None of this should surprise those conversant with Austrian economics. The “fundamentals” of the economy have been and remain awful because the government and Federal Reserve are consistently doing the wrong things. The apparent recovery, fueled by Bernanke’s sheer money creation, has been bogus all along.

Bubble, Bubble, Bubble

For some reason, people still cling to the vague hope that – at least if we wait long enough – the market always goes up, and “buy and hold” is a great strategy. Let’s look at a long-term chart of the S&P 500:

Does the above chart really look like the US stock market is in store for smooth sailing? Just about everyone except Chicago School economists now recognizes, after the fact, that the United States obviously went through a tech and dot-com bubble in the late 1990s and then a housing bubble a few years later. Is it really so difficult to understand that trillions in government budget deficits over the past few years, coupled with unprecedented inflation by the central bank, have set the economy up for yet another crash?

Alan Greenspan’s low-interest-rate policy in the wake of the dot-com crash spawned the housing bubble. Greenspan’s Fed didn’t actually eliminate the need for a recession, but instead postponed the crisis and made it fester. When reality hit in September 2008, Ben Bernanke was in charge of the Fed and implemented his predecessor’s failed approach times ten.

No matter how many pundits and famous economists declare otherwise, Bernanke did not save the day with his interventions. He has simply postponed the day of reckoning yet again, and we can expect the final crisis to be much worse than the mere collapse of a few major investment banks. (The short documentary Overdose makes the case in a chilling fashion.)

Ben Bernanke Engineered the “Recovery,” All Right

In a perverse way, the pundits are correct in crediting Ben Bernanke’s extraordinary programs for “rescuing” the stock market. If we zoom in on the chart of the S&P 500 and superimpose the monetary base, we can see how closely the two have moved since the crisis began.

Although the above chart shows a decent fit, in reality the stock market responded very quickly to changes in the expectations of Fed expansion. Specifically, the sharp upswing in the S&P 500 in March 2009 coincided with the announcement of the Fed’s full strategy for (what we now call) QE1, and the market rally in the late summer of 2010 began as knowledgeable Fed officials made it clearer and clearer that QE2 would kick in after the fall elections.

Of course, those economists who believe Bernanke is engaging in a tight-money policy would point to the above as evidence in their favor – the Fed just needs to print more, because it’s worked twice already! But if one believes that showering trillions of newly created dollars into the financial sector (with the specific aim of bailing out the very parties who made reckless loans and investments during the housing bubble) is notconducive to a healthy recovery, then the booming stock market of the last few years should have been an ominous sign. Note that this isn’t 20/20 hindsight; other Austrians and I have been warning that this “recovery” has been bogus all along, and that the stock market could collapse at any time.
Inflation Lifts All Boats

None of the above analysis implies that investors should dump all equities immediately. It is true that the prospects for real economic growth are terrible – especially in the Western countries – over the next decade, because of increased regulations and swollen government debt loads. But at the same time, various central banks, especially the Federal Reserve, have been all too willing to create new money as an apparent solution to every crisis. (A case in point was the absurd proposal for the Treasury to issue two trillion-dollar platinum coins to evade the statutory debt ceiling.)

In this environment, someone relying on fixed-income investments (such as private annuities or, heaven forbid, government retirement checks) could be wiped out by massive price inflation. As awful as the US real-estate and stock markets might be in the short and medium run, holding a portion of one’s wealth in assets not denominated in fiat currency may turn out to be a very wise defensive move. (The problem with shooting the moon on precious metals is that for all we know the dollar will crash next year and Obama will make it illegal to buy and sell gold.)

Conclusion

The US economy still needs to recover from the festering malinvestments that accumulated during the previous two booms. By pushing interest rates down to zero and bailing out the very people who made such bad financial decisions in the first place, the Fed and Treasury are doing everything they can to exacerbate the problem.

In this volatile world economy, investors can expect continued volatility in the stock market. The only thing we can really be sure of is that the government will use each new crisis to justify further extensions of its power. At some point the feds will probably seize the highly volatile 401(k)s and other stock-market holdings from citizens and replace them with “safe” government annuities.

Knowledge of Austrian economics doesn’t render someone an expert investor, but it certainly gives advance warning of the major trends in the economy. Those investors who rely on the Keynesians featured at CNBC think that another stimulus package or QE3 might do the trick.

Why Is the Stock Market Crashing? was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

If you’re looking for the internals of the market, try breadth. That is, if you want to judge how intrinsically strong a rally is, look at how broad it is. Is it just concentrated to a few of the big stocks (banks and basic material, for example). Or are all stocks marching up in lock stop on higher earnings and higher valuations. Is the equity premium visible?

Take a look at the chart below. It’s the advance-decline index on the New York Stock Exchange from early 2007 unto today. The scale of the chart is less important than the trend. The index tracks the difference between advancing and declining issues on any given day. When there are more advancers than decliner, the index is bullish. When there are more decliners than advancers, it’s bearish.

NYSE A/D Ratio Looking Toppy

If you’re trying to use the A/D ratio as a predictor of what’s next (and who isn’t?) then what does it really tell you? The chart above shows you that market breadth started to deteriorate months ahead of the actual high in the Dow Jones (which came later that year in October.) The June-July revelations that two Bear Stearns funds were in trouble accelerated the deterioration.

The March 2009 low in the A/D ratio more or less coincided with the low in the index. There wasn’t any advance warning from the index. That’s likely because the March lows were reversed by the active (and perhaps direct) support of the Federal Reserve via interest rates and a program of Treasury bond buying.

Whether the Fed worked a way, via its primary dealers, to get stocks moving too (another word is ‘manipulation’) is an interesting but ultimately unanswerable question. The important point here is that nothing in the fundamental mechanics of the market indicated a reversal. It was an external event.

And what about now? The A/D ratio is going up, up, and away. It could be that corporate cash positions are solid, the employment market won’t get worse, and that the end is in sight for the U.S. housing market. Some combination of these factors could explain the steady advance of stocks since last March. But maybe not.

Our guess is that this is simply evidence of the Fed’s Great Reflation (see Marc Faber’s March Gloom, Boom, and Doom Report). All the new money created by the Fed, and the new lines off credit made available to U.S. financial institutions, made its way into the stock market by force off habit. It was easy to borrow and there was only one sensible place to put it: stocks.

But is that still the best trade going now?

No.

Your best bet, as we’ve said for a while, is to retire now. Gradually liquidate your stock portfolio and pare it down. People are buying stocks now because it’s what they’ve always done and what they’re still told to do. But as a wealth survival strategy, the stock market is a death trap.

You should, by our reckoning, own a small portfolio of stocks leveraged to positive Black Swans (low probability but high magnitude events that drive a share price higher…like the discovery of a new ore body or the development of a new drug). These are the sort entrepreneurial ventures that will create new wealth. A portfolio of these business experiments is like a call option on the world we’ll live in after governments have gone bankrupt and lost the ability to perpetuate the follies of the previous credit bubble.

But for now, the public sector campaign to bail out the plutocrats in the private sector is in full force. And in the meantime, the public sector in Europe is trying to save itself. Markets in Europe have reacted with contented indifference to the affair in Greece. Has anything important happened there?

Well, the Greek government presented a plan to cut spending by $6.8 billion. If effected, it will reduce the deficit-to-GDP ratio from 12.7% to 8.7% in the next year, which is pretty ambitious. The Greeks plan to do two things: raise revenue and cut spending.

The Greeks will raise taxes on fuel, tobacco, and sales taxes. And if the communist unions don’t derail the plan, bonus payments to public sector servants will be cut by 30% and wages will be frozen for civil servants.

If Greece is having a fiscal crisis, why is anyone in the government getting a bonus payment at all?

The Greeks have $20 billion in sovereign debt maturing in April and May of this year. The negotiations between the Greeks and the rest of Europe are trundling along. But to what end? The Germans refuse to pony up for a bail out. But will the EU sacrifice Greece to save the Euro as a currency?

Nobody knows. But our main point today is that you should not think Greece has gone away. It’s true that since February, the cost of insuring sovereign governments against default has fallen. According to the folks at Bespoke Investment Group, only Vietnam, Argentina, and Egypt have seen wider credit default swap spreads in the last two months.

So we have a pause in the crisis-think. Markets rally on reflationary monetary and fiscal policy. But the underlying structure of the fiscal welfare/warfare state is badly damaged. This is still an excellent time to reduce your exposure to stocks and add, on the dips, your exposure to precious metals and precious metals equities (in full knowledge that even gold stocks are going to decline on another general decline in stocks).

It’s probably not just stocks you should re-think, though. Last week we mentioned that fund manager Colonial First State (owned by the Commonwealth Bank) has told investors in its Mortgage Income Fund that it could be as long as four years before they get their money back. The average age of the 17,000 investors in the fund is 74 years old.

Redemptions in the $850 million fund were frozen not long after the Federal government guaranteed bank deposits. High-yield mortgage trusts are not bank accounts. Investors and pensioners who treated them like high-yield bank accounts — because that’s how they were sold — were suddenly not generating needed income on precious savings. And now the savings are locked up.

But it wasn’t just the government guarantee that pummeled the mortgage and property funds. It was the underlying securities. On February 9th, Colonial announced it would wind down the Mortgage Income Fund because the bad debts on some of the underlying property loans were, “too big to manage.” It has another $1 billion of pensioner savings locked up in similar funds.

Now without knowing the composition of assets in the other funds, it would be hasty to say that mortgage funds in general are lousy investments. However we’re inclined to think just that. But more importantly, there’s a point here about having your money locked up in large pools of capital these days.

These large pools of capital — mortgage funds, property funds, super funds, 401(k) plans in the States — are extremely attractive to people who need capital. Call it “captive capital.” Banks covet it because it keeps them cashed up when facing declining asset values in commercial and residential property.

Governments covet the capital even more. It’s a ready source of funding for government deficits. If you can compel banks to buy government bonds (via credit requirements), or if you can compel savers to own government bonds for “safety” and “annuity” reasons, then you can force people to fund your deficits. That means you may not have to cut spending so deeply that you lose an election because of it.

So what should you expect and what should you prepare for? Higher taxes are a given. “Nutter expected to tax sugary drinks, set trash fee,” reports a Philadelphia newspaper. The Nutter in this case, quite appropriately, refers to the Mayor. He’s taxing fizzy drinks and garbage to raise extra money for the city. At the city and state level, you can expect a lot more of these creative ways to finance spending — along with cuts in services.

This is part and parcel of the over-reach of the Welfare state. If the U.S. Warfare State has over-reached in Iraq and Afghanistan, it’s been over-reaching domestically for years with programs paid for out of an empty pocket. The same is true in Europe, Japan, and increasingly, in Australia.

Some places are better off than others. Australia has a relatively smaller public sector debt burden. But the country overall, if you look at the net foreign debt, owes its prosperity to foreign lenders. You can expect the strain on public sector finances to only increase in the coming years.

All of that suggests, to us anyway, that you should re-think your reliance on traditional income and savings vehicles. Look for changes to be made that make it harder for you to get at your money. Or, if you can withdraw it from certain accounts and schemes, you will do so at a massive penalty. Governments need capital. And when they can’t compel you to use yours to finance their spending, they are going to get at least a pound of flesh if you choose to remove your money from the system.

What should you do instead?

As we said above, a small portfolio of stocks — business projects leveraged to very high returns — is nearly the only good reason to stay in stocks. The other good reason is that as governments monetize debts and confidence in paper money fails, stocks may beat inflation a lot better than cash. The rally of the last year is evidence of that.

Next week, when we get back to Australia, we’ll take on the main objection to all of this: deflation. That argument is simple. As the global debt burden becomes too heavy, it will crush asset values, leading to falling asset prices across the board, including precious metals. We have too many objections to this to list here. But stay tuned next week. Until then!

Regards,
Dan Denning
The Daily Reckoning Australia
Whiskey & Gunpowder

March 5, 2010

Why the Stock Market Is a Horrible Wealth Protection Strategy was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

But underneath the elation over Dow 10,000 lies the palpable feeling that this rally is to be “rented,” not “owned.”

As cool weather descended upon the Northeast U.S., risk appetites started to wane. At the beginning of October traders and investors finally sobered up. Were they second-guessing whether government spending could actually kick-start a sustainable recovery? Both stocks and corporate bonds sold off sharply.

Then today I woke up to these headlines:

“Stocks Climb as New Week Starts for Wall Street.”

“Hasbro 3Q profit rises 8.8 pct on cost-cutting”

“PetMed Express 2Q earnings rise 12 percent”

Here’s why you shouldn’t believe the hype…

Cost Cutting Does Not Equal Top Line Growth

Over the next several months, mainstream pundits and forecasters will start worrying about tepid hiring, even as the pace of job losses slows. As we “lap” the 2009 corporate cost cutting by early 2010, and top lines fail to rebound, earnings estimates will have to come back down. I’m amazed at how many sell-side analysts are modeling V-shaped recoveries in 2010 earnings. Most stock prices are simply disconnected from reality.

Sell-Off at the First Sign of Trouble

The bulls are now enjoying their victory lap after having bid the Dow Jones industrial average above 10,000 last Wednesday. It’s puzzling to see “investors” happy about buying into a market that’s clearly overvalued. A rational, disciplined investor would be fearful about buying today, after prices have been jacked up by an unprecedented seven-month rally.

Bulls see any cautious sentiment-that “rented rally” feeling-as a source of more untapped buying power, but I see it as a reflection of weak hands being the marginal buyers; at the first sign of disappointment, they’ll look to sell. My read of the sentiment surveys is that patient value investors are skeptical and bearish, while momentum investors are bullish simply because prices have been going up.

Fund Managers Won’t Ride to the Rescue

Despite the popular sentiment that “fund managers gotta keep buying into year-end to avoid underperforming,” which would keep this market in the stratosphere, the odds heavily favor lower stock prices in the coming weeks and months.

Data from reliable sources like TrimTabs show that not only is the labor market far weaker than advertised, but net inflows into stock mutual funds have slowed to a trickle, occasionally turning into outflows. This tends to give mutual fund managers itchier trigger fingers, since cash balances in equity mutual funds are already near record lows.

Pensions aren’t going to ride to the rescue either, since they were, with 20/20 hindsight, overinvested in stocks in 2007.

Buying Momentum Could Run Out

Momentum players face the prospect of having nobody-aside from another momentum investor-willing to buy their expensive stocks at today’s prices. Patient, disciplined investors are only willing to buy at much lower prices. This could lead to an air pocket where the market could correct dramatically and quickly, without an obvious catalyst — not that there is a shortage of bearish catalysts, ranging from bank failures to home foreclosures to a crisis in fiat money.

Some pundits point to corporate mergers and acquisitions as reasons to be bullish, ignoring that fact that most deals occur closer to the peak of markets, and most deals destroy shareholder value, because the buyer overpays.

Corporate CFOs and Treasurers are happy about the recent bull market in risk. They know much more about their prospects than outside investors, so their balance sheet management is telling. In a word, the approach toward capital structure is “defensive.” Heavily indebted companies are flooding the market with follow-on stock offerings to pay down debts. They’re also taking advantage of the Pollyannaish mood of the corporate bond market to issue risky bonds at attractive rates, as default risk seems to be a distant memory of bond buyers. Many corporate bond investors have taken the Fed’s bait to reach for yield, regardless of credit risk.

Most investors, however, have permanently dialed down their risk appetites, and therefore will not chase this expensive market. Those buying stocks at today’s valuations—especially U.S.-centric finance and retail stocks—will have a very hard time finding someone to pay an even higher price in the future.

Will Government Solve the Problem? No.

The big questions back at the beginning of the month: What kind of economic environment do we face? And more important, what’s already priced into the stock market? Here’s my view on these themes: As we see with “cash for clunkers,” government stimuli simply steal demand from the future.

Another big question is how will policymakers respond to a sluggish-to-nonexistent rebound in hiring?

The labor market is dealing with a structural imbalance fueled by government-sponsored housing and credit bubbles. Many will call for the government to “solve” this labor market problem, which will cause a new type of market dislocation. By early 2010, some will push for the federal government to start hiring the chronically unemployed in “New Deal” type of programs. [Count on this-Ed.]

But more importantly — because this is not yet a mainstream view — the real job creators in the U.S. economy, small businesses, will not expand hiring as expected. There are many reasons for subdued hiring plans; an emerging reason to avoid expansion and hiring will be heightened expectations that tax rates will soar in the future to pay for out-of-control government spending.

The economically illiterate, and those with preconceived “big government” agendas, will use any crisis as an excuse to expand government. You’ll be ahead of the game if you realize — as many in the media and academia clearly do not – that the government has no resources. It’ll take money out of one of your pockets, skim some off for its cronies, and expect you to be grateful when they put some of it-debased by the Fed’s inflation, of course-back into your other pocket.

Where you stand on this will determine your expectations for the future performance of most stocks (ignoring special situations). I certainly don’t enjoy having such a bearish outlook on the economy, but it’s the conclusion I reach after weighing all the evidence about the real economy; the credit markets; and policymakers’ damaging, distorting influence.

I’d recommend you adjust your portfolio accordingly.

Regards,
Dan Amoss

October 19, 2009

This Stock Market Rally Is Rented, Not Owned was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

For what you care to make of it, here is an oddball way to analyze what you should buy and to diversify your holdings pleasurably, and probably far more safely than what is left to try.  There are two basic choices:  give the other half of your shirt to someone like Edward Jones and see how long it takes to lose it, or put everything into cash, metal, and gold sands, volcano power, or something else totally outside normal stocks and the ken of mere mortals.  Agora Financial comes up with a lot of interesting propositions in areas I am totally ignorant about, so I decided to stick with what I know, which is luxury items and grocery stores.  Huh?

At present fundamentals are roughly as safe as downtown Beirut, and Technical Analysis isn’t working well because volume is controlled by a few enormous funds, while government intervention is playing havoc with individual stocks, whole industries, the value of the dollar, interest rates, and so forth.

What we could use is a way to “read” what volume, movement, and patterns once told us, and some sensible way to decide what will store intrinsic value best.  Never mind profits, just holding on to the current value of what we have will do nicely in a world with 1/4% interest rates on a CD.

If you want to know what the average Joe is thinking don’t pull out your big blue book of ten-year stock charts and start looking for cycles. This is a whole new game and requires modern tools.  Two you need are absolutely free and available 24/7 on your Internet and the other is usually set out on Thursdays, free to pick up.  The hopes and fears of these bad years are to be found on Craig’s List and e-Bay and in what I will always think of as the “Thrifty Nickel,” now called “American Classifieds.” Those will tell you a lot more about economic and psychological conditions than the S&P will. Not a Keynesian in the bunch.  What is fascinating is how the offerings demonstrate traditional Technical Analysis basics, including volume, support and resistance levels, and trends.  Best of all, they are totally independent from the actions of managers of large funds peering at each other in terror wondering what “a prudent man” should be doing.  Glory be, there’s a way to take the pulse of the country at the most fundamental (pun intended, of course) levels, ranging across a wide socioeconomic spectrum.

The prevailing mood of the country, measured by this method, demonstrates two factors clearly:  at ground zero individuals are still having to turn loose of their toys to survive, but there is a sense, through recovering prices in some areas, that the economy is looking up in many eyes.

It may seem a little odd to analyze the economy in terms of what luxury goods in private hands are available and bringing, but consider that those are where intrinsic value was stored when times were good in the past.  Many Americans are being divested of past treasures because the credit-based consumerism of the last couple of decades had most people believing that times would always be good and that their houses were a sure source of ever-increasing equity, much better than old-fashioned savings accounts and paying cash.  They raided their brick piggy banks consistently, and then the housing market smashed.  No savings, upside down mortgages, houses such a glut on the market that in some cases banks have demolished–literally–brand new “MacMansions” complete with the de rigueur granite kitchen counters, rather than see them destroyed by squatters. The stock market plunged half way to ruins and despite a hefty Spring Fling a lot of folks see it going down again sometime soon. That left the Baby Boomers more than a little concerned about what were supposed to be their golden years, and those ten years or so younger in agony over the paper profits despite being warned for a couple of years to get out.  Yes, it cost a nasty sum to get out of the fund a manager had locked you into until ’10, but not nearly as much as leaving it there would have.

Back down in the trenches it is even possible to read a lot from the sequence in which goods have come on the market.   First went the toys bought by young men who put windfalls into bass boats, fancy trailers to haul them, and bigger or extra trucks.  Life was good, jobs seemed secure, no wife or kiddies, buy that value on credit…and then hours started being cut and jobs lost [Painfully close to home—Ed.].

Farmers in trouble from rising fuel, feed, and power costs had to start turning loose of “extra” tractors and implements, almost unheard of in the annals of mechanized mules which are good for many, many decades of service.  It is amazing how many tractors seem to be needed; we’ve got four and still don’t always have just the right one for an atypical job.  Given the choice of giving up a perfectly good 1954 John Deere or his youngest, some men might have wistful thoughts before listing Big Red for sale.  This is part of knowing both the value and price of everything as well as what people set the most store by, not useless information.

The $150/barrel crude oil hit independent truckers an unbearable blow, and many small firms had no choice but to shut down.  I have trucker friends who said it wasn’t worth the wear and tear on their rigs at what they would make on a job with Diesel rising four dollars.  The man we got Black Dog #5 (the pride of the now defunct Long Shot Trucking Company) from had tears in his eyes when he had to sell the Dawg, his joy and the last “tractor” to go, and spent half an hour pointing out all the glories of that beautifully-maintained beast that will haul a dry van box with 55,000 pounds of goods in it after he had clinched the sale.  What we paid for it is practically a sin, but he couldn’t hold out “until times get better.”

Then the “We’ll travel when I retire” dream popped, and motor homes and big travel trailers started coming up for sale, along with golf carts, and finer cars.  Reduced income, 401Ks in the cellar, houses that can’t be sold without the most horrifying loss, “down-sizing,” and something had to give.

This time last year we bought six used motor homes and travel trailers in excellent shape for fifty dollars a running foot, never more than a hundred.   These days the price is more apt to be $150/rf. The high-end models still aren’t selling, and little is as sad as a dealer’s lot, but either all of the more modestly priced rooms on wheels have changed hands or those who own them are feeling a little less frantic.

Grandma’s sterling silver that was only used at Thanksgiving has been all but a glut on the market for months…Silver has a special place in my heart, and the thought of treasures that have been in the family for perhaps a couple of centuries cast on the altar of believing things would never change, the house would always provide extra income hurts. Silver is rising dramatically on e-Bay; it requires more and more knowledge and research to find bargains.   Last month I was buying sterling flatware at roughly $10-12/utensil, and tonight people are asking $15-$17 for standard patterns. The latest trend is also turning loose of fine china at bargain basement prices.

I still won’t buy the classic hedge of postage stamps (very fragile, don’t know enough), loose diamonds (not sure the IDC can maintain inflated prices; am buying sapphires and rubies), or antiques other than jade and bronze (more portable, sturdier.)  This weekend good antique furniture appeared in large amounts suddenly, although the prices are “overly sanguine,” shall we say?

In some ways storing intrinsic value in items like the last two may not sound exceptionally bright, but that’s one of the hazards of shopping.  You find things you just can’t resist.  I have a printout on my desk right now for a 1985 XJ6 Jaguar we’re going to go look at tomorrow: one owner, always garaged, 138,000 miles, custom wheels worth two-thirds of the asking price, engine you could eat off of, all of the touches for which a real Jaguar is famous, and she’s got to go.  He’s asking $1200 for a very luxurious car with at least another hundred thousand miles in her. In short, it is a grand time to want to buy cars if you have cash, even new ones.

A classic Rockefeller story is of purchasing a yacht early in the thirties for a thousand dollars a running foot, which, he said, “Seemed like a very good price for a yacht.”  Indeed, it was…and he had the cash at the right time.

The moral of this tale is to use what you know best to manage your cash correctly now.  Other than that, put it in gold, silver, survival supplies and equipment…and even a few things that merely make your eyes light up.  Life is short, and beautiful objects of intrinsic beauty will gladden your heart and are a lot more pleasurable than giving in to that urge to get back into the market.

I saw in 1992—when the interest rate dropped to a shocking four per cent—that in years to come widows and retirees were going to be in for very bad times.  Why didn’t anyone else who isn’t a professional analyst?  Why didn’t they believe their “men of affairs,” as financial advisors used to be called?

I expect that this will turn out better than a prospectus promising that if we buy six stocks two will fail, three will do reasonably well, and one will give us thousand per cent returns.  If I’m wrong, I’m buying at 25 cents on the dollar in a lot of instances, and a Jaguar will always be a Jaguar.  The world seems to be one giant yard sale, and I submit that traditional luxuries will recover sooner than Government Motors will.

Regards,
Linda Brady Traynham

May 14, 2009

Gathering Intrinsic Value in the Aftermath of the Credit Bubble was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

In general, fundamental analysts concern themselves with a company itself. They dig into financial statements and balance sheets. They calculate assets vs. liabilities, sales vs. profits — all the nitty-gritty details to find out what a company is really worth.

Fundamental analysis can be a great way to find stocks for your portfolio that you plan on holding for a long time. But just because a company looks great on paper doesn’t mean the stock market will agree. In the short term, anything can happen. And that’s where technical analysis can help.

Technical analysts rarely worry about companies themselves. They’re more concerned with the company’s stock price. Using charts or other systems, a technical analyst tries to decide where a stock price is going next.

A solid technical analysis system is a great way to take advantage of short-term stock moves. In fact, my proprietary charting system is one of the reasons for Options Hotline’s incredible success. I look for stocks on the verge of big moves up or down. Then I choose the best options to take advantage of the move.

As you may know, I’m also a big advocate of having a firm trading strategy in mind. To help guide that strategy, I also calculate to very important numbers — support and resistance.

These two numbers are the bread and butter of technical analysts. Each one tends to calculate support and resistance in different ways. So it’s not really important to tell you how I calculate them. It’s just important to know what the terms mean.

The technical answer is, support is an area of expected institutional buying. Resistance represents expected professional selling.

Simply put, support represents the expected “floor” of a stock. That is, the lowest price you can expect it to go. That’s because when the price falls to this price, institutions and investors tend to step in, buying up the stock. That buying “supports” the stock price.

Think of it this way. Suppose a fictional company, Widget Co., is trading for $53. And let’s say that brokerage houses have a lot of standing orders from their clients to buy Widget Co. at $50.

In other words, these orders will not trigger as long as Widget Co. is selling for more than $50. But if the stock falls to $50, the brokers start executing the limit orders. All of a sudden, there is a flood of buyers for the stock. The demand keeps the price up.

Of course, support is not foolproof. In fact, stocks can and often do break through their support lines. It means that more people are selling the stock than are buying…so the bears are in control.

When a stock breaks through resistance, on the other hand, it’s a bullish sign. Resistance can be considered a stock’s ceiling. It is the price a stock is expected to have trouble breaking through.

Just like with support, resistance is controlled by institutional investors. Except this time, it is the price at which they can be expected to sell the stock.

For example, assume Widget Co. stock is at $53. But instead of falling, the stock rises. And keeps rising.

In this example, a lot of people will want to take profits if the stock rises $10. So they put in limit orders…and if the stock hits $63, the selling begins. The shares flood the market, driving the stock price down.

Of course, resistance isn’t absolute, either. And if there are more buyers than sellers, the stock will break through resistance. It’s a good sign the stock is on a bull run.

Knowing a stock’s support and resistance can help you decide what to do with your options. That’s because an option’s price follows a stock price. So knowing the “floor” and the “ceiling” can help you determine your trading strategy.

Remember, if a stock breaks through support, it is falling — and the bears are in charge of a stock price. If you have a call option, it can be very bad news for you. You may want to consider selling the option in case the stock goes even lower.

Of course, a lower stock price is what you want to see if you have a put on it. So if the stock breaks through resistance, it should mean profits for you. You really have two options now. You can sell the option, locking in your profits. Or you can ride the stock down, squeezing more profits out of your option on the way.

Just be careful, because the stock can turn around without warning. If you hold on, monitor your position carefully and use proper trading discipline to sell at the best price.

(As you can probably guess, the opposite thinking applies to resistance. If you own a put and a stock breaks through resistance — meaning it’s heading higher — consider selling the put. If you own a call, use your money management system to decide whether to take profits or hang on for more.)

Remember, if you want to make a lot of money in options, it is essential to buy and sell at the right price. Support and resistance are two tools to help you find that right price. Use them correctly — as part of your total money management system — and you should quickly increase your profits.

Sincerely,
Steve Sarnoff

October 23, 2007

Chart Your Way to Profits was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

It might sound cliché…but I’ve found tangible proof that there’s some truth to those stories. At least one of Wall Street’s most trusted companies is pulling the wool over your eyes. It’s everything short of a deliberate attempt to steer you away from the stocks it doesn’t approve of.

I’ll explain in a second. But first, a little background is in order.

The story starts with a man named Philip Fisher.

A stock analyst who survived the market crash of 1929, Fisher made his mark with a landmark book, Common Stocks and Uncommon Profits. In fact, it was the first investment book ever to make The New York Times best-seller list. And while most people like to associate Warren Buffett’s investment style with Benjamin Graham’s, the Oracle of Omaha admits that Fisher inspired him, as well.

That’s partially because Fisher was a strong advocate of buying and holding. He once said the best time to sell was “almost never.” Of course, he didn’t mean you should blindly hold onto losing stocks…he meant that if you did your research right before you bought — and paid attention thereafter — you’d never have to worry about selling.

So it’s pretty amazing when you realize that Fisher was primarily a growth investor. He didn’t care about a company’s fundamentals…he cared about its business. He loved companies that were “highly speculative and beneath the notice of conservative investors or big institutions.” In fact, he famously bought Texas Instruments and Motorola long before they were household names — and even held Motorola until his death.

In Common Stocks and Uncommon Profits, Fisher spelled out 15 questions he used to evaluate a company. They were pretty open-ended and could be subject to interpretation. They were not, as he put it, “determined by cloistered mathematical calculation.” They were:

1.     “Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?”

2.     “Does the management have a determination to continue to develop products or processes that will further increase total sales potentials when the growth
potentials of currently attractive product lines have largely been exploited?”

3.     “How effective are the company’s research and development efforts in relation to its size?”

4.     “Does the company have an above-average sales organization?”

5.     “Does the company have a worthwhile profit margin?”

6.     “What is the company doing to maintain or improve profit margins?”

7.     “Does the company have outstanding labor and personnel relations?”

8.     “Does the company have outstanding executive relations?”

9.     “Does the company have depth to its management?”

10.  “How good are the company’s cost analysis and accounting controls?”

11.  “Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?”

12.  “Does the company have a short-range or long-range outlook in regard to profits?”

13.  “In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholder’s benefit from this anticipated growth?”

14.  “Does the management talk freely to investors about its affairs when things are going well but ‘clam up’ when troubles and disappointments occur?”

15.  “Does the company have a management of unquestionable integrity?”

Now, I’ll admit, there’s nothing groundbreaking here. Fisher’s 15 questions are fairly well known, and you can find them or slight variations all over the Internet. But I recently discovered that some of Fisher’s wisdom has been purposefully been withheld from investors. In fact, one of Wall Street’s most trusted Web sites glosses over some of what Fisher had to say.

You see, Fisher also listed five “don’ts for investors”:

1.     “Don’t buy into promotional companies.”

2.     “Don’t ignore a good stock just because it is traded ‘over-the-counter.’”

3.     “Don’t buy a stock just because you like the ‘tone’ of its annual report.”

4.     “Don’t assume that the high price at which a stock may be selling in relation to its earnings is necessarily an indication that further growth in those earnings has largely been already discounted in the price.” (Or put simply, price to earnings isn’t everything.)

5.     “Don’t quibble over eighths and quarters.” (That is, don’t stress over a few cents difference in price.)

Please pay attention to No. 2, in which a man hailed as one of the greatest investors says there’s nothing wrong with trading bulletin board and Pink Sheet stocks.

I ask you to pay attention, because the good folks at Morningstar.com think you shouldn’t know that rule.

It’s true. Its Web site has an Investor Classroom, which includes a profile of Philip Fisher. The article patiently explains his love of growth stocks. His 15 points are spelled out in detail. And then it goes on to paraphrase Fisher’s “don’ts” — all three of them. Not five…three.

Any bets on which ones are missing? Here’s a hint — they’re the ones that have nothing to do with fundamental analysis or exchange-traded stocks. See for yourself here.

Now, I know — Morningstar can easily claim it’s doing this for investors’ own good. That over-the-counter stocks can be risky…and discounting fundamental analysis may encourage bad research.

But whatever its reasons, one thing is clear — Morningstar.com is not giving you the whole story on Philip Fisher’s investment philosophy. Yet if it worked for him, why can’t it work for anyone else?

Best,
Gunner

July 27, 2007

What Morningstar.com REALLY Doesn’t Want You to Know was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“Six months ago, total transaction volumes on the Shanghai and Shenzhen exchanges were less than US$5 billion per day. That figure now stands 10 times as high, at $50 billion per day. This volume is something China can be proud of, barring one minor detail, namely that the central bank and various policymakers would much rather not see it happening.

“Even as central bankers exhort the country’s citizens to beware of bubble-like conditions in the stock markets, investors appear unruffled, reversing the policy impact of any announcement. Be they students, farmers or construction workers, every Chinese living in the two big cities of Shanghai and Shenzhen appears now to have a brokerage account. Conversations in the normally noisy dai pai dongs in Guangdong province and Hong Kong drop to a quick hush whenever the subject of stock tips comes up…(Dai pai dongs are uniquely Cantonese eateries, generally specializing in a limited range of food items. Besides the delicious and cheap food, the eateries are also known for their communal seating and extremely high noise levels.)”

The Associated Press reports that it’s a case of stock market fever for Chinese investors:

“Millions of first-timers are getting involved in the frenzy as Shanghai’s main market gauge continues to post eye-popping gains.

“After watching Chinese stock prices gallop upward for months, Ding Xiurui wanted a piece of the action.

“The 45-year-old office worker stood in line at a bustling brokerage last week to open her first trading account. She brought her sister, who opened an account too. They joined millions of other novice investors who are jumping into a market that has soared to dizzying heights, with prices up more than 51% this year.

“‘We still can make money,’ Ding said as she stood at the counter at Tiantong Securities with the paperwork for her new account. Asked what stocks she would buy, Ding said: ‘I don’t know. I’m still learning.’

“China is in the grip of stock market fever. Shares are changing hands in record numbers as first-timers pour in new money. Some are mortgaging their homes or dipping into retirement savings to finance a frenzy of trading known as chao gu, or ‘stir-frying stocks’…

“Last week, the Shanghai index passed the 4,000-point mark for the first time, and economists say it could break 5,000 in a month…

“‘We are opening 40-50 new accounts a day,’ said Zhang Jun, deputy manager of the Tiantong Securities branch. ‘Six months ago, it was four-five a day.’

“Nationwide, the number of trading accounts has soared 30% over the past year, to 95 million, one-sixth of them opened in the past four months, according to the China Securities Depository and Clearing Corp., which is owned by China’s two stock exchanges.

“Stock prices are 30-40 times earnings, an unusually high ratio for many major markets, which some say makes them unrealistic.

“‘But that is not paying attention to earnings growth, which is very, very strong,’ said Goldman Sachs’ Hong Liang.

“And many investors believe Chinese leaders will prop up prices to avoid turmoil ahead of a key Communist Party meeting in late 2007 and the Beijing Olympics in 2008.

“‘We hear that before 2008 the government won’t let prices fall,’ said Ding’s sister, Ding Jingxian. ‘We’re not afraid.’”

Interesting Sound Bites

• Wanting a “piece of the action”
• Opening an account but not knowing what stocks to buy: “I don’t know. I’m still learning”
• Mortgaging homes to buy stocks
• “Dipping into retirement savings to finance a frenzy of trading known as chao gu, or ‘stir-frying stocks’”
• “We are opening 40-50 new accounts a day. Six months ago, it was four-five a day”
• “Stock prices are 30-40 times earnings”
• “Earnings growth is very, very strong”
• “Chinese leaders will prop up prices to avoid turmoil ahead of a key Communist Party meeting in late 2007 and the Beijing Olympics in 2008”
• “We hear that before 2008 the government won’t let prices fall”
• “We’re not afraid.”

I do not think I have seen as many sound bites in an article that short ever before. This seems eerily reminiscent of the Nasdaq before it collapsed. Here is a chart sent to me by “B.C.” for comparison purposes:

Nasdaq vs. Shanghai

Mortgaging homes to buy stocks…after a quadruple run-up in prices! Yikes. And we are seeing the same kind of rationalizations we saw before: “‘But that is not paying attention to earnings growth, which is very, very strong,’ said Goldman Sachs’ Hong Liang.” Is anyone asking if the earnings growth is sustainable?

I guess my favorite sound bite is the idea that the government will not let the stock market fall. If that were remotely possible, would the Nascrash have happened, or would the Japanese stock market have plunged like it did? Would housing prices in Florida and mortgage lending have imploded?

Of course, it’s different in China. In every bubble you hear the same melody, even if some of the lyrics change. Certainly the idea of stir-fried stocks is a new one. But one line is always present: We have no fear. Ultimately, the market proves otherwise, 100% of the time.

Regards,
Mike Shedlock ~ “Mish”

May 18, 2007

Stir-Fried Stocks was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

I firmly believe it is my job to be as blunt about that as possible. The potential rewards of options are very tempting, and anyone who forgets about the potential downsides is toast.

Unfortunately, those stark warnings also scare away people who could benefit from options. People who have built solid portfolios…and can easily afford to speculate a bit. They’re the complete opposite of traders who blindly rush in focused on the gains. Instead, they only see the potential losses…

That’s why I offer a simple suggestion — try options trading for yourself. With just a few minutes a day, you can learn how profitable options can be, without risking a single cent.

In the old days — as little as a decade ago — the best way to do this was by paper trading. As the name suggests, it doesn’t involve any real money…or even a broker.

Instead, you simply chose an option and kept track of it each day. With a few simple calculations, you could see how you would have done if you actually made the trade.

There are still plenty of good things to say about paper trading. For one thing, it forces you to work — tracking down prices and calculating potential profits. If you’re going to put that much time into an activity, you might be more inspired to do well. It’s a good trait to have if you ever decide to trade for real.

Still, the pen-and-paper method is a little outdated now. Today, lots of Web sites offer “virtual trading” — free computer programs that let you practice trading without putting any money at stake. Most require you set up an account…not an actual brokerage account, but a membership account — containing basic information like your age and interests.

Of course, some of these sites might use this information to try to sell you stuff. And with privacy concerns a big issue today, you might want to be careful with how much information you hand over. My advice is to stick with the programs on well-known trading sites. Obviously, they have a reputation to maintain, and they aren’t going to do anything to risk alienating a potential client.

When you sign up, you’ll get a username and password to get to your account. You’ll also get a small sum of virtual money to start trading with. (Beware of a site that offers to give you more fake money in exchange for real money. The point is to avoid spending ANY out-of-pocket cash.)

I must be honest, I haven’t signed up for many virtual trading accounts — so I can’t honestly compare and contrast them all for you. However, a colleague recently opened up a mock account on the Chicago Board Options Exchange (offered by Options Express)…so I can tell you all about that.

The CBOE virtual trading site starts you off with $5,000 in virtual money. You can use that fake money to simulate trading any of the securities the CBOE tracks — from stocks to options, even some futures.

The Web site does its best to make the trading as realistic as possible. Price quotes are based on the actual prices seen on the exchange. When you wish to buy something for your virtual account, you are given the same kind of choices that you’d face if you were actually buying a real security.

You can dictate limit and stop orders. You can make day orders or standing “good to cancelled” orders. You can even choose to write options or use covered calls.

After you make your virtual order, the software does the rest. If you placed a market order, the security is added to your virtual portfolio. If you used a limit order, the program won’t place your order until the real market hits your limit price.

Everything you need to know is spelled out for you — the program even levies a virtual commission charge on each of your trades.

After that, it’s just a matter of logging in to see how you’re doing. You can also set sell orders, even trailing stops.

Programs like this can be a very useful tool for gauging how well you’d do in the options market — making any lingering fears disappear.

Of course, there are some important differences between real investing and virtual investing that you need to keep in mind.

It’s a lot easier to trade when you’re not spending real money. But virtual trading is so lifelike, you might actually lose sight of that when you really start trading. This is especially true since actual trading will involve money you can afford to lose. If you’re not careful, it will all seem like a game…and in games, taking unnecessary risks is part of the fun.

The solution is to treat your virtual account as actual money. Don’t make crazy trades just because you can. Instead, only make trades you’d make in real life. It’s not only the best way to get a feel for how you’d actual do with options, but it’s also the easiest way to transition from virtual trading to real trading.

Once you see how much money you’re missing out on by not using real money, it won’t be long before you’ll want to try your hand at actually trading options.

Sincerely,
Steve Sarnoff

May 11, 2007

Practice Makes Perfect was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Introduction

Although I read and collect information and ideas every day, whenever the day comes each month when I actually have to start writing this report, the words of Gene Fowler (an extremely successful screenplay, sports, and humorous writer) come to mind: “Writing is easy. All you do is stare at a blank sheet of paper until drops of blood form on your forehead.”

On these occasions, I then usually turn to works of science, politics, history, or philosophy in the hope of calming down and finding some inspiration. Since so many investors look to investment advisers such as myself, whom they often call “gurus”, for guidance on the future of the markets, I think it is appropriate to remind my readers of these words of Lao Tzu (the sixth-century Chinese sage): “Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.”

I have mentioned this because I was recently invited by my friend Manish Chokhani, of Enam Financial Consultants in Mumbai (the most successful investment bank in India), to give a presentation. The founder of the company, Vallabh Bhanshali, introduced me by saying that his staff consider me to be a hero for having correctly predicted the bull market in Indian equities in 2002, and for having called in 2006 for the 30% May/June sell-off. I felt deeply embarrassed by this, as I know only too well that I have made just as many, or even more, poor and erroneous market calls as correct ones in the course of my life, and not only about economics and asset markets but also about people… Moreover, I know people who are far more knowledgeable about the financial markets than I am – people such as Henry Kaufman and Peter L. Bernstein – who focus on presenting well-researched facts in their excellent papers, publications, and presentations, and refrain from making predictions.

In fact, addressing large audiences makes me feel uncomfortable – not because of the size of the audience, but because, as a contrarian, it is not desirable for my views to be popular and because assets that I consider will perform well in the future seldom attract large crowds. Two friends of mine, Jon Thorn and John Shrimpton, who manage, respectively, the India Capital Fund and the Vietnamese Dragon Fund, used to have tiny audiences when they presented at investors’ conferences. But as their markets more than doubled in size, so did their audiences.

In 1981, I was invited to speak about bonds at a gold conference that had attracted over 500 participants. Just one person came to my presentation. (September 1981 saw the end of the bond bear market, which had begun in 1942.) A small audience can sometimes be distressing for a speaker, but at such times they would be wise to remember Victor Borge, a Danish pianist with a sharp mind and humorous bent, who fled to the United States in 1940 and made a name for himself with his brilliant blend of musicianship and humour. One evening, in Flint, Michigan, Borge performed to a sparse audience. The sight of so many empty seats might have discouraged the average performer, but the witty Borge looked out over the audience and exclaimed: “Flint must be an extremely wealthy town. I see that each of you bought two or three seats.” (Lateral thinking at its best!)

As an investor looking for guidance from newsletters, blogs, financial publications, and conferences, I would also be mindful of Ralph Waldo Emerson’s words: “Do not go where the path may lead; go instead where there is no path and leave a trail.” Unfortunately, in today’s high-liquidity driven global investment environment, I find it hard to identify an asset class “where there is no path”. There are far too many smart – and not so smart – treasure hunters who have bid up every imaginable investment class right around the world. It is only in the most unusual places that I can find true value (often, however, in assets that are difficult to invest in), as opposed to relative values, which certainly do exist. The problem for investors is that, as the German theologian Dietrich Bonhoeffer wrote, “If you board the wrong train, it is no use running along the corridor in the other direction.” (Bonhoeffer opposed Nazism and was executed in prison for his involvement in a plot to overthrow Hitler.)

I mention this because it will become increasingly important for investors not only to decide which asset class train they want to board, but also, and even more importantly, whether they want to board any of the asset trains. If we look at the economic and financial history of capitalism, we can see that over periods of five to ten years there were always some assets that performed well. But there were times, such as in the early 1930s and the 1970s, when very few assets appreciated. Gold and gold shares performed well in the early 1930s. And in the 1970s, precious metals, and energy and energy-related shares, appreciated dramatically. But what were the chances that, in 1929, an investor would have had all his assets in gold, or, in the 1970s, in energy and precious metals-related investments? Moreover, in both cases, these investments had to be liquidated at some point because, as is always the case, “over-staying” eventually leads to huge losses. And this is where I see the biggest problem in the current investment environment. At the beginning of a bull market in an asset class, there are very few participants. But by the tail end of the boom the vast majority of market participants have become convinced that the boom will last forever or that a greater fool will soon emerge and take them out at a higher price. (This is likely to be the thinking among private equity fund managers.) So, in every boom, the majority of investors eventually get caught when the investment bubble bursts, as was the case in 2000 with high-tech stocks and in 2006 with US homes.

In last month’s report, entitled “When Too Many Investors Think Alike, Nobody is Thinking”, I pointed out that a peculiar feature of the bull market in asset prices since 2002 has been that all asset prices around the world have appreciated in concert as a result of highly expansionary monetary policies, which has led to excessive credit growth and a credit bubble of historic proportions. Therefore, if my theory of slower credit growth in future holds, it is conceivable that, for a while at least, all asset markets (with the exception of bonds and cash) could come under pressure, albeit with different intensities.

In fact, asset markets would come under pressure even if credit growth continued at the present rate and didn’t accelerate. In this instance, investors would be better off not boarding any investment train at all and, instead, staying at the station loaded up with cash. (However, they would still have to decide what kind of cash to hold.)

An Attempt to Pierce Through the Investment Mist

I have mentioned in the past that the first signs of credit tightening would be visible in the performance of US brokerage stocks. Recent pronounced weakness not only of brokerage shares, but also of other financial stocks and, in particular, sub-prime lenders, would seem to confirm that the “irreparable cracks in the financial system”, about which we wrote in the January issue of this report, are now spreading. These cracks are now causing some “illiquidity”, not only in the household sector but elsewhere in the system as well. First, it is important to understand that mortgage debt has begun to grow at a slower pace largely because home prices are no longer appreciating. The growth in the mortgage market was about equal to nominal GDP growth between 1980 and 2000. But, in the 2000 to 2006 period, a massive breakout from the trend occurred and, combined with a decline in the saving rate, drove consumption and GDP growth. But, as home prices began to decline in 2006, and as problems in the subprime lending market became evident, lending standards were tightened to their highest level in 15 years. Declining home prices and tighter lending standards brought about a slowdown not only in mortgage debt growth but also in overall debt growth. Mortgage debt, which grew at an annual rate of 10.2% in the second quarter of 2006, declined to an annual growth rate of 8.6% in the third quarter and to 6.4% in the fourth quarter. It is likely that mortgage debt growth slowed down further in the first quarter of 2007, and will decline even more in the second quarter given the problems in the sub-prime lending industry and the tight lending standards.

In the meantime, household debt growth in the United States has declined from a peak of 11.9% in the third quarter of 2005 to 6.6% annual rate in the fourth quarter of 2006. According to David Rosenberg, the fourth-quarter 2006 annual credit growth was the slowest since the third quarter of 1998 and the sixth consecutive quarterly deceleration, “which hasn’t happened since 1956″ (emphasis added). Now, ceteris paribus, this significant slowdown in mortgage and household debt accumulation would have already brought about a significant slowdown, or even a decline, in US consumption. However, because of the stock market rally in the fourth quarter of 2006, equity wealth increased by 4.2%, or an annual rate of 18%.

Moreover, as David Rosenberg notes, “just as households are beginning to curb their appetite for debt, the once-dormant corporate sector stepped up its borrowing sharply in Q4 (M&A related perhaps?). Net debt raised by the nonfinancial corporate sector steamed ahead at a 10.9% annual rate in Q4, almost double the Q3 pace (of 5.9% annualized) and the strongest pickup in seven years. You have to go all the way back to the cashburn era of 2000 Q2 to see the last time that the corporate sector outdid the household sector in terms of debt buildup.” And as David Rosenberg correctly suspects, corporate borrowings have been rising along with M&A activity. But corporate borrowings are far smaller than household debt; therefore, while corporate debt growth has increased by around US$100 billion since the second quarter of 2006, household borrowing has grown since then by around US$300 billion. (Note also how, in the late 1990s, debt growth took off.)

Now, this deterioration in household debt growth hasn’t yet led to a consumer spending decline; but, very clearly, retail sales are now growing more slowly. Continuous consumption growth was therefore driven less by household debt growth in the fourth quarter of last year and the first quarter of this year, than by the continuation of an increase in household wealth and the selling of US equities by the household sector. But herein lies the problem. If declining home prices are now joined by equity prices that are either declining or no longer rising, it will only be a matter of time before consumer confidence declines and the consumer either slows down their spending further or stops spending altogether.

Slower consumption growth, as a result of tighter lending standards and flat or declining equity prices, should have the following consequences. The US trade and current account deficit will no longer expand at an accelerating rate. This should lead to a relative tightening of global liquidity, which would likely be unfavourable for asset prices but could temporarily strengthen the US dollar and even more so the Yen.

The full extent of the sub-prime lending problems isn’t known. However, since at least 12% of the mortgage market – whose total size is over US$1.2 trillion – is comprised of sub-prime loans, the fall-out could be considerably worse than expected. This certainly seems to be indicated by the recent poor performance of banking stocks and, as indicated above, brokerage shares. My friend Gerard Minack of Morgan Stanley recently published a figure showing how financial sector earnings have exploded in recent years. Figure 12 depicts earnings growth for the financial and nonfinancial sectors indexed to a common base (1990 = 100).

As can be seen, the financial sector’s earnings rose 14-fold since 1990 to an annualised US$251 billion, whereas the rest of corporate earnings experienced only a fourfold increase, to US$636 billion. I have mentioned in earlier reports that if we were to include in the financial sector’s earnings financial profits from speculating in all kinds of derivatives and financial products by industrial and multinational companies, the profit contribution from financial earnings to S&P 500 total earnings would be more like 45%. Also, the recent contribution to profit growth would amount to around 70%. Therefore, I suppose that if asset markets failed to appreciate further, financial earnings would begin to decline and likely pressure S&P 500 earnings. (Aside from the financial sector, the energy and material sectors have in recent years also boosted S&P earnings. Never before have energy and financials contributed so much to the S&P profit pool.)

In the past, poor performance of financial stocks has always been an unfavourable indicator for the entire stock market. In an economy that has become addicted to credit growth, this should be even more so! The other point to remember is that if corporate profits no longer expand, the ammunition used by the corporate sector to take over other companies and to buy back their own shares is likely to diminish. Last year, a record US$548 billion worth of shares were retired by corporations buying back their own shares and by acquisition-minded private equity funds. Any reduction of this activity in 2007, when simultaneously the increasingly “illiquid” household sector is likely to diminish its equity purchases further, is going to have an unfavourable impact on the stock market. I may add that, sooner or later, private equity funds will place the acquired companies back on the stock market and so increase the supply of equities through high IPO activity.

If the assumption is correct that global liquidity is tightening – at least relatively – as a result of a stagnating US trade and current account deficit, the asset markets that benefited the most from surplus liquidity should come under some pressure. I am thinking here in particular of the extended emerging stock markets, which in this scenario could be vulnerable to corrections of between 20% and 40%. In turn, a decline in these peripheral markets should have an impact on Japan and, in particular, on the Yen.

Regards,
Marc Faber, PhD

April 16, 2007

“Relax, the Over-all Market Probably Won’t Tank” was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

As my colleague Chris Mayer wrote in this space on Wednesday, “Diligence and discipline and selectivity are keys. As I’ve said before, we don’t invest in the market. We invest in specific opportunities in the market. Not the produce section, but specific avocados, onions, and melons.”

I view my Strategic Investment recommendations in a similar light. While my top-down approach differs a bit from Chris’s bottom-up approach, we share the goal of finding winning stocks for our readers. Macroeconomic analysis can increase the odds of finding them. If the produce section is consistently good, we want to look for opportunities there — and avoid the overripe beef in the meat department.

The Picture of Panic

The CBOE volatility index (VIX) indicates how volatile speculators expect the stock market to be in the future. More specifically, the CBOE defines the VIX as “a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.” When it’s low, stock options are cheap, and when it spikes upward, stock options become expensive. During Wednesday’s meltdown, the VIX recorded one of the largest percentage spikes in its 14-year history:

To what can we attribute such a move? Who’s to blame?

Not very much has changed over the past week. Simply put, risk now matters. The market often chooses to ignore fundamentals until they suddenly matter. After nearly everyone’s joined the bullish camp, the slightest defection back toward the bearish camp can produce the type of market action that we saw Wednesday. Markets go into a free fall when buyers sit on their hands, waiting for the plunge to stop.

For too long, the market has been caught up in such pointless distractions as anticipating the Fed’s next interest rate move or using the three-week Northeast U.S. weather forecast to trade natural gas futures. While such distractions make nice stories for the financial media, they shouldn’t form the foundation of investment decisions.

My advice to Whiskey & Gunpowder readers is to take a good look at the fundamentals supporting the value of every stock you own. Then separate the wheat from the chaff. You want to buy and hold solid companies with favorable macroeconomic winds at their backs. And you want to avoid overpaying for these shares.

What would I define as “overpaying”? Here’s where we delve into the art/science of security analysis. A stock may appear cheap if it has just delivered a few years’ worth of impressive earnings results. But it may, in fact, be expensive if a one-off economic event like the housing bubble temporarily boosted earnings. If earnings per share decline 50%, a 15 P/E stock immediately becomes a 30 P/E stock. Traders will punish this stock, likely pushing it back down to its typical 15 P/E range — or below.

S&P 500 Price-to-Peak-Earnings

How can we judge if the market is cheap or expensive when earnings fluctuate so wildly? One of the best ways to do this is to calculate the market’s price-to-peak-earnings ratio. The market as a whole is pretty well defined by the S&P 500, an index of the largest 500 stocks on U.S. exchanges (measured by market value). It’s now trading at about 18 times peak earnings, so it’s quite expensive by historical measures. And peak earnings happen to be the earnings from the last 12 months, when conditions have hardly been better for Corporate America.

Steve Saville, editor of The Speculative Investor, incorporates Austrian Economics-based analysis and advanced charting into his newsletter ideas. He was kind enough to allow me to reproduce the following chart for Whiskey & Gunpowder readers:

Source: www.speculative-investor.com

Steve dissected 80 years of market history into secular (long-term) bull and bear markets. Only instead of using indexes, he defines bull markets as periods of expanding P/E ratios and bear markets as periods of contracting P/E ratios. Market prices and earnings can move up together, down together, or independently of each other. But major peaks and valleys in the price-to-peak-earnings ratio provide reliable signals of change in the market’s long-term tide.

The public’s fear of consumer-level inflation spiraled out of control in the 1970s. This period was pretty unique in financial market history. It demonstrated that investors are not willing to pay a high multiple of earnings in a high CPI (consumer price index) environment. Look at the 1966-1982 bear market in the chart. While earnings grew rather dramatically over this 16-year period, the S&P went practically nowhere. The price-to-peak-earnings ratio compressed all the way down to about 8 by 1982. Who cares about earnings growth if it just keeps pace with CPI inflation?

I agree with Steve that we are in a secular bear market similar to the 1966-1982 market, where the index went nowhere, but the price-to-peak-earnings ratio contracted to single digits. While history never repeats exactly, it often rhymes.

If I had to go out on a limb and choose the most likely outcome over the next decade, I’d expect the S&P 500 will fluctuate in a trading range between 1,000-1,500, while earnings grow enough to push the price-to-peak-earnings ratio back below 10.

Look also at the 1995-2000 period on the price-to-peak-earnings chart. The initial dividend yield was low starting in 1995, and dividends didn’t grow much over the next five years, but returns were huge. Investors were willing to pay double the P/E ratio to get into stocks because they feared missing out on the biggest boom in history. These market returns were driven by speculation, not fundamentals, and the consequences were costly during 2000-2002.

A Closer Look Reveals Strength in Energy Earnings

So which market sectors will remain attractive investments through a period of higher market volatility? You want to own companies that produce what consumers need and can afford without exotic financing arrangements. The energy sector provides a great starting point for your search.

Veteran economist Ed Yardeni produces great chart books. Here is one that provides us with a good perspective on how much energy sector earnings have contributed to overall S&P 500 earnings. Since the 2003 bottom, energy stocks in the S&P 500 have grown from 5% to 10% of the index’s market value. But this huge price move was supported by fundamentals. Energy’s share of total S&P 500 earnings grew from 6% to 13% over this time frame. This trend has plenty of room to run over the next decade because the bull market in energy stocks has not pushed them to overvalued levels:

Source: www.yardeni.com

Many are worried that the commodity pricing environment cannot possibly get any better. But at 3% of the average family budget, gasoline is not prohibitively expensive. Neither are the other energy commodities. Gasoline prices could climb to 10% of the family budget without significantly altering demand.

If this were to happen, consumers would just cut 7% worth of discretionary or leisure spending to offset this price hike. Given the good probability of this occurring over the next 10 years, you want to own stocks whose earnings benefit from higher energy prices and avoid stocks whose earnings will be undercut by them.

Source: www.yardeni.com

Government Refuses to Let the Free Market Allocate Scarce Resources

Odds are good that the government will eventually throw a wrench into orderly free market gasoline pricing. Many in Congress think that consumers should not have to prepare for a long period of expensive gasoline. The U.S. Congress appears ready to fight on their behalf if this occurs. The Oil & Gas Journal reports:

“U.S. House Rep. Bart Stupak (D-Mich.) introduced legislation aimed at preventing price gouging for gasoline, natural gas, and other forms of energy. The bill, which has 78 cosponsors, would give the Federal Trade Commission explicit authority to investigate and prosecute anyone found artificially inflating energy prices, he said…

“Under the bill, FTC would be empowered to exercise its new authority at each stage of energy production and distribution. It would be allowed to impose fines up to $150 million against corporations and fines up to $2 million and jail sentences up to 10 years for individuals found guilty of price-gouging…

“Stupak said that during the 109th Congress, 123 House members cosponsored a similar bill he wrote, and several more signed a discharge petition to bring it to the floor. ‘There was strong support for my bill, but the Republican leadership blocked it from being considered. This Congress, I look forward to working with my colleagues on both sides of the aisle and to help protect the American consumer from energy price gouging,’ he said.”

This sounds frighteningly similar to Venezuelan dictator Hugo Chavez’s actions in Venezuela. He is threatening fines and imprisonment for shopkeepers who hike prices above a government-mandated inflation limit. But these sorts of price controls only prompt suppliers to start smuggling and black market operations. One way or another, the free market will ensure that goods like gasoline supplies will flow to consumers willing to pay the highest prices.

The government tried price controls in the 1970s and only created frustrating gas lines. Thinking that they help the little guy, price controls actually bring about the very shortages that lead to hoarding and inflationary spirals.

But government influence over the economy doesn’t stop in Congress. The Federal Reserve is the other half of the dynamic interventionist duo, with plenty of inflationary tools at its disposal.

Liquidity From the Free Market May Dry Up…

“Liquidity” has become the new buzzword explaining why financial markets have remained tranquil and expensive. But the past few days of action in the stock and credit default swap markets hint that this wave of liquidity may be drying up.

A good parallel to the wave of liquidity was the IPO environment for tech stocks in 1999-2000. Companies with little chance of developing profitable business models were easily financed. Investors lined up around the block, desperate to buy ownership stakes.

Near the peak of the Nasdaq, speculative demand for IPOs indicated that we were in a new era of easy financing for IPOs. Liquidity seemed abundant. But within months, it had vanished and every tech IPO over the next few years became difficult to finance. Subprime mortgage lenders are the IPO buyers of the housing bubble, and they have left the market completely or dramatically tightened lending standards.

…But the Fed Will Be the Inflator of Last Resort

Markets can seize up and go into free fall when a flood of free market financing dries up. New Century and NovaStar will certainly not be hungry for subprime paper. They’ll be lucky to survive their recent implosions.

So the Federal Reserve will attempt to rise to the rescue. Many believe that it will be powerless against the forces of deflation, but it’s not smart to bet against central bankers’ ability to destroy the value of paper money. The Fed will act in concert with most central banks around the world to keep the inflation game going.

A large, increasing global debt load creates constant demand for the money and credit necessary to service it, and if the free market refuses to supply the money and credit, central banks will. The free market’s supply of credit dried up during the Great Depression and the Fed’s inflationary ability was hampered by early 20th-century banking and monetary policy restrictions. It was powerless to stop a cycle of defaults.

The Fed’s 21st-century inflationary tool kit is far more potent and flexible. Deflation cannot happen when governments can create infinite quantities of money and credit at zero cost — and are insensitive about returns on investment, malinvestments, bubbles, and ever-growing trade deficits.

But bailouts do not happen without consequences. The faster central bankers inflate their currencies, the faster gold will return to its place as real money in the eyes of the public. You’ll want to have a full allocation of gold-related investments as insurance.

Prepare for the Next Wave of Inflation

So the Fed and the federal government will attempt to magically protect us from both stock market crashes and gasoline shortages. After years of relative tranquility, stock market investors are due for some turbulence. If you are exposed to financial markets, it’s not too late to reassess the fundamentals supporting the value of your investments.

In the inflationary environment I expect, you’ll want to avoid holding long-term bonds and increase exposure to select precious metals, energy, and “old economy” infrastructure stocks and minimize exposure to consumer discretionary stocks. Companies vital to the production of developed and emerging market economy needs — energy, food, and water — will enjoy strengthened competitive positions.

Replacement values of the physical assets on their balance sheets will grow year after year, supporting their stocks’ values. An entrepreneur (assuming environmental permitting were even possible) could probably not construct an oil refinery for anything less than twice the cost of buying the portfolio of refineries offered by shares of Valero in the stock market.

Conversely, what sorts of barriers to entry characterize an apparel retailing business? All you need is access to credit, low-cost clothing supplies, and a lease at the local shopping center. Companies that can deliver consistent, sustainable (i.e., not one-off, housing bubble-driven) earnings should assume market leadership positions in the near future.

I plan on profiling such companies for my readers and for attendees of the March 14-17 Investment U conference in Phoenix.

Good investing,
Dan Amoss, CFA

March 2, 2007

Revisit Fundamentals When the Market Panics was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.