Dancing On The Edge Of A Cliff
Published on May 1, 2010
As many of our clients have some level of exposure to the stock market, I am writing to all clients to warn of a potential market fall in the near term. I do not pretend to be a great "trader" or "market timer," but several indicators of extreme optimism are converging at the same time that usually accompany important market tops. Put another way...watch out below!
Given the underlying weak fundamentals of the economy and the short-term technical extremes that are present, downside risk is very high in the near term, and investors aggressive and conservative alike should probably consider standing aside in this current environment. Moreover, in the bigger picture, as we are still in the throes of deflation and what we believe is a longer-term bear market, all of the upside progress of the recent past is a bit like dancing on the edge of the cliff--all is fine until it isn't. That does not mean markets cannot continue at present extremes a little longer--but I believe any extension will be short lived and altogether wiped out by a much larger market drop. Bottom line: In my opinion, this is not currently a long-term "buy and hold" market, and investors stand to lose much more than they will gain at current levels. I will touch more on the specifics of my conclusions and the potential risks to those conclusions later in the letter.
That cheery introduction was for those clients who like to read the last chapter first, or would rather get to the destination than view the scenery along the way. For all of the analysts, engineers, and financial nerds out there, we will be discussing principles of risk management, an update on the battle between inflation and deflation, current economic and stock market indicators, and how a good understanding of each of these concepts merits a bearish conclusion in the near term. That is not to say that the bears will be right, but the probabilities are currently stacked in their favor.
A Note on Evaluating Risk vs. Reward
One of the primary foundations of good investing is risk management. Risk management is not the avoidance of risk altogether--as there is no such thing. Your investments (or lack thereof, as I'll discuss below) are always at risk! In the decision to deploy capital in order to achieve income or capital gains, you take on all of the accompanying risks of the underlying investment. In the decision to remain "in cash," you are either making your capital available to your bank for their own trading (for which they may pay you interest on your account or a return on your CD) or you are investing directly in the debt of the U.S. government. Remember, dollars are just debt receipts of the U.S. government.
When you invest your money into other assets, you bear the risk of those other assets--typically, risks that involve the performance and value of the underlying collateral of your investment, whether that be stocks,real estate, commodities, etc. When you "save" your money in terms of U.S.dollars, you bear the risks that face the U.S. debt--typically, the long-term loss of buying power through inflation. Thus, there is no such thing as a "risk-free" investment or the avoidance or risk taking! Ultimately, you always face risk of some sort--it is simply a choice of which risks you wish to bear.
So, back to defining "risk management"... Risk management is not the avoidance of risk altogether, but the skillful pairing of appropriate risk taking with sufficient and realistic return potential. Risk must be matched with sufficient reward.You should make sure that your wealth is positioned such that your probable downside potential is, at a very minimum, matched by your probable upside potential. For example: if you are risking 50% downside to achieve a 10% total return, you are risking too much to achieve your potential gain. If your likely downside is 50% on your investment, then your likely upside should be at least 50%. Risk management done well assumes a return potential that is 150% to 200% of your probable downside (read: 1.5-2 times). Risk must also be matched with realistic return potential.Return potential must be at least as probable as downside risk--and here again,the greater the weighting of probability towards reward, the better.
If everything has to go right for your investment in a specific company or property to work out, this would be a severe mismatch of reward and risk potential and, frankly, a bad investment. Upside potential--no matter how high--does not offset the improbabilities of actually achieving that upside potential. The more variables that must independently succeed to bring about the profitability of an investment, the less probable will be the success of that investment. While it is possible for the investment to succeed, it is not probable --and ignoring the probabilities within the realm of investments is gambling.Gambling is fun, and it sometimes can work out well, but it certainly is not profitable for the vast majority of its participants
So, your wealth is in a constant state of investment in all of its forms (stocks, bonds, real estate, commodities, annuities, cash, CDs,etc). You should consider each aspect of your investment portfolio--and your cash savings!--to determine what risks you face in light of the rewards you are chasing. If you think that you are just avoiding risk altogether in cash, have a brief discussion with someone from Germany (think "Weimar Republic"),Argentina, Iceland, Zimbabwe, or, perhaps, even the U.S., as the U.S. Dollar has lost 33% of its value since 2001. That brings us to the discussion of deflation vs. inflation, which has everything to do with the appropriate positioning of your wealth between cash and paper assets vs. tangible assets.
The Big Picture: Deflation vs. Inflation
I have written to you before to discuss the battle between deflation and inflation and its ultimate impact on the market. As I wrote in August,we are actually in a period where we face both the effects of deflation and inflation at the same time--deflation in the price of non-necessities (retail goods,travel, entertainment, etc.) and general inflation in the price of necessities(such as food, gasoline, utilities, etc.). Ultimately, I believe that deflation will win out initially--and this will have a dramatically negative impact on the stock market, overvalued tangible assets, and the economy in general. (This will be review for those of you who read our latest newsletter that dealt with the definitions and descriptions of both inflation and deflation. Please feel free to contact Susana Dryden, our Director of Client Services, via email at clientservices@jrwinvestments.com or via her extension at (877) 579-1031 ext. 144 if you would like a copy of the last newsletter.)
In summary, the total money supply includes all cash, bank deposits, debts, and outstanding credit lines. In the simplest of terms, this includes the cash in your pockets and in your checking and savings accounts,the mortgage you have on your home, the credit line you have on your house, and the business line of credit for your company. It includes the margin you have on your stocks as well as the debt of other corporations and governments you hold in bonds as an investment. It includes student loans, credit cards, and every other form of cash or debt you can think of. Now, multiply that concept over the population, our government, and all of the businesses that exist and operate within the confines of the U.S. Dollar, and you have a good concept of the total money supply.
When the money supply is increasing through the creation and expansion of additional debt each year, this is inflationary. Remember the fun part of the housing bubble--when it was being inflated with basically unlimited debt and lending? Inflation and deflation are driven by brute supply-and-demand fundamentals. If you increase the total money supply, you reduce each individual unit's value and buying power. That is why prices tend to rise in an inflationary cycle. It is not because the goods of the economy become more valuable; instead, it is because the dollar loses some of its value--and,therefore, more dollars are required to make the same purchase of goods. More money supply also equates to more demand as there are more units of buying power (even though they are reduced in value) chasing the same number of goods.
Picking on the housing bubble a bit more, we experienced an incredible increase of home prices driven by an influx of demand for homes...driven by an influx of buyers who were supported in their efforts to acquire the American dream through cheap debt. More money through debt/mortgages equated to more people able to make a home purchase-- which equated to more demand for a"limited" supply of homes. This large amount of debt created by the banks expanded the money supply and played a large role in reducing the value of the dollar.Moreover, the housing supply wasn't really "limited" until there was increased demand created by the issuance of debt. If you add to the leverage all of the home builder, vendor, supplier, realtor, loan officer, etc. profits, plus all of the home equity lines that were used on the homes, and then add a massive amount of additional leverage used by the banks to gamble that home prices would go up in perpetuity, voila! With the slightest turn in consumer sentiment, enter the housing bust and deflation to ruin the party. Welcome to the other side of the bubble and the mass deleveraging cycle that we call deflation.
Deflation is evidenced by the destruction of the money supply. When the economy is buffeted by mass defaults and foreclosures,bankruptcies and debt write-downs, this decreases the money supply tremendously. Add to that mass credit card limit reductions, credit line closures, bank restrictions on lending and leverage, as well as the widespread unemployment that drives wages down, and you also reduce the growth side of the money supply to be far outstripped by the debt destruction. Going back to supply vs. demand,you have reduced the supply of money for the same number of goods. Therefore,each monetary unit enjoys greater buying power and the number of those monetary units available to chase goods and make purchases is reduced. Therefore,consumer demand for goods drops, causing price decreases in general.
We believe that the deck is stacked in favor of deflation despite the efforts of the government or the Fed to drive inflation for the reasons listed in the next section. Please forgive the length of the next section in advance. We feel that these economic realities deserve some attention, as they are largely being ignored by the mass media.
Macroeconomic Concerns and Those Pesky Deflationary Forces...
Ever wonder why the government can go on a printing,borrowing, and spending spree without causing mass inflation? The short-term reason is quite simple. The rate at which the government is printing,borrowing, and spending is still outpaced by the rate at which the money supply is being reduced through defaults, foreclosures, debt write-downs,bankruptcies, etc. While the following negative economic trends listed below remain, there is no need to fear mass inflation in the near term. However, the real trick is being able to utilize the current distresses in the economy caused by deflation to invest and prepare for the ultimate inflationary forces coming down the road that will be caused by the current attempts to "reinflate" our economy. The delayed reaction to all of the government's inflationary policies will be quite powerful and relatively devastating to the value of paper assets down the road.But, for the short term, it looks like deflation will win out and provide clients one of the greatest investment opportunities of their lifetime across many different sectors and asset classes. So, take a seat, remove all sharp objects,pour a strong drink, and let's sift through some of the major concerns that face our markets... I promise good news on the other side of it all!
1) Consumer spending, which comprises roughly 70% of our economic output and bottom line, will continue to fall. This is very deflationary!
o High unemployment not only reduces the number of people who have enough income to continue spending as before, but it also paralyzes those who remain employed as they fear for their own employment.
o Higher unemployment also drives up the savings rate, meaning that the already-reduced incomes of those who remain employed go more towards savings than towards consumer spending as employees prepare for the worst.
o Wages are decreasing as the competition for employment is increased by the large run employment pool.
o Businesses have reduced employee hours to cut back on overtime and to disqualify employees from receiving costly full-time benefits. This causes the already-reduced wages of employees to go towards paying for those costs once covered by their benefits.
2) Taxes are on the rise on the local, state, and federal levels. Tax increases further reduce anemic consumer spending and create a significant drag to economic growth. As government spending tends to produce zero to a negative net economic benefit, these tax increases have historically produced a deflationary effect.According to extensive study by the current president's head of the Joint Council of Economic Advisors, Christina Romer, tax increases have a negative impact of three times the size of the tax increase.
o In addition to the federal government's current plan to allow taxes to rise significantly next year, state and local governments are facing record budget shortfalls and rapidly attempting to raise taxes to fill in the gaps.
o 46 out of 50 states are facing budget deficits for this fiscal year.
o 38 out of 50 states are now running a negative balance on their state unemployment insurance and are being subsidized by the federal government to pay their extended unemployment claims.
o Taxes are being increased to attempt to offset budget imbalances that are driven by spending programs which have been the life support of the economy. Just as these life supports have run their course, the tax increases necessary to begin paying for them will hit already-hurting consumers, thus reducing their ability to spend all the more.
o State and local pension obligations are severely underfunded, and the recent stock market and housing losses have only exacerbated the shortfall. If those shortfalls are to be filled, either taxes or employee contributions must be increased. Either option reduces current consumer spending and is very deflationary. Option number three is to reduce pension benefits, which reduces spending power for those who depend upon their pension, which is also deflationary.
3) Home prices, which were the primary driver of our growth through the mid 2000s (via consumer spending, which came from debt pulled out from inflated home values),will continue to drop, decreasing net worth and consumer sentiment and increasing pressure on the housing market with more foreclosures, defaults, and write-downs on the horizon. Just as the debt creation that spurred the housing boom was very inflationary, the housing bust and resultant destruction of equity and debt through bankruptcy and foreclosure are very deflationary.
o There is still more than 2 years of supply on the market, nationally speaking, whereas a healthy residential market has fewer than 6 months of supply to support stable or even increasing home prices.
o There is a LARGE wave of potential defaults and foreclosures still to come as many homeowners' loans are resetting throughout 2010 and 2011. Many of these homeowners had very small teaser rate payments that are now ballooning to 2-5 times the teaser rate on homes that are now half the value of what they were worth when they were originally purchased.
o (I am often asked why their rates will be higher if the 10-year treasury, CMT, and LIBOR rates, which are often utilized as benchmarks for rate resets, are so low. The reason is that many of these teaser rates had a minimum spread increase that was much higher than these lower rates, thereby guaranteeing a rate increase that would be at least 150% to 200% higher than the original teaser.)
o Interest rates are at historical lows, and some of the government stimulus that has been used to keep rates low is starting to subside. Even in the midst of incredible stimulus, tax credits, and government spending, the housing indexes have continued to roll over, suggesting that without the life support, the housing market would have been and probably will be much worse.
4) Commercial Real Estate
o Where exactly is the extra $1.4 trillion in debt refinancing needed for commercial real estate in the next 12-18 months coming from? (Hint: "likely from nowhere", resulting in credit write downs, restructures and foreclosures)
o The sublease market for retail, office, and industrial is anywhere from 25-50%below the "market" lease rate. We believe that the sublease market IS reflective of the actual market rate when concessions and vacancy factors are taken into account. This is very negative for those commercial asset classes exposed to tenant rollover in this current market. Simultaneously, this is very positive for those buyers who await the inevitable discounts that these assets face when sellers are forced to dump them via short sale or foreclosure.
o As a side note, hotels are still facing their worst market on record--even worse than that of the Great Depression. This will provide a great buying opportunity over the next few years.
o As for multifamily (apartments), one must secure significant discounts in this market, as the downturn has provided unique risks to this particular asset class. Many people are now moving in with roommates or back in with their parents, which is having a significant negative impact on general market occupancy and demand. Moreover, as more and more homes are abandoned or foreclosed, many of these homes turn into rentals that compete within the multifamily space, thereby driving up supply. Decreasing demand and increasing supply means lower prices and a great opportunity for those who are patient and selective.
5) Geopolitical Risk
o Nothing puts a damper on global trade like trade wars or just old fashioned, regular wars.There are multiple global tensions brewing largely unnoticed by the general public:
o Ecuador's oil grab
o Iran's nuclear development
o N. Korea's nuclear development
o China's currency disputes
o China's global commodity grab
o Israel vs. Hezbollah
o Russia's astern bloc power grab
o Portugal, Ireland, Iceland, and Greece vs. theEU
o U.S. vs. Taliban
Stock Market Indicators at an Extreme
If the last section does not have you considering a well-timed exit of stocks at their current levels after a mere 70% rebound rally, then perhaps picking on the stock market directly will put you over the edge. This next section is in honor of the super financial nerds and engineers who can't get enough technical analysis. If you have mistakenly made it this far expecting a fascinating read, I apologize! The bottom line is that major stock indicators point to the fact that we will probably reach a very important market top in the next couple of months...and that the major direction of the market over the next few years is to the downside. For those who want the details...
Technical indications that we are at or near an important top in the stock market:
1) The price-to-earnings ratio is pricing in a full recovery of earnings by next year to pre-recession levels and is sitting 30% above long-term historical norms. Do you really expect the economy to be running like it was back in 2007 by next year?
2) The Dow's dividend yield is 2.5%. Given the fact that the only market tops of the past 100 years at which the dividend yield was lower were in 2000 (at 1.4%) and 2007 (at 2.1%), we are certainly in dangerously overvalued territory. Even at the 1929 market high before the Great Depression, the dividend yield was at 2.9%.
3) Lagging upside momentum accompanying increased prices (a sign of stock market exhaustion).
4) Lagging NYSE 10-day volume (a sign of fewer buyers driving the rally).
5) An eight-week average of insiders' sell-to-buy ratio of 4.18-to-1, nearly as high as it was in July 2007 (near the all-time peak).
6) Nearly 10-year extreme in the equity put/call ratio. (Calls were about 3 to 1 to puts,indicating a very large and extended bullish bias, with little downside protection--this begets panic selling if equities go down.)
7) A Daily Sentiment Index (trade-futures.com) of 92% bulls is equal to the most extreme level of optimism in nearly 3 years (basically, a general consensus that the market will continue going up with very little divergent bias).
8) A level of weekly buying climaxes that ranks in the top ten over the past 20 years.
9) There have been multiple major bullish magazine covers (pop culture is a contrary indicator).
10) A bearish minority in the Investors Intelligence Advisors Survey that rivals the lowest extreme in nearly 23 years (i.e., extreme low readings of bearish sentiment, indicating that most everyone thinks the only direction is "up" for the market).
11) 30-day NYSE TRIN hovering near .90 (measure of volatility within advancing vs. declining equities).
12) The VIX (which measures volatility) is at extreme lows in the mid teens.
13) Mutual fund managers are sporting some of the lowest cash levels of recent years,indicating an overly bullish expectation of non-stop progress, and also removing a great deal of future buying power from the market (as that money has already been spent).
By no means do these indicators guarantee a near-term downturn, but they certainly point in that direction. The deck is stacked against a perpetual stock market rise that ignores long-established historical norms and an eventual regression towards the mean. This could be the one time in history when the markets do not regress to their long-term valuations, but are you willing to bet your wealth on it?
The probable downside is about 650 to 700 on the S&P and about 6500 on the Dow. Given the stretched nature of the current stock market rally and its current valuations, long-term probable return expectations are between -6% and 2.8%. So, probable downside is basically 30-40% and historical upside, at best, is roughly 3%. That perfectly defines a bad risk-to-reward relationship unless you are shorting the market to profit from its potential fall.
The Good News, Which I Promised
The good news is that for those of you who are prepared, we will be undergoing one of the greatest investment opportunities of our lifetime, now and throughout the next few years. Should the powerful forces of deflation prevail in the next few years, assets across the board will undergo significant discounts if they have not been reduced already. As we have been for the past 2+ years, we advise clients to deploy capital slowly throughout the ongoing downturn. There will be many opportunities along the way. The goals for the next few years should be principal protection over reward chasing, broad and patient diversification, and careful selection of unique individual investment offerings along the way.
We wish you all success in each of your investment endeavors. As always, we are happy to be of assistance as you evaluate investment opportunities and attempt to position yourself to succeed in this current market environment. If you would like to set up an appointment with us along those lines, or if you have any particular questions about this letter or other related topics, please feel free to contact me via email at jungerecht@jrwinvestments.com or on my office line at (877) 564-1031 ext. 112. If you would like one of my past newsletters or PowerPoints, feel free to contact Susana Dryden, our Director of Client Services, atclientservices@jrwinvestments.com or at her office extension of 144.
Best Regards,
Joshua Ungerecht
CEO and Chief Investment Officer