Saturday, October 19, 2013

October 19, 1987 - Black Monday 26 Years Later: Could It Happen Again?

On this day 26 years ago the U.S. stock market fell over 22% in a single trading day. This was the largest one day fall in stock market history (by far).


This is what the world watched that night as they came home and turned on the nightly news.


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Could it happen again?

A specific cause of the crash was never determined, but many investors believe that it was due in large part to a new trading strategy called portfolio insurance. Automatic sell orders were set up to protect investors against losses should the market begin to fall. As the drop began, the portfolio insurance sell orders were triggered every step along the way causing a cascading collapse.


In today's market, not only is that danger still there, it is far worse because of the use of high frequency trading. These machines, which dominate close to 70% of the trading in the markets on a daily basis, have the ability to turn off and walk away when things get troublesome. This was seen during the flash crash in 2010 when the DOW fell 1,000 points in a few minutes.


The first flash crash was a warm up and the next will be far larger. Why? No changes have been put into place since the first flash crash hit to protect the markets from another event from occurring. Understanding that it is coming is like understanding that a hurricane will hit the east coast, a tornado will strike the Midwest, or an earthquake will hit California. If all the physical elements are in place for an event to occur, then eventually it will.


On a price to earnings ratio the stock market is far more overvalued today than it was in 1987 (see graph below). Optimism is at insatiable levels as the market (incorrectly) believes that it can never fall with the support of the Federal Reserve behind it. The first downdraft in the next (and what I believe to be final of this secular bear market) decline could be breathtaking.

For more on the stock market's next decline see: How QE Will End & Why


U.S. Government Debt: $17 Trillion Breached

CurrentDebt Held by the PublicIntragovernmental HoldingsTotal Public Debt Outstanding
10/17/201312,117,282,743,815.334,958,307,364,148.2417,075,590,107,963.57
The media celebrated both the new highs in the U.S. stock market and Google crossing the historic 1,000 level all day on Friday. The lost headline was the United States government debt crossing $17 trillion as the trillion dollar milestones have no longer become news. As the bond market bubble begins to deflate and interest rates rise, the world will find out that these numbers represent a real debt owed to a creditor. When those creditors begin to understand they will never be repaid we will simultaneously begin the unwind of this ridiculous stock market euphoria.

Friday, October 18, 2013

The United States Is Destroying Itself From Within: How Empires Fall

We are moving further and further into the financial twilight zone as asset prices stimulated by QE are rising while the fundamental economy continues to deteriorate.

This creates huge imbalances between the rich and the rest (middle class, young, and poor) as the rich benefit from the surging asset prices while "the rest" are left with stagnating wages and a rising cost of living.

Those that have study history understand that this imbalance ultimately leads to a breaking point and it is the cause of every great empire's decline throughout history. As night follows day, the U.S. empire is heading down the same exact same path.

The following video looks at the top 0.7% and the (growing) wealth they control.


Stock Prices & Debt Rise: The Fundamentals Needed To Support Both Have Not

The following graph is one of the best I have come across to help visualize why the U.S. stock market has experienced the rise in prices over the past two years. Since September 30, 2011 the S&P 500 has risen over 50% while the Earnings Per Share on those stocks have risen by only 12%.


This means that rising prices have been due exclusively to P/E expansion (investors paying more money for the same level of earnings). This can be used to measure "froth" in the market. This chart is now a few weeks old and with the S&P 500 hitting a new all time record high in yesterday's trading session (and profits most likely falling due to the slowing economy) the gap between prices and reality has diverged even further.

In the real economy the same process is occurring with debt and economic growth. The red lines show the debt taken on to stimulate the economy and the blue lines represent the resulting growth.


Both these charts represent unsustainable trends. Either company earnings must skyrocket to meet the current prices paid for those earnings and economic growth must skyrocket in order to pay for the debt taken on, or both will meet gravity.

Wednesday, October 16, 2013

Understanding The Debt Ceiling & Our Current Monetary System

The following video provides a simple and illustrated walk through on how our current monetary system functions. It shows how the government borrows money, how the Federal Reserve pays for this borrowing and how the large banks profit from the process at every step along the way.

When you begin to understand the system in place, it will completely change the way you view almost every aspect of the economy and financial markets.


Tuesday, October 15, 2013

Finding Reality In A Sea Of Madness

At a time when the United States stock exchange is blasting off to new all time record highs....


The world stock market capitalization is approaching new all time record highs....


And bond yields are at or close to all time record highs around the world.....


Most investors and analysts are dialed in on how to capitalize 
on the future gains that these paper asset bubbles will provide 
in the months and years ahead. Very few investors, surrounded
by this type of euphoria, have the ability to think rationally. One of
them is Marc Faber who took the time to call into the Bloomberg
set this week and provide a perfect comment to sum up the concern
 investors should be facing regarding their portfolio. The talking
heads, who are accustom to 24 hours a day of financial analysts
pumping stocks and bonds (who sell stocks and bonds for a living),
 dismissed the comment as if it was some sort of mistake.

When asked if there is a safe haven available to investors:


"There is no safe haven. Bank deposits are not safe, which used 
to be safe. Money in treasury bills is not 100% safe because there
 is inflation in the system and you hardly get any interest. Bonds 
are not very safe anymore because eventually interest rates will 
go up. Equities in the US are relatively expensive by any valuation 
metrics you might use. I don't see anything particularly safe. 
The best you can hope for is that you have a diversified portfolio
 of different assets and that they don't all collapse at the same time."




Sunday, October 13, 2013

How QE Will End & Why Commodities Are Still In A Secular Bull Market

We are rapidly approaching the point of "peak debt" globally. This has been referred to here on this site as the end of the debt super cycle, which began over 70 years ago.

The end of the debt super cycle means that many of the developed economies that have used debt to create growth will no longer have the ability to service their current debt or take on additional leverage. The debt of a country can be seen at the individual (consumer), corporate, banking, and government level.

In the United States the total debt in relation to the size of the overall economy (debt to GDP ratio) reached  370% in 2008 before it peaked.


This chart is certainly troublesome as it shows how far the United States still has remaining in the deleveraging process to bring the debt back to healthy/manageable levels. A reduction of just 20 basis points on this 370% debt to GDP ratio has put the country into a depression, temporarily masked by government spending and quantitative easing . Imagine what would occur if real a deleveraging took place? Here is the chart again with banking (financial) debt removed, showing the three remaining categories (GSE's are Fannie Mae, Freddie Mac, and Sallie Mae which can be considered part of government debt). Click for larger image.



Now for the scary part. The United States balance sheet looks like a time bomb waiting to explode (and it will), but viewed against the rest of the world the U.S. is not even the worst offender.

The following shows that the balance sheet for Japan, the U.K. and the Eurozone is far worse than the United States.


Does this make the United States debt situation more attractive? Of course not. It only shows that the current debt super cycle is a global phenomenon. Each one of these four developed regions (which make up the lion's share of global GDP) are approaching the point where they will have hit "peak debt," as the private portion of the U.S. balance sheet did in 2008.

The first question is always, with such staggering debt levels why has this not occurred already? This same question was posed for those who argued that the real estate market was in danger back in 2004 and 2005 as there appeared to be no issues on the surface.

The answer is that these countries have had the ability to roll existing debt (similar to refinancing a home) and borrow new debt (another buyer purchasing a home at a greater price) at ultra low interest rates. Just as the housing market reached its maximum point of leverage when interest rates rose, the same will occur on a much larger scale for the entire debt market across the developed world.

The next question is; Central banks are holding interest rates down with their QE programs in the United States, Europe, Japan, and the U.K. With the ability to print an endless amount of money, can't they just keep rates down forever?

The answer is no. Ultimately the market is going to overpower the central banks. This can occur in multiple ways. One way would be for investors to simply get nervous (or understand) that the debt they are holding fundamentally has no value as it is impossible for these debtors to ever repay. We could wake up any day to a very sharp sell off in the bond market for one of the bankrupt developed nations. The problem with debt markets, which can be seen in the case of Lehman Brothers below, is that while stocks tend to track down in a linear fashion, bonds are more likely to collapse overnight. Investors believe up to the very last minute that they have most of their value, until they don't.

A second scenario could occur if some of the trillions of paper currency currently being printed by central banks globally began to move toward commodities. So far during this QE experiment money has flooded into paper assets globally (specifically the US stock market) and real estate (globally and more recently the United States).

Commodities prices have not received the benefit of this freshly printed money. Since 2011, the major commodities have fallen in an almost steady trajectory. They have become the most hated asset class on the planet (considered by many to be in a new secular bear market).

The following shows the steady decline of the major metals since 2011:


The next chart shows the entire commodities index since the secular bull market began in 2000. There was a cyclical rise into 2011 and a steady and relentless decline since that peak. Hedge funds have slowly off loaded their commodity positions and many commodity based funds have even shut their doors over the past few weeks.


A secular bull market usually moves through five waves during its completion. This is called the Elliott Wave cycle. The second and fourth waves of the cycle are correction (downward waves). We experienced wave one up from 2000 to 2008, corrected into early 2009 (wave two), then experienced the second wave up (wave 3) into 2011. We have been in the second corrective wave down (wave 4) since .


How low will this wave go before it completes? Based on the chart above it could fall much further. However, as just discussed, pessimism within the sector has reached incredible levels. I like to buy assets that I believe are in secular bull markets when they have declined in price and sentiment is low. This usually causes me to begin buying before a bottom is in place.

New money created by the central banks around the world has flooded into paper assets. If some of that money were to rotate into commodities it would put the bottom in on the current cyclical move downward.

This brings us back to what could potentially slow the QE purchases globally. If commodity prices begin to rise it creates inflation in assets that people use during a day to day basis (unlike the inflation seen in the paper financial markets thus far during the global QE experiment). If real inflation rises (gasoline, food, utilities, health care, or the goods purchased at the store), investors will demand a greater return on their money to compensate for inflation risks. This will cause yields to rise, and it will reveal the true corner that the Federal Reserve and other central banks have painted themselves into.


This process will bring about the endgame of the debt super cycle. A new monetary system is put in place about every 40 years and the current one began in 1971. We are overdue for what has occurred naturally throughout history. This will not bring about the end of the world, it will just bring change. Those that understand it is coming will take advantage of the short term chaos and purchase assets at inexpensive prices (the paper and real estate assets currently back at bubble prices).

For more on the corner the Fed has painted itself into see: The Coming End To The Fed's Illusion

 
h/t MISH, Short Side Of Long, ZH