Dear Diary,
Wow! Dow down 334 yesterday. Talk about volatility. Things are getting interesting.
Meanwhile, what’s wrong with the Bowery?
We search high and low. We can’t find a bum or an alcoholic. The area no longer looks anything like the old down-and-out Bowery of the 1960s and 1970s. Everywhere you look you see the latest fashions… chic New Yorkers… and $600-a-night hotel rooms.
Last night at dinner, our companion nodded toward a nearby table and said, “Look, there’s Michelle Pfeiffer.”
The name sounded familiar, but we couldn’t place her. So we were not as impressed as we should have been. But the Bowery has definitely gone upscale.
Credit Distorts Everything
“Credit…” explained our friend Stephen Jones, the president of an investment management firm here in Manhattan, “… the whole US economy has lived on credit for nearly 30 years. It has distorted everything. Even the Bowery.”
Credit has seeped into all sectors of the economy. But there are two places where it has wrought the most “growth”: Washington, DC, and New York City. The two biggest borrowers: Washington and Wall Street. The money leaks into all the surrounding counties and boroughs.
Stephen has just published a paper that details an even better way to value the stock market than the Shiller P/E and Tobin’s q. After all, if you’re going to follow the “buy low, sell high” rule, you need to know where high and low actually are.
“Is this market as overvalued as we think?” we asked him.
To bring dear readers back into the picture, our Simplified Trading System (STS) calls for getting out of the stock market and buying gold when the trailing P/E of the S&P 500 goes over 20. And buying back into stocks when it drops below 10.
We asked Stephen to take a look at our system to see if he could improve it.
“The problem is the quality of earnings,” Stephen explained. “If you normalize earnings, the P/E is well over 20… and you should definitely be out of the stock market, if you’re following your rule.
“Earnings are thought to be good things… and on a micro level, of course, they are. So, we don’t look at them too hard. But we should. Because they have to come from somewhere.
“If you have an economy where the typical household has less money to spend than it did 15 years ago, you have to wonder where those additional earnings are coming from.
“This is where it gets interesting…. and it’s why my way of valuing the stock market is better than Tobin’s q or the Shiller P/E. I begin with the value of stocks relative to GDP. This gives you a better picture.
“The earnings of US corporations have never been higher. But GDP growth is running at half the rate of the 1980s and 1990s. Employment is going down. (I don’t mean the employment rate you read about in the newspapers. I mean people with real jobs as a percentage of the population.) And incomes are stagnant.
“Under these circumstances, how is it possible for corporate earnings to rise?”
“Negative Earnings for the Next 10 Years”
As Stephen suspected, we already knew the answer: debt.
“Since 2008, debt has not gone down. It’s gone up,” Stephen continued
“This not the ‘Great Deleveraging’ that it was advertised to be. In 2007, there were a total of $69 trillion of debt-backed securities in the world. Now, the total is $90 trillion.
“This new debt has added a lot of buying power and profits to the economy. But it’s temporary. It’s not normal. And it has to go away when the debt bubble pops.
“Take out the debt-driven sales, and US corporate profits shrink back to normal. But of course, P/E ratios go up because there’s less ‘E.'”
What does that mean for stock investors?
“It probably means negative earnings for the next 10 years.”
We think it might mean something else. Earnings depend on debt. So do stock prices. And so does the economy. It took $21 trillion of extra debt to jack up stock prices to today’s level. If the EZ money were to dry up, the economy and the stock market would be hit hard.
And then?
For nearly 30 years, the message from the Fed to US stock market investors has been the same: We have your backs.
How likely is it that central banks would forsake speculators now?
Not very.
The last two bear markets wiped 40% and 50%, respectively, off the value of the US stock market. Each time, the Fed was quick to react with more cash and credit.
How likely is it now that Janet Yellen will stand aside as the market delivers a bitter correction?
More on that next week…
Regards,
Bill
Further Reading: If Stephen is right, the bull market in US stocks rests on shaky foundations. We strongly urge you to take steps now to protect your gains. To find out exactly how to do that… and also how to position your portfolio to profit as selling momentum builds… read on here.
Did We Just See a Global Interest Rate Hike?
One of the best arguments for more QE from the Fed is the global slowdown we’ve been warning about.
The euro zone is on the brink of its third recession since the global financial crisis. And it hasn’t been able to break out of “stall speed” for the last six years.
Japanese growth has had its ups and downs. But it’s been in the doghouse more or less for the last 24 years.
China – which was supposed to be the “engine” that pulled the global economy out of its post-crisis slump (remember that one?) – has been slowing steadily over the last four years.
Overall, the emerging markets are growing at nowhere near the blistering pace we saw at the start of the new millennium. And some – most notably Brazil and Russia – are flat lining.
And a strong US dollar is set to make an already bad situation worse…
A strong dollar has been the big currency story of 2014.
Investors are piling into the buck because: (1) the US has become a relative bright spot in terms of global economic growth, (2) QE is winding down (at least as advertised by the Fed, and (3) investors expect the Fed to raise interest rates sometime next year.
This means one thing: an effective tightening of global monetary conditions.
As “our man across the pond,” MoneyWeek editor John Stepek, observes:
The dollar is the world’s reserve currency. In other words, it’s the most widely used and most important currency in the world. Cheer or hiss that fact as you see fit – but it’s true. The world needs lots of dollars to do business. So if the dollar gets more expensive, so does doing business.
Put (very) simply, a stronger dollar is like a global interest rate hike.
This has the potential to seriously roil markets. And whether the Fed responds with more QE or not, we recommend you make preparations for a sizable drop in US stock market prices.
The global economy is sliding back toward recession. US share buybacks are slowing. Investor risk appetite is waning. And valuations remain frothy.
For more about what to do, read Bonner & Partners senior analyst Braden Copeland’s special report here.