Saturday, April 28, 2012

Satellite View Of The Global Economy & Investment Opportunity

To understand the problems the global financial system faces ahead you can read countless books, data reports, and analysis to put together a very long presentation with an endless amounts of charts. What this long and drawn out process will lead you to is one very simple conclusion:

The world today has borrowed more money than it has the ability to pay back.

This is not the case for every country in the world, nor is the case for every company within a certain country, nor is it the case for every citizen who does business with that company. There are countries that chose not to run massive spending programs when times were good, just as there are families who decided not to take out the maximum home equity line when prices were rising.

However, due to the way our financial system is interconnected today, the decision a small family makes in Japan with their savings has an impact on a business in America. This is a concept known as the butterfly effect (for more see 2012 Outlook: Global Butterfly Effect).

This is why next week I will spend more time focused on Spain's bond market than checking on Apple's share price. I believe an analysis of a particular stock must first be looked at through a satellite view of the global economy. Then once that understanding is put in place (capital flows, trade deficits, currency movements) you can then lock in on a certain country, then lock in on certain sectors within that country, then lock in on certain companies within that sector. Most analysts do the opposite, and it is why they are always surprised when rogue events or "black swans" send share prices off a cliff (or soaring higher).

With that said, let's go back to the big picture:

The world today has borrowed more money than it has the ability to pay back.

The following chart, one that I return to often from Kyle Bass, shows the global debt to GDP. GDP (Gross Domestic Product) is the total size of an economy. Analysts use debt to GDP ratios to help determine when an individual, corporation, or country will enter the danger zone and be unable to pay back what it has borrowed. Carmen and Reinhart in their instant classic "This Time Is Different" came to the conclusion after studying hundreds of years in data that this danger point for government debt was 90% debt to GDP.

Looking at the purple line above you can see that as of 2010 total global debt to GDP had grown to 310%. This is why bond markets around the world began showing tremendous signs of strain that have only been calmed with an enormous amount of central bank support (much more on that in a moment).

The world is suffocating in debt, and beginning in 2008 investors around the world found out what happened when confidence in this mountain of toxic IOU's cracked. When subprime mortgage borrowers began missing payments it triggered a loss in confidence in the paper promises outstanding everywhere. The following shows the rise in household debt (blue line) vs the rise in household income (red line) in America. When the divergence occurred America became a nation dependent on credit to grow, and when that credit could no longer grow (2008) the country found out that the income was not there to pay back what was borrowed.

This situation is going to take a long time to correct itself. To help put this chart into perspective, we can bring the timeline back to the 1920's (the previous credit boom that created the Great Depression) to show how far we have left to bring the American economy back to healthy debt to GDP levels.

We need to review the charts above because the global financial crisis began on America's shores, but we recently discovered that it was not only Americans who borrowed more than they could afford.

The financial crisis, beginning in early 2010, moved to Europe where it has completely destroyed the economies of Greece and Portugal. The hurricane is now over Spain where it is annihilating everything in sight. We found out this week that Spain's unemployment rate has now reached 24.4% and the youth unemployment is now over 52%. The percentage of those that are "long term unemployed" has surged, and the jobs in manufacturing, construction , and agriculture have essentially disappeared (seen in graphs below).  The unemployment rate in Spain today is now higher than the absolute worst time in the Great Depression in America. All signs point to things getting much worse.

Spain's government debt was downgraded again this week to BBB+.  As I have discussed in detail here in the past, their banking system is insolvent with only the European Central Bank life support to keep it from disintegrating. Spain's housing market, currently in free fall, appears to have no bottom in sight. This will continue to lower bank reserves at a time when money is flooding out of the system through deposit withdrawals.

Spain will have to decide whether it wants to continue onward through this depression trapped in the euro currency or remove itself and default. One of my favorite writers, MISH, summed it up in excellent fashion this week:

"Eventually will come a time a (Spanish) politician will hold up a copy of the EMU treaty, declare it null and void, and the debt null and void right along with it. That politician will be elected."

There are two major elections over the coming months that may determine whether or not certain countries within the EU remain part of the insane asylum they are trapped within or remove their country and move back to their previous currency. Of these is Greece on May 6th where the debt crisis is front and center.

The second is a country that had been under the radar (so far); France. France's economy is showing tremendous signs of strain as retail sales this week recorded the largest month over month fall ever, plunging from 50.2 down to 41.4 seen in the chart below.

French banks have a monstrous sovereign debt exposure to another country called Italy. Remember Italy? They are the third largest economy in the EU with a government debt to GDP ratio over 120%. When the Italian government bond crisis escalates again (rates have already begun creeping higher) it will put enormous strain on the French banking system causing many banks to possibly be nationalized. This, in turn, will put enormous strain on the French government debt market.....and on we go.

The response to this crisis has been met around the world with the largest display of global Quantitative Easing (printing money to purchase debt) the world has ever witnessed. The following chart shows that over the last five years central bank balance sheets in have grown by a staggering $8 trillion. This only accounts for Europe (European Central Bank), UK (Bank of England), Japan (Bank of Japan), China (People's Bank of China), and the United States (Federal Reserve).

There was $300 billion in balance sheet expansion in the first quarter and over $1.6 trillion in the last year. While most people watch the Federal Reserve with the printer key on pause (for the moment), they are missing that around the world the other central banks have picked up the baton and they are running full sprint ahead.

QE programs lower interest rates (helping governments, businesses, and consumers borrow) in the short term. Countries such as Japan have also used QE programs to enter the FOREX market directly and push the value of their currency lower. A lower currency value helps boost exports (goods become cheaper abroad).

This has created a currency war, and we are only in the beginning stages. Over the next few years the government bond crisis will move from Europe to Japan to the UK to the United States. Europe has faced problems with monetizing the debt directly due to restrictions put in place when the euro was created. Japan, the UK, and the United States have no such restrictions on central bank intervention. Their central banks have, and will continue, to keep the throttle full speed ahead on QE knowing that any slow down could bring the mountain of debt collapsing down around them.

While there will be liquidity shocks in the months and years ahead, causing over leveraged investors to have to temporarily sell assets to raise cash, I believe the biggest winner in this currency war will ultimately be gold and silver. The market vane index below shows gold optimism soaring during its rise over $1900 last September.  Heavy pessimism has now once again come back into the market as it has moved lower and consolidated over the past 7 months.

After being large sellers over the last decade, central banks have entered the market and become major purchasers of gold.

While pessimism toward the physical metal has moved lower, pessimism toward the gold mining stocks has moved into uncharted territory. The following chart, put together by James Turk, shows the number of gold grams needed to purchase the XAU (the broadest gold mining index). It shows that the mining shares, relative to the price of gold, are now the cheapest they have been during this entire bull market. Even cheaper than the liquidation plunge downward during the 2008 financial crisis.

Can these stocks go from extreme undervaluation to even lower levels? Of course they can. If you believe that gold will be priced higher in 3 years then these stocks represent incredible buying opportunities (they are currently priced for a complete collapse in physical gold). Just as with any stock in any sector there are going to be big winners and losers. I recommend doing your research before making any investment decision. Two mining stock newsletters (people that study these companies full time and do not collect money to promote stocks) that I personally subscribe to are:

- John Doody's "Gold Stock Analyst"
- Dave Morgan's "Morgan Report"

If you are looking for a specific fund that invests in mining shares I would take a look at John Hathaway's Tocqueville Gold Fund, symbol TGLDX.

How about silver?

The following chart shows the annual price of silver against the broadest measures of the money supply: M1 and M2. M3 is far greater in size than M1 and M2.

This chart shows how far silver would need to move higher in order to account for the paper money that has been created during this debt crisis so far. The Federal Reserve purchased 62% of all treasury issuance last year. There will be far more printing ahead.

As with gold and mining shares, silver will see tremendous pressure during any liquidation type events the global economy faces. However, based on what is taking place around the world I believe that all three represent tremendous value for a portfolio looking out 3 to 5 years.

If you currently own no precious metals or mining shares I always recommend beginning with physical metal. I personally use and recommend Goldmoney. They allow you to purchase physical metals electronically and store them in safe locations around the world. You can open an account in just a few minutes by following the link below. GoldMoney. The best way to buy gold & silver

After taking a satellite view of the global economy, for a bird's eye view of the US economy see Unemployment Payments Stop - Rent Payments Begin.

Energy Costs: Make Decisions Today For Tomorrow's World

Future Money Trends provides an excellent video below discussing the "breaking point" for our economy in terms of rising energy prices. The video is overly dramatic (as they usually are) but it provides a good reminder that everyone should make simple decisions today based on higher energy costs tomorrow. Specifically where you live in proximity to where you work, dine, shop, and what kind of car you drive to get there. Living somewhere you can walk (or take public transportation) to restaurants, stores, and your office will help tremendously if and when we hit the coming energy shock. If you are planning on purchasing a home, think about how higher energy costs will negatively or positively affect future buyers looking at your home in relation to how far they will have to drive.

Just as with everything else on I discuss on this site, higher energy costs are not "the end of the world," they just provide a different world. Similar to the changing economy, simple decisions you make today (before a crisis hits) will have you ahead of 99% of the rest of the world. If I am wrong and oil falls back down to $30 and stays there forever (like many who blame current prices on "speculators" believe) where does that leave you? With an energy efficient car and a home that is close to your office. Not that big of a disaster.


Thursday, April 26, 2012

Wall Street Journal Interview: Jim Rogers

Legendary investor Jim Rogers, co-founder of the Quantum Fund with George Soros, took some time to speak with the Wall Street Journal this week on China, commodities, and American politics.


Student Loans: The Next Bail Out?

Out of the question you say? Not in an election year.

And just imagine how easy would it be since most student loans are owned by the American government (taxpayers).

What do massive student loans, unemployment claims ending, and foreclosures picking up mean for retail stocks ahead? See Unemployment Payments Stop - Rental Payments Begin.

Unemployment Payments Stop - Rent Payments Begin

The following table shows jobs lost during February 2008 through February 2010 sector by sector. It then shows the jobs created from March 2010 through March 2012 in those same sectors, providing the percentage of jobs that have returned.

As you can clearly see there have been some big winners and losers. Construction employment has remained in a steady depression with 99% of jobs lost still gone three full years into our "recovery." This is due to the obscene amount of over building that took place in single family homes, apartments, office buildings, and retail centers. 

Manufacturing employment has also been through a very rough period with 80% of the jobs not returning. The following excellent graphic from the Wall Street Journal a few weeks ago shows that this is not only due to the economic downturn but increases in productivity (factories continue to use more machines over men).

The economic downturn in America has pushed more and more people toward low wage work in order to survive. The following graphic shows that 24.8% of Americans are now moving down toward jobs at McDonald's after discovering that their jobs lost (see list above) are not returning. Click for larger image:

This discovery is also being made by students leaving school. USA Today provided a startling statistic this week: 53% of college graduates (bachelor's degree holders) under the age of 25 are underemployed. 

Student loan debt crossed the $1 trillion mark in March of this year. $85 billion of this debt was delinquent at the end of the third quarter in 2011. My guess is that a far greater amount of this debt is delinquent today. This is easy to imagine with 53% of these debt holders underemployed.

The savior for the unemployed during the current depression has been the extended emergency unemployment benefits. Many of the state unemployment rates have declined recently which has created an upcoming "cliff" when these benefits will be turned off. Based on current unemployment rate trends 700,000 Americans will lose their monthly payment in June.

Ironically, what is creating this upcoming cliff is the artificially low unemployment rate I have discussed here often. As more and more Americans give up looking for jobs because they have been out of work for so long they are no longer counted as unemployed. This causes the unemployment rate to fall which has triggered the stop in emergency unemployment benefits in many states.

The second major boost to the unemployed has been living for free. Many Americans have found that when they stop making payments on their underwater mortgage the bank does not call or bother them. Some have lived payment free for 5 years (and counting). 

A major delay in the foreclosure process was last year's robo-signing scandal which delayed almost 100,000 foreclosures per month. Ironically once again, this delay in foreclosure processing has created an artificially low supply of homes on the market making some areas feel like there is an actual recovery occurring.

Let me provide a quick real life example of how this shadow inventory works. I live in downtown Charlotte, NC. There is a high rise luxury condo building that was started during the boom (2006-2007) with 408 units. It now sits completed, looking beautiful, in the center of the city with less than 20 people that have closed on condos. It is an empty building.

The Charlotte Observer this week told the story of a couple who put down a $90,000 deposit and is trying to get out of their contract on a two bedroom unit they purchased for $700,000. 

This past week the construction debt on the building was purchased by an investor for $100 million, and they immediately filed for foreclosure on the developer. This means they purchased every unit for $245,000. 

The downturn Charlotte market is about to see first hand, like a magic trick, what happens when shadow inventory turns into real inventory.  What is the comparable purchase price now for this couple's $700,000 2 bedroom condo? Somewhere far less than $300,000, providing them with a $400,000 loss.

This is how a market naturally heals itself. The investor (based on their past history) will most likely turn the building into apartments. The 400 units of new supply for rent will drive down rents significantly in downtown (Charlotte is pretty small).

This process will be taking place across the country as the shadow inventory continues to become real inventory.

Here's a quick thought experiment for you:

If Americans who were living for free will have to now begin making rent payments, and Americans who have been receiving unemployment checks every month will now collect nothing, what will this do to consumer spending?

Analysts for stock promoting financial companies are in love with retail stocks right now at sky high prices and lofty valuations. We have been told that the American consumer is "back."

Others will take the information above and decide to take a "short" position on retail stocks. These people believe that Americans will lean toward trying to shelter and feed their family vs. purchasing new clothes and hand bags.

We'll check back a few years down the road to see who made the correct investment decision.

For more on the residential real estate market see 2012 Real Estate Outlook.

h/t Credit Write Downs, Wall Street Journal, Zero Hedge, Charlotte Observer

Tuesday, April 24, 2012

Residential Real Estate: The Government Monster Grows

Over the weekend I discussed three important components of the economy; consumer spending, employment, and housing, that are not recovering to pre-bubble levels and continuing to act like an anchor dragging growth. Today we take a closer look at housing.

The Case-Shiller price index was released this morning for the month of February. It showed a .8% month over month decline, the sixth straight monthly decline, bringing the index to new post bubble lows. Home prices are now lower than where they were a full decade ago, meaning if someone bought into the "index" (the average price home in America) after 2002 they are now underwater.  Obviously those that bought after 2005 are in far worse shape.

Are we close to a bottom? The answer to that question depends on how well you believe the government can continue to finance new risky mortgage loans moving forward. An FHA loan today allows a borrower to purchase a home with as little as 3.5% down. Housing bulls say that most people will choose to put more down even if the requirement is so low. What is the actual average FHA loan down payment? 4%

Last week Freddie Mac 15 year mortgage rates reached an all time record low at 3.11% seen in the graph below.

The artificially low rate loans (that will explode like time bombs on Freddie Mac's balance sheet when interest rates rise) are still not stimulating the mortgage demand needed to wake the housing zombie. The following graph shows mortgage applications (demand) against the affordability of loans (lower rates). As rates move lower, more people continue to say they don't care.

Then there are refinancings which have also seen a slow and steady decline since the 2002-2004 (home equity party) period.

How big has the government mortgage market become? The following graph shows that since 2007 private first mortgage debt has declined by $600 billion. The government backed first mortgage debt has increased by $1.1 trillion.

With shadow inventory hidden from view home builders in many areas are once again cranking out speculative homes (building new homes that are not yet under contract with the "speculation" that a buyer will emerge to purchase them).

Last month the Fed ran a stress test on the largest banks to determine what would happen if home prices continued to fall. Their downside estimate? Another 20% decline. Now why would the Fed use such an "impossible" number during a stress test? I'll let you decide on that.

For much more on the residential housing market and the shadow inventory supply see 2012 Real Estate Outlook.

h/t Calculated Risk, Michael Panzner, The Big Picture, Dr. Housing Bubble, WSJ

Sunday, April 22, 2012

Is There An Apartment Market Bubble? Interest Rate Impact

Multi-Housing News published an excellent article this week that asked a simple question; Is There an Apartment Market Bubble? It was followed with three answers from various participants. All three respondents agreed that there was no apartment bubble, but I'd like to review the answer I found most interesting (because he was closest to the correct answer). First we'll begin with the question:

MHN: In many of the top U.S. markets, apartment pricing appears to have returned to, or be close to, peak levels achieved in 2007. In certain cases, cap rates are once again sub-4 percent. Is there a possibility of a bubble developing in multifamily real estate driven by the low cost of capital, low yields in alternative investments, aggressive projections of apartment incomes in valuation and/or any other factors?

And the response from Ray Huang, Independent Research Firm:

"We do not currently see a bubble in apartment values. If our forecasts for apartment rent growth prove accurate—and we forecast positive, but decelerating rent growth over the next several years—apartment values look to be in proximity of fair value, maybe even a little cheap. Our main benchmark is the fixed income market. Unlevered IRR premiums to 10-year Treasuries, BAA corporates and high-yield bonds (a case can be made to compare return hurdles to any three of these indices) are all in-line or larger than historical averages. If we are in a bond bubble—and we don’t pretend to be smart enough to answer that question—then yes, apartment asset values may be inflated. However, if such proves to be the reality, a lot of other asset classes may also be inflated, not just apartments or commercial real estate in general."

Analysts such as the one above measure the cap rate spread against the 10 year treasury. Based on where treasury bond (federal government bond) interest rates are today he feels that apartments are being correctly priced and in some cases are still undervalued. The only problem would be the unlikely "black swan" type event of treasury bond rates rising. If this were to occur then apartment values would plunge.

This is exactly what is coming to the market. Hundreds of billions in capital are once again pouring into the real estate sector because they are chasing price momentum and they are chasing bond yields down. I can imagine an analyst approaching the owners of a real estate investment trust and showing them a few quick models of what would happen if interest rates were to rise just a tiny amount. They are probably thrown out of the room with laughter as analysts were back in 2006 when they ran quick calculations on subprime residential loans with questions like "What would happen if interest rates rose?" 

Unlike residential single family real estate, the recent hysteria in the apartment market and purchases of these buildings at insane price levels means we are much closer to the top than the bottom.

For much more on this discussion see the 2012 Commercial Real Estate Outlook.

Present Stock Market Guides: Is This Time Different?

After looking at a century long view of the stock market in Historical Guides: Stock Market Cycles & Public Ownership to determine that we are in a secular bear market, we now look more in depth at our current situation today to determine if "this time is different."

The common perception from most financial adivisors, financial analysts, investor sentiment readings, and the general person on the street is that America faced a crisis in 2008 which was dealt with and we have moved on. The stock market fall was only a brief stumble, and the economy is now back on track with only higher earnings growth, lower price to earnings multiples, and higher dividends all equaling higher stock prices ahead.

I want to take a moment here to discuss why this time may be different. The stock market is a forward looking indicator (maybe the best leading indicator) because people have the ability to press sell or buy on a keyboard in just a few seconds. Actual indicators within the economy occur on a lag because it takes time for companies to build new factories, higher workers, and increase inventory volumes.

During our current counter-cyclical move in the economy and financial markets which began back in March of 2009 the stock market has led the way forward at an almost relentless pace, moving from 666 up to 1378 where it stands today.

During a normal business cycle the lagging economic indicators will track the market higher as the economy begins to recover. There are numerous economic indicators that track this data such as manufacturing reports and GDP growth. Most of these indicators have moved significantly higher during the recovery, however, this time has been different in that some of the key economic data points that are normally soaring at this point in a recovery continue to weaken. Let's review them now.

1. Consumer Confidence Has Not Recovered

A major benefit a rising stock market has is its impact on consumer confidence through the "wealth effect," simply meaning that if someone sees $400,000 in their 401k they are more likely to take out a loan to purchase a car than if they have $200,000 in their 401k.

The following graph shows consumer sentiment against employment. While they consistently tracked together in the past, during this recovery while the unemployment rate has fallen consumer confidence has not recovered.

This is important for numerous reasons. The first is that the consumer in America hit a wall in 2008 with their ability to borrow and spend. At well over 200% private debt to GDP, consumers were only able to finance an increase in spending and the ability to pay off previous debt incurred through additional home equity loans (home prices rising) or a rising stock market. When both of those peaked and begin to turn down rapidly, the power of leverage was (and is still today) felt in reverse.

In addition to many people no longer having the ability to spend, many also do not have the desire (the most direct measure of confidence) because they do not believe in the recovery. Many Americans have watched the stock market rally with a very suspicious eye, which is why most have not participated during the run up and still continue to sell stocks today (see Historical Guides: Stock Market Cycles & Ownership for more).

Lastly, looking at the anomaly in the chart above (the most recent divergence) one can also cast a skeptical eye on the validity of the unemployment rate falling.

2. Unemployment Has Not Recovered

The chart below shows the percentage of Americans with jobs:

This is the chart analysts and economists should follow when trying to determine the validity of the monthly jobs report. The reason why the number of Americans working continues to plunge while the unemployment rate continues to fall (artificially projecting strength) is due to the number of Americans that have been unemployed so long that they have given up looking for work (no longer counted as "unemployed").

Some will argue that a portion of the number Americans not working is due to baby boomers retiring, and they are correct. However, a retiring worker does not add to the strength of an economy or stock market. These boomers (and they make up a small percentage of the number due to many having to work beyond their ideal retirement age) now become sellers of stocks and bonds from their 401k in order to pay their monthly expenses. They also become an additional drag in terms of social security and medicare costs needed to fund their retirement.

This trend is taking place across a large portion of the developed world (see Japan for an extreme case study). The baby boomer "boom" created during their peak spending earning and spending years (1990 - 2010) has now turned into the "bust" created by their peak savings and social security spending years. While I could write about the baby boomer effect on the economy for days, one of the best studies on this topic was released last year from Harry Dent titled The Great Crash Ahead.

3. Home Prices Have Not Recovered

The last recession in America in 2000 was short lived due to a massive reduction in interest rates from the Federal Reserve and a subsequent explosion in home prices, which stimulated the economy through the previously discussed "wealth effect," home equity withdrawals, construction jobs, real estate sales/mortgage related jobs and all the other side industries that fed off the growth such as cabinet and counter top companies.

The US replaced a stock market bubble with a real estate bubble, but during the most recent downturn home prices have fallen every step of the way negatively impacting the "wealth effect" as well as putting millions of people out of work that counted on the sector.

The real estate bubble has been replaced during this recovery with a government spending and student loan bubble, both of which have combined to form the (final) American debt experiment.

A recent study showed that home prices close to a college town cost $200,000 more than home prices just outside a college area. Why? Students today receive endless amounts of government funds for school and they are maxing out these loans across the board. Offering unlimited student loans allows universities to charge ridiculously high prices knowing that students can pay the tuition with just a few signatures on a loan document. The business of college has never been better. Many of the unemployed youths are now going back to school for a master's degree because they know the student loans are available and they can "hide out" until this temporary recession ends.

The problem with this?

Students who leave school with $50,000+ in student loans (which cannot be discharged through bankruptcy) now have $50,000+ less capital to put toward their first home. This only delays the process of becoming a home owner.

What else is delaying this process?

The harsh reality is that even when they graduate from 6 to 8 years of college with an impossible mountain of loans to pay, there is still not a job waiting for them. So what are these kids doing? They are moving back home with Mom and Dad - another crushing blow for the housing market. The following chart shows the percentage of young adults living at home. Notice particularly the 25 to 34 group (those finished with college) that are immediately moving (and staying) back in the nest.

The following shows the stock markets movement through 2012 against how it performed last year. So far they have begun the year on almost identical paths (you may remember the euphoria in the market around the end of April last year).

During this recovery the economic data has confused most analysts. While many indicators show strength, others (such as the big three above) continue to show major weakness. Many feel like the following couple when trying to get a gauge on the economy's future:

The stock market is rising, but unemployment claims are once again rising and moving back toward the "recession area" of 400,000. Real estate permits and starts are beginning to rise, but a closer look shows that it is only the multi-family sector showing strength: the rental market. Retail stocks continue to rise, but retail spending and confidence remains in depression like states.

Jeremy Grantham, one of the most famous hedge fund managers in history, released his most recent newsletter this past week. In it he discussed that it is almost impossible for a money manager or analyst to remain bearish on the future direction of stock prices if the market has moved up for more than 2 - 3 years, even if all the economic data suggests that there is an ice burg dead ahead.


Because he will lose his job. In America we need to see results immediately. We look at where the stock market finished in a single trading session and then we look to find out what made it move up or down that day (which of course has very little to do with that day's movement).

Our CEO's are judged based on their most recent quarter. Politicians are judged based on their current term and most recent term. Money managers are judged based on how much their fund is up or down that year. This is why you'll see funds add the best moving stocks to the portfolio on the last day of the quarter, also known as "window dressing."

I do not manage money, and I do not charge a fee for the content on this site so I have the benefit (because I am small potatoes) of having the same freedom that a hedge fund god such as Grantham has been provided. We can tell you exactly how we feel about the markets based on the data, not based on the recent price moves.

For those out there that have a financial advisor who works for a major financial company I would recommend taking a few minutes to read Grantham's letter provided below. It will open your mind to why someone who told you to sell everything at 666 on the S&P 500 is now telling you everything is looking great at 1378.

Grantham Q2 Letter

Historical Guides: Stock Market Cycles & Public Ownership

I began reading John Mauldin's fantastic weekly newsletter, which he provides for free on his website, after I finished his book Endgame last year on the global sovereign debt crisis.

This week Mauldin took a look at secular bull and bear market cycles in the stock market, one of my favorite topics and one that I have discussed often because I feel that studying history is a tremendous way to get a glimpse into the future.

Mauldin noted that secular bull and bear markets have an eerie tendency to last 17.6 years, basically to the month. Let's briefly take a look at this phenomenon:

In the fall of 1929 the DOW was at 380 (after reaching bubble levels through the roaring 20's). Over the next 17.6 years the market moved through a secular bear market and in the middle of 1947 the DOW was at 220. In the chart below the green blocks show the 17.6 secular bull markets, while the red blocks show the 17.6 year secular bear markets:

Over the next 17.6 years the DOW entered a secular bull market touching 900 at the start of 1965. Then, another secular bear market began lasting...17.6 years, leaving the DOW still stuck at 900 in the middle of 1982 after being ravaged in real prices through inflation.

From the middle of 1982 through February of 2000 the DOW rose from 900 to 11,700, moving through another 17.6 year secular bull market.

In February of 2000 through today we have been in a secular bear market. The  market has essentially moved sideways through long rallies and brief crashes.

Understanding that we are in a secular bear market means we can study from the past to understand how to navigate in our current environment. Similar to the (1929 - 1947) and (1965 - 1982) bear markets, the government is doing everything in their power to intervene and "stimulate" the economy. This creates an underlying layer of inflation in the system that tends to keep markets nominally moving sideways although they are correcting downward in real terms (purchasing power).

Based on history, our current secular bear market in the stock market will end in August of 2017. Looking at how we are progressing through the process that time frame almost "feels" right because governments around the world will do (and currently are doing) everything in their power to slow down the natural process of correction (letting the economy heal), however, this ultimately makes the problem worse and brings the final cleansing crash and sentiment drop needed to create a market bottom.

Secular bear markets do not mean that the market goes down every day, month, or year during the cycle. In fact, during secular bear markets the market goes up 50% of the time. This means you have to pay understand to where you are in the secular cycle by paying close attention to the counter trend rallies like the market is running through today (this differs from a bull market when you can just buy and hold with your portfolio on auto-pilot (1982 - 2000).

One of the arguments analysts and brokers on television (the people who sell stock for a living) argue is that for the past four years average Americans have been pulling their money out of the stock market and putting it into bond funds, cash, or other investments. They argue that this has created a large amount of "money on the sidelines" waiting to take this current (bear market) rally much higher.

Another look back at history paints a different picture. From 1900 to 1950 only 4% of households owned stocks. Think about that for a second because it almost seems impossible based on the world we live in today where every American is told the best financial advice is stocks for the long run in a 401k. In the late 1920's, at the peak of the stock market bubble/mania that roared all through that decade, the ownership levels only touched 10% of the public at the highest point.

Fast forward through to the 17.6 year bear market cycle that ended in the middle of 1982. At this point, over 30 years later only 17% of the American public owned stocks. Stock ownership at that time was considered as crazy; a guaranteed way to lose money after inflation. Bonds at the time were yielding over 15% so there was no need to even risk your money in the "rich man's casino."

This extreme low in sentiment set the stage for the next 17.6 year bull market, but what gave it the rocket fuel was the introduction of the 401k, which allowed contributors (many times matched by companies) to put pre-tax income into the stock market. As the market roared higher year after year, more and more people began to dream of early retirement from their 401k stock portfolio.

In the year 2000 over 60% of the public was investing in the stock mark, reaching a peak of 67% in 2002. It went from a fringe speculation to regular savings. College graduates after 1996 believed that investing in the stock market had always been the way people save for retirement. Television networks like CNBC were created in the 90's to make the topic even more mainstream.

After experiencing two major market crashes (2000 - 2002 and 2008 - 2009) the public sentiment toward stocks over the past decade has declined tremendously from 2000. This is part of a natural bear market cycle. Stock ownership has now fallen to only 50%. 

Where do we go from here?

Many believe that as the market moves higher, those 20% that have left the market will come roaring back in. They have already priced this "cash on the sidelines" into their models for growth.

But what if they didn't? Imagine if another 20% left the market bringing the average down to 30% stock ownership - still way above the historical trend.

With baby boomers retiring and terrified of market losses and a younger generation that has only known a bear market, is it possible that the numbers could revert closer to the historical mean?

If you believe that we are in the beginning of the next major bull market then you want to be one of the first to tip toe back into the water. If you follow history and the 17.6 year cycles, then you know after a 100% counter trend rally (which we have just gone through) this is the most dangerous time of all to jump back in.

For Part 2 of this discussion and a look at real time data see Present Stock Market Guides: Is This Time Different?