This past week, Houston, where I live, was flooded by a torrential down pour. However, it was not the rain itself that was the problem, it was the surge in rivers that flow through Houston. As far away as Austin and Dallas, rainfall had already began to flow into the San Jacinto and Colorado rivers which eventually culminated in rising water levels in Houston. Furthermore, Houston is designed so that water flows into the streets and eventually into the bayou and rivers out to the Gulf of Mexico. It didn’t take much more rainfall to send the rivers cresting over their banks creating a castastrophe following Memorial Day.

Like Houston, the financial system has been flooded with liquidity over recent years which has ultimately only had one place to flow – the financial markets. That excess liquidity has sent prices soaring to record highs despite weakting macro economic data. While many hope that the Central Banks can somehow figure out how to keeps the rivers of liquidity from overflowing their banks, history suggests that eventually bad things will happen. Of course, for investors, that translates into a significant and irreperable loss of capital.

As I discussed earlier this week, the next decade will likely be rather disappointing for investors. To wit:

“When using a relative comparison, in this case 10-years, what Shiller’s data does provide is a key understanding as to what market returns should be. The chart below compares Shiller’s 10-year CAPE to 10-year actual forward returns from the S&P 500.”

“From current levels history suggest that returns to investors over the next 10-years will likely be lower than higher. We can also prove this mathematically as well as shown.

Capital gains from markets are primarily a function of market capitalization, nominal economic growth plus the dividend yield.  Using John Hussman’s formula we can mathematically calculate returns over the next 10-year period as follows:

(1+nominal GDP growth)*(normal market cap to GDP ratio / actual market cap to GDP ratio)^(1/10)-1

Therefore, IF we assume that GDP could maintain 4% annualized growth in the future, with no recessions, AND IF current market cap/GDP stays flat at 1.25, AND IF the current dividend yield of roughly 2% remains, we get forward returns of:

(1.04)*(.8/1.25)^(1/10)-1+.02 = 1.5%

But there’re a “whole lotta ifs” in that assumption. More importantly, if we assume that inflation remains stagnant at 2%, as the Fed hopes, this would mean a real rate of return of -0.5%. This is certainly not what investors are hoping for.”

But despite the math, historical precedence or statistical tendancies, hopes run high that “this time is different.”

This weekend’s reading list explores the current state of the markets – is it rational or is it just nuts?

1) Markets Are Correct More Than Economists by Joe Calhoun via Alhambra Partners

“Perhaps the best method for observing the economy though is to forget the statistically massaged economic data and just look at it through the lens of the market. I am not a believer in a strong version of the efficient market hypothesis but there is a wisdom of crowds and markets are right a heck of a lot more often than economists (even a clowder of economists; apparently their performance doesn’t improve when their predictions are aggregated). And so, while I do find some uncomfortable year over year comparisons in some of the economic data, it is hard to square with what is happening in the currency, commodity, bond and stock markets.”

2) Proof The Stock Market Has Gone Nuts by Herb Greenberg via CNBC

“In 1841, Scottish journalist Charles Mackay wrote the classic, ‘Extraordinary Popular Delusions and the Madness of Crowds.’

If he were alive today, Mackay would likely have had a field day with the new website, Mergerize, which by its own description, ‘crowdsources predictions on mergers and acquisitions.’

It’s only a matter of time before those crowdsourcing M&A speculation have their day of reckoning, as well. In the meantime, might as well play the slots. More fun and better odds.”

3) The Fed’s Next Bubble by John Hussman, Ph.D. via Hussman Funds

“Unfortunately, the Federal Reserve has now created the third financial bubble in 15 years. Focusing on two variables – inflation and unemployment – the Fed has missed the most important consideration: the risk to financial stability. It is the same mistake the Fed made during the housing bubble. This mistake will ultimately end just as tragically. The only question is how much worse the Fed makes the situation in the interim. If investors develop a fresh preference for risk-seeking (which we can never rule out), we would observe that shift through the behavior of market internals, and we would expect to dial back our concerns about immediate market risk (though we would encourage a material safety net in any event). Even if that occurs, don’t think for a second that the eventual outcome for the financial markets or the economy would ultimately be better for it.”

4) Expensive Is the New “Cheap” For Bull Market by Joseph Ciolli via BloombergBusiness

“‘Investors are being dragged kicking and screaming into the stock market because, while valuations are not cheap, there really aren’t any better options,’ Tom Mangan, who helps oversee about $6.4 billion as a money manager at James Investment Research in Xenia, Ohio, said by phone. ‘Investors will have to identify undervalued stocks individually, not by sector.’

While elevated, the U.S. stock market’s overall valuation isn’t far from its historical average. The S&P 500’s price-earnings ratio is 18.8, about 2.4 points above the 10-year mean and 38 percent below its 1999 record.”

5) Stock Market Complacency Is Back by Sam Ro via Business Insider

“From Bianco’s note: ‘Our PE/VIX market emotion indicator climbed to 1.3 on S&P trailing PE of 18 and 3m avg VIX of 14. A level between 1.2-1.5 signals complacency. There was similar complacency going into summer last year, with S&P trailing PE at 17.5 and a calm market kept VIX at 10-14. The complacency persisted to July but then faded as the risk of higher yields came on falling unemployment, but yields ultimately stayed subdued preventing any major summer sell-off. Yet a selloff began in late Sept as oil prices started cracking and the dollar climbing.’

Bianco illustrated this in a pair of charts, the bottom one decomposing the PE/VIX to its various components.

As you can see, this measure signaled similar warnings ahead of the dotcom bubble bursting the global financial crisis coming to a head.”