Chancellor: U.S. bull market can’t go on forever

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A specialist trader works inside a booth on the floor of the New York Stock Exchange in New York City, U.S., October 6, 2021. REUTERS/Brendan McDermid

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LONDON, Nov 24 (Reuters Breakingviews) – Crunching numbers won’t provide the winning investment formula. Instead, successful moneymaking involves what Alexander Ineichen, a Swiss financial analyst, calls “applied wisdom”. Financial assets look potentially vulnerable with interest rates at their lowest level in five millennia, U.S. stocks trading at record valuations and no shortage of irrational exuberance. The wise investor, says Ineichen, should be aware of such risks, but that’s not reason enough to rush for the exits.

Ineichen’s brilliant new book, “Applied Wisdom: 700 Witticisms to Save Your Ass(ets)”, offers everything you need to know about investment. The first rule, as former U.S. President Barack Obama concisely expressed it, is “don’t do stupid shit.” Many investors are choosing to ignore this sound advice. Instead, they are piling into special-purpose acquisition companies, stratospherically priced cloud businesses, dodgy cryptocurrencies, so-called non-fungible tokens and the like. Their actions violate another key rule, articulated by George Soros, that “good investment is boring.”

While some of today’s high-flying investments may succeed, it’s hard to separate tomorrow’s winners and losers. Many new technologies were written off when they first appeared which later proved popular. In the 1920s, the wireless music box was dismissed by an employee of Radio Corporation of America as having “no imaginable commercial value.” Thomas Watson, the brilliant head of IBM, thought in 1943 that the world had no need for more than five computers. Economist Paul Krugman in 1998 predicted that the internet would have no greater economic impact than the fax machine. And even when technologies take off, speculators have often been burned, whether buying RCA shares in 1929 or dot-com stocks 70 years later.

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The bull market in government bonds has been running for four decades. Falling Treasury yields have propelled the American stock market to ever-higher valuations. At some stage, the markets will run into Stein’s Law, named after the late Herbert Stein: “If something cannot go on forever, it will stop.” But Stein’s self-evident dictum tells us nothing about timing. In the late 1990s Japanese government bond yields fell to what appeared at the time to be impossibly low levels. Yet for a quarter of a century sellers of JGBs, in expectation of rising yields, have lost money.

The trouble is that markets are complex systems, which are by their nature unpredictable. “Only fools, liars and charlatans predict earthquakes,” said the seismologist Charles Richter. Ineichen invokes Gump’s Law (derived from a line in the movie “Forrest Gump”), to the effect that life is a box of chocolates because you don’t know what you’re going to get. That doesn’t stop people from attempting to forecast. But research shows that forecasters with the biggest media profiles are especially bad at the job. Nassim Nicholas Taleb quips that Wall Street firms hire economists to “provide stories to their less sophisticated clients.” In short, as Peter Drucker, the management consultant, once wrote, “forecasting is not a respectable human activity.”

None of this provides much comfort to today’s investors. On the one hand, there’s no doubt that U.S. stocks are extremely expensive by historic standards. And applied wisdom, according to Ineichen, means paying attention to the lessons of history. (In the words of music journalist Steve Turner, “History repeats itself. Has to; no one listens.”) Past experience suggests that purchasing stocks at inflated valuations carries the risk of a permanent loss of capital. On the other hand, there’s a danger in leaving the party too early, since, as John Maynard Keynes never quite said, “markets can remain irrational longer than you can remain solvent.”

It’s not just a question of irrationality: U.S. stocks have traded above their long-run average valuation for at least 25 years. Ineichen cites the late Martin Zweig’s two cardinal investment rules: “Don’t fight the tape” and, more pertinent to the current day, “Don’t fight the Fed.” Wisdom lies in watching markets. Wait until the facts change, and then change your mind. Ineichen is an exponent of “nowcasting”. This involves tracking real-time indicators – derived from market trends, corporate earnings forecasts and various economic measures – to gauge whether the current market trend is intact or set to reverse.

Ineichen’s firm, IR&M, provides weekly updates of market and economic data. His latest report finds that the American economy continues to surprise on the upside. Economic sentiment remains strongly positive, although it has dipped slightly from the extraordinarily high levels reached after lockdowns ended. The Philadelphia business outlook survey is also very positive. Corporate earnings estimates continue to be upgraded for all sectors, with energy companies performing best of all. Of the 23 U.S. indicators tracked by Ineichen, there are only three red flags (namely, consumer sentiment, housing starts and the National Association of Home Builders survey).

These real-time measures don’t indicate that the roof is about to collapse on the New York Stock Exchange any day soon. Yet Ineichen goes too far when he claims that nowcasting is to forecasting what astronomy is to astrology. Markets aren’t as well-behaved as planets – as Isaac Newton, a hapless investor in the South Sea Bubble of 1720, is reported to have said at the time, he could forecast the movement of the heavenly bodies but not the madness of people. And as Ineichen acknowledges, markets are moved by opinions rather than economic facts. Nowcasting may help with market timing but it’s still only a model, and thus subject to Box’s Law, which states that “all models are wrong. Some are useful.”

In April 1928, the Austrian-Swiss banker Felix Somary hosted Keynes at his home in Zurich. The world’s best-known economist was bullish on U.S. stocks, arguing that thanks to the Federal Reserve there would be no more stock market crashes. Somary, known as the “Raven of Zurich” for his gloomy prognostications, begged to differ. A crash was coming, he predicted: “The crash will come from the gap between appearances and reality. I have never seen such stormy weather gathering.”

Today, the gap between appearances and reality is even greater than prior to the Great Crash. That’s an opinion, not a forecast. Still, as David Attenborough, the British natural historian, wisely observes, “walking on thin ice is always risky.”

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Editing by Rob Cox and Oliver Taslic

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