Saturday, July 19, 2014

Why The Reformed Broker, Josh Brown, Is Wrong On U.S. Stocks

One of the most widely followed financial sites on the web is The Reformed Broker, with articles written daily by Josh Brown. Josh is a money manager alongside Barry Ritholtz at Ritholtz Wealth Management. I read both Josh and Barry's sites daily because they provide excellent, well-written content on what is happening in the markets. More importantly, they have many opinions that are starkly different from my own.

I think you could sum up Josh's opinion of the U.S. stock market as cautious in some sectors, but bullish on the market as a whole. Anyone who has read this site for more than a few weeks knows that I am currently bearish on the near term potential for U.S. stocks and feel that only a small portion, at the most, of investor's capital should be in U.S. stocks. There is far more value that can be found overseas; see How The Home Bias Phenomenon Impacts Investors.

This week Josh wrote an article titled A Quick Lesson On Market Tops where he presented reasons why investors should stay long the U.S. stock market at today's all time highs.

Reason 1: Although we are currently selling at the same PE ratio as we were at the market’s top in 2007, there is one very important difference – we’re at about half the yield on the 10-year treasury versus back then.

My thoughts: I view the fact that we are at half the yield on the 10 year treasury as a major headwind for stocks in the years ahead. Why? The treasury yield impacts every asset in the world; especially those located in the United States. Corporate bonds tend to track track treasury yields with a built in spread so if treasury yields are low it allows corporations to borrow at lower rates which increases profits. Lower rates allow buyers of commercial and residential real estate to purchase and refinance property at a lower rate which increases profits and disposable income. It allows state and local governments to roll over and issue debts at a lower rate which provides additional capital to spend into the economy. I can go on and on.

The decline in yields has been a turbo charge to the economy since 2009, but we now need to look at what is going to happen moving forward with yields and how that will impact stocks. What happens if yields have bottomed and continue to move higher? The boost the economy has received has helped turbo charge stock prices. If interest rates were to move in the opposite direction from here it would create the opposite effect on the economy and potentially stock prices.

Reason 2: In 2007, virtually all economic growth was coming from private sector leverage, specifically in the real estate market. Today, lots of growth is also coming from leverage – but it’s mostly the Fed printing to buy bonds from the Treasury and then letting them mature and roll off. This is funding deficit spending and preventing a lot of really tough budgetary battles in Congress. This is powering a slowly-growing economy and a record amount of buyback activity which is helping to fuel corporate prosperity, which in turn, theoretically, is creating private sector jobs.The whole mutually beneficial system I’m describing is what Jeff Gundlach has called a “circular financing scheme”. He says that if it works, it’s the most important invention since the telegraph.

My thoughts: The private sector is still in a coma, and the Federal Reserve is now in the process of ending their QE program which they tell us will be followed by an increase in rates. If the U.S. stock market has moved higher due in large part to a circular finance scheme centered around the Fed's QE program, and the Fed is telling us that scheme is coming to an end, is that not a problem?

Reason 3: We’re nowhere near the PE ratio the S&P 500 printed at the height of the dot com boom.

My thoughts: The fact that we have now crossed every valuation point in history by P/E standards (including the 1929 and 2007 tops), but we are still below the 2000 mania peak should not make investors feel comfortable. That is like saying I drank 15 beers in the last 2 hours and I am good to drive home because my friend drank 20 beers in 2 hours one night last week and he did not get pulled over. In addition, a large portion of the mega-overvaluation back in 2000 was concentrated in a small portion of the technology market (as Josh correctly notes in his article). The mean stock in the S&P 500 today has a higher P/E ratio than it did in 2000.

Josh called out Rick Santelli last week on CNBC regarding confirmation bias, and I would caution him to make sure he is not making the same mistake. U.S. stock bulls have been absolutely correct in staying long stocks the last few years, which have outperformed almost every other major asset class on earth. However, I believe that since early 2012 U.S. investors have been playing Russian Roulette by remaining in the market at these incredibly lofty valuations. Just because they have not found the bullet in the gun does not mean it is not waiting for them. Now is the time to put the gun down and walk away while you are (way) ahead.

Commercial Real Estate Cap Rate Case Study: Dunkin Donuts In Charlotte, NC

Globe Street reported this week that a commercial property home to a Dunkin Donuts close to my home just sold for $1.43 million. Bryan Belk, from Franklin Real Estate Services, who represented both the buyer and the seller said it was the lowest cap rate he has seen for a Dunkin Donuts property. The cap rate was 5.5%.

A 5.5% cap means the buyer paid $1.43 million for an income stream of $78,500. The income stream is referred to as the Net Operating Income (NOI), which is essentially income (rent Dunkin Donuts pays the property owner) minus the expenses to operate the building. It does not include mortgage payments.

The building is in a great spot for a Dunkin Donuts, located on the "breakfast" side of the street (the side of the street traffic moves on the way to work in the morning). The drive through is routinely so busy there is a line to enter from the main road. 

I would imagine this will continue to be a great business for many years into the future (Dunkin Donuts currently has a lease in place through 2024). However, will the buyer of the building ultimately make money on the property? 

As with almost any investment around the world, purchasing this building today is a bet on the future direction of interest rates. Investors are searching for yield and they have moved out on the risk spectrum in order to try and find a return. Purchasing a commercial building involves many potential risks, some of which are:

- The individual owner of the Dunkin Donuts store could get into financial trouble and be forced to sell. 

- One or more competing breakfast stores could open up along the same route to try and capture some of the morning market share. 

- The building could catch on fire or flood. 

You must also weigh the fact that there is additional work involved with purchasing a building vs. buying a stock or bond where you simply collect your dividend or interest payment every month. The owner of this building (which most likely has a professional management company in place) must take the time to monitor the management company. The owner is a 1031 exchange investor from California. 

When you purchase a property today you must think about what investments you will be competing with in the future when the time comes to sell or refinance. Commercial real estate is usually financed under 10 year terms, so the most obvious competitor would be a 10 year treasury bond (the risk free investment). What if 5 years from now the 10 year treasury bond has risen from its current yield of 2.5% to 5.5%?

No one is going to purchase a commercial building with the risks just discussed at a 5.5% cap rate if they can receive that same 5.5% return from a risk free bond that requires no management. That means the cap rate on the commercial building would need to rise to provide a spread large enough to attract investors in the open market. Let's say that spread remains at 3% and the cap rate rises to 8.5%. 

What is the building worth at an 8.5% cap rate with an income stream of $78,650?

$925,294 or $504,706 less than what was paid for the building. This scenario assumes that no problems occur with the building or the Dunkin Donuts operating within it; only that interest rates more toward a more rational level.  It also does not include the cash flow made on the property during the years before the sale. If the buyer paid cash for the building and received $78,650 per year, then the loss would fall to only $111,456. When you include cash flow, however, you are not considering the opportunity cost of where the money could have been invested if it was not put toward buying the building. 

This is just one example of the losses coming in the future for those that are reaching for yield today. The commercial property market does not exist in a vacuum. A rise in rates will lead to many areas of the current artificial economy shrinking or shutting down. This will lead to layoffs, which will lead to a loss in discretionary spending. Will someone stop at Dunkin Donuts to pay $5 in the morning for coffee and donuts if they are struggling to pay their power bill? What would an investor be willing to pay for the commercial building if the business viability of its tenant were called into question?

If you can begin to move your mind through a thought experiment like this you can put yourself into a future world and work backwards to understand how to profit from its arrival. 

Thursday, July 17, 2014

Carl Icahn Is Very Nervous

In the brief clip below, Carl Icahn is asked to comment on Druckenmiller's comments on the danger behind the Fed's loose monetary policy. He notes that the Fed has admitted they do not understand how their policies will impact financial markets, meaning they are flying blind as they insert 4 trillion printed dollars into the financial system. He is "very nervous."


Tuesday, July 15, 2014

Rick Santelli Live From The Insane Asylum

The video below went viral yesterday afternoon after Rick Santelli had one of his trademark meltdowns on set. The meltdowns occur every few weeks due mostly to the fact that Santelli, who now exists as the lone voice of reason within the entire CNBC studio, has to listen to Fed worship 24 hours a day, 7 days a week.

Every once in a while he tries to interject and explain to the "experts" that printing 4 trillion dollars will ultimately have some sort of negative impact on the economy, but those thoughts usually end up with the type of rampant hatred thrown back at him below.

Yesterday Rick faced an entire panel of Fed loving maniacs, which was not enough, so CNBC went live to some remote trading room to bring in another voice to explain to Santelli why printing trillions of dollars only strengthens an economy over the long term.

I moved back to Charlotte in March and I realized after watching this clip today that I have not turned on CNBC once since I've been home. I don't even know where to find it in my channels. I used to watch the 8:30 am release and discussion around economic data, but even that became such a circle of misguided Fed worship that it is unbearable.

I try to spend 50% of my time reading and listening to bullish analysts, newsletters, books and videos and 50% of my time listening to bearish analysts, newsletters, books and videos. I do the same for inflation vs. deflation debates, US vs. global strategies, commodities vs. bonds vs. stocks, etc. etc.

I try to seek out ways to disprove economic theories I have learned over the years so I do not suffer confirmation bias. After studying history, I still believe that the current global experiment of fiat currency which began in 1971 and has now morphed into endless global government spending combined with endless global quantitative easing is going to end in complete disaster. I have not been able to find any way around the disaster's ultimate arrival.

I feel for poor Rick in the video below. On the CNBC studio, he now exists as the only sane person in an insane asylum and he cannot possibly explain to anyone around him why pumping heroine endlessly into the economy might ultimately end up hurting it, severely. What I find most fascinating, and what made me want to discuss this video today, was not only the people on the show attacking Rick's opinions but the re-posting of the video on major financial sites across the Internet discussing how misguided and confused Santelli is on Fed policy.

Liesman ends by telling Santelli that higher interest rates, inflation or a reduction in the value of the dollar have not occurred which means he is incorrect in his analysis that the Fed should not be conducting crisis monetary policy in a time of non-crisis. Alan Greenspan was held up as a God for keeping interest rates low, until the crisis arrived in 2008. Bernanke and Yellen are held as gods today. Time will tell if Liesman and his Fed friends end up with their reputation in the trash dumpster, along with the once mighty Maestro; Alan Greenspan.

Chasing Yield