Exited, Pursued by a Bear

We may be on the verge of learning more about how much capital has been wasted by the malinvestments of the past decade. I believe that the single most important stock group is the financial group. It is the financials that reflect whether the "marks" that are assigned to assets are accurate, and if they are inaccurate, in which direction the inaccuracy is. As Shakespeare might have said, leverage is all (unfortunately), and the financial stocks reflect this modern reality.




When economic activity is increasing and especially when it is accelerating, financial institutions have strong capital bases and compete with each other to lend funds. When there is a sound base for economic expansion, as in the 1980s and 1990s, the lenders have lots of good credits to consider, and in return, the good credits are able to provide substantial collateral and/or down payments to the lender. So the loans tend to be net profitable to the lender.






Internet 2.0 and weak dollar matters aside, and government spending (i.e. Fed "money") notwithstanding, there are no signs of that happier situation in the country as a whole as we approach two full years since the trough of economic activity. The top tier "Too Big to Fails", namely JPM and WFC, have uninspiring stock charts and have continued to underperform a rising stock market. This is just what happened in 2006 and 2007. On the other end of the quality scale among the TBTFs, here is a 5-year stock chart of BofA. A renewed bear market in the stock is threatened. (Please be aware there is no prediction here of what the stock price will do, especially in the short term.) But I will disclose that I have sold the stock short, creating my own micro-mini hedge fund considering I own a considerable amount of offsetting but not very liquid long positions in a similar place but with, I feel, better value for the price.






To a somewhat lessened degree, Goldman Sachs and Morgan Stanley have stock charts that look like BofA's.




There has also been no sustained sign of life in the truly moribund giant financials, Citigroup/AIG/Fannie/Freddie, all of whom were saved from some form of bankruptcy by direct support from the central authorities.




I take this as a bad fundamental sign. If matters go well in the economy, one will look for sustained outperformance in these companies. Right now, I prefer not to fight the tape. And since the Fed is scheduled to end QE 2.0 imminently, a cautious or bearish stance toward stocks is no longer fighting the Fed. If the Economic Cycle Research Institute (ECRI) is correct in their prediction of a significant global industrial downturn beginning this summer, these global financial companies should see their own business both diminish overall and switch more toward less profitable segments, such as fixed-income trading rather than M&A and stock trading.




There are also valuation metrics which resemble those extant at the 2007 peak. To wit, here is a chart from the Andrew Smithers website. Please note that the S&P 500 is up from where it was when this chart was created. Click HERE for an explanation of both independent valuation measures this graph utilizes.



The averages are at similar degrees of overvaluation as have rarely been seen in the past 11 decades.




People protest that current values are "OK", because interest rates are so low. My response is a "Yes, but" type of response. Interest rates are low because organic credit demand is lacking. This is the problem of our current biflation.




The nominal price of homes is flat to down. Housing grew to be such an important source of non-revolving credit that it became the animal that could sit wherever it wants. When housing went down and continues to stay down, significant percentage upticks in credit demand in much smaller sectors (smaller from a credit standpoint) fail to replace housing's importance. Thus, capital was credited to savers such as myself, but there is a surfeit of capital relative to users of capital. So, the weak credit environment explains the low interest scenario (without justifying the extremism of the zero interest rate policy of the Fed), and that goes hand in hand with weak economic growth prospects. These weak prospects are, in my view, enough to be consistent with much lower stock prices.



It is my view that all the money-printing, bailouts, happy talk from the media, and the like, have lulled investors to sleep. However, how many investors realize that from their respective bottoms in fall 2008 and winter 2009, gold has has a somewhat greater appreciation than the Dow Jones Industrial Average, dividends included? In other words, since the stock market bottomed in nominal terms in March 2009, it has actually declined further in terms that I prefer, namely gold.


Meanwhile, not only is housing double dipping, but autos are dipping as well, and at a much lower annual rate than was the case at the peak in the aughties. From J. D. Power and Associates:


High Gas Prices and Lower Incentive Levels Contributing to Dismal Start for May New-Vehicle Retail Sales





" . . .Retail sales in May are being hit by several negative variables—specifically, high gas prices, lower incentive levels and some inventory shortages," said Jeff Schuster, executive director of global forecasting at J.D. Power and Associates. "As a result, the industry will likely be dealing with a lower sales pace at least through the summer selling season, putting pressure on the 2011 outlook.'"




It is clear from the title, the above excerpt, and the whole text of the press release (which makes clear that most U. S. and global auto manufacturers have no exposure to Japanese parts and thus can make all the cars the market can afford), that the automakers' main problem is that when they tried to raise prices (by removing or decreasing incentives), buyers could no longer afford their merchandise, in view of the economy in general and gas prices in specific.




Because homebuilding and the industries that feed off of new home sales and home resales are so depressed, the ongoing depression in those industries will not be enough to cause a new recession. It will however be enough to eventually cause the accountants to lose patience with unrealistic valuations of real estate owned by banks (REO) and the value of mortgages, especially second liens. This is why I highlighted BofA above.





Finally, real people are feeling just like the stock market when the stock averages are adjusted for gold's price. They are seeing and feeling no improvement in their lives. Here are two examples. Gallup.com runs a daily crawl on its website that tracks a measure of employment levels and discretionary spending. Currently, the average respondent is spending $62/day. My recollection is that 3 years ago, when I started following the same website, spending was about double that. And this is not adjusted for the general increase in prices. Thus, people are truly squeezed. On the same site, the hiring/not hiring differential is only +12 today. It was +25-30 3+ years ago, when unemployment was rising, so this level is at best consistent with employment growing in line with population growth (in my very humble opinion).




The second example is Bloomberg's Consumer Comfort Index. This has sunk to 9-month lows:


So when I think of the intersection of markets and the economy, I think that the American people have it right. They know what's happening in their jobs, communities and bank accounts. For the first time in memory, a technical recovery in the economy and a surge in the stock market has left almost all people behind. There is no magic to this. It simply reflects an amazing amount of money printing. It is my supposition that all this new base money has been created by the Fed because the amount of capital that was destroyed (misallocated/malinvested) was massive. The weakness in the dollar, which commentators usually wrongly describe as strength in gold, simply reflects that the country was never really as rich as it was measured as being in the late 1990s till the Great Recession finally brought the reality home. One of these days, the stock market will resume being a weighing machine rather than a voting machine. What the nominal pricing will be is unpredictable, but one of these days, a look at the 110 years of the Smithers chart suggests that the stock market will be depressed as far below its average as it is now above.





That's why, for what may be a summer of negative economic news, I have fled growth-oriented investing and weak-dollar investing and have circled the wagons around the basic investments of gold, cash, and Treasuries. Barring general systemic collapse, the worst that can happen to me in this posture is that I do not participate in some up-moves. But I can sleep a lot better that way than if capital is destroyed by what I view as the stock market reverting to normal pricing of pre-owned securities.



Copyright (C) Long Lake LLC 2011

Stocks Increasingly Frothy

Gallup's continuous polling is showing a continuing stagnation with a downward trend in discretionary consumer spending.

In this context, the buoyancy of many consumer stocks makes little sense. There's a difference between optimism and investing based on hope against the facts. When even a semi-free market has essentially no value placed on money for as long as two years, with Treasuries paying less than one dollar in total interest per $100 invested for two full years, then the profit outlook for reinvested profits, which is what helps drive the stock market, is poor.

Ultimately what matters in investing is value. Two standard ways to decide on the value of companies ties to their earnings and to the value of their assets. The accountant and investments expert Andrew Smithers, who loudly and contemporaneously called the stock market a bubble in 2000, has just provided another quarterly update of his estimate of the fair value of the S&P 500.

Please look carefully at the linked chart he provides on his website. His earnings-based (CAPE) estimate of fair value and his asset-based estimate (q) are in close agreement that the stock market is massively overvalued. Averaging fair value provided by CAPE with that provided by q gives a fair value of about 725. This in turn means that based on Friday's closing prices, the stock market can be estimated to be about 57% overvalued.

People point to ultra-low interest rates to justify high valuations. Unfortunately, that's circular reasoning. A dead economy is required to justify near-zero short-to-intermediate interest rates. If one carefully studies the Smithers chart, one can look at the 1930s and 1940s, as well as the early 1920s, to find times when there were low to very low interest rates and very low stock prices in relation both to earnings power and assets.

Not only are American common stocks very risky, their prices are increasingly disconnected from the experience of everyone I know and every poll or survey I see. No one I know sees business doing especially well or about to do well. The idea that stock traders know better is a dubious one. It's far more likely that ultra-cheap money is fueling the bull moves in all sorts of assets. The investor's task is to separate wheat from chaff, AIG from Chubb, Honda from GM, stocks vs. Treasuries circa 2000 and circa 2007.

The situation re stocks is reminiscent of the old punch line, "Who are you going to believe, me or your lying eyes?"

Another analogy is Wile E. Coyote suspended in midair.

Yet another analogy is a chart of the Japanese stock market since 1989. It looks like ours, about a decade out of phase. It shows several massive bull moves in a 21 year structural bear market.

This blog has argued for a long time that the best places for investment money were the trend-following ones of being long Treasuries (and implicitly other high quality bonds) and gold. Both of their structural bull markets remain intact. The gold bull is mildly extended short-term and is up about 30% year over year, which is a red flag. The 30 year Treasury is also extended, but the longer duration bonds represent the only part of the Treasury curve which I believe is not yet in bubble valuation.

The chronic weakness of consumer spending continues to support the Treasury bull, and the Fed's response is to print money, which then supports the gold bull. In that context, stocks (other than precious metals stocks) are an afterthought.

Someday the trends will change. Are they changing here and now?

I doubt it.

Copyright (C) Long Lake LLC 2010

In Equity, Veritas

This blog was begun late in 2008 with the motto as titled above. It is nice to see a somewhat mainstream economist speak out in favor of lest debt and more equity. Here is an excerpt from Andrew Smithers in We need to turn to equity financing:

We are surely running up against the limits of debt, not only in the private but also in the public sector. . . We must therefore turn to other ways. One of the two possibilities is to rely on more equity and less debt for financing investment. The other is to transfer wealth from debt owners to equity owners through inflation.

People say default in some sort, such as through inflation or more overtly, is inevitable for the U. S. Federal Government. Yet the application of common sense, the cessation of market-distorting activities by the government at the implicit point of a gun and the restoration of an economy designed to serve the people rather than their masters in Washington will allow their government to get back to where it once belonged.

Smithers' article is very much on the right track. There is little time to lose.

Copyright (C) Long Lake LLC 2010

Smithers the Bear

Regular readers of this blog know that I frequently refer to valuation measures that are updated quarterly by British economist Andrew Smithers, who bravely published a book in 2000 warnings that stocks were vastly overvalued. Bloomberg now reports that he has more negative views to share:

Profit margins for U.S. companies are likely to tumble from last quarter’s record, a decline that will lead to much lower earnings than analysts expect, according to economist Andrew Smithers.

“The corporate sector’s outlook is extremely bad,” Smithers, founder and chairman of the investment-advisory firm of Smithers & Co., said last week in an interview. “I can’t see any way out of it.”

The article goes on to mention that he calculates corporate profits margins to be at a record since such data began to be collected in 1947 and concludes:

Margins “are likely to fall a lot” as governments restrain deficit spending next year, reducing cash flow elsewhere in the economy, the report said. Companies will bear the brunt of the shift as opposed to households, which are heavily in debt and save relatively little, in his view.

The decline in margins will lead to profits falling “well short of expectations,” he wrote. Analysts foresee earnings at companies in the Standard & Poor’s 500 Index rising 34 percent this year and 18 percent next year, according to data compiled by Bloomberg.

This view appears consistent with ECRI's growing caution on the economy. Even a growth slowdown of moderate severity is likely not baked in the analysts' cakes.

Copyright (C) Long Lake LLC 2010

Financial Markets and Health Care "Reform"

Whether an investor considers the just-passed reshaping of the health insurance system in the U. S. as beneficial reform or "deform", your thoughts quickly turn to that which you can control: your money.

I confess that I have not kept up on the amount of tax increases that are now scheduled to take effect over the next few years before the real costs (benefits to recipients) are felt by taxpayers. For now, this legislation withdraws spending power from the public and taxes interest income and capital gains, I believe with a new 3.8% "Medicare tax" (a misnomer, as revenues go to the general fund).

This is occurring while two fundamental measures of stock market valuation each show at least 50% overvaluation: cyclically-adjusted price-earnings ratio (CAPE) and "q" (valuation of non-financial stocks based on replacement cost). Please click HERE for a link to Smithers & Co.'s chart and commentary on this.

Can the anti-stimulus measures of upcoming revenue enhancements and the real and psychological effects of increasing taxes on income derived from savings (which savings derive from income that has already been taxed) provide the impetus for declining stock prices and rising prices of Federal debt?

In other words, the Japan scenario, in which imposition of a national sales tax was associated with the above results in the 1990s?

Yes.

Copyright (C) Long Lake LLC 2010

Stocks Remain Overvalued Along with Most Other Financial Assets

Please click on this graph for more detail. It shows to related measures of long-term stock market value as of 9/17/09 based on estimated replacement cost of the assets of companies comprising "the market".

Stock market veterans will automatically correlate this with the Dow or S&P 500.

The eye notes that at the so-called secular bottom of the market averages this winter, valuation was only average. The eye also cannot fail to note that descents from high valuations and rises from undervaluations have been long-term events, though of course with choppiness.

This ratio does not predict any short-term stock price movements.

However, my favorite unloved metric is dividend yield of the average stock--which is said to be below 2% for the S&P 500 average stock (?market cap weighted) vs. that of the 5-10 year Treasury note.

Stocks currently provide inadequate current income and are overvalued. That suggests that risk is high. This is so in my view especially with the attempt of stocks today to rally despite another dismal unemployment report out of BLS.

Unfortunately, gold and silver are momentum plays now; bond yields are "low" (whatever that really means); cash is trash; and Big Finance rules the roost for the nonce along with Big Government. Business is playing defense.

So should most investors.

Copyright (C) Long Lake LLC 2009