The Doctor is In

Doctor my eyes have seen the years
And the slow parade of fears without crying
Now I want to understand
--Jackson Browne

Dr J may have outdone Mr P with his end of year missive (and that's saying something). He makes a number of thoughtful points.

There are two primary theses for why long term rates have started to rise: 1) investors are worried about the inflation implications of recent rounds of central bank money printing, 2) investors are forecasting that the QE programs are working and that economic activity will fundamentally pick up. Dr J presents data that discounts both. Instead, he presents an argument in favor of a third thesis: that the recent increase in interest rates is due to investors dumping low risk assets in favor of high risk assets in response to Fed rhetoric that the central banks is targeting higher asset prices in attempt to create a 'wealth effect.'

The Fed has tried this before. As John notes, 'we've seen this movie a few times now, and the ending never changes.'

He also reiterates the overvalued state of the markets. In addition to the 10 yr valuation models that he has shared before (which current project ~ 4% annual stock mkt returns over the past decade, Dr J demonstrates that various valuation methods suggest that stocks in aggregate are about 40% overvalued. One of these approaches employs the Q ratio, which is essentially a ratio of stock price to underlying asset replacement value.

Over the long term, the Q ratio averages about 0.7. After bouncing off that level during the waterfall decline two years ago, Q has risen to 1.12--a level that suggests general overvaluation that has historically been surpassed only during the late 1990s bubble run-up. In fact, note that current valuations exceed those prior to the 2008 collapse.

Finally, near the end of the missive Dr J notes how market returns are not normally distributed. Returns are skewed to the left (a.k.a. negatively skewed). While the median market return is slightly positive, the distribution has a shortened right tail (lower than normal chance of large gains) and an elongated left tail (higher than normal chance of large losses). Current market climate exacerbates the 'unpleasant skew' associated with future returns.

A fine missive. One of those worthy of multi-reads.

position in SH, TLT