Wednesday, October 7, 2015

The Market Decline Is Baked Into The Cake: Why U.S. Stocks Are Going Lower

We've spent the last two years here on this site discussing why the U.S. stock market represents a potentially dangerous asset to overweight within an investor's portfolio.

Stocks recently hit an all time record price to earnings ratio when looking at the median stock of the S&P 500. While the 2000 market peak was skewed drastically higher by the technology sector, this time around the entire market was (and still is) incredibly expensive. By expensive I mean investors are willing to pay a high price to own the future (potential) earnings stream of a company. The investor's share of these profits comes in the form of dividend payments.

These dividend payments represent the second leg of the market's parabolic rise since mid 2011. Along with stock buybacks (which reduce the number of outstanding shares available increasing the value of the remaining shares), companies have continuously raised their annual dividend payments to show yield starved investors around the world that the warm waters of the U.S. stock market were open for business.

Not everything that has occurred over the last four years has been a mirage. U.S. corporations were, up until recently, hitting all time record profits as a percentage of GDP. This has come in large part from the continuous reduction of their employee costs. In other words, companies have improved productivity.

These three pillars of stock market growth have historically been mean-reverting data points. At some point in the future they will move from stock market stimulants to anchors dragging the market lower. 

Pillar One: Price to earnings ratios are sitting at levels where stocks have previously put in secular bull market tops. For a full discussion on P/E ratios and secular markets see: Secular Bear Market Review: Sentiment & Valuation Surrounding U.S. Stocks. You can see in the chart below the P/E ratio for U.S. stocks still remains in the 5th quintile (extremely expensive) after falling just off the highs seen earlier this year.

Pillar Two: Profit margins are one of the most mean reverting economic data points in history. Why? Because competition always enters the market. 

Pillar Three: Stock buybacks and dividend payments are actually the most frightening. These were largely paid for with borrowed money; corporate debt and/or junk bonds. As you may have heard over the last few weeks the junk bond market has already begun to implode (see chart below) and corporate debt rates are rising. As soon as it is no longer profitable (or possible) to borrow money to buyback stocks corporations will stop. If the market begins to fall corporate insiders will retreat from their purchases. Remember corporations always buy back the most at market peaks and disappear like cockroaches at market bottoms (when they should be buying). This is due in part to human psychology and in part to the way decision makers are paid; meaning they try to cash out and prolong the party as long as possible at the expense of future quarters which will be on someone else's watch (and bonus period).

No asset class that has become the darling of global investors goes up forever (U.S. stocks have been the darling asset class since early 2012). Eventually mean-reversion returns and what you experience on the way down is a series of waterfall panic declines, similar to what we saw in August. Moves tend to be more violent on the way down because hot money tends to enter markets late and when they realize the trend has been broken they quickly exit. Looking from a behavioral perspective, investors fear losses far more than they enjoy gains. This fear creates irrational selling during declines, which tends to peak at capitulation bottoms. Another reason for waterfall declines is the build up of margin (debt used to purchase stocks) on the way up. As prices rise, so does confidence in future price gains and the courage to use debt to purchase more stocks. This strategy did not work out well for the Chinese over the past year, and the story will end the same for U.S. markets.

The instabilities in the financial system are already baked into the cake like a fragile snowbank resting on the side of a mountain. It is not a question of whether the snow bank will become an avalanche, it is only a matter of when it will occur. People spend their lives trying to figure out which snowflake will create the instability that moves the entire snowbank, hoping they'll be able to time their exit from the mountain before that snowflake hits the surface.

This is exactly what we see throughout the markets and financial system. Central banks have built an unstable snowbank that looks perfectly calm on the surface. The snowbank has been building for so long people have completely forgotten the reason for the last collapse. Nowhere is this more noticeable than Ben Bernanke's recent media tour promoting his new book "The Courage To Act." By "act" he means printing trillions of dollars, saving bankrupt companies and holding interest rates at 0%. Those that understand finance know true courage would have been letting bankrupt companies fail and raising rates to protect the middle class savings of America. Just as the perspective surrounding Greenspan shifted from the "savior of the world" to "the man responsible for destroying it," people will eventually look back and understand it was Bernanke who was/is responsible for the next major crisis.

If we know the markets are unstable and we know the most expensive markets represent the most danger (U.S. stocks), then the question is not whether stocks will ultimately continue their decline, but what will happen next?

The world will once again look to the Federal Reserve to see if they have "The Courage To Act." My bet is this courage will arrive in the form of QE4 and/or negative interest rates. We are well overdue for a natural recession in the United States and there are many global landmines around the world (emerging market corporate debt, China, commodity company blow-ups, geopolitical concerns, or the vast array of global real estate bubbles). The global economy is already slowing down because the world is drowning in debt. Debt charges growth in the short term at the expense of the future and the future has arrived. The world was considered at the point of "peak debt" in late 2007 as we entered the global financial crisis. Most people believe we have been deleveraging and paying down debt since then. What actually happened? The world has borrowed over $60 trillion on top of the debt mountain that was already in place in 2007. This was not only made possible, but encouraged by global central banks which have held rates close to 0% for years:

While expanding their balance sheets rapidly through QE programs (we will have another full discussion on the coming crisis in Japan soon):

What happens if we enter a global recession at the same time one of the major economic swans enters a crisis (for example, China experiences a hard landing)? The Fed's response (QE4) will most likely make the first 3 seem small in comparison.

The better question is, what is the ultimately endgame? This will occur when one or all of the major central banks loses control and credibility within the financial markets. Can the Fed engineer another artificially recovery in asset prices? Maybe, but they are moving closer to the point when the markets no longer believe in their "magic powers." You could feel this begin to happen over the past few weeks if you were paying close attention. After they announced they would not be raising rates the U.S. markets sold off. They immediately began sending out their "talking team" to say that they still plan to raise rates in 2015 because the economy is strong. They have already begun to chase their tail, and when they lose control people will look back years from now in disbelief that market participants actually regarded them with some kind of godlike power.

The "Fed behind the curtain" has fooled an entire generation of investors. When the curtain is pulled there will be chaos and opportunity for those who have been patiently waiting.

For more see: Governments & Central Banks Do Not Control Market Movement

Wednesday, September 16, 2015

Kyle Bass On China & Emerging Markets

Part One:

Part Two:

Circular Logic World: Jeff Gundlach On The Fed & Dollar Strength

From an interview with

"We’re in a funny kind of circular logic world, where, since the Fed acknowledged a strong dollar could become a variable, that meant the odds of the Fed increasing interest rates declined. One of the reasons the dollar stopped strengthening is the consequence of the Fed mentioning its strength has been problematic, meaning there's less likelihood of them tightening. But the reason the dollar was getting so strong was that the Fed was talking about tightening.

You see the circular logic: The dollar is strong, so they can't tighten. So the dollar weakens, so they
 can't tighten. So the dollar strengthens, so they can't tighten, so the dollar weakens, so they can't tighten. And around we go. That’s where we are right now." 

The Fed's Rate Decision: What We Do & Do Not Know

Let's start with what I don't know: what the Fed will do tomorrow. I have no idea. Here's my best guess; they will not raise rates and they will talk tough on raising rates "soon" if data warrants it. Since no one knows what the Fed will do but the Fed, we can focus on what we do know....

The CAPE price to earnings ratio on the S&P 500 currently rests at 25.5. That level is close to where stocks peaked in 2007 and a long way from the mania peak in 2000. Can the markets launch into a final round of irrational exuberance a la 1999 and push to those previous mania highs? Of course. Do I want to risk my capital hoping that happens? Nope. I'd rather play Keno at the gas station because the odds are better.

The average CAPE price to earnings ratio going back to the late 1800's is 16. Previous secular bear markets have bottomed when the CAPE reached single digits. I believe we are currently in a bull market rally (2009 to present) within a secular bear market that began in 2000. I also believe we're likely to see a single digit CAPE before the current bear market ends, but I'll be a buyer of many U.S. stocks before the broad market gets there. What does that mean in the short term (next few years)? U.S. stocks are going a lot lower.

There was a tremendous amount of attention paid to the sharp move higher in the VIX (fear/volatility) index during the sell-off a few weeks ago. However, when you take a step back you can see that move looks like a blip on the radar compared to recent market panics. I believe the VIX will experience additional (even larger) surges as we move forward.

The average length of an American economic recovery is 40 months. We are currently in month 74 of the current recovery, which makes it longer than all but 4 in history. Why have recoveries tended to last longer in the most recent decades? The Federal Reserve and U.S. government have intervened in the markets to juice them up whenever they begin to show weakness. This creates an environment where fear leaves the economy, speculation flourishes, and investors leverage up knowing the Fed and government "have their back." The result is always the same; a massive collapse. Recessions, bankruptcies and price declines strengthen the economy and allow it to begin growing again on a stronger foundation. Like a drug addict entering rehab or a forest fire helping germinate and create new growth, removing that natural healing process creates the boom bust cycle we have been experiencing on a larger and larger scale.

U.S. bonds are sitting close to multi-century lows. They look about as dangerous as U.S. stocks if not more. I do not believe interest rates will move back to the 15%+ range we saw in the late 1970's (although its possible), but I do think rates will move, at the least, back to their historical range between 5% and 7%. From a starting point of 2.2% today on the 10 year treasury this would decimate real estate prices, raise corporate borrowing costs (crush profits) and raise annual interest costs the U.S. government owes on its $18 trillion and growing debt pile.

I continue to accumulate U.S. cash and dollar cost average into precious metals (silver and gold mining shares), agriculture, and emerging markets (see below on Brazil). While I believe all these markets have short term downside potential (hence the cash accumulation), they represent significant long term value combined with massive pessimism. I do not know the day these assets will bottom, but I believe they will all perform better than the stocks, bonds and real estate of most developed markets (US, Japan, UK, etc.) over a 5 year period from current levels.

For more see: Brazilian Financial Markets In Complete Panic

h/t Street Talk

Tuesday, September 15, 2015

The U.S. Economy Is Massive

An incredible visual walk-through showing the GDP size of American states in relation to entire countries around the world. Sometimes you can forget how big the U.S. economy is. It should also provide a pause for concern considering the GDP of Illinois is about 3 times the size of Greece and Illinois is bankrupt.

Friday, September 11, 2015

Brazilian Financial Markets In Complete Panic

Back in December last year every financial article and media outlet on the planet was reporting on the panic in the Russian financial markets. To summarize the situation:

- The currency was in free fall
- The stock market was plunging
- Bond yields were surging
- The central bank announced a surprise overnight rate hike of 6.5% to bring the benchmark interest rate to 17%! (To help put that in perspective, the U.S. markets are completely hysterical right now regarding the Fed raising rates to 0.25%)
- Citizens throughout Russia were spending the night pulling their money from ATMs (and buying U.S. dollars) in fear their money would be gone (or worthless) by the next day

Every once in a while (and it's very rare, trust me) I end up timing markets well. On December 16, which can probably be considered the absolute peak of Russian hysteria, there was one article on earth with an insane writer who was arguing why Russia represented a buying opportunity. You can read it here (hint; I am the writer):

Russian Financial Markets In Complete Panic

About 10 months later the currency is about exactly where it was when I wrote the article (against the U.S. dollar). If you invested in a 3 year bond like I discussed in the article you are on track to make your 18% this year, and if you bought stocks you purchased into the best performing asset class on the planet in 2015.

Why do I bring this up? Because I don't want you to call for medical help when I tell you the following:

I think Brazil represents a similar buying opportunity today. 

Hopefully I don't have to paint the background picture for you on how terrible things are currently in Brazil. Every media outlet, television station, financial article and radio show are currently discussing why Brazil is about to enter a 200 year depression and the currency, stock market, real estate and Brazilian bonds are about to fall 90% from here.

Yes, they have a political crisis. Yes, their government income is falling as their obligations are rising. That's what happens when your economy goes into recession. Yes, inflation is running high. Yes, government bond yields are rising, stocks are crashing and the currency is in free fall. Yes, they (corporations and real estate developers) borrowed a ton of debt in U.S. dollars and a lot of that debt will default.

........By the way, as a quick side note, when someone borrowers a ton of money and they don't pay it back, who ends up getting hurting the most? The lender. Who is the lender? Mostly U.S. banks. Think about that for a moment because in the 6 million articles written on the sovereign debt problems I have not seen that mentioned once.......

Let's collect ourselves for a moment and take a deep breath, take a step back, just as we did with Russia. Let's look at the much bigger picture.

After the sovereign debt crisis in the late 1990's, emerging markets around the world began accumulating massive foreign exchange reserves (almost exclusively in dollars). As U.S. dollars poured into their countries due to their trade surpluses they recycled the dollars back into United States assets (treasuries, mortgage bonds, or cash).

Why did they do this? If there was another currency crisis like we experienced in the late 1990's they wanted to have ammunition ready to fight it. If their currency began to fall rapidly against the U.S. dollar they would have the ability to sell dollars in the open market and buy their local currency. Foreign exchange markets work just like stock markets. If a massive buyer enters the markets to make large purchases it will stop the price from falling or cause it reverse course and rise.

How large is Brazil's war chest? 368 billion dollars. This is the seventh largest reserve accumulation in the world. For the complete list click here.

Brazil's total debt to GDP, which includes corporations, citizens and their government, is only 128%. That makes them one of the most responsible borrowers on the planet relative to the size of their economy. The debt to GDP ratio for Brazil has risen since the chart was put together below (but so has every other country above them).

Stripping away their corporate and individual debt you can see their government debt to GDP is only 59% in 2015. To help put this in perspective, Greece did not enter crisis until they reached 130% debt to GDP, the U.S. is over 100%, and Japan sits at over 250% debt to GDP today!

Unlike Russia, I do not think the Brazilian stock market (in general) has fallen enough to make it a safe entry point (it's getting close), but I believe the currency and the bond market have. A three year government bond in Brazil currently pays a little over 15% annually.

What are the risks? The currency can continue to plunge (probably likely in the short term) and/or the government can default on their debt (I believe the latter is highly unlikely). If the currency continues to decline you are getting paid to wait. Is it likely the Brazilian real will be lower against the U.S. dollar tomorrow and perhaps even 6 months from now, but I believe it will be higher than the U.S. dollar in 3 years.

If you came down from Mars, landed on earth, and only had the data from two countries (the U.S. and Brazil), but you didn't know the names of the two countries, 100% of the martians would invest in Brazil.

As I mentioned when discussing Russia, the idea of investing in Brazil is considered insane by almost everyone on earth as I type this today. That is part of the main draw for me personally as an investor. I like to buy things when everyone hates them and they have strong long term fundamentals. Brazil will rebound eventually. Perhaps I am early, or very early, as a buyer (I almost always am), but the intoxicating fear around Brazil tough is enough for me to begin making purchases.

Wednesday, September 2, 2015

Rick Rule On Why Asset Prices Have Remained Artificially High For So Long

Rick Rule began working in the securities industries 41 years ago. At 62 years old, he is one of the wealthiest (he is a billionaire) and knowledgeable people in the world regarding natural resource investing. In the quick segment below he talks about why he believes financial asset prices have remained artificially high for so long.