Saturday, September 20, 2014

A Review Of Natural Market Cycles & The Coming Reversion

The current bull market run in U.S. stocks has now crossed over 2000 days, making it 5.5 years old. It is the fourth longest in history (trailing only the 1949, 1974, and 1990 runs). The average bull market in U.S. stocks is 3.16 years and the median bull market is 2.16 years (a bull is considered over after a 20% decline or more).

It would surprise many to know that the current run of consecutive months with job gains in the U.S. is the longest in history. The next three occurred in 1989, 2000 and 2007.

I find this second statistic and the chart above fascinating. You'll notice that the top 4 runs of consecutive job gains all occurred within the last 25 year period. I believe three major factors account for these recent record runs (these are broad strokes; it would take numerous books worth of writing to discuss this subject in its entirety).

The first is that the government changed the definition of employed and unemployed in the early 1980's. If you are a Realtor that makes no money and works with a customer for 2 hours one month, you are considered employed. The same goes for a part time worker at 20 hours a week who is seeking (and probably needs) full time work.

The second factor is the stimulating effect of declining yields on assets over the past 32 years. The cost to take on debt has declined steadily alongside commercial real estate cap yields (falling cap rates equal higher prices, see Commercial Real Estate: How Prices Are Determined). The ability to borrow more has turbocharged the entire economy while the real estate industry has created an army of jobs over the past few decades (if rates were to begin rising this stimulant would become a depressant and many of these jobs would disappear).

The third factor that has turbocharged the recent job runs has been the involvement of the Federal Reserve and federal government in the economy.

In the early 1980's the American government began to run massive deficits in order to stimulate the economy. In the 1990's these deficits were combined with loose monetary policy in order to stimulate growth. In the 2000's the two continued to be used together only on steroids. Today the world does not even remember a time when the U.S. government or Federal Reserve were not solely responsible for the growth within the U.S. economy.

The "new" economy has become such a perverse creature of its former self that it looks like a meth addict continuously seeking its next hit. Greenspan said that we entered a period of "Irrational Exuberance" after the stock market crossed 100% of nominal GDP back in 1996. The only problem is that due to these combined stimulant/drug injections into the economy we have been above that point almost every moment since. The real wash out has not arrived yet. 

We know what happens when booms are artificially juiced to run longer than they naturally would; the busts become equally larger on the downside.

Analysts now believe that stock market gains and job growth are a permanent part of the economy because company earnings will experience straight line growth into the future, forever. The following is a real quote by Jeffrey Saut, someone that people take seriously in the financial world:

“Since 1989 the S&P 500’s earnings have grown by 6.15% annually. Extrapolating that into 2020 implies earnings of $183.36. Using the historical median P/E ratio of 15.5x yields a price target of 2842 in 2020.

Here is the chart that illustrates Saut's permanent earnings growth. No more recessions. Market cycles no longer exist.

Do you see on the chart above how previous earnings booms were followed by an equal or greater bust? This is the natural cyclical flow of an economy. Expansions lead to contractions which wash away the excess and create the foundation for the next period of expansion.

Manufacturing Costs For The Top 25 Export Economies As Currency Wars Rage On

John Mauldin posted the interesting chart below this week showing the cost to produce goods in the top 25 export economies. A few of my thoughts:

Over the past two years companies in the United States have been discussing how they are bringing their manufacturing back to domestic producers because the cost is equal or below the bids they are receiving in China. The chart below illustrates how China has rapidly caught up with the United States in the cost to produce goods (great news for America, not great news for China). 

There are only nine countries now less expensive than the United States. Mexico and India are less expensive than China which had provided a boost to their overall economies in recent years (and should continue to help moving forward). Indonesia is the most attractive producer in Asia. 

The price of labor in Europe makes their manufacturing costs less competitive. That is already correcting itself as wages are in free fall due in large part to massive youth unemployment (the invisible hand working). 

Japan, a country heavily dependent on exports, carries a higher cost burden than many of the Asian exporters. This is part of the reason why Japan (along with Europe) is so focused on reducing export costs through currency devaluation. A reduction in the value of your currency is like a magical reduction to the cost of your exports with no wage reductions needed. 

The chess pieces will continue to move as the currency wars rage throughout the remainder of this decade (and possibly beyond). I believe that when the smoke clears the Japanese yen will experience the greatest losses while gold and silver will experience the greatest gains.

For more see: Japan Is A Powder Keg Searching For A Match

Bill Fleckenstein Brought Out To The Firing Range On CNBC

The market continuously moves through a steady psychological cycle of human emotion. During the depression stage of a market decline no one wants to admit they own the asset, and they can only discuss the potential risks of the market moving lower. This is the absolute best time to begin accumulating a position within that asset class (examples in today's markets would be precious metals, agricultural grains, uranium stocks and the Russian ruble).

As prices rise and investors gain confidence psychology slowly shifts until it reaches the complete opposite end of the spectrum. During this period, usually between thrill and euphoria, the fear that prices could potentially move lower is completely washed away.

We are at this psychological point for U.S. stocks. At this stage the mainstream media likes to lump together a group of talking heads like a firing range to verbally assault anyone left on the planet who could potentially even think about not having their clients "all-in" U.S. stocks at current nose bleed price levels.

This week CNBC brought on Bill Fleckenstein who created a short fund at the peak of the stock market back in 2007 (a short fund profits when prices fall). He closed his short fund in February 2009 (the market bottom) because he felt central banks would print an enormous amount of money and stocks would experience a relief rally.

This would probably be the closest example available of an analyst who has a complete understanding of monetary policy and its impact on the financial markets, however, the CNBC host tells Fleckenstein he misunderstands monetary policy, at which he can only laugh.

The remaining portion of the segment consists of the three U.S. stock bulls assaulting Fleckenstein relentlessly for not currently being 100% long U.S. stocks. Fleckenstein is currently in the early stages of opening a new short fund to capitalize on the U.S. stock market's next collapse, just as he did back in 2007.

Thursday, September 18, 2014

Seth Klarman On The Complacency Before Chaos

The following is a piece from billionaire Seth Klarman's recent letter to his investors. It provides an incredibly well-written summary of where we are in the financial markets today.

Klarman manages the Baupost Group, one of the largest hedge funds in the world:

We don’t know now (nor do we ever know) what the overall market will do. As we’ve discussed in recent letters, there are reasons for investors to be frightened but also numerous individual opportunities worth seizing. Today’s limited opportunity set means that we are still holding sizable cash balances, about 35% of the portfolio at June 30. This dry powder will become more valuable if the markets become more turbulent.

Equity markets continue to hit successive record highs, volatility remains strikingly low in equity and most other markets, and inflation is ticking higher. Investors have clearly grown weary of worrying about risky scenarios that never seem to materialize or, when they do, don’t seem to matter to anyone else. U.S. GDP, for example, was recently restated to minus 2.9% for the first quarter of 2014. Normally, this magnitude drop signals recession. Equities, nevertheless, marched relentlessly higher.
In today’s ebullient markets, we see many investors ratcheting up their own risk levels--buying substandard credits and piling up leverage are two favorite methods--in an attempt to generate near-term performance.
The financial markets could be getting closer to an inflection point, where the economic weakness that the bond market seems to be reflecting derails the more optimistic equity market. Or perhaps things can go on forever exactly as they are: a “Goldilocks” stock market resulting from a tepid economy, dampened volatility, and relentlessly low interest rates. Amidst the market rally, complacent investors continue to ignore a growing array of global trouble spots. Contrary to claims from the Obama Administration, the world is not a tranquil place at present. As such, risks facing investors seem to be rising but are not yet priced into the markets.
Late in a market cycle--when bargains are increasingly hard to find, valuations are lofty, and most investors have been scoring handsome gains for a number of years--we can say from experience that history tends to rhymeMoney becomes more freely available to pursue even the most marginal of opportunities. Dollars pour into venture capital, and the largest buy-side firms take strategic stakes in hot, late-stage private investments just prior to an expected big money IPO. Specialized funds are raised, regularly and easily, to invest in things like Greek private investments, Spanish real estate, or European non-performing loan pools. Willing investors abound for these. It doesn’t matter that market prices have mostly rebounded, prospective returns are thereby limited, and the capital in those funds is likely to be put to work whether or not prices warrant and even if conditions on the ground deteriorate. With investment bankers and hedge fund executives canvassing Europe today to bet on recovery, you have the increasingly common circumstance of proliferating “opportunity funds,” absent only the investment opportunity. Some clients of hedge funds today are, in a sense, disintermediating themselves, funding new entities to bid higher for the same sort of assets their other, more disciplined managers are already bidding more judiciously for. The discipline problem in this case is not that of the legacy managers; it may just be that of the clients.

The pressure to reach for return virtually ensures that many investors will take greater and greater risk for less and less potential reward at market peaks. If you can’t find bonds that yield 8%, better grab those offering 6%. Or 4%. If you need 8% to meet your bogey (assumed pension fund returns, for example, or promised returns to investors), then you will be prone to own increasingly risky assets or leverage up the safer ones. These pressures, as much as any indicator, are today signaling danger. Investors today are bidding ever higher amidst frenzied competition to buy pools of non-performing loans, and then leveraging them up to get double-digit returns. Mortgage securities backed by questionable loans issued to dicey borrowers now trade close to par and yield a downright stingy 3-5% where they once yielded a generous 15-20%. A recent brokerage report excitedly touted the new HoldCo PIK Toggle notes of a Croatian consumer goods retailer. Nearly every word of that description is a flashing red light to seasoned investors.

To put it a bit differently, writer and investor John Mauldin is right when he says that there is “a bubble in complacency.” Fear has effectively been banished. The members of the Fed know it. Stock traders who chase the market to new highs almost daily know it. Implied volatilities (and realized volatilities) are historically low (the VIX Index recently hit a seven-year low), and falling. The Bank for International Settlements recently cautioned that financial markets are euphoric and in the grip of an aggressive search for yield. The S&P has gone over 1,000 days without a 10% decline, according to Birinyi Associates. Dutch and French 10-year government bond yields are at 500 and 250 year lows, respectively; Spain, 225 years. Spanish debt yields were recently inside of U.S. levels.
Increasingly, hopes and dreams are being capitalized as if the future is certain and nothing can go wrong, as if up cycles such as the present one don’t inevitably sow the seeds of the next decline. The European Central Bank recently cut its deposit rate to an unprecedented minus 0.1%, and Mario Draghi assured that he isn’t finished. Can this be done without consequence? Investors have become numb to risk because such policies continue, seemingly forever, and new measures (such as European and now even Chinese QE) are regularly threatened and claimed to be costless and reliably effective. We are far from convinced of this; indeed, the higher the level of valuations and the greater the level of complacency, the more there is to be concerned about. Even as reported inflation remains quite subdued, signs of incipient cost increases are increasingly evident. We are seeing them, for example, in apartment rents, construction costs, and salaries of newly minted engineering graduates and oilfield workers.

Like global equity markets, credit markets have been surprisingly resilient, and our worry meter is high here, too. Ecuador recently issued $2 billion of ten-year bonds, as the market shrugged off its 2008 default. Kenya also completed a $2 billion offering, the largest ever debt sale by an African country, according to The Wall Street Journal. That offering attracted $8 billion worth of bids. In the U.S., issuance of low-grade credit is at record levels, as is covenant-lite issuance. Yields are at or near historic lows, which is especially nutty for junk credits, including the hideously risky CCC-rated issues. June CLO issuance set a record. Given changes in regulation, Wall Street has far less capital available to support the trading of this burgeoning junk issuance and the corresponding surge in debt ETFs. A sudden change in rates or sentiment could lead to serious market instability. When is harder to predict than if. While we are not predicting imminent collapse (market timing is not our thing), we are saying that a selloff, greater volatility, and investor losses would hardly be surprising from today’s levels.

In markets, it’s always hard to tell, in the words of the old commercial starring Ella Fitzgerald, Is it real or is it Memorex? Is the market nearly triple its spring 2009 level because things are better, or do things feel better because the market has nearly tripled? Indeed, we can do a simple thought experiment that might be revealing: How would everything feel if the S&P 500 were suddenly cut by one-third or one-half? Would such a drop drive astonishing bargains, or would the U.S. economy soon falter, with festering problems such as unemployment, the federal, state and local deficits, the long-term fiscal situation, and the creditworthiness of most sovereigns suddenly seeming ominous?

It’s not hard to reach the conclusion that so many investors feel good not because things are good but because investors have been seduced into feeling good—otherwise known as “the wealth effect.” We really are far along in re-creating the markets of 2007, which felt great but were deeply unstable when shocks started to pile up. Even Janet Yellen sees “pockets of increasing risk-taking” in the markets, yet she has made clear that she won’t raise rates to fight incipient bubbles. For all of our sakes, we really wish she would.
h/t Zero Hedge

Wednesday, September 17, 2014

Mark Cuban On Startups & The Desire To Win

Mark Cuban discusses the value in funding startups outside of Silicon Valley, the desire to win in the business world, Cyber Dust and Shark Tank.

It's no secret that Cuban, who appears on this site often, is one of my favorite business personalities in the world, and I listen to and read his thoughts/advice at every opportunity.

Tuesday, September 16, 2014

Marc Faber On Diversification

Some positive words this week from Marc Faber on diversification: "I hope that when the collapse happens, I'm only going to lose 50% of my money." (only partially kidding of course)

A slightly different tone than what we currently hear from the rest of the financial world which has already booked 20% plus annual returns for at least the next five years by staying 100% invested in U.S. stocks. 

Faber is now berated on CNBC for admitting he diversifies a portion of his portfolio in precious metals. With the anniversary of the Lehman Brothers bankruptcy this week, here is how the major asset classes have performed over the last six years:

Silver +71%
Gold +61%
S&P +58%

We'll check back in a few more years to see how things have progressed from here. My guess is there will be less mocking of Faber on CNBC for admitting he owns a portion of his portfolio in precious metals. 

h/t Zero Hedge

Monday, September 15, 2014