When the Ruler Is Broken, It's Hard to Tell What's Right

Maybe stocks are returning to normal... One frenzy is behind us... Introducing 'Wittgenstein's ruler'... Bonds, commodities, and inflation... An interview with George Gilder... When the ruler is broken, it's hard to tell what's right...

Maybe, just maybe, the stock market is starting to return to normal...

I know that's nothing regular Digest readers expect me (Dan Ferris) to say.

So don't misunderstand what I mean by "return to normal."

I'm still bearish on the overall stock market. I still think U.S. stocks are bumping against their most expensive valuations in history, according to all the metrics that have correlated most closely with historical returns.

For example, the price-to-sales (P/S) ratio of the benchmark S&P 500 Index has negatively correlated with subsequent 10- and 12-year average annual returns about 90% of the time since 1928.

In other words, when valuations have been high, the returns that follow have been low.

Today, the P/S ratio of the S&P 500 is 3.17, meaning share prices of the United States' biggest companies are more than three times higher than their sales. That might sound like a lot, and it is...

The P/S ratio of the S&P 500 now is 35% higher than it was at the peak of the dot-com bubble.

I could cite plenty of other metrics, but you get the picture... I've painted it for Digest readers at least a dozen times before. I still expect a drop in the S&P 500 in line with previous all-time high valuations, somewhere between 50% and 65%, and an even bigger drop for many individual stocks.

I feel like that drawdown is within sight. That's what I mean by "return to normal." And I promise, as painful as it would be for those who aren't prepared for it, a bear market in stocks would be a very good thing in the long run.

The more investors grow accustomed to high valuations getting higher, the more distorted their thinking becomes... the more inclined they'll be to engage in dangerous speculations... and the worse they'll be blindsided when reality reasserts itself (as it always has and always will).

So when I say, "Maybe the stock market is starting to return to normal," I mean that today's valuations are way above normal, and maybe that's all about to change over the next several weeks and months.

Here's why...

The first reason I think we're headed back to more normal valuations is that some of the most egregious signs of speculative frenzy appear to be behind us...

I'm talking first and foremost about "meme stocks." The most popular one today is AMC Entertainment (AMC).

The stock's 52-week low is $1.91, reached on January 5 of this year. Its 52-week high is $72.62, achieved on June 2 of this year. That's right... It became a 38-bagger, a 3,700% winner, in slightly less than five months.

Today, a little more than two months after becoming a 38-bagger, AMC is trading around $33, a drop of more than 50%. Shares are still egregiously overvalued, but the fact that they're down more than 50% is reassuring to me.

It could be a sign that the market feels like it sucked in enough losers and is ready to show them what happens when you have no idea what you're doing.

The other famous meme stock, GameStop (GME), looks about the same. Its 52-week low, hit on August 7, 2020, is $4.06. And its 52-week high, reached on January 28, is $483. That's a 119-bagger from bottom to top. It's trading in the $150s today, down nearly 70%.

Short sellers are wading back in to at least one meme stock...

I also noticed that, about a month ago, AMC canceled plans to sell as many as 25 million new shares for proceeds of approximately $1 billion. The Financial Times reported that AMC appeared "to have hit the limit of what its existing shareholders will tolerate."

Then, just yesterday, a report came out that said Odey Asset Management, a fairly well-known hedge fund, had taken a short position in AMC. In a letter to investors, Odey manager James Hanbury told clients that retail investors' frenzied meme stock speculations were among several factors that have "created major distortions" leading to "compelling short opportunities."

You might recall that the meme stocks soared so high so quickly because retail-investor buying prompted large hedge funds to buy to limit rapidly growing losses in large short positions.

With $4.1 billion under management, Odey is not enormous by today's standards. But the fact they're willing to step back into the fray tells me perhaps they believe the worst craziness is finally behind us now... that the meme stocks will trade more in line with their business prospects.

AMC owns movie theaters and has $11 billion in debt. GME owns stores that sell old video-game DVDs. Both businesses have been in decline for a decade or more.

These stocks traded in the ballpark of 0.1 times sales before all the meme-stock nonsense. Today, AMC is around 14 times sales, GME around 2. A return to pre-nonsense levels would send both stocks down to roughly 95% or so below current levels, and closer to 98% or 99% below their meme-era highs.

Odey's AMC short is the right way to bet – if you must bet at all.

In this case, I see that the market is getting back to its long-term job of assigning asset prices that reflect the fundamentals.

Ben Graham, the father of value investing, said the stock market is a voting machine in the short term and a weighing machine in the long term. So maybe the voting period on meme stocks is over.

Let the weighing begin...

The weighing Graham was talking about is the real function of all markets. Markets take in an unfathomable number of inputs and condense them into a single output... prices.

Prices are supposed to be the most informative bits of economic data in existence. They're supposed to be an accurate assessment of the amount of real wealth one must fork over to acquire anything from a gallon of gas to a share of equity.

Indeed, the Efficient Market Hypothesis says that stock market prices do exactly that. Unfortunately, as my colleague and True Wealth editor Dr. Steve Sjuggerud coincidentally mentioned in yesterday's Digest, that hypothesis is a half-baked theory that's mostly the province of college professors.

Most real investors know it's buncombe.

When a stock goes up 119 times in a few months, you know markets aren't 100% efficient...

Markets can make big mistakes. That's why you must learn to ask if the market is accurately measuring the value of the company, or if the company's price is accurately measuring some flaw in market participants' thinking.

It's a classic case of "Wittgenstein's ruler" – a term coined by trader and author Nassim Taleb in his book Fooled by Randomness and named for Austrian philosopher Ludwig Wittgenstein. (I mentioned this book a few weeks ago when a subscriber wrote in asking about good reads on risk.)

Using the example of book reviews, Taleb explained the idea of Wittgenstein's ruler. As Taleb wrote...

A book review, good or bad, can be far more descriptive of the reviewer than informational about the book itself. This mechanism I also call Wittgenstein's ruler: Unless you have confidence in the ruler's reliability, if you use a ruler to measure a table you may also be using the table to measure the ruler. The less you trust the ruler's reliability... the more information you are getting about the ruler and the less about the table.

That last sentence pulls it all together and tells you why it's an important idea for investors. If the ruler – stock market pricing – is not reliable, you need to remember that and learn to spot the times when it's not giving you a helpful measurement.

The most naïve investors believe that the meme stocks near their peaks were being accurately measured by the market. But really, the ruler was flawed, and the stock prices were measuring just how insane locked-down, stir-crazy speculators hopped up on stimulus checks and claustrophobia can get.

And like Taleb said, when the table is telling you more about the ruler than the ruler is telling you about the table, the ruler is not reliable. The market prices of GME, AMC, and other meme stocks were simply not reliable. The market for those stocks was – and still is – badly broken. Although, not by as much.

Their recent price action... AMC's inability to keep milking the broken market for new equity money... and Odey's willingness to wade into an area that closed down at least one hedge fund (Melvin Capital) suggests that maybe, just maybe, the weighing has begun.

Another sign telling me investors are feeling a little cautious is the global bond rally...

It has been going on for months...

U.S. Treasurys have outperformed stocks since early May. The iShares 20+ Year Treasury Bond Fund (TLT) is up about 7.6% since May 4, with the S&P 500 up 6.4% since then.

To be fair, yes, I also realize the S&P 500 just made a new all-time high today, so we're still riding the crest of the longest, craziest bull market wave in history...

But for bonds to be outperforming stocks at the same time is notable.

The global bond rally has pushed more than $16.5 trillion worth of sovereign debt into negative-yielding territory, up from just $12 trillion in mid-May. That's getting close to the all-time high of $18 trillion in negative-yielding bonds set last December.

And, yes, we're talking about negative-yielding bonds, meaning if you hold them to maturity, you're guaranteed to lose money.

In light of Wittgenstein's ruler, I'm not sure what the bond market is really telling us...

But I know it's not telling a story the way a novel tells a story. Financial markets don't tell stories in real time. The stories are made up by humans after the fact.

Market stories based on real events are like semi-fictional movies and TV shows about real events. Some of the stuff really happened, but important items are always changed or left out to make the story work.

So it's most accurate to say that I'm not sure what story to tell about the bond market rally.

Enough investors could be getting worried about inflated asset prices and are fleeing to the safety of bonds. That's a classic tale. Perhaps they're more worried about deflationary forces than inflationary ones, another classic bond market yarn (which has gotten rave reviews for the last four decades).

But if the deflation and inflation tale is the one the audience wants to hear, then maybe the bond market is as broken as the stock market.

After all, who in their right mind buys a bond knowing full well that if they hold for the long term, they're guaranteed to lose money? That's what you get with most U.S. Treasury debt these days, after adjusting for inflation.

The U.S. 30-year Treasury bond yields about 1.9% today. How many people, if any at all, really believe inflation will run at less than 2% for most of the next 30 years?

Another timeless market tale is the one about rising commodity prices indicating burgeoning inflation...

We've pointed out the various spikes in commodity prices over the last six months or so...

Lumber is among the most notable... with futures rising more than 200% from November 2020 to May of this year, only to recently complete the round trip with a 66% decline.

Plenty of other commodities are still rising in price...

The Bloomberg Commodity Index – which measures energy, grain, and metals prices, and more – is up 21% year to date. That's better than the roughly 20% rise in the S&P 500 during the same period.

Even the Fed's official inflation gauge, the Consumer Price Index ("CPI"), has risen lately. It rose 4.2% in April, 5.0% in May, and 5.4% in June, as compared with the same months last year.

But, remember, the CPI doesn't include a lot of important stuff in its measurement, like housing prices. Multiply the CPI by two or three, and you'll probably get to the ballpark of what real people who earn wages are putting up with these days.

The Federal Reserve has called inflation "transitory," but I get the impression that not many people really believe that.

It's a little weird to watch bond yields fall while commodity prices and inflation measures rise...

(Remember, falling bond yields mean rising bond prices.)

This scenario – lower yields but higher prices and inflation – doesn't make a lot of sense, considering that bond payments are fixed and you don't want the currency you're getting those interest payments in to depreciate.

If it does make sense, investors could be saying they'll buy anything and everything to get rid of their depreciating currency.

Prices of all kinds of regular goods outside of the financial market certainly tell the inflation story. CBS News recently reported that "rents are going through the roof across much of the U.S."

In June, the U.S. median rental price rose 8.1% to $1,575. Rents hit new highs in 44 of the largest 50 markets. Memphis, Tampa, Riverside, California, and Phoenix all saw gains of more than 20%.

You've probably heard that used car prices have soared out of sight, too. The Manheim Used Vehicle Value Index looks like a meme-stock chart...

These prices could be measuring lower supply relative to demand.

But maybe inflation causes and exacerbates shortages, too, exaggerating supply-and-demand dynamics. Maybe rising prices are measuring the brokenness of the ruler that measures them – the U.S. dollar.

But remember, we're talking about Wittgenstein's ruler here. We're saying that market signals aren't necessarily telling us about asset values. Instead, rising asset values might be telling us something is very wrong with the market-pricing mechanism.

So maybe inflation will actually help the broader stock market transition from "voting machine" to "weighing machine" to back to normal. Maybe. But still...

No matter where I go, I can't completely escape the feeling that financial markets aren't acting right today...

The skeptic in me says that the meme-stock trade washout could be just another rotation from one bubble and into another that hasn't started yet.

It reminds me of an old bumper sticker I heard was found on cars in Silicon Valley after the dot-com bubble blew up. It said something like, "Please, God, Just One More Bubble."

And one more after that... and one more after that... in an endless series of rolling bubbles as investors genuflect before the U.S. Treasury and the Federal Reserve (and the Holy Ghost?) and rotate from one speculative play to another... anything to get rid of their cash.

Gee... When you look at it that way, the meme-stock folks gambling away their stimulus checks don't look quite as crazy.

Here's another example...

I spoke with author/philosopher George Gilder about the value of money in the newest episode of the Stansberry Investor Hour...

You can listen to the whole conversation here.

For those who don't know, George is known for many best-selling books, and we discussed some of the ideas in his 2015 book, The 21st Century Case for Gold: A New Information Theory of Money.

George talked about the absurdity of fiat money. He said instead of sound money in the form of gold, we have "a hypertrophy of finance," with some $7 trillion of currencies traded around the world every 24 hours. He says that's 70 times the value of all the goods and services traded each day, and that all the profits go to fewer than a dozen banks.

I'm not an economist (thank goodness), but $7 trillion of currencies swirling around every 24 hours can't be normal. It's like seven trillion bets that everybody else is using the wrong ruler and now you've found the right one, until tomorrow at least.

The global currency market as Gilder described it to me is the ultimate unreliable ruler...

It's the teeming essence of malfunction and corruption.

It now seems that I should never have started out today by talking about a "return to normal." How does anything return to normal when the measure of what's normal is so permanently and completely broken and deformed?

But I thought I was headed somewhere really solid with this Digest. I thought I was going to tell you something like, "Don't worry, if all this market nonsense is driving you crazy, I think it's almost over..." And a significantly large part of me still feels that way, as I said.

Historically speaking, stock market returns should not be all that impressive in the years ahead...

But really, would it surprise anyone if the S&P 500 rose another 20% by the end of this year? And another 20% or so next year? Would another meme stock rally or some other new asset price bubble shock anyone?

Probably not.

In the end today, it might be painfully obvious to you, me, and anyone who reads this that I have many more "maybes" and questions than definite answers this week.

But that's the point right now. You should get used to it and be prepared. As unsatisfying as it is, this is the new normal in financial markets. When the ruler is broken, it's hard to tell what's right.

What should you do?

I can answer that question.

Prepare, don't predict. Preparing means holding stocks, bonds, plenty of cash, silver, gold and maybe a little bitcoin if you're comfortable with it.

To be fair, you could also argue there's never been a time when the stock market was a better measuring stick than it is today. There have always been speculative episodes and as long as humans are humans, there always will be.

Once again, though, that only means that you need to understand when prices are measuring asset values... and when asset valuations are measuring investor appetite for increased risk.

Most people don't even know there's a difference.

New 52-week highs (as of 8/5/21): ABB (ABB), American Homes 4 Rent (AMH), Asana (ASAN), CBRE Group (CBRE), CoreSite Realty (COR), Costco Wholesale (COST), Dollar General (DG), Quest Diagnostics (DGX), Alphabet (GOOGL), Intuit (INTU), Liberty SiriusXM Group (LSXMA), Cloudflare (NET), Novo Nordisk (NVO), NVR (NVR), OptimizeRx (OPRX), Palo Alto Networks (PANW), Invesco S&P 500 BuyWrite Fund (PBP), ProShares Ultra Technology Fund (ROM), Sea Limited (SE), S&P Global (SPGI), Square (SQ), ProShares Ultra S&P 500 Fund (SSO), Thermo Fisher Scientific (TMO), Vanguard S&P 500 Fund (VOO), and Zebra Technologies (ZBRA).

In today's mailbag, a pair of contrasting takes on China... What do you think? As always, e-mail your comments and questions to us at feedback@stansberryresearch.com.

"I totally agree with that subscriber who mentioned China was a totally communist state with leaders who live to dominate its people. China is our ENEMY. The only difference between China and Iran is at least Iran is honest and upfront about hating us. (Their people protest in the streets with signs saying "Death to America.") The hard liners in China have the same sentiments about the U.S. only they hide behind a false wall of political double talk to make people in the U.S. think they are not all that bad. China would NOT hesitate to kill us all off, if they thought they could get away with it.

"Xi has some very big problems. The one child policy that went on for decades is now coming back to bite China in the backsides. Now there isn't enough young people to take the place of older retiring folks in their economy. So their brand of Social Security is imploding. And the population problems will take decades more to unwind. Couple that with the fact that China HAS to grow its economy 5% to 6% every year to stay viable and the most recent fallout of their government imposed stock market death roll and you can see their country is in for a long period of struggle. Not to mention all the negative forces put on them by Trump and now continuing with the Biden plan. There is still a ways to go with their stock market freefall." – Paid-up subscriber John M.

"There is one fact that everybody chooses to ignore. Economically, China has been taking the U.S. to the woodshed for a full generation now. This is not news, it is history. While the U.S. peaked in everything economically as a nation, China was the up and coming, room-to-run upstart. We planted factories and distribution centers in China to try and capture some of their action, but essentially we have failed in so many different ways with that. Quite simply, copying is not an American strength, while innovation is ... or at least was.

"We are losing that innovation advantage in everything except technology, which of course the Chinese simply copy in an almost instantaneous and often not so ethical manner.

"The U.S. dollar is their next big target. If they can uproot the dollar, they will become the foundation-ally secure, next economic dynasty, with all of its charter and perhaps fiat advantages.

"The Chinese stopped buying or rolling over our treasuries about 5 years ago and started buying even more of our much better valued, private, physical assets. They have also been mining and stockpiling gold bullion for at least 5 years. They've just clamped down on cryptos because they are not part of their plan either. The bottom line here is that investing in U.S. dollar denominated assets now has significant false floors and ceilings. The rules of the game have changed. We've blown off the false (growth and debt) ceilings and the false floor (of too big to fail) is feeling the weight of Wall Street's self-rewarding misdirection...

"The least desired and colored asset class in the U.S. right now appears to be gold, followed closely by silver. Per our Stansberry teachers and lessons, we should be looking ahead toward what the rest of the investment community is totally ignoring. Metals remain innovative because they are supply limited, rare earth essentials to both productivity and end use applications. Value should be measured on innovative weighted scales which will matter so much more, beyond this temporary (or transitory) horizon we can see today. Forever lasting foundational assets are worth more than the world realizes anymore. Far more than puff-of-air bytes of something which could nothing of substance tomorrow." – Paid-up subscriber John C.

Good Investing,

Dan Ferris
Squinting through the smoke in Eagle Point, Oregon
August 6, 2021