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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.

The Real Economy is Weak

The Real Economy is Weak

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.

Source: https://fred.stlouisfed.org/series/CIVPART

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.

Source: https://fred.stlouisfed.org/series/LNU01375379

Source: https://fred.stlouisfed.org/series/LNU01300060

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.

Stagnant Wages

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.

Source: http://www.pewresearch.org/fact-tank/2014/10/09/for-most-workers-real-wages-have-barely-budged-for-decades/

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.

Red October

Red October

A few weeks ago on the 20th of September the United States Federal Reserve announced it would begin unwinding it’s $4.5 trillion balance sheet starting in October. The Federal Reserve undertook unprecedented action in the wake of the 2008-2009 financial crisis when it expanded it’s balance sheet from $900 billion to as high as $4.5 trillion in order to buy worthless mortgage backed securities and other assets that no one else would–as well as government bonds.

As the Fed unwinds it’s balance sheet by selling assets and not rolling over existing assets, the money supply in circulation will shrink.

If the money supply shrinks will the value of the S&P 500 as well?

So why does this matter? Well, as pointed out at the beginning of the year over at Benzinga.com, the S&P 500 is 97% correlated with the Adjusted Monetary Base. As the Adjusted Monetary Base goes up, so does the S&P 500, as the Adjusted Monetary Base goes down, the S&P 500 goes down.

The Adjusted Monetary Base is the sum of currency (including coin) in circulation outside Federal Reserve Banks and the U.S. Treasury, plus deposits held by depository institutions at Federal Reserve Banks.

Source: https://fred.stlouisfed.org/series/BASE

So the by reducing it’s balance sheet, the Fed will lower the Adjusted Monetary Base and thus the S&P 500 would experience downward pressure.

But that isn’t the only headwind.

Reduction in Share Buybacks

The Federal Reserve lowered interest rates to near zero for almost seven years. Low interest rates means it’s less expensive to borrow money. A lot of companies have taken advantage of these low interest rates to issue bonds (a way of borrowing money) at low interest rates and then used the proceeds not to invest in people, factories, or equipment, research and development or other business growing endeavors, but instead to use the borrowed money to buy back their own shares.

Source: http://www.marketwatch.com/story/sp-500-companies-slash-share-buybacks-despite-record-cash-levels-2017-06-21

Bond issues increases the debt companies have on their balance sheets, but also boosts their share prices, even when the companies aren’t performing any better. An example Simon Black of Sovereign Man uses is Exxon Mobil. Exxon is #4 on the Fortune 500.

In 2006, the last full year before the Federal Reserve started any monetary shenanigans, Exxon reported $365 billion in revenue, profit (net income) of nearly $40 billion and free cash flow (i.e. the money that’s available to pay out to shareholders) of $33.8 billion. 

At the time, the company had $6.6 billion in debt. 

Ten years later, Exxon’s full-year 2016 revenue was $226 billion, net income was $7.8 billion, free cash flow was $5.9 billion and the company had an unbelievable debt level of $28.9 billion. 

In other words, compared to its performance in 2006, Exxon’s 2016 revenue dropped nearly 40%, due to the decline in oil prices. 

Plus its profits and free cash flow collapsed by more than 80%. And debt skyrocketed by over 4x.

Source: sovereignman.com

Exxon Mobil is just one example. There are a variety of other blue chip stocks with shares prices that are higher despite lower profits and higher debt.

Share buybacks have declined in 2017. While the trend looks to continue upwards, rising interest rates will make it more expensive for companies to issue bonds and use the proceeds to buy back stock.

Source: http://www.marketwatch.com/story/sp-500-companies-slash-share-buybacks-despite-record-cash-levels-2017-06-21

Headwinds

Despite the article image and title I certainly don’t know that October will see the stock market dip into the red. It would make sense if it did, but the S&P 500 continues to make new highs in spite of the Federal Reserve tightening, lackluster GDP growth and saber rattling from both North Korea and the United States.

But it is another headwind.

At some point there will be a stock market correction. That is simply how markets work since the advent of central banking and hence the business cycle. It has take much longer than I expected for there to be a correction. I didn’t believe that President Barrack Obama would leave office without seeing a stock market crash, but he did.

But markets have been on a steady climb since early 2009 and the bull market is looking long in the tooth. The S&P 500 could continue to rise for the foreseeable future, but with this new headwind of balance sheet reduction in addition to interest rate hikes, it might be time to take some dollars off the table and pivot some assets into alternative opportunities.

Trumpty Dumpty

Trumpty Dumpty

Article image above is by Chloe Cushman

Humpty Dumpty sat on a wall,
Humpty Dumpty had a great fall.
All the king’s horses and all the king’s men
Couldn’t put Humpty together again.

Denslow’s Humpty Dumpty

Back in February of 2016 Candidate Donald J. Trump stated, “I hope I’m wrong, but I think we’re in a big, fat, juicy bubble.”

Source: https://www.cnbc.com/2016/02/08/trump-markets-in-a-big-fat-juicy-bubble.html

In the first presidential debate in September of 2016 Trump stated the US economy is, “in a big, fat, ugly bubble.”

He also presciently said that when Obama returns to the golf course (did Obama ever leave the golf course?) that the U.S. Federal Reserve would raise interest rates.

Source: http://www.businessinsider.com/we-are-in-a-bubble-trump-debate-attacks-federal-reserve-chair-yellen-2016-9

Candidate Trump seemed to have some understanding that U.S. Stocks and Bonds are in a Bubble.

So President Trump should be concerned that the bubble is going to pop on his watch. But he seems to have pivoted to taking credit for the stock market just a few weeks after his election.

“We’re doing really well. The fake news media doesn’t like talking about the economy. I never see anything about the stock market” setting new records every day, he said.

Source: https://www.cnbc.com/2017/02/16/donald-trump-tweets-that-hes-the-reason-the-stock-market-is-rallying.html

I don’t know that Trump listens to any of his advisors, but if he did and I was one of his advisors, I’d encourage him to distance himself from the stock market.

Why?

President Obama got the advantage of the stock market high induced by low interest rate monetary heroin, and Trump is likely going to have to cope with the inevitable stock market crash and withdrawal.

President Trump is a Humpty Dumpty, perched upon the top of a stock market bubble, which is about to collapse.

President Obama had just 2 rate hikes over 8 years

President Obama began his presidency going into a time when the US Federal Reserve was providing extremely accommodative monetary policy. He then had near zero interest rates for the first 2,521 days of his presidency (just one month shy of 7 years out of 8) then the Fed Funds rate was hiked once for his last year.

Technically it was hiked a second time, but only for the last month he was in office and after Trump had won the election.

Effectively, rates were only hiked once in 8 years.

Rates have been hiked 3 times since Trump was elected

If you count the last rate hike during the Obama presidency, Obama had two rate hikes. If you consider the second hike during Obama’s Presidency was just 37 days before he would vacate the White House, he really only saw one rate hike.

Within 54 days of Trump’s inauguration the Fed raised rates from 0.50–0.75% range to the 0.75-1.00% range. Within 145 days of Trump’s inauguration, rates increased again to the 1.00-1.25% range. So Trump has began his presidency going into less accommodative monetary policy and has already seen 2 hikes during his presidency and 3 since he was elected.

Setting Trump up for a Fall

Virtually no one who lives inside the Washington, D.C. beltway likes Trump. The established powers in Washington hate Trump. The leaders in Trump’s own party hate him.

Trump’s whole presidency was based on spitting in the face of the established powers in the Imperial City of Washington, D.C.

Fed Chair Janet Yellen is a Democrat appointed by Obama and she was criticized by Candidate Trump during the campaign–if she is like virtually everyone else in the Imperial City then she can’t stand Trump.

Artificially low interest rates that are manipulated down by the US Federal Reserve and other central banks cause asset values to become artificially inflated in a bubble. President Obama received the “benefit” of these artificially low interest rates: the economy was able to limp along and the stock market continued to rise as valuations were artificially inflated by the cheap money.

In order for the US Federal Reserve to normalizes interest rates they need to pop the asset bubble they’ve created. I don’t know if the Fed realizes they’ve created a bubble, but if they do, then popping it on Trump’s watch would be ideal from their perspective.

What better way to get Trump out of office than to raise interest rates, pop the stock market bubble which would result in a recession and then ensure that President Trump is not reelected?

In the Machiavellian world of short term political expediency, Trump would do well to distance himself from the markets and put pressure on the fed to retain a more accommodative policy. It will make the problems worse but it will delay the pain. It’s certainly not the right thing to do but it’s what Presidents have been doing for decades.

Obama’s Sweetheart Deal

Obama’s Sweetheart Deal

Former President Barrack Obama had many advantages in his presidency. He had the vast majority of the media firmly behind him, a sense of inevitability, support from the establishment, strong support from higher education institutions and he ran against weak candidates.

One of his greatest advantages was the unprecedentedly low interest rates throughout his eight years in office.

In fact no President has ever had lower rates for longer.

As President Obama was fond of reminding folks: America was recovering from the worst economic crisis since the great depression. His defenders can point to the fact that rates were that low because they needed to be.

Before we go Any Further

Now before I go any further, I want to make two points. One, the United States President does very little to impact how the US economy fairs.

In my opinion the President has more power than he should have but less than people realize. The President gets blamed when the economy is doing poor and gets credit when it is doing well. But it’s all unwarranted.

The second point is that artificially low interest rates are destructive. They cause bubbles and the ensuing financial crises. The 2000 dot com bust, the 2008-2009 financial crises were caused by a number of factors, but one large and consistent factor was artificially low interest rates set by the U.S Federal Reserve. Interest rates should be determined via a market based price discovery system not by the soviet style central planners occupying the Eccles Building.

The Obama Presidency was marked by the Lowest Interest Rates Ever

It’s almost comical how tightly low interest rates corresponded with the Obama Presidency. After he was elected, but before he took office the US Federal Reserve lowered interest rates to 0.25%. The lowest they have ever been.

Artificially low interest rates do in the short term provide an economic high similar to the short term euphoric feeling narcotics are reported to produce. But in the long term they are incredibly destructive to an economy.

But politicians either don’t understand this or simply don’t care and want to goose the economy so they can get re-elected. More likely both.

The US Fed Funds rate during Obama’s Presidency were the lowest ever for the longest ever

Now the Fed (probably by design to at least have the superficial appearance of impartiality) can point to the fact that they began raising interest rates in November of 2015. They also raised rates a second time in the 8 years of Obama’s reign on Dec 14, 2016, after Donald J. Trump won the presidential election.

In other words, leading up to and for nearly the first 7 years (2,521 days) of Obama’s presidency, the Fed Funds rate was set at 0.00-0.25%. For roughly the next year they were set at 0.25-0.50%. Then about a month after Trump’s election, for the last month of Obama’s presidency, interest rates were raised to 0.50–0.75%.

This is the most accommodative monetary policy the United States has ever had. This low interest rate policy began to be withdrawn as Obama prepared to vacate his residency at the White House.

Practically speaking rates were only hiked once in 8 years.

(Source: https://en.wikipedia.org/wiki/History_of_Federal_Open_Market_Committee_actions#cite_note-FOMC-15)

The Political Nature of the U.S. Federal Reserve

Democratic President Barrack Obama nominated Democratic party member Janet Yellen as US Federal Reserve Chairwoman

Despite the ridiculous and hollow rhetoric that the US Federal Reserve is impartial, it is a political institution that is integrated within the Federal Government.

Like all Federal Reserve Chairmen (or in this case Chairwoman) Janet Yellen was nominated by the President and confirmed by the Senate. Janet Yellen is a member of the Democratic party and was nominated by the de facto leader of the Democratic party.

Is a rational person really supposed to believe that Janet Yellen (or any other Fed Chair) who is a member of a political party, who is nominated by the leader of a political party, suddenly becomes a completely impartial overseer of the economy?

Of course not.

Obama got the High

The key takeaway is that the Obama administration was supported by an ultra-loose monetary policy that provided a strong tailwind for stock prices albeit at the expense of the real economy. A stock and bond bubble was also re-inflated.

The Fed has reversed gears and has begun a tightening cycle.

Obama was very fortunate to have gotten out of office before the next Federal Reserve fueled economic crisis hits. The economy is even weaker than it was before the great recession of 2008-2009.

Obama was the Fed’s sweetheart but he’s no longer in the office. So the Fed might not be as motivated to keep the bubble inflated and the charade going.

This is doubly true because Obama’s successor is universally despised. The powers that be would love to remove Trump from office and prevent him finishing out his first term, but at a minimum they will work to ensure he never sees a second term.

One way to do that is to crash the economy while Trump is president and hang the blame around his neck.

More on that in another article.