Monday, September 1, 2014

Who Is Really Enjoying Labor Day In America?

Let's review a quick summary of the "recovery" in U.S. labor markets as America takes a much needed day off work. We'll begin by looking for winners within the labor market to try and determine who should be celebrating this holiday. The following chart shows the change in real median income from 2009 to 2014 across race and ethnicity.

If we cannot find growth looking at race, where else can we look? Ah yes, class. The next chart shows the change in pay across each income level, and we have found it. The top 20% of wage earners experienced income gains during this period while the bottom 80% have declined. 

A report this week showed that within the upper middle class of the United States (income from $75,000 to $99,999), 55 percent have absolutely zero in savings. Most can be considered as having a negative net worth due to massive debt loads that continue to grow. 

So as we celebrate this labor day a select few within our borders can continue to cheer the divide that grows within America; the haves become far more wealthy while the middle class slowly erodes into the enormous pool of the poor. Those that study history know that the Roman Empire did not fall due to some great outside military force. It crumbled due to the rot that grew within the foundation of its own economy. The divide between the rich and the rest grew so large that the empire destroyed itself from within. 

Sunday, August 31, 2014

Wall Street's Black Swan Event Is The Most Likely Scenario

There has been discussion over the past few weeks throughout the financial world regarding the divergence between the S&P 500 and the 10 year U.S. treasury bond. Modern economics and finance teach us that when the economy improves, the stock market improves, and bonds usually fall (bonds fall in price when interest rates rise). Rates rise because when the economy improves, inflation rises and investors demand a higher return to compensate for inflation risk. There is also a "rotation" of out bonds back into the now more attractive world of stocks.

Since April of the year we have seen U.S. equity and bond prices rising together. Bond prices rising means yields falling, which has created the puzzling divergence in the graph below.

We're going to time travel back through history twice to try and figure out what is happening here. The first trip back in time is to the last post crash boom during 2003 to 2007. We see that during this entire period, in general, stocks and bonds rose together. It would appear that the two moving in tandem is less rare than we have been told.

Now let's flash back to 1981. Here is the key chart. Take a look at the 10 year treasury yield from 1981 to present.

You can see that treasury bonds have been in a bull market for 34 years. With hiccups along the way, yields have been falling in a steady downtrend for decades. Therefore, the only time stocks and bonds moved in opposite directions for long periods of time was when stocks were falling. This is why bonds have always been considered the "safe" investment to move into when stocks fall; because bonds always move higher when stocks fall, right?

Investors today believe that the most likely scenario under our current period of economic growth is to have money "rotate" out of bonds and into stocks. The second most likely scenario is a surprising decline in economic growth where money moves out of stocks and back into bonds (remember bonds always rise if stocks fall, right?). The third most likely scenario is that stocks and bonds continue rising together as they have been since April. With the U.S. financial markets the most desired location for global capital, why can't stocks, bonds, real estate, the currency, and everything else within U.S. borders rise in price forever?

There is a fourth scenario. It is not considered the least likely by the mainstream world, it is now considered impossible. Based on sophisticated computer programs churning data that goes back decades, we have been told this event is like the 1987 stock market crash; it can only happen once every hundred billion years.

The impossible scenario, the ultimate black swan, would be for U.S. stocks and bonds to fall simultaneously for an extended period of time. How far back do you have to go back to see this once in a billion year event occur? The 1970's, when stocks moved sideways the entire decade (experiencing free fall downdrafts along the way). The real returns on stocks were destroyed by inflation. Bonds fared far worse with rates rising steadily throughout the entire decade (bond holders lose principal when rates rise, something no one remembers is even possible).

After a decade of destruction, U.S. citizens did not want to hold stocks and they definitely did not want to hold bonds. What did they want? Gold. There were huge lines around coin shops during the final months of 1979. We know now that January 1980 was the ultimate opportunity to sell gold and move back into U.S. financial assets at their most hated moment in history. 34 years later, we are at the exact opposite extreme.

I do not believe U.S. stocks and bonds falling simultaneously is a black swan event. I believe it is the most likely scenario. I would not recommend holding U.S. stocks or bonds at today's prices. I believe that both asset classes are highly overvalued and arguably in bubble territory. The next logical question for someone living in the United States would be: "what could you possibly hold if you sold your U.S. stocks and bonds?"

It would surprise almost everyone living within U.S. borders, but we live in a global financial world and there are stock and bond markets in almost every country on the planet. Some of those currencies, bonds, and stocks are not only at fair value but some are already or close to being undervalued

(As a quick side note; most are not undervalued. Almost everything around the world is expensive today and finding value is extremely difficult; the reason for my current love for cash)

There will come a time again in the future, I hope in my lifetime, when U.S. financial assets are sold off, undervalued and hated the way they were in 1980. People at that time will promise never to return back to the U.S. financial markets again, which will signal the greatest buying opportunity in our lifetime for U.S. assets.

So is there anything actually worth buying today? I discussed a few things I am purchasing in small quantities earlier this weekend as I continue to focus on raising cash for the future, see:

S&P 2000 Vs. Silver 19.50 - Which Is The Better 5 Year Bet?

Labor Day Weekend

This cartoon perfectly sums up the relationship with my wife and I during this labor day weekend at the beach. While she would like nothing more than to leave all cell phones, ear buds and even books in the car when we head out to the beach this afternoon, I would love to be able to set up a desk bring a lap top.

We'll probably meet somewhere in the middle (I get to take my phone and an economics book to read). 

As a quick side note, I'm not some miserable person. I just enjoy the process of building a company more than staring out at the ocean. I understand that 98% of the people reading this, like my wife, will think I'm insane.

One of my favorite quotes from Mark Cuban:

“The thrill of victory in business blows away the thrill of victory in sports. Business is a sport 24/7/365. What does it take to be a successful entrepreneur? It takes willingness to learn, to be able to focus, to absorb information, and to always realize that business is 24/7 where someone is always out there to kick your ass.”

Inside The High Frequency Trading Machine

As the world's attention has once again moved away from high frequency trading (following the storm surrounding Michael Lewis' Flash Boys release earlier this year), people no longer care that the stock market is run by machines.

The following video from CNN Money gives you three minutes inside the high frequency trading monster; Citadel. As discussed numerous times here, I believe the next market liquidation will be far worse than the last because when things go bad these machines simply turn off and step away. The original flash crash was only a warm up for the big one that is on the way.

People in California found out this week that living on a major fault line of the earth's crust leads to earthquakes. The same exact argument could be made for a high frequency dominated stock market; it is only a matter of time. 

And, CNN Money asks if this is good for the average investor:

For more see:

How High Frequency Trading Crushes The Day Trader

To go much deeper down the rabbit hole to find out what the polite boys are doing at Citadel see:

Nanex - The Quote Stuffing Trading Strategy

Saturday, August 30, 2014

The Importance Of Walking & Moving Throughout The Work Day

I am very fortunate that most days I work from home. Last year I worked for a large commercial real estate finance company which was my first ever "office" job. The long hours of sitting still were tough for me because I'm someone that generally likes to be moving and talking, but I also knew that it was unhealthy. Fortunately, I got into a rhythm of taking breaks and walking around the pond outside with my co-workers throughout the day, which I believe improved our overall performance. Moving also helps stimulate creativity; see How Taking A 20-Minute Walk Everyday Transformed My Approach To Work.

Sitting Is Killing You

Friday, August 29, 2014

S&P 2000 vs. Silver 19.50 - Which Is The Better 5 Year Bet?

I try to spend about 50 percent of my time studying the financial markets reading, listening or watching analysts and economists that are bullish. I try to spend the other 50 percent of my time within the bearish camp. I would recommend everyone try do this to avoid confirmation bias; one of the most difficult psychological emotions to avoid while investing.

As markets move through cycles people naturally move, like a force of gravity based on human psychology, toward the side the market is moving. As stocks move up bears cannot withstand it and move into the bullish camp. This happens for natural psychological reasons as I just mentioned but it also happens due to career risk. If a professional in the financial world finds himself away from the crowd, and he is wrong for any period of time, he is terminated (or his fund loses investors). The ocean of financial capital around the world has no patience for under performance for any length of time; especially when the world's most popular index (the S&P 500) is on fire.

Overall throughout my investing lifetime I have enjoyed decent gains in the financial markets by investing in what makes the most sense to me and not what makes the most sense to the crowd. I entered the silver market with tremendous force in late 2005 through late 2007. I bought some at $7 and some at $15, but averaged around $11 through the period. I still hold the position. I felt like a genius at $50 an ounce in April of 2011 for buying and holding, and I feel like an idiot today for not selling at the top because it's back down to $19.50. At these prices I'm once again accumulating the way I was during 2005 and 2007 (Here's why).

I liked Chinese stocks in September 2012 and I like agriculture and uranium stocks today (click the links for a discussion on each asset class). The Chinese purchase has worked out great and time will tell on the recent agriculture and uranium buys.

One area of the market that I have continued to avoid since late 2010 has been the United States stock market. This was a semi-bad move from late 2010 to 2011 and disastrous move from 2012 to today due to the U.S. market's vertical and explosive tear upward.

Has anything changed? No. I felt the market was overvalued in late 2010 and I feel that it is wildly overvalued today (Here's why). No one cares today about corn, wheat, uranium, or silver (which is great, I hope I can continue to accumulate for a long time), they are only focused on the darling U.S. equity market. 

It has become more and more difficult to find bearish views on the market to provide the "50% of my time" study. One of the best writers within the bearish camp is John Hussman. I think he provides a well thought-out argument for why the market should turn down in the (near) future. Like me, he has been (incorrectly) bearish on the U.S. market for years.

When we reach the tail end of a cyclical run the bulls move from patting themselves on the back to an all-out assault on anyone who is betting on a downturn. One of those assaults this week came from John Swedroe of who wrote; Why Care About What Hussman Forecasts?  He lays out a decimating analysis of Hussman's longer term fund returns (1% return vs. the market average 8% return).

When we reach the end of a market cycle these type of articles make a lot of sense to investors. They are what pushes those that have been on the sidelines (or partially on the sidelines) "all in." Another way to look at it would be to ask; what would the market average returns look like for Hussman's funds vs. the S&P 500 if we were sitting at the peak of the cycle and the market turns lower (Hussman has bets in place that profit or avoid losses in a market decline)?

The efficient market theory enters the lexicon when the market is roaring. "You should always stay with stocks for the long run." "Looking at the long term chart you can see that every dip should always be bought."

What if every dip should not be bought? What if we are sitting at a historical peak in U.S. financial markets; both bonds and stocks? What if the next 20% decline is bought by you, but it is not bought by everyone else, and the market moves another 40% lower? What if it takes 25 years to come back to our current (historically overvalued) peak, the way it did in 1929? Do you have another 25 years to continue buying the dip?

I'm not saying that this will occur or even that it is the most likely event to occur. However, based on current valuations of U.S. stocks and bonds it should certainly be in the realm of possibility (20%?). The following chart comes from Ray Dalio, arguably the most successful hedge fund manager in the world today. His team believes that the expected annual returns moving forward on U.S. stocks and bonds after adjusting for inflation is currently at the lowest point in history (1%):

A 1% return could come in a variety of ways. It could come from a 70% decline followed by large annual gains that average out to a 1% return over the next decade. It could come from the markets moving sideways for 10 years. Either way, doesn't it make you a little nervous that the smartest team of financial analysts in the world are anticipating the worst returns on U.S. assets in history?

I thought John Swedroe's hit piece on John Hussman was actually well written, until I reached the very end and he came over the top with this:

"One reason to do so is that he isn’t telling me, or you, anything that other sophisticated investors (such as pension plans, hedge funds and mutual funds) are unaware of. The market has already priced the risks on which Hussman bases his analysis. He just believes he’s smarter than the collective wisdom of the market. Or, at least, he wants you to believe he is, even if he knows better."

Oh no John, if you could have only stopped before you reached that paragraph. In reality, the market has priced in a world better than absolute perfection moving forward and when the market moves back to reality, I certainly hope Mr. Hussman saves that sentence.

In the meantime, S&P 2000......2500.......3000......Great.

I'll just be buying agriculture, uranium stocks, silver, foreign bonds, Chinese water companies, Russian oil companies and all the other things that the world either hates or does not know exist. I do not manage money so I have no risk of losing "assets under management." I do not work in the financial industry so I have no career risk. I'm just a normal business owner who loves the financial markets.

Hussman and I will check back in with everyone else in a few years to see if sanity has returned. If it hasn't, we'll keep buying the stuff people hate and shorting the stuff people love.

Deaths From Police Shootings: America vs. Other Developed Countries

A major news event in the United States a few weeks ago was the shooting of Michael Brown by a police officer in Ferguson, Missouri. The incident has sparked outrage across the country on the use of police force and racism (as well as ongoing rioting in the town of Ferguson).

I do not pay enough attention to news events like this to have any opinion on the matter, but I came across the following infographic this week which I thought was shocking.

Thursday, August 28, 2014

How Far Away Is The U.S. Government Debt Crisis?

First, the consensus view:

Sounds great right?

The video above makes it appear that we are once again back at the point where the U.S. Federal debt is not a problem in the near term (over the decade) but still a problem "sometime in the future."

Their analysis is based on some key assumptions:

1. The economy is out of the woods are there will be no recessions in the future
2. Interest rates will not rise
3. The demand for U.S. dollars and debt will stay strong forever

Let's review these assumptions one by one:

1. The economy is out of the woods are there will be no recession in the future

We are already over 5 years into the current cyclical recovery. The average recovery throughout history has lasted 39 months or 3.25 years. We are due for a natural turn down immediately, never mind some point far away in the future.

A recession (or relapse into financial panic) would cause the government to "stimulate" with additional deficit spending while tax receipts fall. The result is the return of trillion dollar annual deficits.

2. Interest rates will not rise

We are currently in the final stages of a global bond bubble. Interest rates on government debt are resting at historical lows going back hundreds of years. This record high price for bonds comes at a time when the fundamentals have never been worse. It is not mathematically possible for the U.S. to pay back what it is currently borrowing without severely devaluing the currency it will pay it back with in the future.

Buying a 30 year bond today at these prices is a guaranteed loss of money.  So why are investors making these purchases? They are not planning on holding the bonds as a 30 year investment, they are planning on "flipping" the bonds to another investor at a higher price in the short term. The same exact psychology took place with the housing bubble back in 2005. It did not matter if the rent payments covered the monthly mortgage on the home, only that there would be a greater fool to step up and pay a higher price next month.

3. The demand for U.S. dollars and debt will stay strong forever

A few months back China and Russia set up the foundation to begin trading through their own currencies (rubles and yuan) to avoid the use of the U.S. dollar. The foundation began construction this week when Russian oil giant Gazprom Neft announced they would begin selling oil for Rubles/Yuan.

The BRIC nations (Brazil, Russia, India, China) sat down this year to begin building a BRIC central bank that would bypass the use of the (US dominated) IMF. The IMF is currently the world's central bank.

These are tiny snowflakes on a mountainside that appear to be nothing as they fall. They are slowly building up pressure on the mountain and there is an avalanche coming in the future. The coming change does not mean the value of the U.S. dollar will fall to zero, but if 95% of world trade is conducted in U.S. dollars and that number falls to 75%, it is going to have a massive impact on the demand for U.S. dollars worldwide.

Ultimately, a percentage of the trillions of U.S. dollars resting on the balance sheets of central banks around the world as a treasure chest of protection against currency devaluations will no longer be needed. For more on why central banks build these reserves and how it will change in the future I would recommend reading The Dollar Trap, one of the year's best books.

When just a small percentage of those trillions are sent back to the U.S. it will unleash the inflation in America that has been building up for years. The problem exists right now at this moment, not some point "in the future." It is only being masked temporarily by the (false) assumptions above. The best case scenario is for an orderly decline in value for the U.S. dollar, not a rush for the exits.

As a side note to make everything I just discussed discussed even more confusing, I am currently bullish on the U.S. dollar in the short term and recommend holding cash positions in liquid rolling short term treasury bills. I only hold this cash while I wait for sell-offs in foreign currency/bond markets. The goal is to continue to diversify out of U.S. dollars when foreign currencies/bonds go on sale.

Wednesday, August 27, 2014

Charting The Parabolic Blow Off Stage Of The U.S. Stock Market

Does it feel like the U.S. stock market no longer corrects downward? That's because it doesn't. Since we entered QE4 (dotted red line below), the size of stock market corrections have ranged from 4% to 5.4% and they are getting smaller as we go.

Prior to QE4, during the initial stages of the current bear market rally, corrections ranged from 8.5% to 19.7%. People were nervous back then. Now, any concerns about the market turning down have completely disappeared. Any down draft is looked at as an incredible buying opportunity. Any rally is looked at as an incredible buying opportunity. This process occurs during the final stage of a cyclical market rally.

Ambrose Evans-Pritchard On How The Next Crisis Will Unfold