Saturday, August 2, 2014

The Fundamentals In Europe Weaken As Financial Markets Hit Record Highs

This week Spanish and Italian bonds reached the lowest yield in history on 10 year government bonds (lower yield means higher price). You can see the moment when the European Central Bank uttered the words "whatever it takes" in the dashed red line below:

As we have covered numerous times, the ECB's "whatever it takes" was the green light for the banks located within the PIGS (Portugal, Italy, Greece, Spain) to begin buying as much toxic government debt as possible. They knew if yields were to rise in the future they had a central bank standing ready to print and purchase the toxic bonds to bail them out.

This process also took away any pressure on governments to create structural reforms within their economies (spending cuts). The chart below shows the steady rise of government debt to GDP for the PIGS since 2010. In other words; as prices of European government bonds have risen to all time highs, the quality of the debt has fallen to all time lows. The sharp drop off in Greece government debt to GDP back in 2012 (green lines) was due to their partial debt default.

In reality, the situation is far worse than the chart above shows because of the enormous debt now resting on the bank's balance sheets which have a conditional guarantee from the governments (think Fannie Mae and Freddie Mac).

Does this all sound insane? It's because it is.

Looking beyond the debt markets, the equity markets in Europe have also grown far more dangerous over the past two years. Share prices have risen from undervalued levels on a price to earnings basis in 2011 to a "fully valued" point today. 

The euro currency is also coming off of a multi-year rise setting up trouble around every corner for a massively overvalued and euphoric set of markets in the European Union.

Marc Faber On The Danger In U.S. Shares & Opportunity In Hong Kong Stocks

Marc Faber spoke with the CNBC studio this week to review the dangers lurking within the United States stock market and review the opportunity he sees in agriculture, precious metals and Chinese shares.

Faber routinely takes heat for being negative on U.S. shares (see the second portion of the segment here), with commentators trotting out his warnings since 2012 that stocks were overvalued (they have been). What they do not remember or discuss is that when pessimism was at a level not seen since the great depression toward stocks back on March 9, 2009 he was calling for a market rally because of the negative sentiment. Faber was bullish on European stocks at their sentiment trough in 2011 and bullish on U.S. treasuries at their sentiment trough entering 2014.

The same cycle will occur again as stocks turn back down, prices begin to find a more healthy value range and sentiment reaches negative extremes. Long term pros will enter the market and pick up undervalued assets while the CNBC studio is once again left trying to figure out what happened.

Here's a look at how Russia, Shanghai and Hong Kong shares are priced on a 12 month trailing earning basis (cheap) vs. other major global markets (expensive).

Opening Offer

Friday, August 1, 2014

The DOW Turns Red On The Year

After a strong GDP report earlier in the week and a strong payrolls report this morning, the DOW found itself in the red on the year after the market closed yesterday (and is down today as I write this).


Markets historically peak during periods of positive economic data and bottom during periods of poor economic data (remember how horrible the economic data was in March 2009?). The stock market is a forward looking measurement of where investors believe the economy (and earnings) will be in the future. A peaking process usually occurs when economic data is still strong, but marginally weakening.

Investors today are looking forward into a world where the Fed is backing away from QE and discussing the possibility of raising interest rates. This will arrive during a very fragile recovery in employment and GDP growth.

Or, the market is turning down because it is extremely expensive and has been rallying relentlessly for over 5 straight years. The market is now more expensive than the price to earnings peak in 2007 when economic data, GDP prints, and employment reports were forecasting blue skies ahead. See Flashback To December, 2007: What Was The Outlook For U.S. Stock Prices?

Or, this is just another brief moment when the U.S. market is catching its breath before blasting off again to higher levels of overvaluation and danger.

While the U.S. market decline will make the headlines this week, my focus continues to be on the agriculture grains (specifically wheat and corn), which have been annihilated through the first seven months of the year (see chart below). I discussed agriculture last week in Corn & Wheat Prices Destroyed: Buying Opportunity?

The Real Story Behind Argentina's Default: Credit Default Swaps

Jim Rickards discusses Argentina's sovereign debt default in the video below, reminding the CNBC hosts that the real problem lies not with the actual government bonds, but the insurance placed on those bonds (through credit default swaps).

While it is easy to see who will take losses on the bonds when Argentina defaults, the derivatives market exists off balance sheet in the darkness so a hedge fund or bank blowup can appear anywhere, anytime. This is what occurred during late 2008 in a much larger context when banks did not know who insured subprime debt through credit default swaps (we quickly found out the largest insurer was AIG, which then imploded).

This process will get much more exciting when Japan's government debt begins to tremble simply due to the size of their bond market and the amount of insurance that has been sold to protect against losses.

Perhaps there will be no noticeable problems in the derivatives market with the Argentina default. Or perhaps we will wake up one morning to hear about a hedge fund that is hemorrhaging cash and their positions are in liquidation. That hedge fund or bank may be insuring another set of derivatives and by shutting their doors it breaks the link in the system (like Lehman). This is the problem with the interconnected nature of the financial markets. Everyone is walking around on a mine field in the dark hoping their next step does not trigger an unseen explosion.

Wednesday, July 30, 2014

A History Of Worst Case Scenarios For Global Stock Markets

Interesting chart below from Patrick O'Shaughnessy, which shows the worst case scenario for stock markets around the world during different time intervals from 1900 to 2012.

The United States market was one of the top performers, which is unsurprising considering the United States dominated the growth in the global economy during the 20th century. The U.S. also never had to endure war taking place on its own soil, which devastated some of the major countries during the WWII years.

There is a case to be made, however, that no market experiences exponential growth forever, especially when that market becomes enormous in size relative to the rest of the world. The common assumption is that if you buy for the long term it makes no difference when you enter the market. You'll notice that 12 of the 21 markets were down for periods longer than 30 years. 

With the United States currently one of the most expensive stock markets on the planet, do investors have 40 to 50 years to recover if something goes wrong?

Jim Grant On Russian Stocks, Gold Mining Shares & Global Debt

More from Jim on the Bloomberg set this week discussing the artificially low yield levels around the world:

35 Percent Of Americans With Credit Have Debt In Collection

The Urban Institute released a report this week titled Delinquent Debt In America, which has received widespread publicity due to a startling statistic.

They report that 35% of Americans with credit have debt in collection. This means you must actually have credit (opened credit card, auto loan, or other accounts), and it does not include mortgage debt. The summary concludes:

Financial distress is a daily challenge for millions of American consumers. Nearly 1 2 million adults — 5.3 percent of Americans with a credit file — have non-mortgage debt reported past due, and they need to pay $2,258 on average to become current on that debt. 

Further, an alarming 77 million Americans — 35 percent of adults with credit files — have debt in collections reported in their credit files, with an average debt amount of nearly $5,178. Debt reported past due, and in particular reported debt in collections, is more concentrated in the South. 

In addition to creating difficulties today, delinquent debt can lower credit scores and result in serious future consequences. Credit scores are used to determine eligibility for jobs, access to rental housing and mortgages, insurance premiums, and access to (and the price of) credit in general (Federal Trade Commission 2013; Traub 2013). 

High levels of delinquent debt and its associated consequences, such as limited access to traditional credit, can harm both families and the communities in which they live. This brief contributes to our understanding of financial distress in America by exploring the spatial patterns of delinquent debt in the United States. Future work will explore the drivers of financial distress and those factors influencing its spatial patterns.

While certain sectors of the American recovery are humming due to the Fed's liquidity injections, the larger economy continues to choke on consumer debt coupled with stagnant wages.

Monday, July 28, 2014

In The New M&A Mania Both Sides Experience Share Price Surges

Hedge fund legend David Einhorn noted in his letter this week that mergers and acquisitions have come roaring back in 2014. The merger period that occurs late in a market cycle (during peak euphoria) can be frustrating for a fund to short some of the most overvalued stocks because when they are taken over their share prices usually surge.

Companies that know they have problems under the surface are quick to agree to any deals at a premium of what their company is currently selling for (the problems under the surface are what David's team has the ability to see). Pushing a merger through allows the selling company's shareholders to cash out at a profit while the losses are absorbed in the future by the buying company. 

These periods of euphoria, as seen in the chart below, tend to occur near market tops. The Fed has turbocharged the current M&A surge because the largest beneficiary of QE has been stock prices and junk bonds which are used to put deals together. 

Normally during a takeover the company being bought out experiences a rise in the stock price while the company buying sees a decline. David noted that this takeover season has a new twist; the buyer's stock prices are also advancing in response to deals, enabling companies, to see gains as acquirers - even of other troubled companies. As an example, Zillow and Trulia announced plans for a merger this week and both shares rocketed higher on the news (I'm not saying these are troubled companies, only showing the example of both sides experiencing rising share prices).

Companies already drunk on euphoria continue to see these deals put together with both sides experiencing share surges, meaning anything could happen as we move forward in the short term. 

What we do know is that the longer this goes on and the more deals that are put together using inflated junk bonds and artificially high share prices, the more pain that will result in the end. When the madness will end is anyone's guess, but we have moved to the point where the steering wheel and brakes have been removed from the car. All that is left now is additional acceleration and prayers for a happy ending. 

Sunday, July 27, 2014

Still Drowning: An Update On Seriously Underwater Homes In The United States

RealtyTrac reported this week there are still 9.1 million U.S. residential homes considered "seriously" underwater (the mortgage exceeds the property's value by at least 25%).

The seriously underwater group accounts for 17.2% of all mortgages. The residential market has slowed considerably during the first half of 2014 and as we have discussed here numerous times; when interest rates resume their ascent higher home prices will resume their decline lower. 

Here are the top 10 states with seriously underwater homes. Click for larger view:

Mark Cuban On Tax Inversions

Corporate (Tax) Inversion Definition From Investopedia:

"Re-incorporating a company overseas in order to reduce the tax burden on income earned abroad. Corporate inversion as a strategy is used by companies that receive a significant portion of their income from foreign sources, since that income is taxed both abroad and in the country of incorporation. Companies undertaking this strategy are likely to select a country that has lower tax rates and less stringent corporate governance requirements."