It's Not Nice to Fool Mother Nature

The 'Comfort Model' hits an extreme... The mainstream media and Wall Street encourage folks to get more comfy... A boom-and-bust cycle is an 'emergent' property... Markets are self-organizing... No one can control a deep, liquid, multitrillion-dollar market... 'It's not nice to fool Mother Nature'...

Investors are comfortable right now...

I (Dan Ferris) know that might be hard to believe.

After all, the S&P 500 Index just logged its worst first half of a year since 1970. And as I detailed two weeks ago, the 10-year U.S. Treasury booked its worst six months since 1788.

That doesn't seem like a comfort-inducing environment.

You probably also don't believe investors are comfortable right now because all the usual sentiment indicators suggest otherwise...

For example, the popular weekly American Association of Individual Investors ("AAII") Sentiment Survey was 42.2% bearish and 29.6% bullish on Wednesday. The AAII survey's long-term averages are 30.5% bearish and 38% bullish.

I won't go through any more of those popular sentiment indicators. Like I told my Extreme Value subscribers a couple weeks ago, I stopped looking at them last year.

These types of surveys reflect what investors say. Prices paid reflect what investors do. And they tell me all I need to know.

Asset manager GMO has an interesting way of assessing prices investors are willing to pay...

In the late 1990s, GMO co-founder Jeremy Grantham and analyst Ben Inker cooked up an indicator based on the price-to-earnings (P/E) ratio. And in short, it told them how comfortable investors were with current market conditions – and whether that comfort was warranted.

It's called the "Comfort Model." And in a recent note, the folks at GMO explained how it works...

The model is based on the simple premise that the conditions which make investors comfortable are high profits, stable economic growth, and inflation of around 2%. The higher the profits, the more stable the economic growth, and the closer inflation is to 2%, the more comfortable investors are. With greater comfort, investors are more likely to pay a higher multiple on the market and vice versa.

When investors have been most comfortable and paid the highest prices – like they did at the peak of the dot-com bubble – markets have tended to perform poorly. Even worse, sometimes that poor performance lasts for years or even decades.

Today, GMO's Comfort Model suggests investors are too comfortable...

It says investors shouldn't be willing to pay a cyclically adjusted P/E ("CAPE") ratio for stocks of about 19 times under the current conditions of flagging profits, economic instability, and 9% inflation. And yet, they're willing to pay a ratio of 30 times.

That's the largest deviation of the Comfort Model since the Internet bubble.

In other words, after a brutal, record-breaking, six-month market performance in stocks and bonds, investors are still more complacent than at any time since the peak of the most expensive stock market ever (as measured by the CAPE ratio that GMO's model uses).

That doesn't look like fear or bearishness to me. It looks like investors still think buying every dip guarantees success.

Right on cue, the mainstream financial media is encouraging investors to get comfy with stocks again...

On Tuesday afternoon, Barron's published an article titled, "Why There's a Chance the Stock Market Has Hit Bottom." And as you can see, it was front and center on the website...

The mention of "a chance" smacks of desperation...

It's basically saying that a chance – any chance – must immediately make the top headlines of one of the most widely read publications in finance.

As I've pointed out before, when the bottom finally arrives – whether it's a year from now or 10 years from now – nobody will be talking about it. As it glides by unnoticed, publications like Barron's will be recommending ways to bet against the S&P 500, banks with the highest-yielding cash savings accounts, and perhaps even how much gold you should own.

The mainstream financial media can't help you find the bottom – and neither can Wall Street...

It's the same way they can't find the top – except by promising you it's nowhere in sight.

Last December, investment bank JPMorgan Chase (JPM) said a sell-off was nowhere in sight. And then, one week later, the S&P 500 peaked. It's down about 18% since then.

If you don't believe me, an article about JPMorgan's note is still up on Bloomberg's website. Note the publication date...

OK, maybe JPMorgan does deserve some credit. After all, it did indirectly tell contrarian investors to sell by telling everybody in the world they should keep buying.

Everybody on Wall Street either thinks the same thing as everybody else or gets fired. So it hardly matters that Bank of America (BAC) – and not JPMorgan – is behind the latest contrarian headline. Here's the headline from Tuesday, posted by Barron's...

It makes you wonder who is more likely to be right...

On one side, the folks at GMO say investors are too comfortable and are still paying too much for stocks. And on the other side, the folks on Wall Street say investors have "thrown in the towel," which is a good thing for market bulls.

They both can't be right.

If you've read my Digest missives for long, you can take a wild guess which side I think is right...

But it's not important to guess which way stocks will go in the next few weeks or months.

Forget about the near term. Instead, look out one, two, five, or even 10 years.

Tell me if you think folks are still being too complacent when looking over a longer term...

For example, does anyone seem to be concerned about the possibility that the U.S. stock market could fall for two decades like the Japanese market did from 1989 to 2012?

(I've mentioned this idea before – and I'll keep doing it. That's mostly because nobody else will say it, and I like having a monopoly on the serious contemplation of extreme risk.)

The closest I've heard anyone come to warning of a Japan-like bear market is when author and speculator Jim Rogers said in a recent interview that the next bear market will be "worse than any in [his] lifetime."

Jim is 79 years old. So he was definitely around during the Japan bear market. And if he thinks the next bear market will be worse than that... we better watch out.

I agree that the current bear market is more likely to surprise investors with more downside than they ever expected. That's especially true given how complacent, comfortable, and eager everyone in the mainstream media and on Wall Street is about finding the bottom.

It would be typical for me to move on right now to a demonstration of how investors are still in love with lousy businesses. I'm talking about companies like GameStop (GME), AMC Entertainment (AMC), Tesla (TSLA), mostly everything in the ARK Innovation Fund (ARKK), and many others.

Then, I would say, "See? They still expect fast riches by buying garbage. That suggests a lot more downside."

But I've done that enough. So let's just act like I did it again and do something else instead.

It's obvious by now that my bearish fears and warnings of the past couple years were justified. It seems equally obvious that equity returns are still priced for perfection.

And I get that nobody cares what I said about what has already happened. We're not living in the past after all. Everybody really wants to know what comes next.

But there's a slight problem with that...

I have no idea what comes next. Nobody knows what comes next.

The best I can do is point out that it would be very unusual if the near-term future bore much similarity at all to the near-term past (the last decade in stocks and last four decades in bonds).

So let's think not about individual stocks. Instead, let's think about the stock market as a whole...

I've discussed Benoit Mandelbrot's "Ten Heresies of Finance" in the Digest before.

The list is generally focused on risk and volatility. Repeating any of these heresies out loud in a meeting at any Wall Street firm would probably get you fired.

Five of Mandelbrot's heresies stand out whenever I reread the list. They are...

• Markets Are Very, Very Risky – More Risky Than the Standard Theories Imagine.
• Market "Timing" Matters Greatly. Big Gains and Losses Concentrate into Small Packages of Time.
• Prices Often Leap, Not Glide. That Adds to the Risk.
• Markets in All Places and Ages Work Alike.
• Markets Are Inherently Uncertain, and Bubbles Are Inevitable.

I recommend you read the entire list of heresies. You can find them in Mandelbrot's 2004 book, The (Mis)Behavior of Markets.

The Comfort Model suggests that most folks either don't know or don't care about the Heresies of Finance. And they certainly aren't heeding their wisdom today.

The last one is especially interesting right now. That's because it suggests that since you can't avoid bubbles, you can't avoid when they burst.

Bubbles and ensuing bear markets are intriguing...

Most folks would probably rather avoid the whole mess and have a much more stable investing environment.

A boom-and-bust cycle is an "emergent" property...

No individual investor tries to bring it about. And yet, it still occurs – emerges – as a collective behavior of the overall market when individuals interact in their attempts to maximize profit and avoid loss.

The website for the PBS science series NOVA explains the idea of emergence well...

Creatures, cities, and storms self-organize, with low-level rules giving rise to higher-level sophistication. Entirely new properties and behaviors "emerge," with no one directing and no one able to foresee the new characteristics from knowledge of the constituents alone. The whole is truly greater than the sum of its parts.

Knowing the plans and strategies of every investor in the market wouldn't help you predict booms or busts...

Besides creatures, cities, and storms, other examples of emergence include ant colonies, slime molds, water, hurricanes, and yes... the stock market. From the NOVA website...

In the 17th century, the economist Adam Smith described an "invisible hand" that guides markets to produce just the amount and variety of goods that the public needs. The stock market has its own "invisible hand." The purely self-interested actions of thousands of buyers and sellers result in the purely blind workings of the stock market – the sudden shifts in activity and valuations, the bubbles and crashes – as well as the market's notorious properties of stupendous intricacy and frustrating unpredictability.

In other words... markets are self-organizing.

We lose sight of that fact as we watch regulators, businesses, individual investors, and intermediaries like lawyers, brokers, and asset managers each make detailed plans and rules tied to their involvement in the markets. In turn, these actions influence all the other market participants.

And it's easy to believe that humans control markets because, after all, humans created them... right?

Wrong.

As I've said before, humans in markets are like fish in water. And just as fish don't control the wind, tides, and currents, no investor or group controls the price action of stocks.

Humans didn't create markets. Markets emerged out of humans trying to live as well as possible by maximizing their labor, capital, and whatever other resources they may possess.

Maybe I should say humans are in markets the way ants are in colonies...

Or the way thousands of single-celled organisms arrange into slime molds...

Or the way hydrogen and oxygen atoms form into water...

An important point about self-organization and emergent properties is that one constituent doesn't direct the group. Each individual just follows simple rules and directs only itself.

And yet, when all the individuals act together, the group behaves in ways that aren't visible in the actions of any individual.

"It's not magic, but it feels like magic," physicist Doyne Farmer once said about emergence.

It feels like magic because none of the individuals in the group are trying to do what the entire group winds up doing.

For example, birds aren't trying to flock. They're trying to avoid hitting the other birds and evade predators. That leads to them flocking – flying in what can sometimes seem like an eerily choreographed dance in the sky.

Markets don't soar and crash because everybody in them decides to make them soar and crash. Rather, they soar and crash because everybody in them is trying to earn a profit or achieve some other individual goal.

Now, I want to know...

How can anyone believe any one person or institution controls a deep, liquid, multitrillion-dollar market?

It would be like a single bird controlling a flock... or one drop of water controlling a hurricane.

It doesn't work that way.

If the U.S. Securities and Exchange Commission ("SEC") controlled anything, it would surely eliminate fraud. That's just one example of market outcomes it can't control.

But it can't do that. Heck, it can't even really discourage it much. We all know fraud happens again and again. And it's guaranteed to keep happening for the rest of time.

If the folks at the New York Stock Exchange or Nasdaq had any real control, they would surely prevent the market from ever falling too much.

But again, they have no such control. The prices of thousands of equities rising and falling together is an emergent property. No single security determines the whole market's movement, and no individual or organization can direct the market whenever it wishes.

Markets fall whenever they like... And no single participant has the power to stop them. (We'll leave the argument about whether or not it's in the best interest of many powerful people when markets crash for another day.)

It's the same thing with the economy, too...

If the Federal Reserve could actually do what it says it's trying to do – keep prices stable and unemployment low – we would never see a 9.1% reading on the Consumer Price Index.

These institutions occupy impressive buildings and hire armies of smart people.

But it doesn't matter... They don't control anything.

Try as they might, markets will do what they'll do. And you, me, the SEC, the New York Stock Exchange, the Nasdaq, and the Fed are all simply along for the ride.

But still, we humans maintain a foolishly persistent belief in the power of large institutions...

And then, we wind up with the consequences of the decisions of people in large institutions.

The same people locked down the entire global economy in the early days of the COVID-19 pandemic. Two years later, we're still living with the horrendous consequences – from 9.1% inflation to chaos in the global travel industry to empty store shelves to car lots and more.

We humans didn't do that. And neither did anybody selling goods and services, airlines, hotels, restaurants, grocery stores, auto dealers... or anyone else.

Whether you're shutting down the global economy or printing trillions of dollars, euros, Japanese yen, and other currencies to try to repair the untold damage... you don't get to decide the consequences of those actions.

They emerge.

Bear markets emerge in their own time and are based on their own rules. They stick around as long as they like. They don't end until they're ready. And they don't tell anybody what they're doing until long after they've done it.

No person or group of people can get together and make a plan to control any of that.

So when I see a bunch of magazine articles about how the bear market is over and the bottom is in...

I know it could be true. But I'm more confident that no one will know until after the fact.

That's because nobody controls it. Nobody makes it happen.

It's just like most of the important things that happen in markets. The bottom for stocks will be just one more emergent result of millions of people all acting in their own self-interest.

And worse than that, any efforts to control the market or try to make it bottom will almost certainly backfire in some way...

It could be as simple as kicking the can further down the road, generating even more unpredictable and potentially unpleasant emergent behaviors that nobody anticipated. That might be a solution in the short term, but it would only make it worse down the road.

Maybe what I'm trying to say in today's Digest is the line from that 1970s TV commercial for Chiffon margarine. It warned, "It's not nice to fool Mother Nature."

To a great extent, central banks and governments are in the business of trying to fool Mother Nature.

Their efforts assume markets are simple machines that can be tweaked with crude tools like money-printing and bond-market manipulations. But the emergent nature of markets suggests they're much more like hurricanes, bird flocks, and slime molds.

Stuff happens.

And I seriously doubt that a bunch of headlines in mainstream financial publications saying the bear market is over could be correct. It's too neat and clean, too easy.

It doesn't work that way.

I don't have any numbers or charts or data to share this week. All I have is my gut and a few decades of experience. And right now, my gut is telling me...

Don't fall for it. Recent rally or not, this bear market isn't even half over yet.

New 52-week highs (as of 7/21/22): Booz Allen Hamilton (BAH) and Option Care Health (OPCH).

Today's mailbag features feedback on yesterday's Digest, in which we talked about a massive rural Chinese banking scam and Robinhood's "Stock Lending" pitch. Do you have a comment or question? As always, send your thoughts to feedback@stansberryresearch.com.

"I read a couple of weeks ago that when a number of depositors were seeking to travel to Henan to protest at the banks that had frozen their money, their 'personal ID/Covid status card' mysteriously changed from green to red for virtually all of them, meaning that they were barred from traveling. 1984 here we are!" – Paid-up subscriber Monty B.

Corey McLaughlin comment: Monty, thanks for the note. That's true. And frankly, the situation is actually worse than you read... People in China who don't even have accounts at the banks where this scam unfolded have run into restrictions related to their "health."

For those who aren't aware, people in many Chinese cities must use an app on their phone that keeps track of their "health code" – which is tied to their COVID-19 status. Before entering buildings, using public transportation, or leaving the city, they must scan a QR code.

If their status shows up "red" – meaning they've recently tested positive or been close to someone who has – they must quarantine for 14 days until being cleared to move freely about the city again.

The invasive tracking is disturbing enough on its own. But it gets worse...

Over the past month or so, some people in the Chinese province where this bank scam unfolded (and protests have broken out among customers who simply want their money) have reported a mysterious change in the health status on their phones.

Here's some detail from a BBC Chinese report...

One bank customer in Zhengzhou told BBC Chinese her status was red even though she had never been in contact with a confirmed case, and her most recent tests showed she was negative.

She added that she was visited by health officials who asked her to stay at home and refused to explain why her status had suddenly turned red...

Some of those folks whose statuses have changed are relatives or friends of the victims of the scam. More from the BBC Chinese report...

One woman who lives in Zhumadian, a town 200km (124 miles) from Zhengzhou, said she was taken to a hotel for mandatory quarantine once her status turned red.

"I am not a customer, it's my dad who deposited money in one of the banks and now he can't get it out," she told BBC Chinese.

"He recently went to Zhengzhou to understand the situation. Once he came back, his health status turned red. My whole family is now in quarantine after our statuses turned red."

A staff member of the health commission in the Chinese province in question confirmed the reports. The staff member said people have to apply to change their health status, then test negative twice in three days before being "green" again.

And we think TVs knowing what we say is bad.

"Corey, not only is Robinhood doing this, but I got a similar message from Schwab! Reading the fine print clearly led me to not partake." – Stansberry Alliance member Rod P.

"Most major brokers do this. Short sellers need to borrow shares in order to short... and where do you think these shares come from? My broker (one of the top 4) splits their lending fees with me and deposits these proceeds into my account monthly.

"A better story is that Robinhood is probably increasing the ability of their clients to short stocks. I guess with elevated volatility it's often too expensive to buy puts. If this is not a contrarian bullish indicator, I don't know what is!" – Paid-up subscriber Lloyd M.

Good investing,

Dan Ferris
Eagle Point, Oregon
July 22, 2022