Stocks seem to go up too much in part because investors believe in the Greenspan/Bernanke/Yellen Put option. The myth is that the Federal Reserve will try to bailout investors during a crash. But high stock prices are not a necessity unlike keeping giant banks and insurance companies solvent and liquid so stocks won’t get bailed out.
If another horrible crash came there would be an outcry as people would claim that pension funds, etc. can’t meet obligations because their stocks went down 55%. The best guess about how the Federal Reserve and Congress would respond is that they would tell pension funds and insurance companies to spend their bonds to make their payments and leave the stock portfolio alone for a long time in hopes that it would recover.
I can imagine the next recession’s bailouts might include the Fed buying bond portfolios at par from distressed investors but not going so far as to bailout stock investors. The Fed could go as far as to buy junk bonds during a crash to help corporations that needed to raise money but they won’t buy equities.
Since interest rates are already close to zero and actually negative in Europe then the Fed and the EU Central Bank can’t cut rates further. It may be difficult to legislate a fee on deposits to make a zero interest bank account become a negative interest rate account which would be needed for the Fed to lower interest rates even further during the next crash. The Fed has lowered rates in the crash of 1987, then lower in 1990, then lowered them more in the crash of 2002-03, then even more in 2008-09 down to zero, so the trend is for the Fed to give the patient ever increasing doses of medicine during each new crisis. Now that the rate is near zero how can it go any lower during the next crash?
The principle of Monetarism is that the Federal Reserve allows businesses freedom to let the Invisible Hand of the market use cheap credit to allocate resources that will make the economy operate in the best way. The problem is that the Invisible Hand only seems to work when it is allocating resources in a business environment instead of in an emotionally driven retail stock market. For example, the barriers to entry for establishing a chip foundry result in chip making decisions driven by cautious professionals. By contrast, in the era of dirt cheap commissions for stock trading and day trading of ETF’s, etc. lots of naïve retail investors can participate in the market even if they are not professional and don’t take time to study the market. Thus the Fed’s copious supply of easy money under Monetarism results in the funds being usurped by naïve speculators instead of by wise industrialists.
The 25 year era of Easy Money from the Fed since the 1987 stock crash has created problems including the great real estate bubble of 1997-2007 resulting in a massive crash of 2008 that Bernanke now says was worse than the Great Depression. Thus Monetarism has been discredited. The implication is that in the future the Fed will be less able to project gravitas and persuade the markets that it can fix a crash. The Fed definitely can succeed in preventing bank runs by rescuing financial institutions the way it rescued AIG and Bear Stearns. But stopping bank runs is not the same as fixing a crashed stock market.
Thus the next crash in a few years may result in stocks not responding very well to stimulus and not getting as much stimulus as they are used to. Investors need to ask themselves is it possible that the Fed bailout success of the 2002 and 2009 crashes were flukes that won’t be repeated during the next crash? If that happens then investors could spend a long time with their stocks stuck in a trading range at 55% to 40% below today’s prices.
Investors need independent financial advice about the risks of not getting bailed out during the big crash. I wrote an article “Is the stock market one giant Too Big To Fail Bank?”
We had a great question come in by request this week that we address the question of whether folks should have gold in their portfolios. Gold can be included under the umbrella of a larger asset class known as commodities. Think of commodities as items used to make or produce other items – such as gold is used to produce jewelry, circuitry and coinage, while timber is used to make lumber and paper, while coal is used to make electricity and disappoint not-so-good kids on Christmas morning (sorry, couldn’t resist). Getting back to gold, the reason an investor may want to consider it as part of their portfolio is because gold is correlated differently from the stock market. Simply put; its pricing moves differently relative to the stock market. This does not mean I’m recommending investors buy gold. Here’s why. Imagine a lump of gold sitting on your kitchen table. […]
The weakness in the labor market is in the middle-skill non-college graduate area. This sector is losing jobs to lower wage Emerging Market countries. The U.S. economy is like a big ship that hit a small iceberg and was taking on water but the compartments have been shut to seal off the rest of the ship from the leak. The ship is sound and will survive. The “leak” is the loss of blue collar middle skill jobs to EM countries. This problem has no solution. It will continue until wages for this sector have become as low as the competing EM countries. Politicians say that workers should get retrained to become more highly skilled, but not everyone is bright enough to become a more sophisticated, well paid, highly productive worker.
The reason there are plenty of unfilled job openings is that employers want too much; they don’t want a mediocre generic worker. Regarding the recent improvement in the “quit rate” where employees show confidence by quitting their job, that is good news, but one must remember that this may only be happening among the most skilled sector of workers. Also the data is warped by the absence of the missing 3.5% of workers who dropped out in 2009 and became the hidden unemployed.
The upper middle class with sophisticated skills are in demand. However they tend to save more than moderate income people so the affluent classes won’t do enough consumption to offset the reduction of consumption from the weak blue collar community. Thus the economy will continue to experience deflationary pressures mixed in with inflationary forces with the net result of very low inflation.
The EM countries, Japan, the EU all urgently need to boost exports by devaluing their currency. The EU and Japan have trade treaties with the U.S. that prohibit export subsidies so the only way for them to get an advantage is through devaluation. The EU’s Central Bank lacks authority to aggressively reflate the economy and it may take several more years of hardship before legislative and judicial authority is granted to the ECB to get aggressive to fix Europe’s problems.
The stage is set for a global economic slowdown that fully justifies today’s low yields. An attempt to escape low yields by recklessly speculating in junk bonds, naked option writing, bank preferred stock, etc. is too risky and could result in severe permanent loss of principal as happened in the 2008 crash.
Labor indicators can be warped by behavioral issues such as hard core long term dropouts who don’t bother to register with the government and are thus not counted. Data can be warped by people who cheat on welfare rules and find ways to go on disability, get nearly free HUD section 8 housing vouchers, free food stamps and medical care, etc. Stock prices and corporate earnings can be warped as I described in many articles on this website. The data that is most reliable is GDP and corporate gross revenue. Corporate revenue per share of stock has been flat since the economic top in 2007 despite growth in real GDP. And real GDP has grown very slowly in the past decade at only 1.8% a year which is below the stall speed of the economy.
The explanation for how consumption remained steady despite the 2.7% median drop in real wages since 2007 is that interest rates dropped, loan terms were extended to stretch out payments, and more people took out student loans.
In a low growth economy where risk of falling back into recession is greater than it is important that investors avoid overpaying for stock prices. The PE10 indicates the SP is worth roughly 1200 but it trades at 2000, a 67% over-pricing. The reason bond yields are low is that they are determined by professional investors who worry that the economy and stocks may be headed into a less than positive outcome, so in anticipation of a flight from stocks to bonds the bond market has received a bid from the marketplace (meaning the price has gone up/yields have gone down).
There is no guarantee that bond prices will move higher, but I feel highly confident stocks are very overpriced and should be avoided by those who respect fundamental valuation principles. It is too risky to pick the exact top for stocks, so it is better to avoid them now. There is an old saying that one should take profits by selling into a rally instead of waiting for a crash to trigger a stop loss. In modern times so many over levered speculators have set up hair trigger stop losses and program trading that it doesn’t take much to trigger another May, 2010 Flash Crash where some people lost 40% in a day. During those times a stop loss order won’t get filled until the market has dropped far below the trigger price.
There are many wonderful long term future possibilities for the economy in terms of new technology but it may take decades to fully implement them and there is no guarantee that a particular company will be able to profitably implement new technology. Lots of new technology was implemented since 2000 but since then we have had lots of deep crashes, high unemployment, low GDP growth, etc. For the next ten years we still have deal with a world where stock prices are too high and will crash, corporate earnings are inflated, investors are too bullish and speculate too much, causing stocks to be overpriced and then crash.
Investors need independent financial advice about the risk of a stock crash. I wrote an article “Pent up wage deflation to make stocks crash”.
To better understand the problems with the PE10 for stock valuation, let’s review the great real estate bubble. Generous government sponsored (GSE’s) financing from FHA, Fannie Mae and later Freddie Mac began in the 1930’s. It grew slowly for 30 years due to the public’s bad memories of the Great Depression. Then in 1965 inflation suddenly grew yet interest rates were often kept at negative real levels. The combination of being motivated by inflation and being nurtured by negative real rates made real estate irresistibly attractive in the 1965-1979 era. Then in 1984 banks started offering Easy Qualifier “Liars Loans” which opened up a new market segment to those who basically couldn’t qualify. So the real estate market had four bullish eras with never a serious systemic integrated national crash for residential real estate.
Then in 1997 the fourth stage of the real estate bubble began when lenders became a lot more lenient in terms of loan approvals as securitization really took off. Before then securitized loans were very conservatively underwritten, however by 1997 lenders discovered they could pass on risk to buyers of loans such as mutual funds or pension funds. This enabled a more aggressive type of easy loan approvals which started a new 10 year extreme parabolic boom that lasted until 2007. The more that real estate went up in value the more that lenders thought there was no risk in lending because they assumed they could always resell foreclosed homes instantly at a profit and that collateral would never go down. The result of continuously larger booms with minimal crashes is that consumers and bond investors and private mortgage insurance companies assumed that real estate was a no risk invest so they offered loans with very low credit spreads over the risk-free Treasury rate. Mortgage insurance was available in the form of Credit Default Swaps at very low prices, which greatly enabled a boom. The four stages of the 76 year real estate boom:
I. 1932 to 1965 GSE lending by FHLB, FHA, Fannie, Freddie (in 1972) where lending occurred in moderation. A history of GSE’s is here.
II. 1965-1981 rising inflation and negative real interest rates create massive real estate bullishness
III. 1984-1997 Easy Qualifiers become more lenient every year creating massive borrowing
IV. 1997-2007 Extreme abuse of Easy Qualifiers securitized as MBS with fraudulent ratings by rating agencies with nothing down, no proof of anything.
The point is that the bubble fed on itself creating (or appearing to create) a fact pattern that implied that real estate was risk free. But it was not risk free; instead the bubble lured lenders and homebuyers into dropping their caution and taking too much risk. Finally Lehman and AIG and the entire banking system had their crisis in Sept., 2008. Could the same error happen with stocks? Are stock investors part of a multi-stage bubble that started with the Oct. 19, 1987 crash and bailout? A constantly rising bubble provides bulls with a chance to make mockery of the PE10 but the fact is that stocks can and did make the same mistake that the real estate market made.
The problem with investing is that sometimes non-professional investors get so emotional about being bullish that they pressure Wall Street to become bullish. Wall Street can’t afford the luxury of talking back to a customer so Wall Street has to go along with bullish myths. Thus the market has been abandoned by professionals and power in the market has been ceded to emotional amateur investors who mistakenly believe the Federal Reserve and Congress can bail them out.
The only way to judge the stock market is to use something other than price because price can be warped by bubbles as it was in the 1965-2007 42 year real estate bubble. By contrast, investment grade bonds due to their boring, low yield nature (and due to investors fear that another Volcker would appear out of nowhere and raise rates to 22%!!!) attract mainly professional investment advisors. To estimate a value for stocks I would start with corporate investment grade bond yields as a benchmark and then add on the Equity Risk Premium (ERP); also I would look at the sustainability and honesty of corporate earnings. Using an ERP of 4% or 5% and a 10 year corporate bond yield of 3% implies an earnings yield of 7% to 8%. The inverse of that implies a PE ratio of 14 or 12. Of course a growth factor needs to be added, but what about the risk of negative growth when the company gets old? So for starters the earnings yield gives credence to a PE in the mid-teens. Obviously a new tech company that is rapidly growing is a special case for growth factors but that can easily backfire as tech companies seem to fade into obscurity faster than non-tech companies.
Given all the bad news about Eurozone and Japan and the high hidden U-6 unemployment in the United States I feel the bull case of using today’s PE is not as strong as using a ten year average of earnings. Then what if my concerns about low growth in the EU and Japan and China are true? Then corporate earnings will go lower since U.S. companies are integrated into world markets.
I see the errors of the 42 year real estate bubble are being replicated in stocks where repeated bubbles make a mockery of fundamental analysis like the PE10. It boggles the mind and seems impossible that a bubble could last 42 years but it did for U.S. real estate. Using stock prices to judge the PE10 is like using a rigged jury to render a judgment. The best sources of an unbiased opinion are those droll bond experts that generate macro forecasts. Many bond experts worry that rates are too low and that the economy will recover, but many of them also worry we are going to be stuck in a Japan-style long term Soft Depression. The key to interest rates is to understand the Invisible Hand (including foreign governments) sets long term rates, not the Fed!
Despite the massive bond buying by the Fed’s QE it really is not much more than what China’s Central Bank has bought. There are two waves of Chinese buying of Treasuries. One is from the Central Bank, and the other is private flight capital. As China’s rich grow more sophisticated and more wary of problems at home they will seek to diversify into foreign sovereign debt and the U.S. is far safer than Euro or Japanese debt. This second wave has not yet begun as Chinese are now mainly interested in real estate and stocks. The worse things go for the EU’s and China’s economy the more they need to devalue the Euro and Yuan by buying our Treasuries which will make it easier for our consumers to buy China’s and the EU’s exports.
Thus I believe that bond prices are more efficient and rational than stocks or real estate. And I believe that the errors of the 42 year real estate bubble are analogous to the errors of the current stock bubble. Mispricing of stocks by irrational members of the general public doesn’t disprove the PE10 just as irrational buying of real estate fooled the issuers of mortgage derivatives into underwriting the mortgage bubble.
Investors need independent advice about the hidden risks of debt fueled bubbles in stocks and real estate. I wrote an article “Deflationary nature of global debt burden”.
Welcome to the next installment in our series of Key Investment Insights: The Benefits of Diversification. In our last post, “The Myth of the Financial Guru,” we concluded with our explanation of the formidable odds you would face if you tried to outsmart the market’s lightning-fast price-setting efficiencies. Today, we turn our attention to the […]
There are two emotions that can derail an investment plan faster than a Nolan Ryan fastball: fear and greed. Fear and greed tend to push investors in the wrong direction at the wrong time. Let’s take a look at these two emotions and how they can impact your portfolio. Fear Fear is a great motivator, and it’s easy to find common examples … Continue reading →
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