Friday, May 1, 2015

Absolute Vs. Relative Value: What If Everything Is Expensive?

One of the most common tactics financial advisors (paper asset sales people) use today is to show the "relative" value of a certain asset class compared to another.

For example, we discussed earlier in the week some stocks are yielding a higher return (through dividends) than what you would receive in a 10 year treasury bond. This is true. On a relative basis looking at stocks vs. bonds, and comparing only the rate of return on your money, stocks look attractive.

When selling the idea of adding bonds to your portfolio you hear U.S. bonds are providing returns far higher than other government bonds around the world (many of which have negative yields), which makes U.S. bonds attractive on a relative basis.

Another extremely common example is; "U.S. stocks today, while very rich in terms of valuation, are far less expensive than they were at the 2000 peak. Therefore on a relative basis to the 2000 peak stocks are still inexpensive."

Flash back to early 2000 as an investor holding U.S. stocks. You were told at that time although the price to earnings ratios were at levels never before seen, they were still less than half of where Japan peaked in 1989. Therefore on a relative basis to the Japanese peak U.S. stocks were very cheap in back in 2000.


The problem with looking at the relative basis of an asset is the comparison asset may also be resting at an insane price. This is extremely important to understand today because so many markets around the world are overpriced (stocks, bonds and real estate). 

Real estate owners in the United States are assured there is no danger ahead because relative to Canada, Australia or China, home price to income ratios look extremely cheap. But what if that's because those countries are in a never before seen real estate bubble? (hint: they are) Isn't that an important part of the relative price comparison that was left out of the discussion?


If you wish to be a value investor you must focus on absolute value. Most stock, bond and real estate markets around the world are extremely expensive on an absolute basis. Take the time to take a few steps back and look around. It becomes easier to see if you take on the lens of relative values. When it becomes extremely difficult to find absolute value around the world you know we are close to the point where the most hated asset in the world (currently) will soon become the most coveted; cash.

Please remember the next time you are speaking with an advisor they receive no income from the portion of your portfolio that remains in cash. Their monthly paycheck is based on moving you from one asset class to the next based on the relative value of those assets.

For more see: U.S. Stocks Mania: Earnings, Valuation & Sentiment Review

Social Media Stocks Plunge

The old adage is the bull climbs the stairs and the bear jumps out the window. Certain sectors of the market can slowly rise for years and investors grow numb to the fact their price to earnings ratios have moved into the stratosphere. This happened with social media stocks, the new high flying technology darlings. After a very rough week of earnings releases it appears investors came to their sense very quickly and painfully.




Can these stocks collect themselves and move further upward into even more absurd valuations? Of course, I do not doubt anything in the current mania. Eventually all assets come back to reality, and the further they move up into la la land, the bigger the plunge will be back to earth.

h/t Adam Taggart

TD Ameritrade: Retail Investors "Fully Invested" In U.S. Stocks

But what about all the money on the sideline waiting to pour in?

Tuesday, April 28, 2015

U.S. Stocks Mania: Earnings, Valuation & Sentiment Review

Let's take a quick walk through the fundamentals, valuation and sentiment surrounding U.S. stocks. First up we have fundamentals which can be analyzed through earnings and sales. However, as Lance Roberts described this past week the two can be very different at major market turning points due to accounting gimmickry by corporations.

Operating and reported earnings have turned sharply lower over recent quarters which has historically been associated with major market peaks. As shown below, it is also important to notice that revenue has tended to lag these downturns in earnings previously. This is because the measures used to substantially boost profitability from each dollar of revenue generated through accounting gimmickry, share repurchases, and cost cutting are finite in nature. When the effect of those manipulations fade, so does the inflated profitability generated from each dollar of revenue.


Up next we have the number one reason to buy U.S. stocks touted by money mangers everywhere: dividend income. We are told dividend income crushes the returns you can receive investing in most bonds today so stocks are "the only place you can safely park your money." What is not mentioned during these presentations is when the economy slows dividend payments can be cut or removed entirely. The chart below shows the number of dividend cuts in Q1 and Q2 this year are sharply above normal recessionary levels. Investors counting on this income for retirement will be quite upset when they receive a letter in the mail letting them know it's no longer coming.


The next chart helps put a valuation perspective on where U.S. equities stand today relative to their current earnings. Using five popular gauges of value the colored circles show where the S&P 500 would be if investors valued earnings today as they have historically. Stocks are 20% to 50% overpriced depending on which metric you choose to use:


What is helping stocks surge to these incredible valuations? Margin debt. March 2015 data shows investors have crossed into new record highs for the amount of money they have borrowed to purchase stocks. The more money investors borrow to purchase stocks the greater the waterfall decline will be due to margin calls and debt liquidations on the way down.


GMO released their 7 year expected return chart this week for various asset classes based on current valuations looking forward. This chart became famous after it was one of the few warning signals at the 2000 peak (it called the 2007 returns from 2000 perfectly). Investors today can expect to lose money in both U.S. stocks (-2% to -3.2%) and U.S. bonds (-1.2%) over the next 7 years. This could occur through a major crash and then a large subsequent rally which would bring investors back (close) to whole from today's prices.


While GMO is nervous about the future the majority of money managers (those that make their living based on keeping your assets in the stock market casino) are not. Barron's Big Money Spring Poll showed 93% of money managers were either bullish or neutral, meaning the worst case scenario would be a market that moves sideways (most think it's going higher). Only 5% polled were bearish.


My favorite new mania headline of the week came from MarketWatch, Hopefully there is no comment necessary on this one:

"Celebrating the new Nasdaq high with a call for 10,000 by 2016" 


The best new mania picture of the week; The Warren Buffett shoes. You know things are getting frothy when you see money managers walking around with these at the country club.


We are truly at historic times in terms of paper asset euphoria The coming crash when the madness finally subsides should be equally epic.

Monday, April 27, 2015

Global Government Bonds Have Become Tulip Bulbs

The bubble and burst we experienced in 2000 was due to overly accommodative monetary policy that led to speculation concentrated in U.S. technology stocks. The response to that crash was an even more accomodative monetary policy that led to a bubble in U.S. real estate, which then spilled over into other real estate markets around the world (Spain, Portugal, etc.). 

When the real estate bubble burst we received a much larger dose of heroin, which has been pumped into the financial markets since 2009. This has not only come from the United States, but from other major central banks around the world (Japan and Europe). As I write, there are rumors that China is preparing to join the QE party. 

This time around the heroin injections are so large they essentially created a bubble in everything. The bubbles in the financial markets today are so pervasive that if you look around they difficult are to spot because almost every major asset class is trading at obscene price levels together. 

However, even in today's "everything bubble" there is an asset class that stands out above the rest; bonds. The insatiable appetite for bonds today has been pushed so far to the extreme that comparisons to tulip bulbs in the 1600's and technology stocks in 2000 may be the only appropriate comparisons. 

Take a look at the chart below which is a European government bond matrix put together by Pension Partners. It provides a snapshot of the yields you will receive as an investor for purchasing a government bond at a specific duration (number of years). The areas shaded red show negative yields, meaning you are willing to pay that government every year to hold your money. 



When you reach the peak of an asset mania it is easy to see that investors are purchasing the asset to "flip" it to the next buyer, not hold it for a long term investment. No one can rationally come up with an argument as to why they would pay the German government to hold their money for 9 years. An investor making this purchase today is hoping to flip the bond to the next buyer at a yield more negative than it stands today. 

The ECB has already announced they will begin purchasing bonds with negative yields, which should only further drive this mania further off the cliff of reality. How low can yields go? I have no idea. To guess would be like putting a final price on Pets.com in 1999 before it reached its zenith and began to free fall. At least at the peak of the tulip bulb mania buyers were not paying sellers a monthly fee to own the tulips. 


53% of all global government bonds currently trade below 1%. $5.3 trillion in government bonds currently trade at a negative yield. Many of these governments have no possible way of ever repaying the money they are borrowing. Their only hope moving forward is to continue to roll the debt and hope there is always a steady buyer there to finance their needs. Back in the days of subprime mortgages there was at least a chance the borrower could or would repay the debt on the mortgage. 

When yields finally bottom and reverse course the widespread destruction in the financial markets will be so pervasive that no asset will be safe in the wake. Both real estate and stocks are dependent on today's low borrowing costs to push their markets further into the stratosphere. 

Many commodities today are sitting at or close to their 2009 lows. Cash is the most hated asset on the planet. I continue to accumulate both (with a much heavier emphasis on cash).