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
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.
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.
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).
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.
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.
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
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 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.
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.
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.
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.”
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.
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.
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.
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.
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.
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.
The total amount of Mortgage debt in the US is $8.74 trillion. The average person who has a mortgage owes $173,995.
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.
I previously wrote about how this time is not different how there are systemic problems with the US economy and the economy at large. I wrote how there is the economic equivalent of faulty wiring in a building. You don’t know exactly when the building is going to burn down but it is only a matter of time.
One of the three main reasons why an economic conflagration is on the horizon and why it makes sense to start preparing now through alternative investments is the real economy is weak.
There are a variety of metrics that show the real economy is weak. I’d like to look at two: labor force participation and stagnant wages.
Labor Force Participation is Down
I don’t like looking at the unemployment rate for two reasons. 1) If people give up looking for work then that lowers the unemployment rate 2) If people lose one full time job but then get two part time jobs that counts as a net job gain, even though the person might be working lower paying jobs outside of their previous field.
The labor force participation rate is by no means perfect either, but it is in my view a more useful metric in today’s economy.
The civilian labor force participation rate is at a level not seen since the 1970s.
And no, it’s not because the baby boomers are retiring. The labor force participation rate amongst those 64 and older has been steadily climbing even as the the labor force participation rate at large has been declining.
The civilian labor force participation rate amongst those in their prime working years, 24-54, has not regained the levels seen before the great recession nor the dot com bubble, despite rising steadily for decades, it’s been trending down since the peak in the late 90s.
Not only are a smaller percentage of people are in the workforce but those that are working face stagnant wages. According to a PEW Research study, when adjusted for inflation wages have barely budged since the 60s.
However, I’m sure that the inflation adjustments used understate the rate of price inflation. If that is the case then real wages have actually fallen.
Fewer People are Working and They are Getting Paid Less
In summary the real economy is weak. A smaller percentage of people are working and they are getting paid less. The labor force participation rate is on par with levels from the 70s and at best people are not making any additional money and quite possibly making less money on average than in decades past, depending on how much trust you have in the official price inflation numbers.
On top of these factors debt has increased dramatically at the Federal, State, and personal levels. More on that next week.
This is not a consequence free environment. The real economic weakness in the US economy is one of the reasons I think that the US economy (and probably global economy) is due for a large correction. It might not happen this year or even next year, but such a correction is long overdue and it makes sense to take some basic precautions through alternative investments.
More on that in the coming weeks.
The S&P 500 is currently in the longest period EVER without a 3% correction. The unemployment rate in the US is just 4%.
The S&P 500 is at all time highs–far surpassing the dot-com bubble and the housing bubble.
Is this the new normal? Is Federal Reserve Chair Janet Yellen right that we won’t see another crisis in her lifetime? Is there even a need for alternative investments when the stock market continues to soar?
Yes, now more than ever.
Faulty Wiring in the Economic House
Let’s say you live in an apartment building you’ve discovered has faulty wiring. You know there is a very good chance it will catch fire and burn to the ground.
Would you continue to go about your business and just hope the apartment building doesn’t burn down?
Or would you do something about it?
Unfortunately most people, if they even know about the risks, ignore them or simply choose not to do anything about them. When the fire starts they will get cooked.
But you don’t have to be one of those people
You can choose to do something about it
We can’t know exactly when but there are plenty of good reasons to believe the US economy is going to undergo an economic firestorm in the future.
Throughout US economy there is the financial equivalent to faulty wiring that will eventually cause an economic conflagration.
You can certainly point to more but here are three of the faulty wirings in the economy:
- The real economy is weak
- Debt at the Federal, State, and Personal levels are un-repayable
- Reckless Central Bank Actions have created a massive bubble in stock and bond markets
Despite all the doom and gloom there are plenty of things you can do to ensure you’re financially safe.
Do Something About It
The wiring in the building needs to be torn out, but landlords aren’t willing to go through the pain, cost and inconvenience of rewiring. All the while the problems get worse.
They’d much rather put on a new coat of paint and pretend like everything is fine.
But you can choose to position yourself so that when the building does burn down, you and your possessions won’t be incinerated.
Similarly, the powers that be in government are too entrenched and committed to maintaining the status quo as long as possible. They have continually demonstrated they are not going to take proactive steps to solve any of these economic problems (and after all they in large part the cause of the problems).
The government will only act when it has no other choice. In other words the government will only act once the crisis has hit and it is too late.
In the coming days I’ll be discussing these three categories of faulty economic wiring: a weak real economy, unrepayable debt and the stock and bond bubble.
Not only that I’ll be sharing actionable strategies through alternative investments to grow and protect your wealth.
It’s not about doom and gloom or prepping for the magnetic poles of the earth to reverse and cause gravity to invert.
It’s just about taking some practical steps in light of the very real and system risks present in the financial system.