How did everything get expensive when reported inflation is low?

Many have been bewildered by the stock and bond markets over the past year.  This includes Nobel Prize winning economist and Yale Professor Robert Shiller who has recently been quoted as stating that the stock market, the bond market and the real estate market all seem “overpriced and expensive”.  He says he is puzzled by the phenomenon and uses the analogy of “lifeboats on the Titanic” where people are willing to pay almost any price for protection from a bad future.

Most investors have been taught that a “balanced” portfolio includes a significant portion (30-50%) invested in “fixed income” because they are told that “bonds make money or maintain their value when stocks lose money” and “bonds protect you from market fluctuations”. This is called negative “correlation”.  This teaching is not entirely correct.

Many times, bond rise in value when stocks are rising and fall in value at the same time stocks drop.  This is called positive “correlation”.  Keep in mind that bonds rise in value as interest rates fall, and vice versa: bonds fall in value as interest rates rise. (Interest rates are at historic lows meaning bond prices have risen to high levels.)

In fact, since 1927, we have had 27 periods where stock and bond correlations have shifted from negative to positive or positive to negative correlation.  Most recently, interest rates have fallen with rising bond prices right along with rising stock prices.  So both the stock market and the bond market seem to many to be overpriced and “expensive”.  In the investment world, the term “expensive” means that if you bought at present prices, your return from interest or stock appreciation would be lower than normal… OR….that prices are likely to fall from present levels.

Despite the claims by many that “markets have a lot of room to run” I think that Professor has a point.  Asset prices in general have risen quite a bit. (Home prices in the “hot” markets have risen despite the lag in other markets.)  Yet, economic conditions, while admittedly improving slowly, are far from “boom times” that would justify a rising stock market.  And, there appears to be a general sense of pessimism regarding the future by the majority of people in the developed world.

I would say that in the aggregate, people have bought the argument that wage inflation and inflation in general is subdued.  Investors are seeking income. And, when income is hard to find, they are willing to pay a premium price to get it…..high prices for bonds and high prices for stocks.  The only restraint on this behavior is fear of loss, but central banks around the world have committed publically to “do what it takes” to protect investors from losses. So, if many people buy in to the myth that inflation will be low for a long time and therefore interest rates will be low for a long time, they will pay ever increasing prices and inflate the value of every form of investment: stocks, bonds, real estate, art, and collectibles. (With low interest rates the present time value of money received in the future is higher than when interest rates are assumed to be higher.) With the exception of single family homes outside of the hot coastal markets, Professor Shiller is right, everything has gotten “expensive” except the price of an hour of human labor and an outdated plasma TV.

A balanced portfolio should have a significant portion invested in low risk investments to balance the higher risks associated with stocks.  Right now, as evidenced by the behavior of some of the world’s best money managers, that low risk investment is very short term fixed income that pays almost no interest, but does not fluctuate in value. Right now, bonds seem almost as risky as stocks. Warren Buffet’s Berkshire Hathaway currently holds almost 20% of their assets in cash!

Has this situation existed before? Can History teach us anything regarding what is about to happen? The answer is Yes and No.  People believe in myths until the myths are proven false. Remember in the 1990’s when tech stocks did not need to be profitable, they just needed to be growing?  Remember up until 2008, residential home prices could never fall?  Remember Y2K when all our computers were sure to crash at the same instant! Right now, the myth is that Central Banks can provide protection from loss by flooding markets with liquidity and that they can do so forever without creating inflation.

 

Professor Shiller is correct, we have had significant inflation in price levels.of stocks, bonds and some real estate. So, can somehow the Central Banks keep interest rates low forever?   And, if not, then when do markets abandon this myth, leading to higher wages, rising inflation, and rising interest rates---all of which will lead to lower stock and bond prices.

(My belief is that governments and Central Banks have a very limited ability in the long run to affect the economy in a positive way. They cannot control interest rates anymore than they can control currency values. Central Banks have proven throughout history that they do have one ability—to create inflation.)

By now, you should understand why market watchers sit on the edge of their seats to listen and react to every word from Janet Yellen of the U.S. Fed and every other worldwide Central Banker. The present situation is dependent on continued low interest rates and continued belief that there is little chance of loss.  It will change when one of four things happen:  1) It appears the Central Banks are going to “allow” interest rate to rise; 2) Market participants begin demanding higher interest because of higher costs; 3) Some geo-political “shock” occurs that causes investors to fear loss; and/or 4) Corporate earnings begin to fall or stagnate and investors decide to take profits, en masse to avoid losses from falling stock values.

My take is that “official” inflation is reported to be low because wages are depressed. I think Central Banks are focusing too much on the costs of labor and commodities—indicators of past cost-push inflation.  They are underemphasizing other costs of doing business. I think corporations are reaching the limits of their ability to borrow and buyback shares in order to report increased earnings per share simply by reducing shares rather than actually increasing profits. I think that rising prices will occur due to the desire and need of public companies to increase profits and these rising prices will lead to a reduction in demand. I think we are already seeing this to some degree as evidenced by struggling retailers.

You see, the average consumer is smart enough to avoid paying too high a price for goods. (Even though they may occasionally be willing to pay too high a price for an investment!)  Sooner or later, I think the market corrects with falling stock and bond prices, providing opportunity to buy attractive businesses at more attractive prices.

When exactly?  NOBODY knows. Markets could rise significantly higher from here. Be patient, careful and prudent.

Don’t assume that the above analysis means I am pessimistic. I am not. I believe that a well managed investment portfolio will produce returns over the long run consistent with historical norms. Markets fluctuate from one extreme to another. Being “well managed” does not mean that we jump in and out—it means we simply adapt to the environment in the same way we adapt and adjust to the changing seasons.

Did the Economy really Grow by 4%? (More like 1.2%)

The story of the last year has been “mixed” signals where many investors have chosen to focus on the good while explaining away the bad.  Hope has overcome fear and markets in the aggregate have moved up.  This is not to say that all stocks rose. My post in May indicated a lot of volatility with many stocks falling by more than 20%. This trend continues into July. While averages have risen, many individual stocks have fallen significantly. (There has already been a form of “rolling” correction by stock and segment.) The problem with the past few years is that everyone is attempting to predict an outcome without admitting that the economic environment is so unusual and extraordinary that outcomes are unknown and unpredictable:

A)  There has never been any period in history where a credit bubble has been followed by prolonged global monetary stimulus with artificially low interest rates—for years. What happens when the stimulus ends and interest rates rise? Answer: Nobody knows.

B)  There has never been any period in history where labor force participation has declined significantly. What happens when the baby boomers have all retired and residential construction becomes a permanently smaller part of the economy? Answer: Nobody knows.

The US economy, as measured by GDP declined by 2.1% in the first quarter of 2014.  (Many choose, myself excluded, to explain this as simply the result of a bad winter.)  The economy in the second quarter is reported to have grown by 4%. But, 1.3% of this increase can be attributed to building inventory. So in the first half of 2014, the economy really only grew by 4% minus 1.3%, minus 2.1% or 0.6%. That is only 1.2% per year growth—not a recession, but not a booming or even an accelerating economy either.

Employment is increasing. Wages are increasing. (Corporations have reached the end of increasing profits by simply cutting employees.)  Yet, the Federal Reserve claims that there is still a lot of “slack” in employment, justifying more stimulus and near zero short term interest rates. The largest effects so far from the stimulus appears to be higher stock prices, more “financial engineering” by corporations, and more cars being sold. These effects are likely to evaporate as soon as the stimulus is withdrawn. Continued stimulus may not eliminate the “slack” in employment markets—it may simply overheat the demand for employees that are presently working, resulting is rising wages and accelerating inflation.  Accelerating inflation will lead to rising interest rates.

The Fed is correct to be careful about withdrawing stimulus too fast. Governments will have a very hard time raising taxes enough to cover higher interest rate costs on bloated government debt.  And, astonishingly, 30% of the people in the US are “in collection” meaning they are technically behind in paying off debts.  Nobody knows the short term effects of allowing interest rates to rise in such an environment.

Corporate earnings are beating estimates on an Earnings Per Share basis.  But, much of this is because of reduced estimates and financial engineering--share buy backs that reduce the number of shares.  Earnings are really not up by much—just there are fewer shares.  Then, if you “normalize” interest rates, corporate earnings would actually be lower by almost 10%.

Given so much uncertainty, it seems foolish to be certain of the near and medium term future.  It has been said, there is the unknown (what we know we do not know) but also the unknown, unknown (what we do not know we do not know). In times like these, it pays to be prudent and cautious.

I think it unwise to join the group who thinks the world economy is “accelerating” in rate of growth. I also think it unwise to be overly pessimistic about the long term. The evidence I see seems to indicate a high probability of steady but very slow growth over the next few years but with an “adjustment” in the short term as we digest the reality of rising costs and interest rates.  When that adjustment is coming is the unknown. What exactly will trigger the onset is the unknown-unknown. 

                                

Be patient, careful and prudent. 

New Book. Restoration: God's Plan for America

Been working on this book on and off for more than two years. Finally was able to finish over this winter.

If you are even a little concerned about the direction of our great country, it might be an interesting read.

Click on the links for more info.

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When Foolish Greed is Expensive

For quite some time I have been writing that speculators were creating a high risk situation for certain segments of the market. I have also consistently warned that chasing the “hot” stock is a sure way of losing money.

Well, the ‘correction’ in many of these previously hot stocks has recently taken place. Here’s some examples of declines from the high this quarter in just the last few weeks:

FireEye              69.5%

Twitter                46.5

Athena Health    46.0

BioMarin            30.0

NetFlix               27.9

SalesForce        22.7

Amazon             22.5

FaceBook          20.8

Tesla                 20.8

 

These losers are all multi-Billion dollar companies. They are not small caps.  These huge % declines occurred during a period when the general market rose slightly and high quality stocks beat the market.

Last post I wrote “Speculators have a tendency to move like a herd, when they exit, usually they all panic and exit at once.” Certainly looks like they all tried to get out of the above “hot” stocks at the same time. Those that bought in the last few months learned that greed is usually a foolish and expensive indulgence.

The good news is that declines in the above listed stocks did not affect WS Wealth Manager’s clients to any significant degree—most WS portfolios performed quite well. The bad news is that much of the money that came out of these stocks is now in the higher quality value stocks and shorter term fixed income securities that long term investors do and should own.

In the aggregate, markets are presently priced based on the assumption that poor economic performance in the last two quarters was due to bad weather.  This is an assumption and not a fact.  If the assumption is wrong and the economy continues to perform below expectations, there will likely be a correction. (Something we have not seen in two years.) But nobody knows for sure because the assumption is based on the future and very uncertain behavior of the global consumer.  We all hope that things are getting better, but hope is not a sound basis for making investment decisions.

So, we still have a lot of uncertainty and therefore still what I perceive as a somewhat dangerous market. Buy, Sell or Hold?  As frustrating as it can be, Hold and caution still seems the prudent course of action for retired or close to retirement investors.

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

Paradox of Uncertainty and Fed "Politics"

Janet Yellen, in her first public speech since becoming the Fed Chair, today expressed concern about the hardships of the unemployed and under-employed, and said the U.S. economy remains "considerably short" of the Fed's goals of maximum sustainable employment and stable inflation at 2 percent.

The "scars from the Great Recession remain, and reaching our goals will take time," she told about 1,100 people gathered at a downtown convention center in Chicago. "The recovery still feels like a recession to many Americans, and it also looks that way in some economic statistics."

One must ask the question, If the 'recovery still feels like a recession' to many, then why are people bidding stock prices upward? And, how much longer can that upward trend continue?


These are unanswered questions.


On thing appears to be certain. The first Liberal Democrat to be Fed Chairman in many years sounds quite political and seems to be willing to spend considerable public resources to lower unemployment levels beyond what many feel is prudent, even at the risk of higher than desired inflation. Obama himself probably could have given a similar speech. No mention of the devastating effect that low interest rates have on retirees who need fixed income from their savings.


The paradox of the current market is that many speculators feel the Fed is wrong. The stock market speculators are betting that the economy is improving much faster than the Fed believes.  


Whichever of the two are correct, it appears that we are likely to see a steeper yield curve with rising long term rates.  This would, in fact, indicate an improving economy, but also a harbinger of inflation and a stock market correction in response to increased buying of fixed income investments. 


The speculators aim to ride the market up and get out before it drops. A significant number of them will probably guess wrong and lose money.


Times like these dictate a bit of caution.

Options Expiration Dates Still Important

As I have indicated in the past, presently markets are heavily influenced by speculators. One of the most important tools used by speculators are options. And, options expire worthless after certain dates creating a lot of volatility.

The situation has not changed. Markets rose up until the days just after options expiration in January. That is exactly the same as what is happening today on 2/24/2014. (It is a clear sign that the market is dominated by speculators.)

But after reaching all time highs in January, market indexes fell by nearly 7% over the next two weeks. One cannot predict with certainty that the pattern will repeat, but it is important to remember that the markets are ignoring a lot of bad economic news.

It appears that speculators are still following the same “logic” that they have followed for a year: A) In a good economy, rising interest rates won’t matter and/or; B) In a poor economy, the Fed will continue or even expand its stimulus. I call this the “you can’t lose” belief.

History teaches that when a significant part of the market adopts this “you can’t lose” belief, it is a sign that there are very few buyers left and a market correction will likely come soon. It is particularly dangerous when those that believe the “you can’t lose” story are speculators. Speculators have a tendency to move like a herd, when they exit, usually they all panic and exit at once.  

Like all of history’s lessons, they are not right 100% of the time. And, the “soon” does not always mean next week, next month, or even next year.

So, we still have a lot of uncertainty and therefore what I perceive as a dangerous market. Buy, Sell or Hold?  As frustrating as it can be, Hold and caution still seems the prudent course of action for retired or close to retirement investors.

 

Stalemate....

Sometimes Mr. Market is depressed. Sometimes he is euphoric. And sometimes he is just downright confused.

I’ve warned in the past December that most stocks seemed to be a bit overvalued.  Come January 21, we saw a bit of a pullback. In fact, by February 3, we saw a drop of nearly 6%, both in domestic and international stock prices. 

Keep in mind that “markets” are made up of millions of investors but these millions can be placed into five major groups: Speculators, Institutional, Not Yet Retired Domestic Individuals, Retired Domestic Individuals, and Non-US Individuals. Each of these groups reacted a bit differently to the pullback.

All of the three groups of “Individuals” decided that the pullback was just the beginning of something worse and many sold off—so much that nearly $30 Billion was pulled out of equity mutual funds and ETF’s. To put this into perspective, flows into equity mutual funds in 2013 totaled about $130 Billion.  So $30 Billion out in only two weeks is a significant wave of selling.

Speculators, and Institutional Investors still confident that a “Buy the Little Dip” program would be successful (As it was in 2013) decided that 6% was enough for a “buying opportunity” and markets have recovered nearly half of the recent drop. Even bad economic news did not hold them back. No matter what bad news they hear, they seem to excuse it away……  It’s the weather. Or, some parts of the terrible employment report are good.  If it really is bad, then the Fed will step in and fix it. Since there are no other alternatives for making money thru investing, they convince themselves that the stock market must be on its way up. Keep in mind this is all “wishful thinking” and quite dangerous.

The truth….nobody is quite sure what, in fact, the near term future holds. The economy has been improving, but very slowly and only with the most massive global monetary stimulus experiment ever attempted.  And, the Fed is slowly unwinding that stimulus with the “Taper”.

So who is right..the pessimistic individuals or the optimistic risk taking hedge fund speculators and institutional investors?  Only time will tell for sure, but if you are part of the Retired Domestic Individuals Group, reasonable caution should be the order of the day.  Stay with a conservative asset allocation. (Not too hot and not too cold) and be particularly cautious with any excess cash.  If the speculators are right, you may miss some of the upside, but if they are wrong, you will have protected your nest egg. Sometimes doing nothing is exactly the right thing to do.

Keep in mind that speculators will exit the markets very quickly and “en masse” when they decide that “momentum” has turned to the downside. The longer we go without a healthy 10% correction, the more likely it will be larger than 10%. Remember the saying “Be fearful when others are greedy”. Well not everybody is now greedy, but a significant number are. So perhaps the appropriate saying for now is “Be careful when speculators are feeling greedy”. It is hard to make money in these types of market conditions but history teaches that it easy to lose money in times like these.

My best guess, markets will fluctuate and it is better than 50/50% that we will see better buying opportunities sooner than later.  Be patient and think long term---like 5 to 10 years out.

 

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.