Dealing with confirmation bias in macro analysis at market turning points

My macro view for most of the global economy is upbeat. My only downbeat views concern deceleration of growth in emerging markets and froth in capital markets. But in the main, market and economic momentum is up and to the right. The natural path is progress. Or at least it has been for the last couple hundred years. In that vein, I see the US in a middling upturn, Europe in an improving recovery and China in a softish landing due to loss socialization. But if you read my daily analysis, it is full of worry and in-depth coverage of downside risks. For some of you, it can be confusing. You’re saying to yourself, “I thought you were upbeat about this.”

A lot of this is process. Maybe it’s my contrarian nature. Or previous experience as a bond guy. I don’t know. But I try to take a holistic view to come up with a macro assessment and then afterwards proceed to rip and tear at that assessment in order to avoid confirmation bias. That’s always been my process and the spectacle makes for contradictory tension. Nonetheless, I feel it is a vital part of the process because we human beings are prone to confirmation bias, seeking out only the information that confirms our views once we have made an assessment. By going the opposite route, I can be sometimes inconsistent. However, it makes for more accuracy and a broad intake of views and less bias in information processing. In short, my macro views are generally upbeat but the analysis is always focused on risk assessment.

In the lead-up to the financial crisis in 2008, I wrote a lot about the overvaluation in housing and how financial fragility created systemic risk. And eventually we had a crisis as a result of this risk. However, in 2009, the risk receded eventually too. And I acknowledged the risk was lower and the opportunity greater almost right from the turn. I didn’t call it as well as Grantham or Buffett. But, I believe my process of taking a view and subjecting it to relentless attack made me recognize the turn faster. And at that time, downbeat confirmation bias was so deeply embedded in the psychology of the market and of pundits, I had to write a post defending my upbeat view pointing to confirmation bias in the blogosphere as the problem. And again, this was why I switched tack to bullish on Europe in June of last year and bearish on Japan in September.

So where am I now?

Right now, the market risks are skewed to the downside. Take a look at GMO’s most recent seven-year asset class real return forecasts.

What is this telling us? What it’s telling me – and this is confirmed by my own risk assessments – is that risks are skewed to the downside now. The expected seven-year return for both large and small cap stocks in the US is negative. And for small cap stocks – think the Russell 2000 – the annual real return forecast here is DEEPLY negative. That speaks to huge downside risk. So, despite my acknowledging that the long-term trend is up and to the right. The medium-term risk is clearly down and to the left.

I have written repeatedly about increasingly unreasonable spreads in high yield and leveraged loans, and about covenant light terms in the leveraged loan arena. I have also become worried about the auto ABS sector where we are seeing a big subprime factor artificially buoying auto sales. The reach for yield is real and it is a clear and present danger to market returns.

As far as equities go, I wrote last month about cyclically-adjusted P/E ratios over 50% higher than mean. This is where the negative 7-year return projected by GMO’s models comes from. And all of the telltale indicators are there that overvaluation in the riskiest classes was widespread before the recent pullback: 75% of recent stock market debuts have been from loss-making firms like Box and Twitter. Some tech companies were trading at 50 times revenue. We saw triple digit P/E ratios for Facebook, Amazon, LinkedIn, Netflix and Tesla. We also saw a doubling in hot IPO shares like Twitter. Nasdaq is still trading at around twice the average P/E multiple as the S&P 500 index.

For me, the turning point was the Candy Crush IPO. Its failure combined with all of the signs of froth has broken the momentum of risk assets at just the point that the Fed is moving from accommodation to a tightening bias. This combination of risk factors sets the market up for some serious headwinds and I think it could get choppy here.

The same goes regarding the convergence trade in European sovereign debt. This was a good trade – and one I recommended last year using the riskiest asset, Greece. But the trade has gone way over the top. Yesterday, I wrote that the risk for Greece and European periphery from Ukraine crisis escalation mounts as this convergence flies in the face of serious political risk. And this is not me just subjecting my upbeat views to attack. It is my wholesale reassessment of the risk profile in sovereign bond markets in Europe as market risk and complacency are moving toward elevated downside risk.

Here’s my subjecting my view to attack. Could this all pan out in the end, after a 10% pullback? Maybe. After all the frothiest segments of the market have been beaten up badly. And if we get the capex uplift in 2014 that some people expect, the real economy could continue up in the US. Let’s not forget that we just printed a 300,000 jobless claims number. That’s materially below where claims had been – and suggests that year-over-year comparisons are maintaining a bullish cast – contrary to what I had written earlier.

Marc Andressen made some good points on Twitter about this. 

• For 7 top consumer tech stocks (FB, TWTR, ZU, TSLA, LNKD, P, YELP): median is off -37.4% from highs.
• For 4 top enterprise tech stocks (WDAY, SPLK, FEYE, NOW): median is off 42.0% from highs.
• NASDAQ overall is off -8.5% from high. Google is off -12.4% from high; Netflix is off -27.8% from high.
• 12 tech IPOs in 2014 so far; median is off -22.0% from high but UP 0.3% from offering price (= effectively flat to offering price).
• Since some big tech co’s now have gargantuan cash reserves, I like to look at Price/Earnings ratios adjusted for cash on balance sheet.
• Apple, the shining jewel of American capitalism, has chinned all the way up to 2014 estimated P/E ex-cash of 11.2.
• Google, the company everyone agrees is the General Electric of the 21st century: 2014 P/E ex-cash of 19.4.
• Big legacy tech foursome 2014 P/Es ex-cash: Oracle 12.6, IBM 11.1, Microsoft 10.7, Cisco 9.5.
• These are still so low as to qualify as generational lows — public tech P/Es haven’t traded this low for this long since the 1970s.
• I’ve said it before and I’ll stay it again: If this is a new tech bubble, it’s managing to bypass all of the big public tech companies.
• So to rationalize all of this, you pretty much have to believe one of three things:
• A: This is the weirdest equity bubble ever, ignores the large cap companies that are easy to trade — not what happened in late 90’s.
• B: Public market still scarred after 2000 and 2008 crashes, hates tech equities, except a handful of companies delivering rare growth.
• C: Or, many large-cap tech companies are in dire trouble, about to be taken apart by new generation of disruptive challengers.

So there’s the counter view. The real economy could be picking up and Andreessen makes good points on the market. None of the large cap tech stocks have come to the party except Amazon.

But, again, look at the Nasdaq. Look at the larger cap new tech companies like Facebook, Twitter, LinkedIn and Tesla. Look at the Russell 2000. Look at cyclically adjusted P/E ratios. All of this is saying to me that the contours of this overvaluation are different but the underlying problems are the same: excessive policy accommodation leading to increased leverage and risk and overvaluation. The momentum trade can continue only as long as the real economy uptrend and policy accommodation does. When those two factors are broken, there will be significant pain because this market is well overvalued. They are not broken yet.