Friday, July 13, 2012

Long Term Government Bonds: The Largest Bubble & Mania In History

During an interview I posted earlier today with Jim Grant on CNBC he began discussing the interest rates on government bonds, which are now hovering at close to 0% for many of the world's developed economies, and he had to stop and chuckle for a moment when thinking about the ridiculous nature of this concept.

I have studied bubbles in depth going back through hundreds of years of history. I have discussed how investments move through four stages of a bull market cycle:

1. Pessimism
2. Skepticism
3. Optimism
4. Mania

I want to take a look at an investment class now that has entered this fourth stage. This is always the most fun point to watch in a market because to the casual observer, the media, and the average financial advisor it not only appears that nothing is wrong; they fall all over themselves to say that you should invest in it.

You know an asset has reached the mania/bubble stage when you begin to see the supply of the particular asset move higher alongside an equal if not greater spike in price. The first lesson in economics tells you that this is the exact opposite of how supply/demand should exist alongside price.

However, when the mania sets in and prices continue to rise, people always, always, always come to the conclusion that "this time is different." They will find an unlimited amount of reasons to justify the price increases.

When looking at the NASDAQ Internet stocks in the late 1990's there was a steady stream of Internet IPO's that entered the market. During the final stage it turned into a flood where hundreds and hundreds and hundreds of new companies were entering the market with no earnings and the future promise of "eyeballs" and "clicks," two very common terms used back in those days. They flooded the market with an enormous supply of shares and those shares rocketed higher in price.

Broadband companies that installed underground wiring were priced to deliver wiring in every square inch of the planet (even though 70% of our planet had no need for broadband cables underground). They began installing cable underground in areas that could never use it. The price of the stock surged alongside the supply of new cables put down. It was a mania in every sense of the word and as stock prices roses higher and higher there were an unlimited amount of analysts explaining how "this time was different." The idea of supply vs. demand was now irrelevant.

Then stocks collapsed in March of 2000.

We moved on next to the real estate market where the supply/price dynamic was far easier to see, yet the rising prices blinded those inside the bubble almost worse than the NASDAQ bubble. A home builder in northern Virginia where I was living during the peak of the insanity built 9 spec homes for one buyer. The buyer had no plans on closing on any of the properties. He planned to do a simultaneous closing for each property and pocket $50,000 in appreciation for each one. The enormous supply of empty homes going up coincided with massive increases in price month after month. Realtors told buyers that "this time was different."

Then home prices collapsed in February of 2006.

The following chart shows the supply of United States debt since 1940. The government still owes this money, meaning the supply is still outstanding, because they have not defaulted on their debt at any point during this period. The total deficit of the United States represents current the supply of treasury bonds outstanding.

You can see on the chart that the supply of treasury bonds has become parabolic in growth, similar to IPO share issuance in 1999 and new homes being built in 2005. If you provided this chart to a freshman level economics major and ask him to draw a corresponding graph in terms of price, he would provide you with something like the following. The red line would show supply increasing, and the blue line would show prices falling as supply moved higher.

The following graph is the actual price of 10 year treasury bonds going back 220 years. Treasury bonds are not touching new highs to represent the danger of this growing supply, they have recently moved below the all time record low yield in history set back in the 1940's. When interest rates fall it means the price of a bond, the underlying asset, moves up in value. Treasuries are more expensive today than at any point in the history of the United States.

The following is the front page of the most recent addition of Barron's magazine. It asks, "What's The Best Bond Fund For You?"

The average American, since the financial crisis erupted in the fall of 2008, has slowly and steadily removed their money from stock funds and piled into bond funds. They are terrified of the stock market falling again, and they are moving into the asset class that their financial advisor says "may have a small return but at least it won't fall in price." The following chart shows the amount of money leaving stock only funds ($545 billion) and entering bond funds ($630 billion) since January 2007.

In 2011 long dated treasury bonds were up over 30% (remember bonds appreciate in value when rates fall). They were one of the best performing assets on the planet.

Treasury bonds have risen in price so far and for so long (30 years) that people cannot even remember a time when yields rose (and bond prices fell). People hear that the United States is adding another $1-$2 trillion in supply every year for at least the next ten years and they want more; just as in 2005 when they heard that home builders were selling an endless amount of empty homes to speculators and they wanted more. The rising prices have put a calm, a numbing feeling, into everyone in the market.

When interest rates begin to rise, and I assure you that they will, it is going to cause more damage to our economy and the savings of investors than the stock market bubble of 2000 and the real estate bubble of 2006 combined.

As treasury bond yields rise so will yields on corporate bonds, municipal bonds, mortgages, and commercial real estate cap rates. Everyone that has priced the 10 year treasury bond into their financial model looking forward is going to be slaughtered.

If interest rates double on a 10 or 30 year treasury bond it means the value of your investment has been cut in half. The average investor has spent the last four years putting their savings into the safety on an enormous time bomb. They will be slaughtered.

When will the mania end? I have no idea. Is it worth dancing on an atomic bomb for a 1.5% return on your money per year? That is up to you. It does not sound like an attractive idea to me. The downside is endless, the upside is extremely minimal.

This same exact story is taking place on the shores of Japan and the UK, and I believe their debt bombs will explode before the United States. But why wait to find out? For 1.5% per year? It is like guessing where to put your money: Spain or Italy. Why put it into either one?

Get your money out of harms way, and if you are very brave and very patient then place a bet on the short of the trade. Those that have the ability and staying power to hold a short position on these debt markets, such as now legendary hedge fund manager Kyle Bass who has an enormous short position on Japanese debt, will be the new subprime characters in Michael Lewis' next novel.

For more on where we stand in the current stock market cycle see P/E Ratios: Stocks Priced For Collapse.

US Real Estate: Where Is The Inventory?

I was reading through the Charlotte Business Journal this morning when I spotted a headline that read: CoreLogic: 19% of Charlotte-area mortgages are underwater.

With 1 out of 5 homes underwater Charlotte is doing much better than the national average, which has now moved up to 31% of all mortgages with negative equity (1 out of 3). The top chart in the graphic below shows this steady rise.

The implications for this simple statistic are obvious. A homeowner who is underwater cannot put their home on the market to sell without coming to the closing table with their own cash. For psychological reasons, most people refuse to use their personal funds (such as selling 401k money) to sell their home. They would rather just ride it out and "wait for prices to recover."

The rest of the underwater homeowners could not sell even if they wanted to because they don't have enough money to bring to the closing table to get a deal done.

The article goes on to say that another 8.3% of mortgages in Charlotte have "near negative" equity, meaning less than 5%. Why is this group important?

It costs 6% of the price of your home to pay a real estate agent to sell it. That means this next group of "near negative" equity is in the same situation as the first: they cannot come to the closing table without bringing their own money.

Adding the near negative equity means 27% of the mortgage holders in the city of Charlotte cannot come to the closing table without their own funds. While these home owners have the option of pursuing a short sale with the bank, I would be willing to guess that a large portion of these residents would rather just hope and pray prices rise allowing them to exit their financial death trap. This is just for the stronger Charlotte market. How many homes do you think are "almost underwater" on the national level keeping that inventory off the market?

I'll give you a hint: the majority of real estate purchases since 2008 have been funded through the FHA's 3.5% down payment program. That means all these buyers have been underwater the day they left the closing table. They need prices to rise 2.5% just to break even on the cost of a sale after paying their real estate agent.

In the meantime, with this underwater inventory being held off the market along with the regular shadow inventory (homes that have stopped paying their mortgages that the banks have not listed for sale) it has created a temporary artificial shortage in inventory.

A friend of mine who sells new homes told me he had a phenomenal month in June. I spoke with a broker-in-charge at one of the major real estate sales offices just a few days ago and she told me that June was one of the best months they had in sales in years. There are bidding wars for a select few properties.

What a show.

Real estate agents have told buyers there is a feeding frenzy for the "limited" supply of available homes. They have told buyers that there is an opportunity of a lifetime to lock in on interest rates at all time historical lows.

No one has told the buyers what happens when the 27% of underwater homes in Charlotte begin to walk away from their mortgages and those homes are then added to the real shadow inventory (which is still waiting to enter the market). No one has explained to them that the time to buy real estate is when interest rates are high and the time to sell is when interest rates are low (if you care about the price you are selling it for).

I will leave you with a piece from the following article from AOL Real Estate titled "Shadow REO: As Mandy As 90% of Foreclosed Properties Held Off The Market, Estimates Suggest." I very rarely cut and paste directly from articles, but based on the importance I wanted to provide just a small piece of their discussion.

The extent to which lenders keep their stock of REOs -- industry parlance for "real estate owned" properties -- off the market may be much larger than most people think.

As many as 90 percent of REOs are withheld from sale, according to estimates recently provided to AOL Real Estate by two analytics firms. It's a testament to lenders' fears that flooding the market with foreclosed homes could wreak havoc on their balance sheets and present a danger to the housing market as a whole.

Online foreclosure marketplace RealtyTrac recently found that just 15 percent of REOs in the Washington, D.C., area were for sale, a statistic that is representative of nationwide numbers, the company said.

Analytics firm CoreLogic provided an even lower estimate, suggesting that just 10 percent of all REOs in the country are listed by their owners, which include mortgage giants Fannie Mae and Freddie Mac as well as the Federal Housing Administration.

Daren Blomquist, vice president of RealtyTrac, said that he was surprised by his company's finding, especially since a similar analysis in 2009 found that banks were attempting to sell nearly twice as much of their REO inventory back then.

When a lender carries an REO on its books, it is allowed to value the home at the price that the foreclosed-on borrower originally paid for it. Once the lender sells the home, it must book a loss: the difference between the original purchase price and the current value. And since home values have fallen by nearly a third since the housing bust, that translates into huge losses for the bank.

If lenders turn their REO release valve to full blast, the deluge of foreclosures cascading onto the market could plunge the country into a recession, said Thomas Martin, president of consumer advocacy group Americas Watchdog.

"If they let the dam essentially break. It could be a catastrophic disaster for the U.S. economy," he said, predicting that some major banks would fail and home prices would nosedive by 20 percent.

That doomsday scenario has many industry professionals supporting lenders' tactics of holding onto most of their REOs. Otherwise, they would be "causing the floor to fall out from underneath the entire market," Faranda said.

For more on the false bottom in US real estate see Home Prices Have Bottomed, Again.

h/t David Rosenberg, Dr Housing Bubble, CNN Money

Jim Grant: We Are Living In The Truman Show

Great interview with Jim Grant who compares our current financial markets to living on the set of The Truman Show. He says the Fed is not out of bullets, but the problem is that the gun is pointed in the wrong direction. He reviews the insane price levels bonds are at today and says that QE3 is on the way.


Wednesday, July 11, 2012

America Is Not The Greatest Country In The World

I was at a friend's house last week and we were scanning through his Tivo list for something to watch when we came across the new HBO show "Newsroom." The opening segment of the show was extremely powerful. While the video below is a slightly edited for time version of the opening, the most important moment of the scene is captured in full. A college student asks a news reporter, who is known most famously for keeping himself indifferent on almost every topic,

"Why is America still the greatest country in the world?"

In a moment of honesty he unleashes the truth that most Americans know in their heart today but do not discuss but you are considered "unpatriotic" if you do. The stupidity of that notion is like ignoring your child when they misbehave because even bringing up the topic of their misbehavior would mean that you don't love them.

I am a younger American who has been left with a bill for a 50 year spending binge that was put on a credit card. The outcome of that situation is going to be a lower living standard for this generation at best and a complete breakdown of the American society at worst.

I think about leaving the country all the time. I can project forward into a future that most people cannot see today, and I try to imagine my children living in that world. America is not the greatest country in the world today, but it could be. And that's why I'm still here, for now.

For more on this topic I would recommend reading an excellent article posted in The Atlantic this week titled To Make America Great Again, We Need To Leave The Country.

ECRI's Achuthan: The Recession Is Here Now

I have tracked the ECRI's extremely debated recession call every step of the way since they made the initial call in September of 2011. After announcing that we would enter recession by the middle of this year and then reaffirming it at every opportunity over the last 10 months (as the stock market surged higher) we are now sitting mid year and economic data has collapsed around the world.

Achuthan's view today: we are in a recession right now. Here is the history of the calls and his most recent video on Bloomberg. The interview on February 24 is interesting because it was close to the peak in the stock market euphoria (Apple rising higher every hour). The media looks for reasons to "justify" stocks moving higher and they immediately dismiss anyone who says there is trouble coming.

ECRI Leading Economic Indicators - September 30, 2011

ECRI's Achuthan: The Coming Recession - December 9, 2011

ECRI's Achuthan Stays With Recession Call - February 24, 2012

Achuthan: US Will Be In Recession Next Month - May 9, 2012

After months of ridicule Achuthan steps back on stage at Bloomberg with no one laughing:

China Panics, US Slows, Germany Flinches

The next installment of the economic cartoon series has been released and it discusses the global slowdown, the European crisis, and how it will play out moving forward.


Tuesday, July 10, 2012

Looking Beyond The Euro Crisis & Understanding The Big Picture

Chris Martensen released an excellent piece this week where he discussed how people behaved in Weimar Germany between 1918 - 1922, the period of time just before hyper-inflation took hold.

This was documented most famously in the book "When Money Dies" by Adam Fergusson. During that period of time Germany was swept with intense bouts of deflation. The government continued to step in during the process and provide printed currency.

Over the years it appeared as if this currency was having very little effect on the price of goods. Just as things would begin to pick up in terms of prices there would be another major downfall creating the specter of massive deflation ahead.

Under the surface, just as today, there was an enormous amount of new money being created. The major difference today which is argued (correctly) from the deflationists is that we live in a credit based economy that relies far less on paper money. This credit has the natural tendency to contract, like gravity, when it becomes to large to be supported by the income levels of the society holding the debt.

This is the exact situation we find the world in today. We are in the process of one of the greatest monetary experiments in history. Never in history has the world been encumbered with so much debt at the consumer, banking, business, and government level. On the opposite side of the ledger, the world has never seen a global central bank response (money printing) with the size and scope we are witnessing today from every country around the world.

The unstoppable force has met the immovable object.

The only sure prediction I have of the future is that the outcome will be a complete disaster. The important, and far more difficult to determine, prediction of the future is how it will play out before we reach that ultimate point of "reset" or annihilation of the current monetary structure.

My long term (5 year) blue print of how the process would unfold, that I have reviewed an updated for well over two years running, is that the global economy and financial markets would experience one more massive deflationary shock; similar to the Lehman experience.

The reason why I feel deflation will occur first is because the sovereign debt crisis has begun first in Europe. Europe, unlike every other major developed country, does not have a central bank with an unlimited ability to print paper currency and purchase debt. The ECB has had to, and will continue to have to, play defense as Europe continues to implode.

It will take a crisis in order for the politicians to come together and beg for printed money. The actual origin of this crisis is unknown. It could be the failure of a bank in Spain, Italy defaulting on its government debt, or Greece finally leaving the Eurozone.

Once this event takes place there will be a serious bout of deflation spread across the financial system. With the global economy rapidly slowing down, discussed in detail in Europe's Virus Is Now Global Contagion, there could possibly be a "perfect storm" ahead for the markets. This topic was discussed this week in an interview with Nouriel Roubini.

My contention has been that during this coming "perfect storm" it will provide a tremendous buying opportunity for assets that will perform well during an inflationary response. I have discussed my personal favorites in the past.

Why do I think this will be a strong buying opportunity?

Once we move past the European disaster and subsequent response we will move on to the larger countries in the sovereign debt crisis; Japan, the UK, the United States. All three of these countries face no such central bank "limitations" that the European central bank faces (they have unlimited and unconstrained ability to print money).

Politicians and economists will look at the European experiment as the incorrect way to handle a sovereign debt crisis. They will try and front run any market moves out of their sovereign debt with a massive QE policy response. This may occur in coordinated fashion from Japan, the UK, and the United States with support from the IMF through the use of SDR's (global currency units that can be printed with unlimited capacity).

Those betting on another deflationary downturn during this coming chapter of the financial crisis will be caught on the wrong side of the trade. You will see gold and silver enter the mania stage of their bull market. The price of commodities, and in some areas real estate, will surge globally. Currencies and well managed government debt markets will see capital flood onto their shores as it flees the debasement of the "Big 3."

Most likely when things spiral out of control there will be price controls and trade wars; possibly followed by real wars. Then there will be a complete "reset" of the current monetary system. The monetary system has "reset" on average through history every 40 years. The current monetary structure was created in August of 1971. The reserve currency of the world, the US dollar which people assume will be in place forever, will also come under pressure.

Back to Martensen's article, where he provides a chart that many of us have seen many times, only he has highlighted certain points of time. The following shows the price of gold during the collapse of the German currency in the early 1920's. You can see during the bull market run as the currency was being debased that there we periods of massive corrections in the paper gold price. During every one of these pull backs the people were told by their government that the situation was under control. Most of the people that purchased some gold as insurance to protect their life savings sold their gold during the pull backs.

What happened next is the story that has been told numerous times. After the third major decline in gold and stabilization in the currency, complacency set in and most German citizens sold their gold for good. By the time the final round of inflation set in it was too late. A life savings in paper investments (stocks, bonds, cash) disappeared almost overnight.

Those that were not tracking the "paper" price of gold but continued to focus on the paper money printing became the new wealthy of Germany.

The following chart shows the current bull market in gold beginning in 2000 and running through July 2012. It shows multiple periods of massive pull backs and extended consolidation (we are currently in one of the periods).

This is when people become afraid to both purchase precious metals and they sell their current positions. They are lulled to sleep and no longer focus on the paper money creation taking place around the world.

Where do we go from here? I think gold can possibly fall to $1200 and silver can possibly fall below $22 during the coming storm in the financial markets. Am I personally waiting to for those possible targets to purchase precious metals? No, I am a buyer today and I will be a buyer if we reach those levels.

I do not focus on the "paper" price of precious metals. I watch the money creation. Do I think we will enter a hyper-inflationary period similar to Germany in 1923? Very unlikely. I think the global "reset" will occur before we get there. A new monetary system will be put in place with gold involved in some fashion. Jim Rickards discussed this topic in detail in his incredible book Currency Wars. With a gold price somewhere above $55,000 you could realistically back a significant portion of the money and credit in existence and immediately halt an inflationary paper money run (this number rises by the hour with global QE taking place).

Jim Chanos: The Psychology Of Short Selling & Why China Is Worse Than Europe

Great interview on numerous topics with the hedge fund legend.


Sunday, July 8, 2012

P/E Ratios: Stocks Priced For Collapse

One of my favorite writers/economists/financial minds in the world today is John Mauldin. He wrote the an excellent book discussing secular cycles in financial markets released this year titled The Little Book Of Bulls Eye Investing, and he writes a must read free column that is released every Saturday morning on his website here.

One of my favorite topics to study, along with the psychology involved with investment decisions, is the history of the financial markets and its participants. I am a firm believer that you cannot know how to navigate the future unless you have taken the time to learn in detail what has transpired in the past.

The major reason for this, as we have discussed numerous times using numerous examples here in the past, is that markets move in cycles. This is due first and foremost is to psychology. A secular market, which usually lasts 12 - 20 years, moves through four stages:

1. Pessimism
2. Skepticism
3. Optimism
4. Mania

By studying the definitive work on this subject titled Manias, Panics, & Crashes: A History Of Financial Crisis you see that this trend has been taking place for hundreds of years through all types of investments. It has taken place in stocks, bonds, gold, commodities, and tulips.

Mauldin has come to the conclusion that over the last 100 years, the average stock market cycle has lasted 17.6 years (somewhat spooky - to the month).

The reason it takes so long for a market to move through a cycle and eventually bottom out is because it takes a long time for the psychology of the market participants to move from mass euphoria to mass pessimism back once again to optimism.

The bull market in stocks that began in late 1982 and ran through March of 2000 was so great that it still has a lingering effect on investors today. The sentiment in the market today, a full 12 years into our current secular bear market in stocks, is far greater than it was during the lows of 1982 (where most portfolios held 0% of their assets in stocks). The sentiment is in a higher range today than most of the last 100 years.

We can see this through something called the Price to Earnings ratio, which essentially means the price an investor is willing to pay for a stock based on the earnings of the company. If P/E ratios are high it means an investor is willing to pay more for a company based on the speculation that it will grow its earnings or more investors will enter the market and push the P/E ratio even higher (known as the greater fool theory).

Before we look at this concept further it is important to understand that this topic applies to almost every investment. It can be seen in commercial real estate through cap rates, which are a measure of the return investors are willing to pay for the annual income on the property. It can be seen in the bond market through the interest rate investors are willing to accept in return for the risk of lending their money to a company/government/etc. for a specific period of time. Commodities are more difficult to determine an exact valuation because they have no return. They still move through secular cycles for reasons I will be discussing.

Back to stocks.

The following chart shows the secular bear market from the year 2000 to present day.

An interesting fact that Mauldin points out in his Little Book is that stocks tend to go up just as much as they go down during a secular bear market. In other words, 50% of the time they are rising.

What tends to happen in bear markets, and this current one is no exception, is that there are long slow rises in the market where complacency enters the mainstream psychology. The market rises over many years creating an environment where it feels like things are once again "different." When the market falls it tends to happen very quickly over a short period of time. This has the effect of catching most market participants on the wrong side of the trade. When investors finally give up and everyone gets back into the market, it collapses again soon after (this is what is taking place today).

The next chart shows the last secular bear market from 1966 - 1982. It shows that the market was rising over 50% of the time, which created confusion during every leg up (especially at the tops) that "this time was different." The falls came swiftly, crushing those that let the optimism enter their psyche.

While these charts help us see both the past and where we stand in the current cycle through the present, they only present one side of the equation: price. In order to understand value, and how close we are to a market bottom, we must apply price to earnings.

The following chart shows the secular bear markets over the past 100 years and where the P/E ratios bottomed to end the cycle. Every previous bear market ended with a P/E ratio at 10 or under. We are currently at 22 today, which is still is mania territory (where most bear markets begin) based on history.

This means investors are still willing to pay extremely high prices for stocks based on earnings assuming that an investor will enter the market in the future and purchase the stock at an even great price to earnings.

What do I believe?

I believe that not only will this bear market end with P/E ratios back under 10, as all markets in history have in the past, but earnings are also going to collapse from their current lofty levels. This takes down both the numerator and the denominator in the equation setting the stage for the grand finale of this current bear market which may end up as the worst in history.

Based on Mauldin's work of the 17.6 year cycles, we have 4.9 years remaining until we reach this ultimate low. At that point, just as they did in 1982, investors will want no part of the stock market. At P/E earning ratios down at 10 or below they will sell stocks assuming that prices will only move lower in the future. This will be the buying opportunity of a lifetime. 

Astute investors at this point will be wondering; if money is flooding out of the stock market, where will it move to find a home? Cycles overlap and for every bull market where pessimism grows and money leaves, there is a bull market where optimism grows and money enters. I will look beyond stocks in the days ahead and preview where I think there is both under and over valuation in other markets today.

Nouriel Roubini: Perfect Storm Coming Will Be Worse Than 2008

Highlights from Nouriel Roubini:

Nothing has been fixed. The toxic large banks have just merged together and become larger.

Without a doubling or tripling in the size of the current European bailout structure (which has not even come into existence yet) you're not going to have a crisis with Spain and Italy in the next six months, you're going to have one in the next two weeks.

The only other option is direct monetization (printing money to purchase bonds) from the European Central Bank (ECB).

The emerging markets are moving toward a hard landing. US growth is stagnant and continues to slow. Europe is a disaster. There is a coming war in the middle east.

It is a global perfect storm, and 2013 could be far worse than 2008. Interest rates are already at or below zero. QE is becoming less effective. Governments are already insolvent, hurting their ability to stimulate economies.