Saturday, March 29, 2014

Why Investors Feel Poorer As The Market Moves Higher

Over the past year I have discussed the "expensive" nature of the U.S. stock market measured by the Shiller CAPE price to earnings ratio and the Tobin Q ratio, see US Stocks Market Value Metrics Show Tremendous Danger Ahead.

The bulls on Wall Street dismiss these metrics because they say we have entered a "new economy." They say these metrics indicate that the U.S. market has been overvalued for 85% of the time over the last 15 years and that can't be possible.

Wrong. What it means is that the U.S. stock market has been overvalued for 85% of the time the last 15 years. It has been fairly valued the other 15%, and it has never been undervalued during that time.

Many people see the stock market going higher, but do not feel wealthier. Why is that?

In inflation adjusted terms, the market has been reaching lower cyclical highs during the rallies and lower cyclical lows during the declines. The chart below helps illustrate this process with the nominal S&P 500 reaching new highs on the top chart, but the S&P 500 divided by the price index (inflation) steadily declining since the true market peak in 2000. While stocks are slightly higher nominally from the 2000 peak, the cost of living (food, energy, housing, medical, insurance, utilities, education) has gone through the roof.

Should the market complete its historical 17.6 year cycle, we will have one more cyclical downturn which will set the stage for the next secular bull market. Following the next major decline the media and masses will declare stocks permanently dead and call them the most dangerous asset an investor can own. This point will mark the best greatest buying opportunity we will see in our lifetime. For more see:

The 17.6 Year Secular Stock Market Update

Friday, March 28, 2014

An Update On Agriculture Buying To Start The Year

I mentioned in the 2014 Outlook to start the year that I was buying wheat, corn and sugar. I am a horrible market timer and certainly do not consider myself a "trader." As I discussed in the outlook, I buy investments that I believe have strong long term fundamentals (5 years out), have recently experienced a price decline and have rock bottom sentiment levels. Waiting for those three to connect causes me to mostly sit in cash and wait for the occasional buying opportunity.

Agriculture has been on a tear since January so I was fortunate in the timing. Just as an update for readers, I am no longer adding to positions as prices have moved higher and positive sentiment has returned. As with all investments, I will hold the positions and hope that prices and sentiment decline again. The only asset I am currently buying is physical silver (strong long term fundamentals, recent price decline, and low sentiment levels).

I am watching Chinese stocks and emerging market debt very closely (specifically Russia, India, Brazil and South Africa). My hope is that the continued taper from the Fed leads to further weakness in their currencies (I guess I could call those four the RIBS?), which would trigger a purchase of 3 to 5 year government bonds denominated in those currencies. As almost always, I will most likely be early, which is part of the process in investing in assets people hate.

This site is focused on global economics/finance and not my personal portfolio, but "what are you doing right now?" is the most common question I receive so I thought I would update.

Wednesday, March 26, 2014

Jim Grant On Investment Opportunity In India

Let's do a brief risk/reward scenario for long term investors:

India has extremely low debt levels, incredible demographics, low wages, and a beaten down currency, stock market and bond market.

The major issue investing in India is political risk. Will their leaders do the right thing in terms of opening up economic growth within the country?

The United States has extremely high debt levels, horrible demographics, the least competitive wages in the world and a massively overvalued currency, stock market and bond market.

In the United States there is no political uncertainy. We know that the political leaders will do the absolute worst possible thing for the country at every possible opportunity.

If you were an investor looking to make a long term (5 to 10 year) investment (currency, stocks, bonds) in one of these countries, which seems like the best risk/reward scenario?

More from Jim Grant after his recent visit to India:

Tuesday, March 25, 2014

Why Jeremy Grantham Refuses To Buy Overvalued U.S. Stocks

It is that time during the cyclical stock market recovery where 99.99% of the world is rushing head first into the market. While money managers could not find a single investor in 2009, they are having their doors beaten down today with new capital to invest. These managers make commissions by placing those funds into the stock market casino. If a manager refuses to invest the capital and recommends holding some cash, they will either under perform the market in the short term and lose the clients or lose their job entirely. While it is almost impossible today to find a remaining rational money manager, the commentary below comes from one of the all time greatest. 

The following two interviews are with Jeremy Grantham, the manager of GMO which currently holds $112 billion under management (one of the largest asset management funds in the world).

In the first interview with Forbes which took place in 2009, Graham discusses why he took his client's money out of the markets in 1998. He said that doing the right thing, pulling some money out of a massively overvalued market, caused him to lose 60% of his asset base. Investors could not psychologically handle watching from the sidelines with any portion of their capital and "miss out" on the spectacular returns received by everyone around them. 
Steve Forbes: Well thank you, Jeremy, for joining us today. First, since you have bragging rights in this situation, what made you a bear, [a] great skeptic? Between 1999 until about a couple of months ago, you were saying, “Stay out.”
Jeremy Grantham: Well, really very simple. Not rocket science. We take a long-term view, which makes life, in our opinion, much easier.
Steve Forbes: Well everyone says it, but you certainly practiced it.
Jeremy Grantham: We actually do it. Well, we tried the short-term stuff and it was so hard; we thought we’d better do the long-term. We just assume that at the end, in those days, of 10 years, profit margins will be normal and price-earnings ratios will be normal. And that will create a normal, fair price. And more recently, we’ve moved to seven years, because we’ve found in our research that financial series tend to mean revert a little bit faster than 10 years–actually about six-and-a-half years. So we rounded to seven.
And that’s how we do it. And it just happened from October ’98 to October of ’08, the 10-year forecast was right. Because for one second in its flight path, the U.S. market and other markets flashed through normal price. Normal price is about 950 on the S&P; it’s a little bit below that today.
And on my birthday, October the 6th, the U.S. market, 10 years and four trading days later, hit exactly our 10-year forecast of October ’98, which is worth talking about if only to enjoy spectacular luck. The P/E was a little bit lower than average and the profit margins were a little bit higher, so they beautifully offset. And given our methodology, that would mean that on October the 6th, the market should have been fairly priced on our current approach. And indeed it was–that was even more remarkable–950, plus or minus a couple of percent.
Steve Forbes: And what did you see during that 10-year period that made you feel–other than your own models–that this was something highly abnormal, that this couldn’t last?
Jeremy Grantham: Well, first of all, the magnitude of the overrun in 2000 was legendary. As historians, you know we’ve massaged the past until it begs for mercy. And we saw that it was 21 times earnings in 1929, 21 times earnings in 1965 and 35 times current earnings in 2000. And 35 is bigger than 21 by enough that you’d expect everyone would see it. Indeed, it looks like a Himalayan peak coming out of the plain.
And it begs the question, “Why didn’t everybody see it?” And I think the answer to that is, “Everybody did see it.” But agency risk or career risk is so profound, that even if you think the market is gloriously overpriced, you still have to get up and dance. Because if you sit down too quickly–
Steve Forbes: Famous words of Mr. Prince.
Jeremy Grantham: If you sit down too quickly, you’re likely to get yourself fired for being too conservative. And that’s precisely what we did in ’98 and ’99. We didn’t dance long enough and got out of the growth stocks completely, and underperformed. We produced pretty good numbers, but they’re way behind the benchmark. And we were fired in droves.
I think our asset allocation, which is the division I’m now involved in, we lost 60% of our asset base in two-and-a-half years for making the right bets for the right reasons and winning them. But we still lost more money than any other person in that field that we came across, which is a fitting reminder that career risk runs the business.
The second interview with Fortune took place this week. I highly suggest reading the entire interview, but I will include just a portion of it below. 

Grantham tells Fortune that just like 1998, his models show a negative 7 year return on the S&P 500 based on the current valuation. You'll note that Grantham believes the markets could rise another 25% from here, but he refuses to put client's money into a bubble that will at some point take it all away. 

Fortune: You believe the Fed's policies, particularly quantitative easing, have slowed the recovery. What's your proof?
Grantham: It's quite likely that the recovery has been slowed down because of the Fed's actions. Of course, we're dealing with anecdotal evidence here because there is no control. But go back to the 1980s and the U.S. had an aggregate debt level of about 1.3 times GDP. Then we had a massive spike over the next two decades to about 3.3 times debt. And GDP over that time period has been slowed. There isn't any room in that data for the belief that more debt creates growth.
In the economic crisis after World War I, there was no attempt at intervention or bailouts, and the economy came roaring back. In the S&L crisis, we liquidated the bad banks and their bad real estate bets. Property prices fell, capitalist juices started to flow, and the economy came roaring back. This time around, we did not liquidate the guys who made the bad bets.
Fortune: But the Fed does seem to have boosted stocks. Even if it did nothing else, doesn't a better market help the economy?
Grantham: Yes, I agree that the Fed can manipulate stock prices. That's perhaps the only thing they can do. But why would you want to get an advantage from the wealth effect when you know you are going to have to give it all back when the Fed reverses course. At the same time, the Fed encourages steady increasing leverage and more asset bubbles. It's clear to most investing professionals that they can benefit from an asymmetric bet here. The Fed gives them very cheap leverage on the upside, and then bails them out on the downside. And you should have more confidence of that now. The only ones who have really benefited from QE are hedge fund managers.
Fortune: Okay, but then I guess that means you think stocks are going higher? I thought I had read your prediction that the market would disappoint investors.
Grantham: We do think the market is going to go higher because the Fed hasn't ended its game, and it won't stop playing until we are in old-fashioned bubble territory and it bursts, which usually happens at two standard deviations from the market's mean. That would take us to 2,350 on the S&P 500, or roughly 25% from where we are now.
Fortune: So are you putting your client's money into the market?
Grantham: No. You asked me where the market is headed from here. But to invest our clients' money on the basis of speculation being driven by the Fed's misguided policies doesn't seem like the best thing to do with our clients' money.
We invest our clients' money based on our seven-year prediction. And over the next seven years, we think the market will have negative returns. The next bust will be unlike any other, because the Fed and other centrals banks around the world have taken on all this leverage that was out there and put it on their balance sheets. We have never had this before. Assets are overpriced generally. They will be cheap again. That's how we will pay for this. It's going to be very painful for investors
For more on what the remaining smart money is doing in the market see:

Insiders Dump U.S. Stocks At Record Levels

h/t MISH

Sunday, March 23, 2014

Insiders Dump U.S. Stocks At Record Levels

In an excellent article from MarketWatch this week, Mark Hulbert discussed an insider selling measurement created by a finance professor named Nejat Seyhun at the University of Michigan.

This metric filters out those who own more than 5% of a company's shares because that group is composed mainly of hedge funds and mutual funds (not true company insiders such as corporate executives). 

With this group removed, he found that true corporate insiders are currently selling their company stock at a 6 to 1 ratio (selling 6 shares to every 1 that they purchase). They are more bearish today than they have been at any time since 1990. 

They only two periods even close to today's record selling came in 2007 and early 2011. 2007 marked the moment just before the greatest market crash since 1929, and early 2011 was just a few months before a 20% market decline. 

Bob Farrell once famously said that "there are many reasons why an insider sells their shares, but one of them is not because they think the price is going higher."

The insiders represent a group that knows what is actually taking place inside a company. How about those that are speculating on what is taking place? They are flush with euphoria.

The Rydex Bull to Bear ratio below shows that traders currently have almost 8 times as much money in bullish funds as bearish funds. This is an all time record high.

Earlier this morning we looked at the average length of U.S. economic recoveries throughout history. The chart below shows the average duration and magnitude of U.S. stock bull markets throughout history. The median duration is 2.62 years with a 91.78% return. The mean duration is 3.16 years with a 127% return.

Our current cyclical bull market in stocks has already broken into the "outliers" group. As a side note, a bull market is considered intact as long as stocks do not drop 20% from their high (we came close in mid 2011). 

The next excellent chart compares the long term performance of the S&P 500 against consumption and debt. The last major secular bear market in stocks (1966 through 1982) had 3 major declines set up in what technicians call a "microphone pattern." Our current secular bear market, which began in 2000, is also set up in a microphone pattern, but we have had only 2 major declines thus far. With the average bear market throughout history lasting an average of 17.6 years (we are currently just over 13 years into the current bear), many believe that we have one more major decline before the next secular bull market begins. Click for larger image:

Layered below the historical stock market chart is the credit and consumption cycles that have driven economic growth since the early 1950's. Since the initial period of savings and living within a household's means, we have now moved past the breaking point of borrowed money which arrived in 2008.  

When Will The Next Economic Contraction Arrive In The United States?

We are currently 57 months into the current period of cyclical expansion. Like the ocean tides, the economy has always moved though periods of economic expansion followed by contraction. Most forecasters believe that we are years away from the next period of contraction.

What will surprise many is that our current expansion is already the 7th longest in history. The average length of an economic recovery is 39 months. 

Due to the Fed's policies of entering the market with force at the first sign of economic weakness or a brief decline in stock prices, analysts believe we have reached a permanently high plateau.

A look at the historical growth (then decline) of real GDP below shows there has not been a major decline for decades. This has been due to the new government policy in the United States to step in with large doses of government spending and printed currency at the first sign of weakness in the economy.

Some would look at this chart and reason that the government has magically removed the business cycle. We now only have periods of growth without the pain of economic contraction.

Others, such as myself, would look at this chart and say that the government has only pushed back the much needed economic contraction to cleanse the system of toxic debt and mal-investment. The longer they pump heroin into the economy to push back the pain, the more painful the withdrawal will be when it arrives.