Dan’s Blog

What to Believe?

Dan Calandro - Monday, August 22, 2016

Major stock market participants threw a temper tantrum immediately following the historic British vote to exit the European Union. After a sharp drop in value institutional investors realized that the real threat to market stability isn’t a mere British exit from the EU, but instead a mass exodus that ultimately causes the Euro to collapse. And knowing that such a collapse is well off into the future, institutional investors swiftly reversed course and bid stocks up to fresh new highs. See below.

In the chart above stocks began the period essentially at fair value. In the five years that followed the Dow Jones Average added 49%, the S&P 500 increased 74%, and the 15-51 Indicator gained 104%.

Those are boom-type returns.

Usually when stock prices increase at such a pace and for such an extended period of time the underlying economy is buzzing right along with it, growing at 5-and-6% clips; interest rates are usually high and/or rising, and a healthy rate of inflation is present in the marketplace. Those conditions are good for corporations, which during these times experience expanding revenues and greater profits. Investors are then rewarded with higher stock prices.

But that’s not the case today.

Since my last blog we learned that the economy barely expanded in the second quarter of the year, growing at a pathetic 1.2% rate. Recall that the first quarter was even worse (.8%). Inflation has averaged just 1.3% this year (2.5 to 3% is preferred), and the 10-year yield is resting at a meek 1.5% (it was 5% during the last boom). This is not to mention that the Federal Reserve is scared to nudge rates up another quarter of a point in fear that such a move would derail the “fragile” economy. As an FYI, the Fed Funds rate was 5.25% during the housing boom. It’s just .50% today.

And even though U.S. interest rates remain way too low, at least they are still positive. Over the last several months many sovereign states have held bond auctions with negative interest rates. That’s a condition where investors pay, not receive, money to lend governments their money. Germany just issued a -.5% 10 year bond, and Switzerland recently held a 42-year bond auction with negative interest rates.

That’s a long time to lend money to make zero income!

If things are so good, as the stock market suggests, then why are negative interest rates in vogue?

And why is gold up sharply (+26%)?

Surging bond demand and negative interest rates are symbols of a scared investment community and their flight to safety.

Investments in bonds for stable governments like Switzerland, Germany, and the U.S. are a way to minimize downside loss and protect capital in the case of another global catastrophe. Gold is another way to hedge that risk. And both investment vehicles are up strongly this year.

The International Monetary Fund (IMF) has been sounding the alarm about another global crisis brewing for a long time, and it has recently added more fuel to their fire. The IMF downgraded global economic growth again and reiterated their call for “urgent” action by the G20 to stabilize the fragile global economy. They noted that advanced economies would get hit the hardest during the next crisis, and that that crisis will be driven by “the intensification of bank distress in vulnerable economies.” (see: Take it From Her, for more information.)

That’s why the value of gold and government bonds has risen so dramatically (yields and bond values move in opposite directions). They indicate a brewing economic crisis.

So why, then, have stocks continued to reach new all-time highs?

Because many powerful people from the Wall Street establishment to the U.S. government disagree with the IMF about the imminence and extent of the festering global catastrophe. For instance, U.S. Treasury Secretary Jacob Lew recently said this in response to the IMF at a global economic summit, “I don’t think this is a moment that calls for the kind of coordinated action that occurred during the ‘Great Recession’ in 2008 and 2009.”

This kind of divergent view – one where crisis is on the horizon and needs urgent action, and another where crisis is a distant possibility that does not warrant proactive corrective measures – is a common theme to most crises – especially the last one.

For instance, many people fail to appreciate President G. W. Bush’s multiple warnings[1] about the troublesome conditions that had engulfed Fannie Mae and Freddie Mac during the housing boom. Warnings are great, indeed, but without corrective action disaster is practically guaranteed. Adding to the near certainty of failure was the fact that Bush did make Fannie and Freddie’s condition worse by expanding their resources and capabilities several times during his administration. He knew it was wrong, no doubt, but he needed war funding; and the expansion of Fannie and Freddie was part of the deal – and Congress was unwilling to legislate reform because they didn’t appreciate the brewing crisis.

During the housing boom stocks climbed to all-time highs in the face of numerous bank failures, presidential warning, and an economy sliding into recession. You would have thought investors would have shifted capital from stocks to bonds and gold. But no “the market” continued on to new all-time highs...only to crash seven months later.

Warnings, in any form, go unheeded all the time. 

The stock market has traditionally been a leading indicator of economic activity because stocks can react to news and events long before consumer behavior driven by those same news and events can affect activity in related markets. Stocks are assessed and priced daily. Not true with the economy.

The economy is measured quarterly in the form of Gross Domestic Product (GDP), and those measurements are reported well after many public corporations have released their quarterly financial reports.

Corporate financials are market reports. They tell investors how much market activity is conducted (revenues), its growth rates, and the profitability of that activity (earnings). The stock market adjusts to them as they are released.

It is important to note that market indicators like the DJIA and 15-51i are simply portfolios of stocks allocated in a manner similar to GDP. That is to say that stock prices should reflect the condition and trends of their underlying economies.

But that’s not always the case.

Take 15-51 component, John Deere, for example. They recently announced their second quarter earnings report and the stock jumped 13.5% in a single day of trading. Listen to the reasons for the gain…revenues were down sharply: construction and forestry sales were down 24% and agriculture was down 11%... earnings per share rose for the first time in 10 quarters, and gained a paltry 1%.—And how’d they do it? Well, John Deere saved money by implementing a massive job-cutting program.

Does that sound like Deere is operating in a booming economy?

Of course not. “The market” is dysfunctional and irrational. That, too, is a common occurrance, especially at market tops and bottoms.

So far this year GDP has averaged 1% growth and stocks have gained 6.5%. The Price/Earnings Multiple, or PE ratio, of the S&P 500 has expanded to 25; its average is 15.

On news of lower sales and a long trend line of falling profits, John Deere implements a massive effort to shrink itself and gets rewarded with a 13% gain and a healthy 21 PE multiple. It’s usually around 14.

Any way you look at it, stocks are over-valued and inconsistent with economic fundamentals – a condition ripe for correction.

When that correction will ensue is always the most popular the question.

And no one has that answer.

As I have said before, I’d be shocked if President Obama escaped a major correction before he leaves office. But he might. Congress has given him carte blanche to spend whatever he wants and the Fed has continued to make it easy. 

After all, national debt was $10 trillion when Obama strutted into office and it will be $20 trillion when he saunters out. By the time he exits office his administration will have spent $30 trillion over the course of his eight years. In the same amount of time Bush spent $19 trillion – which Obama called "unpatriotic." The point here is simple: it’s a heck of a lot easier to hold-off recession when a government is allowed to throw trillions of dollars around haphazardly. And haphazardly is a fair descriptor. The economy proves it.

But that doesn’t mean correction will never occur. It just means that Obama will get lucky if it didn’t happen while he was in office. That’s it.

People email me all the time, I should’ve done this, or I should’ve done that. I suppose it’s only natural to question yourself. But to those people I say this…

Read THE BIG SHORT, written by Michael Lewis, or watch the movie based on that published work. With less Hollywood flair the book details the stories of a few investors who watched the 2008 crash develop and bet against the Wall Street establishment – who so often create investment products that they don’t fully understand and then trade them in environments that they fail to properly assess. THE BIG SHORT is a modern day story of David and Goliath, where the little investor beat the establishment because they maintained their focus on fundamentals.

Wall Street has a bad habit of creating unfounded euphoria that is based blindly on greed-ridden ambition. Their actions inflate markets to ungodly valuations that place them in a vulnerable position that can only lead to disastrous consequences for investors and taxpayers. The investors in THE BIG SHORT didn’t buy into their spectacle. Instead they shorted it (in other words, they sold high first during the boom, and then bought low during and after the crash.)

Wall Street was on the other side of their transactions; they bought high and sold low – which is why so many failed and required emergency funding and bailouts.

So if you think Wall Street knows everything, and that your investments are safer with them, think again. 

The same is true with stock market indicators. They are not the know-all and tell-all of economic indicators. Gold and yields are telling a completely different story than stocks. One of them is right.

So the question to ask is: Who/What do you believe?—Jacob Lew or the IMF, stocks or bonds-and-gold, hype or fundamentals?

There are two sides to every coin.

You can either place your bets in the hands of the Wall Street establishment or place them in yourself and what you believe.

Wall Street has been cataclysmically wrong before; and if history repeats like it usually does, they will be hugely wrong again.

Exposure to stocks should be measured. Gold is good and cash is king.

Stay tuned…

The road to financial independence.

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