is a CAPE of 27.27 too high, especially when the historic norm is closer to 16? The answer to you may sound obvious, but before you do answer, you have to consider where you would put your money instead. If you choose not to buy stocks, your immediate option is to put your money in bonds and the base rate that drives the bond market is the yield on a riskless (or close to riskless) investment. Using the US treasury bond as a proxy for this riskless rate in the United States, I construct a bond PE ratio using that rate:

Bond PE = 1/ Treasury Bond Rate

Thus, if you invest in a treasury bond on August 22, with a yield of 1.54%, you are effectively paying 64.94 (1/.0154) times your earnings. In the graph below, I graph Shiller’s measures of the CAPE against this T.Bond PE from 1960 to 2016:

Download T Bond Rate PE data

I also compute a ratio of stock PE to T.Bond PE that will use as a measure of relative stock market pricing, with a low value indicating that stocks are cheap (relative to T.Bonds) and a high value suggesting the opposite. As you can see, bringing in the low treasury bond rates of the last decade into the analysis dramatically shifts the story line from stocks being over valued to stocks being under valued. The ratio is as 0.42 right now, well below the historical average over any of the time periods listed, and nowhere near the 1.91 that you saw in 2000, just before the dot com bust or  even the 1.04 just before the 2008 crisis. 

4. Its cash flow, not earnings that drives stocks

The old adage that it is cash flows, not earnings, that drives stocks is clearly being ignored when you look at any variant of PE ratios. To provide a sense of what stock prices look like, relative to cash flows, I computed a multiple of total cash returned to stockholders by companies (including buybacks) and compared these multiples to Shiller’s CAPE in the graph below:

S&P 500 Earnings and Cash Payout

Here again, there seems to be a disconnect. While the CAPE has risen for the market, from 20.52 in 2009 to 27.27 in 2016, as stocks soared during that period, the Price to CF ratio has remained stable over that period (at about 20), reflecting the rise in cash returned by US companies, primarily in buybacks over the period.

Am I making the case that stocks are under valued? If I did, I would be just as guilty as those who use CAPE to make the opposite case. I am not a market timer, by nature, and any single pricing metric, no matter how well reasoned it may be, is too weak to capture the complexity of the market. Absolutism in market timing is a sign of either hubris or ignorance.

The Market’s Kryptonite

At this point, if you think that I am sanguine about stocks, you would be wrong, since the essence of investing in equities is that worry goes with it. If it’s not the high CAPE that is worrying me, what is? Here are my biggest concerns, the kryptonite that could drain the market of its strength and vitality.

1. The Treasury Alternative (or how much are you afraid of your central bank?)  If the reason that you are in stocks is because the payoff for being in bonds is low, that equation could change if the bond payoff improves. If you are Fed-watcher, convinced that central banks are all-powerful arbiters of interest rates, your nightmares almost always will be related to a meeting of the Federal Open Market Committee (FOMC), and in those nightmares, the Fed will raise rates from 1.50% to 4% on a whim, destroying your entire basis for investing in stocks. As I have noted in these earlier posts, where I have characterized the Fed as the Wizard of Oz and argued that low rates are more a reflection of low inflation and anemic growth than the result of quantitative easing, I believe that any substantial rate rises will have to come from shifts in fundamentals, either an increase in inflation or a surge in real growth. Both of these fundamentals will play out in earnings as well, pushing up earnings growth and making the stock market effect ambiguous. In fact, I can see a scenario where strong economic growth pushes T. bond rates up to 3% or higher and stock markets actually increase as rates go up.
2. The Earnings Hangover It is true that we saw a long stint of earnings improvement after the 2008 crisis and that the stronger dollar and a weaker global economy are starting to crimp earnings levels and growth. Earnings on the S&P 500 dropped in 2015 by 11.08% and are on a pathway to decline again this year and if the rate of decline accelerates, this could put stocks at risk. That said, you could make the case that the earnings decline has been surprisingly muted, given multiple crises, and that there is no reason to fear a fall off the cliff. No matter what your views, though, this will be more likely to be a slow-motion correction, offering chances for investors to get off the stock market ride, if they so desire.
3. Cash flow Sustainability: My biggest concern, which I voiced at the start of the year, and continue to worry about is the sustainability of cash flows. Put bluntly, US companies cannot keep returning cash at the rate at which they are today and the table below provides the reason why:

Year	Earnings	Dividends	Dividends + Buybacks	Dividend Payout	Cash Payout
2001	38.85	15.74	30.08	40.52%	77.43%
2002	46.04	16.08	29.83	34.93%	64.78%
2003	54.69	17.88	31.58	32.69%	57.74%
2004	67.68	19.407	40.60	28.67%	59.99%
2005	76.45	22.38	61.17	29.27%	80.01%
2006	87.72	25.05	73.16	28.56%	83.40%
2007	82.54	27.73	95.36	33.60%	115.53%
2008	49.51	28.05	67.52	56.66%	136.37%
2009	56.86	22.31	37.43	39.24%	65.82%
2010	83.77	23.12	55.53	27.60%	66.28%
2011	96.44	26.02	71.28	26.98%	73.91%
2012	96.82	30.44	75.90	31.44%	78.39%
2013	107.3	36.28	88.13	33.81%	82.13%
2014	113.01	39.44	101.98	34.90%	90.24%
2015	100.48	43.16	106.10	42.95%	105.59%
2016 (LTM)	98.61	43.88	110.62	44.50%	112.18%

In 2015, companies in the S&P 500 collectively returned 105.59% of their earnings as cash flows. While this would not be surprising in a recession year, where earnings are depressed, it is strikingly high in a good earnings year. Through the first two quarters of 2016, companies have continued the torrid pace of buybacks, with the percent of cash returned rising to 112.18%. The debate about whether these buybacks make sense or not will have to be reserved for another post, but what is not debatable is this. Unless earnings show a dramatic growth (and there is no reason to believe that they will), companies will start revving down (or be forced to) their buyback engines and that will put the market under pressure. (For those of you who track my implied equity risk premium estimates, it was this concern about cash flow sustainability that led me to add the option of allowing cash flow payouts to adjust to sustainable levels in the long term).

So, how do these worries play out in my portfolio? They don’t explicitly but they do implicitly affect my investment choices. I cannot do much about interest rates, other than react, and I will stay ready, especially if inflation pressures push up rates and the fixed income market offers me a better payoff. With earnings and cash flows, there may be concerns at the market level, but I bet on individual companies, not markets. With those companies, I can do my due diligence to make sure that they have the operating cash flows (not just dividends or buybacks) to justify their valuations. If that sounds like a pitch for intrinsic valuation, are you surprised?

The Market Timing Mirage

Will there be a market correction? Of course! When it does happen, don't be surprised to see a wave of “I told you so” coming from the bubblers. A clock that is stuck at 12 o'clock will be right twice every day and I would urge you to judge these market timers, not on their correction calls, which will look prescient, but on their overall record. Many of them, after all, have been suggesting that you stay out of stocks for the last five years or longer and it would have to be a large correction for you to make back what you lost from staying on the sidelines. Some of these pundits will be crowned as great market timers by the financial press and they will acquire followers. I hope that I don’t sound like a Cassandra but this much I know, from studying past history. Most of these great market timers usually get it right once, let that success get to their heads and proceed to let their hubris drive them to more and more extreme predictions in the next cycle. As an investor, my suggestion is that you save your money and your sanity by staying far away from market prognosticators.

YouTube


Datasets

1. PE ratios from 1960-2016
2. Shiller CAPE and T.Bond PE (1960-2016)
3. S&P 500: Earnings, Dividends and Buybacks (2000-2016)
4. CAPE Market Timing Test

Another Market Crisis? My Survival Manual/Journal!

I would be lying if I said that I like down markets more than up markets, but I have learned to accept the fact that markets that go up will come down, and that when they do so quickly, you have the makings of a crisis. I find myself getting more popular during these periods, as acquaintances, friends and relatives that I have not heard from in years seem to find me. They are  invariably disappointed by my inability to forecast the future and my unwillingness to tell them what to do next, and I am sure that I move several notches down the Guru scale as a consequence, a development that I welcome. To save myself some repetitions of this already tedious sequence, I think it is best that I pull out my crisis survival journal/manual, a work in progress that I started in the 1980s and that I revisit and rewrite each time markets go into a tailspin. It is more journal than manual, more personal than general, and more about me than it is about markets. So, read on at your own risk!

The Price of Risk

For me, the first casualty in a crisis is perspective, as I find myself getting whipsawed with news stories about financial markets, each more urgent and demanding of attention than the previous one. The second casualty is common sense, as my brain shuts down and my primitive impulses take over. Consequently, I find it useful to step back and look at the big picture, hoping to see patterns that help me make sense of the drivers of market chaos.

It is my view that the key number in understanding any market crisis is the price of risk. In a market crisis, the price of risk increases abruptly, causing the value of all risky assets to drop, with that drop being greater for riskier assets. While the conventional wisdom, prior to 2008, was that the price of risk in mature markets is stable and does not change much over short periods, the last quarter of 2008 changed (or should have changed) that view. I started tracking the price of risk in different markets (equity, bond, real estate) on a monthly basis in September 2008, a practice that I have continued through the present. Getting an a forward-looking, dynamic price of risk in the bond market is simple, since it takes the form of default spreads on bonds, and FRED (the immensely useful Federal Reserve Database) has the market interest rates on a Baa rated (Moody's) bonds going back to 1919, with data available in annual, monthly or daily increments. That default spread is computed by taking the difference between this market interest rate and the US treasury bond rate  on the same date. Getting a forward-looking, dynamic price of risk in the equity markets is more complicated, since the expected cash flows are uncertain (unlike coupons on bonds) and equities don't have a specific maturity date, but I have argued that it can be done, though some may take issue with my approach. Starting with the cumulative cash flow that would have generated by investing in stocks in the most recent twelve months, I estimate expected cash flows (using analysts' top down estimates of earnings growth) and compute the rate of return that is embedded in the current level of the index. That internal rate of return is the expected return on stocks and when the US treasury bond rate is netted out, it yields an implied equity risk premium. The January 2015 equity risk premium is summarized below:

Implied ERP Spreadsheet (January 2015)

That premium had not moved much for most of this year, with a low of 5.67% on March 1, and a high of 6.01% in early February, and the ERP at the start of August was 5.90%, close to the start-of-the-year number. Given the market turmoil in the last weeks, I decided to go back and compute the implied equity risk premium each day, starting on August 1.

ERP By Day

Note that not much changes until August 17, and that almost all of the movement have been in the days between August 17 and August 245 During those seven trading days, the S&P 500 dropped by more than 11% and if you keep cash flows fixed, the expected return (IRR) for stocks increased by 0.68%. During the same period, the US treasury bond rate dropped by 0.06%, playing its usual "flight to safety" role, and the implied equity risk premium (ERP) jumped by 0.74% to 6.56%. 

I did use the trailing 12-month cash flows (from buybacks and dividends) as my base year number, in computing these equity risk premiums, and there is a reasonable argument to be made that these cash flows are too high to sustain, partly because earnings are at historic highs and partly because companies are returning more of that cash than ever before. To counter this problem, I assumed that earnings would drop back to a level that reflects the average earnings over the last 10 years, adjusted for inflation (i.e., the denominator in the Shiller CAPE model) and that the payout would revert back to the average payout over the last decade. That results in lower equity risk premiums, but the last few days have pushed that premium up by 0.53% as well.

My computed increases in ERP, using both trailing and normalized earnings, overstate the true change, because the cash flows and growth were left at what they were at the start of August, a patently unrealistic assumption, since this is also an economic crisis, and any slowing of growth in China will make itself felt on the earnings, cash flows and growth at US companies. That effect will take a while to show up, as corporate earnings, buyback plans and analyst growth estimates are adjusted in the months to come, and I am sure that some of the market drop was caused by changes in fundamentals. The argument that a large portion of the drop comes from the repricing of risk is borne out by the rise in the default spread for bonds, with the Baa default spread widening by 0.17%, and the increase in the perceived riskiness (volatility) of stocks, with the VIX posting its largest weekly jump ever, in percentage terms.

The Repricing of Risky Assets
When the price of risk changes, all risky assets will be repriced, but not by the same magnitude. Within mature markets, you should expect to see a bigger drop in stock prices at more risky companies than at safer ones, though how you define risk can affect your conclusions. If you define risk as exposure to the the precipitating factor in the crisis, I would expect the stock prices of  companies that are more dependent on China for their revenues to drop by more than the rest of the market. Since I don't have data on how much revenue individual companies get from China, I will use commodity companies, which have been aided the most by the Chinese growth machine over the last decade and therefore have the most to lose from it slowing down, as my proxy for China exposure. The table below highlights the 20 industry groups (out of 95) that have performed the worst between August 14 and August 24:

Notice that commodity companies comprise one quarter of the group, with a few cyclical and technology sectors thrown into the mix.

Looking across markets geographically, changes in the equity risk premium in mature markets will be magnified as you move into riskier countries and thus it is not surprising to see the carnage in emerging markets over the last week has exceeded that in developed markets, with currency declines adding to local stock market drops.

Percentage Return in US dollar terms

In the picture below, I capture the percentage change in market capitalizations between August 14, 2015, and August 24, 2015 in U.S. $ terms, with the PE ratios as of August 14 and August 24 highlighted for each country:

via chartsbin.com
Note that this phenomenon of emerging markets behaving badly cannot be blamed on China, since it happened in 2008 as well, when it was the banking system in developed markets that triggered the market rout.

A Premium for Liquidity?

There is another dimension, where crises come into play, and that is in the demand for liquidity. While investors always prefer more liquid assets to less liquid ones, that preference for liquidity and the price that they are willing to pay for it varies across time and tends to surge during market crisis. To see if this crisis has had the same effect, I looked at the drop in market capitalization, in US $ terms, between August 14 and 24 for companies classified by trading turnover ratios (computed by dividing the annual dollar trading value by the market capitalization of the company):

Liquidity classes, based on turnover ratio = $ Trading Value/ $ Market Cap

Surprisingly, it is the most liquid firms that have seen the biggest drop in stock prices, though the numbers may be contaminated by the fact that trading halts are often the reactions to market crises in many countries, that are home to the least liquid stocks. If this is the reason for the return divergence, there is more pain waiting for investors in these stocks as the market drop shows up in lagged returns.

To the extent that market crises crimp access to capital markets, the desire for liquidity can also reach deeper into corporate balance sheets, creating premiums for companies that have substantial cash on their balance sheets and fewer debt obligations. To test this proposition, I classified firms globally, based upon the net debt as a percent of enterprise value, and looked at the price drop between August 14 and August 24:

Net Debt/EV = (Total Debt- Cash)/ (Debt + Market Cap - Cash)

The crisis seems to have spared no group of stocks, with the pain divided almost evenly across the net debt classes, with the largest price decline being in the stocks that have cash balances that exceed their debt. Note, however, that the multiples at which these companies trade at both prior and after the drop, reflect the penalty that the market is attaching to extreme leverage, with the most levered companies trading at a PE ratio of 3.11 (at least across the 15.76% of firms in this group that have positive earnings to report). If your contrarian strategy for this market is to screen for and buy low PE stocks, this table suggests caution, since a large portion of the lowest PE stocks will come with high debt ratios.

As the public markets drop, the question of how this crisis will affect private company valuations has risen to the surface, especially given the large valuations commanded by some private companies. Since many of these private businesses are young, risky startups and that investments in them are illiquid, I would guess they will be exposed to a correction,  larger than what we observe in the public marketplace. However, given that venture capitalists and public investors in these companies will be self appraising the value of their holdings, the effect of any markdown in value will take the form of fewer high-profile deals (IPO and VC financing).

What now?

A market crisis bring out my worst instincts as an investor. First out of the pack is fear pushing me to panic, with the voice yelling "Sell everything, sell it now", getting louder with each bad market day. That is followed quickly by denial, where another voice tells me that if I don't check the damage to my portfolio, perhaps it has been magically unaffected. Then, a combination of greed and hubris kicks in, arguing that the market is filled with naive, uninformed investors and that this is my time to trade my way to quick profits. I cannot make these instincts go away, but I have my own set of rules for managing them. (I am not suggesting that these are rules that you should adopt, just that they work for me..)

1. Break the feedback loop: Being able to check your portfolio as often as you want and in real time, with our phones, tablets and computers, is a mixed blessing. I did check my portfolio this morning for the damage that the last week has done, but I don't plan to check again until the end of the week. If I find myself breaking this rule, I will consider sabotaging my wifi connection at home, going back to a flip phone or leaving for the Galapagos on vacation.
2. Turn off the noise: I read the Wall Street Journal and Financial Times each morning, but I generally don't watch financial news channels or visit financial websites. I become religious about this avoidance during market chaos, since much of the advice that I will get is bad, most of the analysis is after-the-fact navel gazing and all of the predictions share only one quality, which is that they will be wrong. 
3. Rediscover your faith: In my book (and class) on investment philosophies, I argue that there is no "best' investment philosophy that works for all investors but that there is one for you, that best fits what you believe about markets and your personality. My investment philosophy is built on faith in two premises, that every business has a value that I can estimate, and that  the market price will move towards that value over time. During a crisis, I find myself returning to the core of that philosophy, to make sense of what is going on.
4. Act proactively and consistently: It is natural to want to act in response to a crisis. I am no exception and I did act on Monday, but I tried to do so consistently with my philosophy. I revisited the valuations that I have done over the past year (and you can find most of them on my website, under my valuation class) and put in limit buy orders on a half a dozen stocks (including Apple, Tesla and Facebook), with the limit prices based on my valuations of the companies. If the crisis eases, none of the limit orders may go through, but I would have protected myself from impulsive actions that will cost me more in the long term. If it worsens, all or most of the of the limit buys will be executed, but at prices that I think are reasonable, given the cash flow potential of these companies.

Will any of these protect me from losing money? Perhaps not, but I did sleep well last night and am more worried about whether the New York Yankees will score some runs tonight than I am about what the Asian markets will do overnight. That, to me, is a sign of health!

The Silver Linings

Just as recessions are a market economy's way of cleansing itself of excesses that build up during boom periods, a market crisis is a financial market's mechanism for getting back into balance. I know that is small consolation for you today, if you have lost 10% or more of your portfolio, but there are seedlings of good news, even in the dreary financial news:

1. Live by momentum, die by it: In trading, momentum is king and investors who play the momentum game make money with ease, but with one caveat. When momentum shifts, the easy profits accumulated over months and years can be wiped out quickly, as commodity and currency traders are discovering.
2. Deal or no deal? If you share my view that slowing down in M&A deals is bad news for deal makers, but good news for stockholders in the deal-making companies, the fact that this crisis may be imperiling deals is positive news.
3. Rediscover fundamentals: My belief that first principles and fundamentals ultimately win out and that there are no easy ways to make money is strengthened when I read that carry traders are losing money, that currency pegs do not work when inflation rates deviate, and mismatching the currencies in which you borrow and generate cash flows is a bad idea.    
4. The Market Guru Handoff: As with prior crises, this one will unmask a lot of economic forecasters and market gurus as fakes, but it will anoint a new group of prognosticators who got the China call right as the new stars of the investment universe. 

If a market crisis is a crucible that tests both the limits of my investment philosophy and my  faith in it, I am being tested and as with any other test, if I pass it, I will come out stronger for the experience. At least, that is what I tell myself as I look at the withered remains of my investments in Vale and Lukoil!

Spreadsheets

1. Implied Equity Risk Premium Spreadsheet (August 2015)
2. Returns (8/14-8/24) and PE ratios (before & after), by Industry Group
3. Returns (8/14-8/24) and PE ratios (before & after), by Country