The Stock Market
Buy Them When They're Cheap
The Dow fell 143 points on Friday. Gold was just about flat. Why the fall in stock prices? Many reasons were proposed, but no one knows for sure. There may not be a reason at all. Stocks don’t need a reason to fall. From time to time, they just do. Not to put too fine a point on it, but asset prices go up … and then they go down. Always have. Always will.
Generally, it’s a credit expansion that drives them up. A credit contraction takes them back down. Credit is still expanding, says economist and author of The New Depression: The Breakdown of the Paper Money Economy Richard Duncan. But come the next quarter, watch out. Duncan reckons “excess liquidity” (as he calculates it, the surplus left over between QE stimulus and what the federal government absorbs through borrowing) is going to contract – sharply.
It hardly matters to us anyway. We buy stocks when they are cheap, not expensive, relative to their historic average. And on a CAPE (Cyclically Adjusted PE Ratio) of 24.7, the S&P 500 now trades at a 50% premium to its historic average CAPE of 16.5. My advice: Get out. And stay out, until the index is cheap again.
The Shellacking Continues
It could well be that the divergences between various market sectors and indexes we have recently pointed out will in hindsight be recognized as having constituted a major warning signal. Of course the correction is so far not big enough to make that determination, but it may be worth taking another look at the comparison chart we recently posted:
NDX, Russell 2000, SPX and DJIA compared. We have added vertical lines that align with the peaks in the indexes – as can be seen, they all peaked at different points in time, spread over a lengthy time period – click to enlarge.
Nasdaq Takes a Hit, Rotation Into 'Safe' Sectors Continues
On Friday momentum stocks sold off with some verve again after the release of the payrolls data. Since the latter were actually quite close to the expected number, they cannot really have been the trigger of the sell-off (in other words, it would probably have happened regardless of the data). A few weeks ago, Charles Biederman of TrimTabs warned that the upcoming tax season could lead to some selling, but there is also the presidential cycle to consider. If the market continues to follow this particular cycle model (it has actually done so year-to-date), it should decline from an April high into an October low. What makes the recent market action interesting is that there continue to be multiple divergences in evidence between different indexes:
Russell 2000 Index, NDX, DJIA and SPX – the former two have been in sync, but have diverged from the other indexes. There are many more intra-market divergences between different sub-sectors that have been put in place over recent months.
The Dow rose 74 points on Tuesday. Gold dropped $3 an ounce. What do you expect? Tuesday was April Fools’ Day.
This should be a good quarter for stocks, according to economist Richard Duncan. He believes “excess liquidity” – cash and credit in excess of what borrowers and spenders actually need – drives asset prices.
We haven’t been able to connect every tarsal, hallux and tibia of Duncan’s theory. But the skeleton, as he presents it, is serviceable … even attractive. The more excess liquidity, the more people use it to bid up asset prices. As excess liquidity goes down, so do asset prices – particularly stocks.
Nejat Seyhun's Take on the Flood of Insider Sales
It should be pointed out that insiders have been heavy sellers of stocks for quite some time. Insiders are almost always early, both in their buying and selling. This is no surprise, as by the very nature of the situation, they have an informational advantage and are bound by legal constraints, which expresses itself inter alia as an often considerable lead time in their activities. If one tries to time one's investments by relying solely on insider data, one will often find one's patience taxed, since what is needed for the investment to produce a positive return is usually that other market participants begin to recognize what the insiders have known all along.
So what is the current situation? As noted at the beginning, insider selling hasn't just picked up recently – it has been quite heavy for a long time now. What makes the current situation remarkable is only that insiders haven't expressed this much skepticism about valuations for some 25 years, as Mark Hulbert reports. He has some interesting information on how the data on insider activity need to be parsed to arrive at actionable intelligence:
“Corporate insiders are more bearish than they have been in almost 25 years. That isn’t good news for the stock market, since these insiders — corporate officers and directors— know more about their companies’ prospects than the rest of us. In fact, you may want to take their pessimism as a signal to ditch some of your stocks or shift into industries in which insiders aren’t heavily selling, such as energy, financials and basic industrials. Just be aware that this record bearishness isn’t evident from many of the insider indicators that get widespread attention on Wall Street—those based on a ratio of insiders who are selling to those who are buying.
According to the Vickers Weekly Insider Report, published by Argus Research, which calculates a proprietary version of this sell-to-buy ratio, insider selling over the last eight weeks, relative to insider buying, is higher than average, but no higher today than it was one year ago—when the S&P 500 was poised to produce an impressive double-digit gain. And in late 2003, just as the 2002-07 bull market was gathering steam, the insiders’ sell-to-buy ratio rose to even higher levels than it is today.
But insider sell-to-buy ratios can be misleading, says Nejat Seyhun, a finance professor at the University of Michigan who has extensively studied insider behavior. That is because the government’s definition of insiders includes a group of investors whose past transactions, on average, have shown no correlation with subsequent market moves: those who own more than 10% of a company’s shares.
Though on rare occasions such a large shareholder also will be an officer or director, in almost all cases it will be an institutional investor—such as a mutual fund or a hedge fund. These entities are outsiders in all but name, and they have the least forecasting ability. For example, Seyhun found that far from being a laggard, the average stock sold by these largest shareholders actually outperformed the market by 0.7% over the subsequent 12 months.
For his calculation, Seyhun strips out the largest shareholders from the sell-to-buy ratio. Currently that adjusted figure shows a record level of insider bearishness. According to this measure, corporate officers and directors in recent weeks have sold an average of six shares of their company’s stock for every one that they bought. That is more than double the average adjusted ratio since 1990, which is when Seyhun’s data begin. One year ago, Seyhun’s adjusted ratio was solidly in the bullish zone, he says. And in late 2003, the ratio was more bullish still. The current message of the insider data “is as pessimistic as I’ve ever seen over the last 25 years,” he says.
Friday's Odd Action
The stock market has spent much of this year trying to exceed its year end 2013 high, and finally succeeded in terms of several indexes in late February/early March. However, it has also dispensed a number of warning shots along the way. On Friday, another such warning shot arrived. A number of momentum stocks were whacked quite badly on Friday, but interestingly, many have actually begun to decline about two weeks ago already.
Friday left the market with a not very pretty daily candle, but what is probably most noteworthy about the action is that it happened on tremendous trading volume. Partly this can probably be ascribed to the expiration, but it is still a bit of an exclamation point considering the many divergences we have been able to observe recently.
Below are a few charts that illustrate the situation. First a look at the Nasdaq and various momentum issues that have been favorites of speculators for some time and have begun to founder a bit.
Nasdaq, 5 minute chart. It gapped up at the open on Friday and immediately started selling off – click to enlarge.
A Rally Met With Disbelief
A big rally is currently underway in Russian stocks now that it seems certain that the Crimea is going to be absorbed into the Russian Federation. Many observers believe the rally won't hold, which is actually a bullish sign. Keep in mind that the Russian stock market is the cheapest in the world. While it is cheap for a great many more or less good reasons, a trailing P/E ratio of about 5 certainly gives investors a big 'margin of error'.
As an example regarding the current state of disbelief, here is a recent Bloomberg missive:
“The rebound in Russian stocks will prove short-lived as President Vladimir Putinfaces stiffer sanctions as he moves toward annexing Crimea, according to PineBridge Investments LLC and Firebird Management LLC.
The European Union and the U.S. announced sanctions targeting Russian officials, and President Barack Obamawarned the nation will face more penalties if it doesn’t pull back from Crimea. Putin is scheduled to address lawmakers today after more than 96 percent of voters in Crimea backed joining Russia in a referendum on March 16.
The Bloomberg Russia-US Equity Index climbed the most in two weeks yesterday and the Micex Index jumped from the lowest level since 2010 as the violence that some investors worried would break out during the referendum didn’t materialize. The Micex fell into a bear market last week, having plunged 15 percent this year, amid concern that Putin’s military incursion into Ukraine would deepen Russia’s economic slowdown. The Micex Index rose 0.3 percent as of 11:03 a.m. in Moscow today.
“There are clear indications that Putin is going to approve the annexation of Crimea and, as soon as he does that, the market will decline,” Ian Hague, founding partner of New York-based Firebird, which manages $1.3 billion of assets including Russian stocks, said by phone from Geneva yesterday. “The annexation will lead to much more damaging sanctions by the U.S. and EU. Russia is not getting away with it.”
A Large Real Estate Developer Collapses
The bond default of solar company Chaori apparently was just the proverbial canary in the coal mine. As we pointed out last week, it struck us as rather troubling that analysts didn't seem to take the Chaori default very seriously. It is worth repeating a quote from a Financial Times article in this context:
Rather than billing Chaori as an alarm bell in the credit markets, many analysts see it as a trial balloon being floated by the authorities as they seek ways to cut overcapacity in certain sectors of the economy.
“The government is trying to send a signal to the market that there are risks to buying investments. They are doing it carefully,” said Christopher Lee at Standard & Poor’s. “This company is so small and in trouble anyway – even if it defaults it is not going to impact the market much.”
In view of the sheer size of China's credit and real estate bubble and the many signs pointing to a perfect storm being on its way, such comments seem quite naïve. A slightly bigger flesh wound is now about to be inflicted. According to Bloomberg:
“A closely held Chinese real estate developer with 3.5 billion yuan ($566.6 million) of debt has collapsed and its largest shareholder was detained, government officials familiar with the matter said yesterday.
Zhejiang Xingrun Real Estate Co. doesn’t have enough cash to repay creditors that include more than 15 banks, with China Construction Bank Corp. (939) holding more than 1 billion yuan of its debt, according to the officials, who asked not to be named because they weren’t authorized to discuss the matter. The company’s majority shareholder and his son, its legal representative, have been detained and face charges of illegal fundraising, the officials said.
The collapse of the company, based in the eastern town of Fenghua, adds to concern of strains in the nation’s real estate sector and comes less than two weeks after the first bond default by a Chinese company. Shanghai Chaori Solar Energy Science & Technology Co.’s inability to repay its debt may become China’s own “Bear Stearns moment,” prompting investors to reassess credit risks as they did after the U.S. securities firm was rescued in 2008, Bank of America Corp. said March 5.
“Chinese developers are extremely exposed to the easy credit that is used to finance purchases and investment,” said Patrick Chovanec, the New York-based chief strategist at Silvercrest Asset Management Group LLC, which oversees $14.1 billion in asset, by phone. “When credit is reined in even slightly, it undercuts demand. This is potentially an inflection point.”
Sell What Everybody Loves, Buy What Everybody Hates
How do you like that? Dow off 43 points on Friday. No bounce back from the big loss on Thursday. And gold keeps going up. It now seems to be aiming for $1,400 an ounce.
Remember the sentiment at the end of 2013? Gold was sure to go down. Everybody said so. Instead, gold and gold mining stocks have done quite well, thank you. The big gold ETF, GLD, is up over 14% so far in 2014. And the big gold miners ETF, GDX, is up 31%.
US stocks, meanwhile, are vulnerable. Want to make a simple trade? Sell US stocks; buy Russian stocks. Almost sure to pay off. Everybody loves the US, as evidenced by stock prices. Everybody hates Russia.
Carded in Aiken
We spent the weekend at a horse show. “Eventing” it is called, with three events – dressage, jumping and cross-country. We were not so interested in the horses or the competitions as we were in the subculture and its people. Riders came from all up and down the East Coast… often with a trainer, several horses and grooms to take care of them.
The whole kit and caboodle comes down to South Carolina, Georgia or Florida for a few weeks in February and March. They rent a stable for the horses and rooms or apartments for themselves. Last night, we went out to a pizza joint for dinner with a few riders, trainers and grooms. We ordered a glass of wine. Then the waitress floored us:
“Can I see your ID,” she asked.
A Slightly Ominous Development
Below we show a few stock market related charts that indicate that the recent rebound may well have been part and parcel of at least some sort of corrective period, in spite of several indexes attaining new highs. Note here that we don't care why the market reportedly fell on Thursday. No-one knows for sure whether the reasons cited in the financial press were really the culprit (allegedly, a worsening of the Russian/Ukrainian situation was to blame; but very often the excuse doesn't really matter. After all, the Ukraine situation was completely ignored so far).
First, a chart of the DJIA and the SPX for comparison purposes. The interesting thing is that the two measures have diverged at the most recent peak. Note in this context that divergences in the performance of various indexes have been increasing since the beginning of the year. That is usually a negative sign.
The DJIA turned back down before reaching a new high, contrary to the SPX, which did (most other popular indexes also reached new highs, but performance divergences have opened up further between all of them) – click to enlarge.
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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.