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Where to Put Money when the Stock Market is Overheated

Where to Put Money when the Stock Market is Overheated

Over the past few weeks I’ve been writing about the faulty wiring in the United States economy that will eventually result in an Economic Conflagration.

The faulty wiring that will ultimately lead to this economic firestorm includes the fact that the real economy is weak, the economy is crushed by profligate debt and that stocks are overpriced and due for a significant crash.

One of the reasons why candidates such as Bernie Sanders and Donald Trump were popular in the last United States presidential primary and general election is because people know that the real economy is weak. They know how much debt they have and they want someone to make radical changes and do something about it.

Unfortunately government has never been particularly good at creating wealth or prosperity.

Some people might choose to rely on politicians to fix things. This website is not for those people. HowIGrowMyWealth.com is for people who want to take some common sense steps to grow and protect their wealth.

Given the faulty wiring the economy it is more important than ever to grow and protect one’s wealth. It might take a while but this faulty wiring will eventually result in a fire that will burn uncontrollably.

I realize this isn’t necessarily very cheery stuff but fear not! There is plenty of room for optimism.

I’m not a doomsday “prepper” or perma-bear and I’m sure that entrepreneurs, if free to do so, will rebuild the economy and usher in greater prosperity that will not be funneled to the politically connected.

I’m also cognizant that the stock market has gone up nearly 300% since the great recession, there hasn’t been hyperinflation in consumer prices and on the surface the crisis seems to have passed long ago. I don’t have a crystal ball and being right early sometimes looks like being wrong.

Despite the relative calm there is faulty wiring in the economy and sooner or later it will spark and ignite blaze that will, to quote Peter Schiff, “will make the financial crisis of 2008 look like a Sunday school picnic.”

The politicians, if they even realize that there are systemic problems in the economy, simply aren’t willing to endure the short term pain and inconvenience of ripping out the faulty wiring in order to fix the underlying problems. So they will continue to kick the can until the economic house burns down.

The bright side is that this will present an opportunity to rebuild the economy based on a strong foundation as opposed to what we have now, a phony economy based on debt, cheap money and consumption.

There will be winner and losers. I’m very optimistic about the future and I want to be counted amongst the winners.

So where am I putting my money?

My asset allocation falls into three main areas. Value stocks, gold and cash.

Value Stocks

Most people love buying things on sale and getting a great deal, expect when it comes to investing. When it comes to investing people want to buy expensive things and hope they go higher. Value investing takes that same common sense, buying things when they’re on sale and applies it to stocks and other asset classes.

The stock market as a whole is overvalued by a variety of metrics. But there are still good deals out there especially in non-US markets. I don’t doubt that value stocks will also go down in the event of a stock market crash but I think they will go down less and they will recover with more strength.

I could write entire articles on value stocks and I have. I’ve written about the value investing metrics I use when evaluating a stock and I also have my own value stock picks based on these metrics.

I share my value stock picks publicly. But I only share if I would buy them today or if I would hold or add to my positions with members of my free email newsletter. I will also let me email subscribers know when I buy or sell a stock first, before I publish that information to this website.

Gold

I don’t think you will get rich buying gold but it could prevent you from getting poor. Under relatively normal circumstances the demand for gold is fairly steady and the supply is fairly steady so for the most part the price of gold will rise with the level of inflation.

Gold is a way to save purchasing power. It’s a way to opt out of the financial system and wait for sanity to return.

If the dollar tanks loses it’s reserve currency status gold will still be valued.

I also think there has been significant effort to suppress the price of gold and depending on how much downward price manipulation there really has been, the price of gold could go up significantly from where it is right now.

If fiat currencies collapse that could very well induce a flight to the safe haven asset of gold that this influx of demand would be very bullish for gold.

Because of the absurd expansion in central bank balance sheets and artificially low interest rates I like gold presents a fantastic value at current prices.

What I write about gold applies to silver–another asset I think will do very well in a downturn. Silver has the added benefit of being an industrial metal that is more widely consumed.

Cash

Long term, like every other fiat currency, I think the dollar will go to zero. So why would I want to hold dollars?

First, I own a month or two of expenses in physical cash in a secure location in case there are capital controls. If there is a panic and people start withdrawing money from the banks the banks might in turn say, you can only withdraw $500 a week or something like that. Withdrawal limits could also be imposed if the US implements negative interest rates and people (very rationally) decide it is better to hold dollars in physical cash so they don’t have to pay interest to their bank for the privilege of loaning their money to the bank.

I reside in the United States and everything is priced in dollars so I need dollars to buy things. If I lived in the eurozone I would hold pounds or euros, if I lived in China I would hold Yuan. If I lived in the socialist paradise of Venezuela I would probably hold dollars (and try to get out).

Secondly, apart from physical cash I also hold dollars in a money market fund as a war chest. If stocks tank I expect there will be bargains to be had. I want to be buying stocks (if they are high quality free cashflow producing companies) when everyone is panicking and selling.

Now I fully expect the United States Federal Reserve to do what it has done in all other crises it has created–it will lower interest rates and buy assets to prop up the markets.

With interest rates already low once they cut rates to zero they will only be able to do things like Quantitative Easing and Negative rates. This is very bearish for the dollar and very bullish for gold.

But in the highly unlikely chance the US Federal Reserve does the right thing and lets the stock market collapse and lets the US government default on it’s debts this could be very bullish for the dollar. So holding some dollars is a hedge against deflation as well as a war chest to draw upon to buy undervalued stocks post crash.

What are some other possibilities?

While the bulk of my holdings are in cash, value stocks and precious metals I also dabble in some other alternative investments.

Cryptocurrencies

I’ve been a skeptic of cryptocurrencies for many years. I’ve also owned them for many years.

If there is a dollar crisis or collapse in the faith of central bankers then more people could turn to cryptocurrencies and could see it rise. Demand for cryptocurrencies could also rise for other reasons pushing the price upwards.

While I think blockchain technology is here to stay the value of any one specific cryptocurrency or token could very easily tank to nothing. Cryptocurrencies are very risky and 90% swings (both directions) happen.

You need to have an iron stomach but having between 1-5% of your liquid net work in cryptocurrencies isn’t the most outlandish idea in the world.

I would only speculate on cryptocurrencies with what you can afford to lose and I don’t considering buying cryptocurrencies investing in a technical sense since I am simply betting on the price going up.

I’ve shared with my readers my Group of Six cryptocurrencies that I’ve chosen to own and speculate on.

Options

Net I’ve actually lost money trading options. I traded options while unemployed and failed to remain dispassionate and objective. I was so focused on making money that I opened positions when the conditions were not ideal and took risks I should not have been taking.

I do believe if you are disciplined and follow the appropriate rules, you can do well trading options.

During a stock market crash volatility spikes and selling options could be a good strategy. When the VIX (a volatility index) spiked up in early February I sold a few options and those positions are doing well as volatility has dropped and the market has recovered. Markets don’t move straight up or down for very long so even if the February selloff portends drops to come, the market doesn’t drop as fast as people think in the midst of the drop.

Real Estate

Unlike all the other assets mentioned above I do not and never have owned any real estate.

Lots of people have made lots of money in real estate. I am working to learn more about this asset class and hope to own my own rental property at some point.

What I like about real estate is that it is easy to use leverage and the tax benefits are ridiculous. You can effectively pay no tax on investment property income and borrow a lot of the money you need to get started.

You of course need to know what you’re doing.

My goals for owning real estate involve owning a multi-family apartment building. The key for me is a cashflow positive property. I don’t have any interest in trying to buy and flip, although some people are very successful doing this. There are lots of ways to make money in real estate and I recommend biggerpockets.com to learn about them.

I think cashflow positive real estate will do okay in the event of a crash. If you’re in an area that has stable employment prospects those workers will always need a place to live and have the money to pay for it. Of course real estate won’t “always go up” and there are a lot of risks and headaches associated with managing property (if you don’t outsource property management).

This is part 5 of 5 of what I’ve decided to term The Economic Conflagration series where I discuss the faulty wiring pervasive the global economy:

Part 1: A Deadly Electrical Fire you Need to Know About
Part 2: The Real Economy is Weak
Part 3: Crushing Debt in the United States Limits Economic Growth
Part 4: Stocks are Overpriced and Due for a Significant Crash
Part 5: Where to Put Money when the Stock Market is Overheated

Stocks are Overpriced and Due for a Significant Crash

Despite the pullback over the past few trading days, the S&P 500 is still far beyond the highs during the dot-com bubble and subsequent bust as well as the housing bubble and subsequent great recession.

If the fundamentals supported the S&P 500 at these elevated prices it would be great but the fundamentals do not…these elevated stock prices are one of the faulty wirings running through the global economy.

Up until the last few trading days, using the Shiller PE ratio*, there has only been one time in the history of the S&P 500 when the Price to Earnings level was higher, and that is the peak of the dot-com bubble.

*Price earnings ratio is based on average inflation-adjusted earnings from the previous 10 years, known as the Cyclically Adjusted PE Ratio (CAPE Ratio), Shiller PE Ratio, or PE 10

Source: http://www.multpl.com/shiller-pe/

While imperfect (I tried in vain to find a Price to Free Cashflow chart for the S&P 500), the price to earnings ratio is essentially how much a stock (or in this case the S&P 500 index) costs relative to it’s earnings. A lower PE is better because it means you are paying less for a stream of income.

Price to book is another metric we can look at and the price to book ratio of the S&P 500 is at a level not seen since the 2008 financial crisis.

Source: http://www.multpl.com/s-p-500-price-to-book

Netflix: A Specific Example

I want to pick on Netflix as an example of an overvalued stock.

One of the most important metrics for evaluating a company is free cash flow. Earnings can be a little suspect because of accounting gimmicky but it is tough to hide free cash flow numbers. It’s one of my value investing metrics.

Netflix (NFLX) has not had positive free cash flow since twenty-thirteen. In 2016 the free cash flow was in excess of negative $1.5 billion and the trailing twelve month free cash flow amounts to over negative $2 billion.

Source: http://financials.morningstar.com/cash-flow/cf.html?t=NFLX&region=usa&culture=en-US

So they are bleeding money and yet as you can see from the chart above, apart from this last week Netflix stock continues to climb.

What is Causing the Stock Market to Rise?

The United States Federal Reserve has bought bonds to lower interest rates and has also bought other toxic assets (like mortgage backed securities “backed” by mortgages that had defaulted).

In the wake of the 2008 financial crisis the Federal Reserve balance sheet has swollen to over $4 trillion. The chart below shows the Fed’s balance sheet in millions of millions (aka trillion).

Source: https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm

This has driven down bond yields and driven up bond prices.

This makes it cheaper to borrow money to buy stocks. It also forces income focused investors to forsake bonds (which have little to negative real yield) and instead pour money into dividend paying stocks.

Companies can also issue bonds at lower rates, and use the proceeds to buy back their own stock.

Source: https://www.wsj.com/articles/companies-stock-buybacks-help-buoy-the-market-1410823441
Source: https://www.reuters.com/investigates/special-report/usa-buybacks-cannibalized/
Source: https://www.wsj.com/articles/buybacks-pump-up-stock-rally-1468363826

The Stock Market is Overvalued

Stocks are overvalued and as bubbly as can be due to reckless US Federal Reserve monetary policy. Last Thursday the 8th the stock market closed in correction territory. It rallied back Friday.

I don’t know if this is the start of a larger selloff into a full on bear market or if this will be contained to a correction.

Since the lows of the 2008-2009 financial crisis there have been several corrections and even a 22% drop in 2011. Those were in an ultra accommodative monetary environment and not in a tightening cycle.

This probably *should* be the start of a bear market but the bulls and the Fed might be able to bid the market back up as they have several times before.

I don’t recommend trying to short the market or (if you own stocks) sell. If you know how to time the market I want to get advice from you because I don’t know how to time the markets.

I do know that stocks are overvalued and due for a correction. If the Fed does step in to prop up the markets it will be more negative news for the dollar. The Fed also doesn’t have much room to cut rates and would either have to sit by and do nothing (unlikely) or restart quantitative easing and negative rates.

This should be positive for foreign value stocks and precious metals. From the lows in 2009 the S&P 500 is up 293%. Even if you bought the S&P 500 at the peak of the 2008-2009 bubble you’d be up 80%. The dollar hasn’t tanked so dollar denominated stocks have been a winner. However, if prices and fundamentals mean something, eventually stocks will correct or the dollar will implode. When that happens it will be critical to your financial survival to have alternative investments in place.

This is part 4 of 5 of what I’ve decided to term The Economic Conflagration series where I discuss the faulty wiring pervasive the global economy:

Part 1: A Deadly Electrical Fire you Need to Know About
Part 2: The Real Economy is Weak
Part 3: Crushing Debt in the United States Limits Economic Growth
Part 4: Stocks are Overpriced and Due for a Significant Crash
Part 5: What you can do about it

Part 5 will be release in the coming weeks. Subscribe below to ensure you don’t miss it.

Dow Drops 4.6% as Volatility Skyrockets

Dow Drops 4.6% as Volatility Skyrockets

Today the Dow Jones Industrial Average dropped 4.6% and went negative for the year.

Investor’s Business Daily summarizes the pullback very well:

“The Dow Jones industrial average fell by 1,175 points on the stock market today, plunging nearly 1,600 points at session lows. Those were the worst one-day and intraday point losses ever for the blue-chip index, something trumpeted across most financial media.” -Investor’s Business Daily

Source: https://www.investors.com/news/dow-suffers-worst-point-drop-ever-but-percentage-loss-not-historic/

However, as Investor’s went on to point out, in percentage terms this is hardly historic.

The real question in my mind is, “does this mark the beginning of a larger selloff?” The Dow was also down on Groundhog Day, that is Friday the 2nd. So this marks two days of declines, with today’s selloff being even larger.

Volatility is Back

Volatility in the market has spiked tremendously as measured by the Chicago Board Options Exchange Volatility Index (VIX). You have to go back to 2015 to see volatility this high.

For all I know the market will stabilize tomorrow or the next day, but it is interesting to me that volatility, which as you can see had been declining for the past two years, is now back in the market.

Gold Stable

Gold was flat/slightly up today.

Cryptocurrencies Continue to Tank

Cryptocurrencies continue to tank. Bitcoin is trading around $7,000 (down from the December 2017 highs of $20,000). Ethereum is down to $700 (from the the January highs of nearly $1,400). Other cryptocurrencies have sold off similarly in the past few months but actually rallied modestly as the Dow and other stock indices sold off today.

Crushing Debt in the United States Limits Economic Growth

Crushing Debt in the United States Limits Economic Growth

There is faulty wiring running throughout the US economy and economy at large. Previously I wrote about how the real economy is weak, pointing to stagnant wages and a low labor force participation rate.

Today I’m going to talk about how debt at the federal, state and personal levels are unrepayable.

Debt at the Federal Level is Unrepayable

As of 1 February 2018 total public debt outstanding is $20,494,566,890,206.07.

Source: https://www.treasurydirect.gov/NP/debt/current

Not only is this debt impossible to repay but it continues to grow with little chance that this spending will subside until it has to.

According the United States Congressional Budget office the US Federal Government brought in $3.3 trillion in taxes in 2016. The US Federal Government spent $3.9 trillion.

But the vast majority of expenses was in areas that simply will not be cut.

The United States spent $910 billion on Social Security, $588 billion on Medicare, $368 billion on Medicaid, and another $563 billion on other mandatory spending which includes items such as Federal employee retirement programs, SNAP (food stamps) and Veteran’s Benefits. So total “Mandatory” spending was $2.4 trillion. These are the kinds of programs that will never be voluntarily cut by any congress and in the case of Social Security and Medicare, will only go up in cost as more people retire.

Not only that, once you factor in interest on the $241 billion in net interest paid on the national debt (another item that congress won’t cut because it would tank the credit rating of the United States) total spending rises over $2.6 trillion. Considering congress keeps borrowing and that interest rates are rising these borrowing costs will only continue to rise.

This leaves $630 billion left to spend.

But $584 billion goes to the military. Which leaves $36 billion left. However in 2016 the US Federal Government spent an additional $600 billion in discretionary money.

Source: https://www.cbo.gov/sites/default/files/115th-congress-2017-2018/graphic/52408-budgetoverall.pdf

The red team politicians will never cut defense spending (the blues realistically won’t either).

Neither side is interested in cutting social safety net programs either like Medicaid or SNAP.

Neither side will cut Social Security or Medicare.

There a Fiscal Crisis on the Horizon

The $20.49 trillion in “Total Public Debt Outstanding” does not include unfunded Social Security and Medicare obligations.

The 2017 Social Security and Medicare Boards of Trustees report has again stated that these programs are underfunded. “The Trustees project that the combined trust funds will be depleted in 2034, the same year projected in last year’s report.”

https://www.ssa.gov/OACT/TRSUM/index.html

The Trustees cite an increase in baby boomer retirees drawing Social Security and Medicare and fewer workers paying into the system.

How will the United States Federal government make up the difference between the benefits promised to be paid out and a depleted “fund”? In reality there is no “fund” and the money from payroll taxes goes into the general budget. Lawmakers only have a few options to “save” Social Security and Medicare: some combination of raising taxes and lowering benefits (either by raising the retirement age or reducing the monetary value of benefits paid out). That is of course unless people start having a lot more kids who in turn have jobs and pay into the system.

The last option, which is really a way of lowering benefits in a dishonest way, is simply borrowing and or “printing” the money to pay the benefits.

But these expenses incurred in 2016 don’t include a multi-billion dollar bailout of some kind, funding a new war or some other large, unforeseen expense. So what would happen to the Federal debt if one of these events occurred?

Debt at the federal level will continue to climb.

Debt at the State Level is Unrepayable

I grew up and lived in Illinois for most of my life. It is just about the most indebted state in the United States, surpassed only by New Jersey.

Illinois only had enough revenue to cover 96% of expenses in 2015. The Illinois government is more than capable of overspending in any circumstance, but the revenue shortfall continues to be exacerbated by the state population decline. A total of 114,144 residents moved out of the state in 2016 and new residents plus births could not offset this exodus. The result was the count of Illinois residents dropping by 37,508 people in 2016.


Source: http://www.chicagotribune.com/news/local/breaking/ct-illinois-population-decline-met-20161220-story.html

Despite this Illinois remains the 5th most populous state in the US and the fact that the fifth most populous state is in such a bad financial position does not bode well.

Source: https://www.mercatus.org/statefiscalrankings

While Illinois can issue debt and for some reason their debt continues to be purchased, their financial risk means the cost of borrowing is high and without a central bank they aren’t able to drive down the cost of borrowing or print currency. Not that those strategies work in the long term, but they don’t have those tools to delay the pain.

I choose to single out Illinois since they spent years of my hard earned tax dollars so recklessly but many other states are in bad shape as well.

Overall state pensions are underfunded by a total of between $1 trillion to $4.3 trillion depending on how well you think the pensions will perform.

Source: https://www.mercatus.org/publication/underfunded-pensions-expanding-and-escalating-challenge

Despite years of economic “recovery” since the 2008-2009 financial crisis these problems have only gotten worse. With this “recovery” getting long in the tooth, what will happen when the economy officially slips back into a recession?

Debt at the Personal Level is Unrepayable

Student Loan Debt

Some of the most indebted people in the United States are also some of the least capable of repaying it. I’m talking about former college students. According to Lendedu.com there are over 45 million individuals in the US with student loan debt. The default rate is 11.5%.

A study by Nerdwallet.com indicated the average person with student loan debt owes $46,597 with a total owed of $1.36 trillion.

Source: https://www.nerdwallet.com/blog/average-credit-card-debt-household/

So there are 45 million people in the US that have a considerable amount of student loan debt.

These are these are the same people who will presumably have to shoulder the burden of the $20 trillion debt and accept delaying retirement or paying more in taxes to pay for baby boomer’s retirement and medical cost.

Auto Loan Debt

US consumers owed $1.21 trillion in auto loans in 2017. Unlike student loans (in which theoretically you borrow money to increase your purchasing power for the rest of your life) or mortgages used to buy a house (which can theoretically go up in value), auto loan debts are taken out on an asset that rapidly depreciates.

On average a person in the US with this kind of debt owes $27,669.

Source: https://www.nerdwallet.com/blog/average-credit-card-debt-household/

Credit Card Debt

While I am sympathetic to people who have to use a credit card to pay for the basics of life such as food or utilities–credit card debt is a horrible form of debt.

Credit cards are primary used to consume and they carry high interest rates. If you need to use a credit card to pay for something it is likely that you will not be able to pay for it later when it effectively costs more due to the credit card interest.

In 2017 individuals in the US owed $905 billion in credit card debt. Households with credit card debt owed $15,654.

Source: https://www.nerdwallet.com/blog/average-credit-card-debt-household/

Mortgage Debt

The total amount of Mortgage debt in the US is $8.74 trillion. The average person who has a mortgage owes $173,995.

Source: https://www.nerdwallet.com/blog/average-credit-card-debt-household/

While housing can go up in price, it is not guaranteed to do so, as many people learned in 2008.

With many Americans burdened with debt and without savings the only way they can purchase a house is to borrow the money. As interest rates rise the cost of a mortgage will increase and therefore people will not be able to borrow as much, the result is that housing prices must fall.

Why Does this Debt Matter?

Debt, specifically debt to consume, does not grow the economy. It is a drag on the economy. The amount of debt in the United States will eventually crush the US economy.

Lets assume for a moment that consumption grows the economy even though it does not. If a debtor pays back the loan that means that is money that goes towards the person who loaned the money and not towards buying goods and service. Thus a person is not able to buy as much in the future when they are servicing a debt, all else equal. So even if consumption did grow the economy consumer debt can only pull consumption into the present at the expense of future consumption.

What does grow the economy is capital investment in machinery, tools, training and other technology that make the economy more efficient and allow the production of more goods and services. If there are more goods and services prices will fall and this allows people to buy more goods and services. If it takes less materiel and labor to make something those people and materials can go to work in other or new areas of the economy that they would not otherwise be free to do so.

With wages stagnant and labor force participation rates at decade lows that does not bode well for Americans to be able to repay these debts.

Another problem is that the person borrowing the money might not be able to repay it, in which case the person who loaned the money will have to take a loss. This does not benefit the economy either.

The massive amount of Federal, State and Personal debt in the United States is a huge drag on the economy and is one of the biggest problems or “faulty wirings” that is coursing through the US economy.

My next article will be about one of the last main areas of faulty wiring in the US economic house: an overvalued stock market.

I’m not all doom and gloom. Far from it. I think there are tremendous opportunities to grow and protect your wealth through alternative investments.