The Stock Market
New Record in Margin Debt
Wow! Peace for our time, the media reported on Tuesday. The stock market celebrated with a 227 point jump in the Dow. Gold slouched away. We would have thought that every possible stock buyer had already placed his order. Where did the money come from to push the indexes even higher on Tuesday?
It was borrowed. That's another record that has been broken lately: margin debt. Never before has so much money been borrowed specifically to buy equities.
As a ratio of GDP, margin debt only saw these heights twice before in recent history: in 2000 and in 2007. In dollar terms, total margin debt stood at $451 billion at the end of January – 15% higher than it was at the peak of 2007 … and nearly 3% of GDP.
But be warned: Hearts and records break from time to time, but never without some pain. The crying begins immediately after a broken heart. After a record high S&P 500, on the other hand, it can take some time.
NYSE margin debt and the S&P Index in real terms (current dollars, deflated by CPI), via Doug Short – click to enlarge.
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Keeping Up With the Debt
More analysis from Chris on the situation in the Crimean Peninsula below. This is a fast-moving situation with big implications for our favorite emerging market, Russia. (Hint: We still think it’s a bargain.)
What we know for sure is that the news out of the region gave the markets a serious case of the heebie-jeebies. The Dow ended Monday's session down 153 (back from a 250-point sell-off). Gold rose by $28 an ounce.
We also know that the Fed’s zero-interest-rate policy … and its $4.1 trillion balance sheet are a standing invitation for trouble. What form that trouble takes will be determined later. Meanwhile, Washington’s mountain of debt gets bigger and bigger – aiming for $20 trillion of official debt by 2020. As it gets bigger it weighs on the economy. Several studies have shown debt slows down economic growth.
Debt – the Name of the Game
Dow down a bit on Tuesday. Gold up a bit. The upward trend of US stocks – and now gold – has not yet been broken. Looking broadly at major trends of the last 50 years, debt was the name of the game from 1980 to 2007. Is it still the most important thing?
From about 160% of GDP in 1980, total debt in the US rose to about 360%. That was a big deal. Not the least because it meant that US businesses availed trillions of dollars in income with no offsetting labor charge.
Stocks, earnings, GDP, employment – with all this borrowed money flowing into the economy, the whole shebang looked good.
When Debt Contracts …
The Dow fell 26 points on Friday. Gold rose a few bucks. Nothing important. After a good fright two weeks ago, investors in US stocks are comfortable again. They've learned their lesson: Whenever the stock market goes down, stay calm; it will always come back.
So here is our prediction: The next time it won't. The next bear market will last at least 10 years … and probably 20.
Why? Debt and demography. Our old friend the late Dr. Kurt Richebächer spelled it out for us years ago:
“You can't build lasting stock market gains or solid GDP growth on debt. Because debt cannot expand forever. Sooner or later it must stabilize and then it must contract. When that happens, all the positive features of debt become negative features. Instead of borrowing and spending more, people must spend less and pay off past debt. Instead of adding to corporate sales and profits, they subtract from them. Instead of driving up asset prices, they push them down.”
Borrowed money has an almost magical effect on the way up. It comes out of nowhere. So there is no labor cost to offset against it. It goes almost directly into corporate profits.
But on the way down Dr. Jekyll becomes Mr. Hyde. Debt has a maniacal effect when it goes into contraction mode. Jobs and wages go down as spending slows … making it harder than ever to pay debt … forcing households to make cuts far beyond what they would have had to do in the good times before.
Soros Fund Places Big Bearish Bet on SPX
According to its latest publicly available filings, Soros Fund Management has increased its put position on the SPX (or rather, the SPX ETF SPY) to the second-highest level ever. Note that the fund seems to have held puts on SPY since at least the summer of 2011, and the position's size is often adjusted, a sign that it has served as a hedge most of the time that is occasionally taken off and then increased again. What is noteworthy about the most recent filing (keep in mind that there is a 45 day delay involved as well, so this was the fund's position at year end 2013) is that the position amounts to $1.3 billion and represents more than 11% of the total portfolio's value. In other words, this was probably not merely a hedge, but rather an outright bet on a decline.
“Soros Fund Management has doubled up a bet that the S&P 500 is headed for a fall. Within Friday’s 13F filings news was the revelation that the firm, founded by legendary investor George Soros, increased a put position on the S&P 500 ETF SPY by a whopping 154% in the fourth quarter, compared with the third. (A put or short position basically gives the owner the right to sell a security at a set price for a limited time, and in making such a bet, an investor generally believes the security is going to decline.)
The value of that holding, the biggest position in the fund, has risen to $1.3 billion from around $470 million. It now makes up a 11.13% chunk of all reported holdings. It had been cut to 5.14% in the third quarter, from 13.54% in the second quarter, which itself marked another dramatic lift on the bearish call.”
Another Warning Sign for Stocks
Both Tom McClellan and Jim Stack recently pointed out that the Coppock curve – a very long term momentum oscillator – has turned down (here are the links to Jim Stack's and Tom McClellan's articles on the topic). It should be pointed out that the Coppock curve is generally better at catching market bottoms than tops, as the stock market tends to make spike lows and rounded tops. As an indicator catching major lows, the Coppock curve has an excellent track record. However, it has been recognized that it does in fact also warn of major peaks, only this requires two downturns in the curve in succession, over a period of about one to two years. As can be seen on McClellan's chart below, a second peak has just been put in. As he points out, the curve could still reverse course if the DJIA rises sufficiently (namely to currently 16,238 points), which would invalidate the signal. Whipsaws do occasionally happen.
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It's Unanimous: There's Nothing to Worry About …
Whenever the stock market begins to correct from a position that exhibits what John Hussman calls the “overvalued, overbought and over-bullish” syndrome, it is worth studying the reaction of market participants to the decline. Both anecdotal sentiment observations and quantitative sentiment studies are helpful in this respect. Given that the pattern we have recently discussed, as well as the seasonal mid-term election pattern, are getting some exposure lately, the probability that a different pattern will actually evolve is rising. Per experience, widely known pattern similarities tend not to continue once awareness of them increases beyond a certain threshold (admittedly it is not knowable where that threshold is). One must therefore consider alternative outcomes as well.
However, we were struck by the preponderance of reports in the financial press that seemed to almost exclusively stress the opportunity the recent sell-off is supposed to represent, while downplaying the risks. The mainstream financial press always has a slightly optimistic slant on things, but previous declines of similar size and speed have created a lot more apprehension as we recall (the last one was in late 2012 on occasion of the budget debate that ended with the 'sequester'). Here are a few examples of what is published these days:
“Market’s 19th Breakdown Sees Bulls Unmoved as Trillions Lost”. As a friend pointed out to us, there is ironically an old Rolling Stones song called “The 19th nervous breakdown” – released in 1966, just as the valuation and real term peak of a previous major bull market was reached. There is little point in repeating all the assertions made in the article – let us just note that the most bearish comment allows that 'we may have to go a little bit lower'. All the fund managers interviewed agree it's a 'buying opportunity'. We are not sure what they mean by that – are those who have not bought so far going to buy now? If so, why?
Weak ISM Misses Expectations by a Mile
On Monday the US stock market was waylaid by an unexpected 'miss' in the manufacturing ISM data. Since this was once again the weather's fault, there's absolutely nothing to worry about. However, the market which had already been weak at the open, was less than enamored by the data release. According to Reuters:
U.S. manufacturing activity slowed sharply in January on the back of the biggest drop in new orders in 33 years while construction spending barely rose in December, pointing to some loss of steam in the economy.
Economists largely blamed frigid temperatures for the chill in economic activity and said they expected a rebound in the months ahead. However, they also cautioned that the economy was receiving some payback after a strong performance in the second half of 2013. "The disappointing data provide further confirmation of a dramatic slowing in economic growth momentum," said Millan Mulraine, deputy chief economist at TD Securities in New York.
The Institute for Supply Management (ISM) said its index of national factory activity fell to 51.3 last month, its lowest level since May 2013, from 56.5 in December.
Bad weather also appeared to hurt U.S. auto sales in January, with Ford Motor Co, General Motors Co and Japan's Toyota Motor Sales USA reported a slide in sales for the month. U.S. stocks fell sharply on the manufacturing data, with the Dow Jones industrial average off 1.5 percent and the S&P 500 losing 1.7 percent. The yield on the benchmark 10-year Treasury note hit its lowest level since early November and the dollar dropped against a basket of currencies.
Mulraine, however, said "to the extent that this weakening can be attributed to weather-effects, we expect activity to rebound meaningfully in the coming months."
January's ISM figure was also well below the median forecast of 56 in a Reuters poll of economists, missing even the lowest estimate of 54.2. Readings above 50 indicate expansion.”
Don't Buy the Dip …
On Friday, the Dow suffered its worst one-day percentage decline since November 2011. The index plunged by nearly 2%. The S&P 500 didn't fare much better. It plunged by 2.1% – its biggest one-day percentage drop since June 2012.
So far in 2014, the S&P 500 has lost 3.1%. And the Dow is down 4.2%. Mainstream pundits say the big fall in US stocks had to do with China. Or with the Fed's tapering of QE. Or with bad labor reports … a slowdown in capital spending … or the drop in foreign trade.
Take your pick. Does this mean the bull market is over? Is it time to sell stocks? Or should you buy the dip?
Our Favorite Way to Build Long-Term Wealth
Dow down 41 on Wednesday. Gold down $3 an ounce. Want something better? Try real estate!
Yes, dear reader, we don't care much for stocks or bonds. We don't trust them. Because we can never get beyond the threshold question: If these were such good investments, why would they be offered to us?
That question comes from years of experience running a business of our own. As long as the business is doing well, we have no interest in sharing it with perfect strangers. If we ever "go public" – watch out, it will be time to sell!
But if you don't trust stocks and bonds, what do you do? Bricks and mortar! Terra firma!
Yes, real estate has its troubles too. Leaky pipes and drafty windows, for example. But at least we understand what they are. We can see them with our own eyes. We saw lots of them last week when we trotted over to an open house two blocks from our office in Baltimore. An apartment building of 13 units is up for auction today. A couple of years ago, there would have been only one or two people at the open house. Last week, there were at least 15, maybe more.
Interestingly, some were people we knew – long-time real estate investors in the Baltimore area. Some were new. One couple was from India. Another man, who spoke English only poorly, was Chinese. How do quasi-slum tenements in Baltimore attract global investors? We don't know. Maybe the proximity of Johns Hopkins University and the Peabody Conservatory of Music. Maybe investors are just looking for a better deal than they can get in major cities.
Is It Time to Sell This Popular Sector?
Sell tech stocks. Buy gold miners. This simple formula is our moneymaking advice for this year. Not that we have any new insight into technology… nor any way of knowing what is ahead for gold or for the companies that dig it out of the ground. Not at all. Our advice is based on ignorance, not knowledge. Not knowing what is ahead, we revert to an old rule: Buy low. Sell high.
Open any newspaper to its financial pages and you will have your answer: Amazon. LinkedIn. Twitter. Zillow. Nest. Facebook. Google. Choose almost any internet-related company, and you will find a good short-sale candidate. Amazon traded at a P/E over 1,000 the last time we looked. LinkedIn trading at about 800 times earnings. As for most of the internet companies, there is no need to look. You will find plenty of "P" but no "E" to divide into it. Many of these companies do not make money; they lose it.
Will they survive the year without crashing?
A Noteworthy Warning
Obviously, during a bubble one cannot get timing advice from John Hussman, and certainly not from us either (our guest author Frank Roellinger and his strict trend-following system are probably far more useful for this purpose- see 'The Modified Davis Method' for details). We can only provide some background information on money supply growth trends and the occasional update on technical conditions. Apart from that, we are frequently wont to pointing out that risk in the market seems quite large – but there is no telling when this risk will manifest itself. What we feel fairly certain about is that when it does manifest itself, it will catch many people unawares, and a lot of the gains that have been made will be given back in a lot less time than it took to attain them.
However, there is another man who is probably worth heeding regarding timing questions, namely Jim Stack. We say this because Stack turned very bullish early on in the recent bull market, and correctly stayed bullish even when the euro-land debt crisis made it appear in 2011 as though the market was on its way back down. We therefore noted with interest that according to a recent press report, Stack is very cautious at the moment:
“One of the first independent advisers to call the current bull market is now raising a cautionary flag. James Stack, president of Stack Investment Research, warns subscribers to his newsletter, InvesTech Research, that the 5-year-old bull is aging rapidly. Although he hasn’t recommended selling stocks just yet, he says risk is rising and has one eye on the exits.
Attention must be paid. Early in his career, Stack, along with the late, great Marty Zweig, predicted the 1987 stock market crash. Twenty years later, in August 2007, he wrote: “We are taking steps to reduce exposure as warning flags increase.”
But unlike some perma-bears who never know when to quit, Stack turned bullish again in early 2009. I remember a conversation at a conference in Orlando that February in which he made the case for a new bull market while I was still very doom-and-gloom.
In a telephone interview from his headquarters in idyllic Whitefish, Mont., last week, Stack pointed out that 2013’s nearly 30% gain in the S&P was the 10th largest in the last 85 years. “I don’t think anyone who was positive on the outlook for 2013 could have expected the size of the advance we’ve seen…,” he told me. Meanwhile, he said, economic trends are “all entering 2014 in strong fashion,” presenting “little probability of a recession in the first half or three quarters of the year.”
But, he wrote in his most recent newsletter, “a strong economic outlook doesn’t negate the possibility of a bear market. The stock market leads the economy, and market peaks precede the start of recession by 5.5 months on average.”
All in all, he told me, “both macroeconomic and technical [indicators] still support more bull market highs in 2014.” But he’s getting worried. “Technically we’re about 15% above long-term historical valuations,” he said. The S&P 500 trades at 19x trailing-12-month earnings, vs. an average of 17x trailing earnings. And then there’s the calendar, particularly the four-year presidential cycle, which is of great interest to technicians and market historians. “The middle two quarters of a midterm election year are historically the weakest,” he said.”
This Market Is Priced for a Crisis … But There Is No Crisis
"You can't trust the Russians," was the warning. It came from a Moscow cab driver, delivered to our son Henry. We had sent him to investigate. From our point of view, it was an unnecessary caution. We never trusted the Russians anyway. Or the Chinese. Or the Democrats. Or wealth managers. Or General Petraeus. Or people from north of Baltimore or west of Hagerstown. But what the heck?
You need confidence to buy Amazon. Or Google. Or Chipotle. You need confidence to buy a US T-bond, too. Or to let a contractor remodel your house on time and with the right materials. But Russian corporate earnings are so cheap right now (in terms of the price-earnings ratio) you don't need to trust Russians to profit from the situation there.
It's why the Russian stock market is our top recommendation to members of our small family wealth advisory, Bonner & Partners Family Office (of which we have some important news below). Since 2009, the world's central banks have put an additional $8 trillion into the global economy. But this flood of liquidity has left Mother Russia high and dry.
The "trailing" P/E (based on 12-month "as reported" earnings) for Russian stocks is 5.7. This is in stark contrast to the S&P 500, which is trading on a trailing P/E of nearly 18.9. (In other words, a dollar of underlying Russian earnings is selling at a nearly 70% discount to a dollar of S&P 500 earnings.) "It is priced for a crisis," says Robert Marstrand, the British former investment banker who serves as the chief investment strategist at our little family wealth project. "And there is no crisis."
Another colleague, Merryn Somerset Webb, editor of British finance magazine MoneyWeek, adds that Russian stocks are:
“… cheap relative to everywhere else, and cheap relative to Russia's own valuation history. Both measures are now much where they were back in 2008, and not far off half their averages over the last 10 to 15 years.
You will say that this makes sense. After all, who wants to pay normal prices for assets which are based in a very abnormal state? Surely anything dependent on a slowing economy, that is in itself dependent on gas and oil, is to be utterly shunned? As is any investment that comes with the appalling corporate governance on offer in Russia. These are all perfectly good points. But there is cheap and there is cheap.”