“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
“There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose.”
– Security Analysis, Benjamin Graham and David Dodd
In a recent post, we submitted that while one could certainly make the case for a year-end rally once Washington comes to its senses, it’s important to recognize the difference between speculation and investment. With markets surging to new highs on the heels of yet another poached punt by politicians, we submit that the majority of today’s market participants may be guilty of Graham’s “unintelligent speculation” – speculating when you think you are investing.
Asset bubbles are like mopeds. They are a lot of fun to ride, but nobody wants to be seen on one. Or perhaps more accurately, nobody wants to be seen picking themselves off the pavement after they crash.
So while there is a speculative case to be made for riding this rally into year-end, “intelligent speculators” should recognize that mopeds grow increasingly unstable at high speeds. Here’s John Hussman on the case for a year-end speculative rally:
Based on numerous past speculative episodes in the financial markets, we know that financial bubbles have often proceeded in an oscillating pattern featuring increasingly frequent cycles of advance, punctuated by gradually shallower declines reflecting an accelerating eagerness to buy dips. This can produce what Didier Sornette has called “log-periodic” oscillations. Given the negative return/risk estimates we observed in April and early-May, I believed that this series of oscillations was ending several months ago. In order to preserve a log-periodic pattern, further oscillations needed to exhibit an even faster alternation between steeply-sloped advances and shallow declines. Yet despite the strongly negative return/risk estimates we already had in April and May, this is unfortunately what has unfolded. With the Fed’s decision last week, we can’t rule out one particularly extreme version of a log-periodic bubble that is consistent with price fluctuations to date. That version is pictured below, and would comprise an advance above 1800 in the S&P 500 over a period of about 6 weeks. Again, this is emphatically not a forecast, but the conditions for a final wave of speculation may have been created by the Fed’s decision last week, and it leaves us unable to rule out this admittedly hypothetical possibility – particularly in the context of what has been a classic Sornette-type bubble to-date.
If interest rates remain under control, if the Fed is able and willing to continue its ongoing and increasing purchases of government debt, if speculators continue to afford the market a higher and higher multiple on lower and lower earnings estimates, than one could make the argument that the stock market’s upward momentum, driven by an increasingly desperate search for return in the absence of alternatives, could propel prices even higher. But history warns that the further markets move from fair value, the more forceful the reversion will be in the future. In other words, today’s gains come at the expense of tomorrow’s returns. It’s like déjà vu all over again. In our next post, we’ll take a closer look at the investment case for stocks at current levels.