Tattered Flags

Where is that old and tattered “Crash Alert” flag? Many times since the start of the rally in US stocks in 2009, we hoisted it. And many times has it failed to give us a useful signal.

But we will bring it out again, if a bit sheepishly… and let it wave, in the warm Argentine air. Why? Do we know a crash is coming? No, of course not. Is our flag a good indicator of what will happen? Apparently not.

 

Caribbean_reef_shark_1

Photo via Wikimedia Commons

 

But we regard it like the “Shark Alert” flags you see on the beaches of Australia. (Down Under is the only country in the world to have a chief of state who was eaten by a shark.)

The “Shark Alert” flag doesn’t mean you can’t go swimming. It means if a shark takes a bite out of you, it’s your own damned fault.

 

flagwarningsystemWhen it comes to shark alerts, a white flag is actually not a good sign. A little aside on sharks: on the South African coast, there are not only plenty of white sharks, but also Zambezi sharks (better known as “bull sharks” elsewhere), which are actually far more dangerous to humans. The Zambezi’s specialty are attacks in murky water and it also swims up freshwater rivers – so if the sea is in turmoil and visibility in the water is poor, it is best to stay away (and one should definitely never enter the water near the mouths of rivers). The problem with this shark is that it will often attack in just knee-deep water, so it isn’t even safe to just wade in a little bit. Many of the disappearances and deaths that are popularly attributed to crocodiles in Africa are very likely actually due to Zambezi shark attacks.

 

Nutty Valuations

Why are we raising the flag again now? Economist and fund manager John Hussman, of Hussman Funds, explains:

 

“Last week, the CAPE ratio of the S&P 500 Index surpassed 27, versus a historical norm of just 15 prior to the late-1990s market bubble. [The CAPE ratio – also known as the Shiller P/E ratio – looks at inflation-adjusted earnings over a 10-year period to control for cyclicality in earnings.]

The S&P 500 price-revenue ratio surpassed 1.8, versus a pre-bubble norm of just 0.8. On a wide range of historically reliable measures (having a nearly 90% correlation with actual subsequent S&P 500 total returns), we estimate current valuations to be fully 118% above levels associated with historically normal subsequent returns in stocks.

Advisory bullishness (Investors Intelligence) shot to 59.5%, compared with only 14.1% bears – one of the most lopsided sentiment extremes on record. The S&P 500 registered a record high after an advancing half-cycle since 2009 that is historically long-in-the-tooth and already exceeds the valuation peaks set at every cyclical extreme in history but 2000 on the S&P 500 (across all stocks, current median price-earnings, price-revenue and enterprise value-EBITDA multiples already exceed the 2000 extreme).”

 

The water is full of sharks, in other words. And that’s why this is the best time to get out of the market in the next eight years, says Hussman. Over that time, he says, the likely return from a balanced portfolio of stocks and bonds is zero.

So nutty are US stock market valuations (in light of the economic situation) that SocGen equity strategist Albert Edwards is afraid he may be going bonkers too:

 

“We are at that stage in the cycle where I begin to doubt my own sanity. I’ve been here before though and know full well how this story ends and it doesn’t involve me being detained in a mental health establishment (usually).

The downturn in US profits is accelerating. And it is not just an energy or US dollar phenomenon – a broad swathe of US economic data has disappointed in February.

One of the positive surprises, payrolls, is a lagging indicator. The $64,000 question is not if, but rather when will investors realize what is going on?”

 

SP-and-PE10The inflation-adjusted S&P Composite since 1870 and the P/E 10 (or CAPE for “cyclically adjusted P/E ratio”). The current level of valuation is nearly at the 95th percentile of the entire history of valuations (in terms of the median stock, it is at the highest ever). Only the peak of 1929 and the tech bubble peak of 2000 saw a higher P/E 10 – click to enlarge.

 

Out of the Box

Previously, we looked at something so counter-intuitive… so contrarian… and so out of the box that many readers thought the craziness must have gotten to us. They urged us to get back into the box as soon as possible. But one of the advantages of being in Argentina, so cut off from civilization, is that we can’t find the box. We are largely out of touch with the news and cut off from popular opinion.

On a typical day, we rise at 7 a.m., chat with the farm manager, eat breakfast outside in the sunny courtyard… and settle into our work. We read a few headlines and stories on our computer. (Yes, we have solar power and a satellite Internet connection.) Then we read more… and answer correspondence. We have lunch. We read some more and we sit down to write.

Then when we are tired of sitting, at 5 p.m., we saddle up a horse and go for a ride. The ride usually takes a couple of hours – simply because it takes so long to get anywhere. Yesterday, we rode up the riverbed toward the old stone mill. A sluice brought water down from an irrigation canal and used it to turn a stone-grinding wheel.

We’ve spent time studying its primitive technology. And we pray civilization will not collapse: We don’t think we could ever figure out how to make it work again. The ride was gloriously beautiful – through huge clumps of pampas grass, across the marshes, up the side of the hill, along a stone wall that led to the mill. A few white puffs of clouds flew across an otherwise pure blue sky; yellow flowers covered the hillsides.

 

Retail money funds as percent of market capRetail money market fund holdings as a percentage of US stock market capitalization have never been lower. As can be seen above, this is a kind of “early warning” indicator – whenever it dips into “excessive optimism” territory, the market usually still has 2 to 4 years of bull market ahead of it before it crashes and burns – click to enlarge.

 

Why the Rich Get Richer …

Having cleared our head, we returned to our thoughts. Lately, we have been thinking about how we – and almost everyone else – misjudged the potential inflationary effects of central bank policies (ZIRP and QE). As we mentioned yesterday, central banks are not really “printing money.” Nor are they really stimulating the economy.

Instead, they are putting credit on sale. Yesterday, Chris provided some detail on how US corporations are using this cheap credit to buy back their own shares. February set a new record for share buybacks. US corporations spent a staggering $5 billion a day on their own shares. That brings the tally to $2 trillion since the bottom in US stocks in 2009 – or about 10% of the total value of the S&P 500.

This is the effect of cheap credit: It gooses up asset prices. It encourages speculation and quick-buck gambling. It does not raise consumer prices or help the real economy. Instead, the rich get richer – because assets go up in price. And the poor get poorer – because real investment, the kind that produces jobs and incomes, goes down.

Curiously, even former Fed chairman Alan Greenspan, now at liberty to speak the truth, said so. “The single biggest problem in our economy,” according to Greenspan, “is a lack of real capital investment.”

 

20150115-stock-buybacksThe pro-cyclical nature of stock buybacks: corporate managers are buying back almost nothing when stock prices are low, and indulge in record buybacks when prices are in nosebleed territory. This is however the exact opposite of their personal buying and selling behavior: insider sales have rocketed higher concurrently with buybacks – click to enlarge.

 

Cash Will Be King

Instead of the kind of patient, sensible, capital investment that we would see in a genuine boom, the Fed’s EZ money policies encourage bubbles. Hussman:

 

“When investor preferences are risk seeking, overly loose monetary policy can have a disastrous effect by promoting reckless speculation and enhancing the ability of low-quality borrowers to issue debt to yield-starved investors.

This encourages malinvestment and financial distortions that then collapse, as we saw following the tech and housing bubbles. Those seeds have now been sown for the third time in 15 years.”

 

All bubbles burst. They burst whether the Fed is raising rates or lowering them. And all bubbles burst in a way that destroys credit but raises up the value of cash. This is the curious phenomenon that almost nobody but us sees coming…

The Fed pumps up the monetary base – made up of commercial banks’ reserve accounts at the Fed plus physical currency circulating in the economy – to about $4 trillion. But instead of a falling dollar, the greenback becomes so valuable that people cannot live without it. Cash will be king. Emperor. Rock star. And Oscar winner. Briefly…

 

cash_kingMeet the once and future emperor

 

Image captions by PT

 

Charts by: Doug Short/Advisorperspectives, S&P Capital IQ/zerohedge, sentimentrader

The above article is taken from the Diary of a Rogue Economist originally written for Bonner & Partners. Bill Bonner founded Agora, Inc in 1978. It has since grown into one of the largest independent newsletter publishing companies in the world. He has also written three New York Times bestselling books, Financial Reckoning Day, Empire of Debt and Mobs, Messiahs and Markets.

 

 

 

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One Response to “Get Ready for a “Zero Returns” World …”

  • Crysangle:

    “When investor preferences are risk seeking” (disfavoured political class searching to buy votes) ” overly loose monetary policy can have a disastrous effect by promoting reckless speculation ” (state enterprise, credit , legislation etc.) ” and enhancing the ability of low-quality borrowers ” (the state) ” to issue debt to yield-starved investors” (the public) .

    What happens when cash becomes so valuable within a country that the state has to, but cannot, get its hands on enough ?

    What is the true proportion of government spending to actual productive GDP ?

    What does it look like when it turns out the economy is actually the state , and that it has pawned every asset at inflated values ?

    What effect does that have on the value of its cash outside of its system , when all new print is understood to only support its existence ?

    I don’t pretend that it will necessarily come to the above , but it is worth bearing in mind also.

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