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Why This Correction Will Likely Lead To Another Painful Bear Market

Back in May I wrote a post arguing that the record-high levels of margin debt should make investors more cautious. Basically, there is compelling evidence to suggest that margin debt is a very good indicator of long-term fear and greed in the stock market.

When margin debt is relatively high it signals that greed is predominantly driving stock prices. Conversely, when margin debt is relatively low it indicates that fear is the predominant factor. If an investor believes it’s wise to ‘be fearful when others are greedy and greedy when others are fearful,’ as Warren Buffett suggests, then it’s probably going to be hard to find a better indicator for long-term investors looking to do so.

This also makes perfect sense from an economic viewpoint. Relatively high levels of margin debt suggest there is little potential demand left for equities and plenty of potential supply to pressure prices lower. Conversely, relatively low levels of margin debt suggest there is little potential supply and plenty of potential demand to pressure prices higher. And, in fact, this is exactly how margin debt has worked its magic on stock prices over the past 20 years.

One of the most valuable ways I have found to view margin debt levels is in relation to overall economic activity. The chart below shows that when margin debt has approached 3% of GDP in the past it’s usually been a good signal that greed has gotten out of hand. Back in April this measure hit a new record. Screen Shot 2015-08-31 at 10.13.45 AMThe reason I find this measure so valuable is that it is highly negatively correlated to 3-year returns in the stock market. When margin debt relative to the economy has gotten very high, 3-year returns have been very poor and vice versa. Right now this measure suggests the coming 3 years in the stock market could be very similar to the last two bear markets we witnessed in 2001-2002 and 2007-2008 after margin debt reached similar levels in relation to the economy.

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What’s more, in the past, when stocks’ 12-month rate-of-change has turned negative it’s usually triggered a significant reduction of margin debt. In other words, once the stock market starts declining over a year’s time record levels of margin debt, which functioned as demand to push prices higher in the past, start to become supply, which pushes prices lower going forward. This is how the last two bear markets began.Screen Shot 2015-08-31 at 10.42.30 AM

Now the stock market only needs to rise by about 3/4 of a percent today in order to maintain a positive 12-month rate-of-change. On the other hand, the longer the current correction in stocks continues the likelier we are to see it evolve into a longer-term bear market, as the massive amount of margin debt stops working in the favor of all of these “greedy” speculators and begins to work against them and they start to become more “fearful.”

And if the past couple of full market cycles are any guide, the potential supply coming to market in this scenario could make the next bear market another very painful one, at least for those who ignore the crystal clear message of margin debt relative to the economy.

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A Brief @Twitter Timeline Of My 11-Month Correction Beard

Late last September I made a vow:

I had been making the case here and on Twitter that the bull market was long in the tooth and there were many signs that could be waning.

At the same time, stocks, which normally have a 10% correction once per year, hadn’t had one since 2011.

Within days my wife sent me this:

But, in just 3 weeks after my initial pledge the stock market fell about 9%…

…until the Fed came to the rescue:

Then the Santa Claus rally took over.

E*Trade called me out, on my birthday, no less.

Then the heat on the beard intensified.

As the stock market made new highs, the beard trolling got pretty loud.

And as the beard grew longer and longer, the media began to take note…

…as did the most creative of technicians.

Then this past Monday the market finally cracked.

To be clear…

…I was just trying to make a point…

…and have a bit of fun in the process.

Mission accomplished.

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Druck Backs Up The Truck And Loads Up On Gold

Back in April I wrote a post titled, “how to trade like Stan Druckenmiller, George Soros and Jim Rogers.” It centered on a quote from Druck that really gets at the key to his incredible success in the markets:

The first thing I heard when I got in the business, not from my mentor, was bulls make money, bears make money, and pigs get slaughtered. I’m here to tell you I was a pig. And I strongly believe the only way to make long-term returns in our business that are superior is by being a pig. I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept everywhere. And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that’s kind of the way my philosophy evolved, which was if you see – only maybe one or two times a year do you see something that really, really excites you… The mistake I’d say 98% of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully. -Stan Druckenmiller

The way Druck generated 30% average annual returns over a period of decades was by being a pig, by putting all his eggs in one basket and watching it very carefully. Considering he may be the most successful money manager alive, you may be curious to learn what Druck is buying today.

Well, you’re in luck! Druck’s latest 13F filing shows that he is currently backing up the truck and loading up on gold. In the second quarter, he bought over $300 million worth making it his single largest position. He now has more than 20% of his portfolio allocated to the SPDR Gold Trust (GLD). This position is more than twice as large as his next largest holding.

Clearly, Druck feels (as I do) that it’s time to get greedy in the gold market.

UPDATE: I just noticed that Stan also bought a sizable position in Newmont Mining, as well. What a pig. 

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One Of The Single Largest Buyers Of Equities In The World Could Now Turn Seller As A Consequence Of The Oil Crash

For months now it’s been popular to consider the oil crash contained, that is to suggest that it has no repercussions outside the energy industry. However, equity investors should take note that one of the single largest buyers of equities in the world may now become a net seller simply due to the oil price crash.

Due to its massive North Sea oil reserves (the busiest drilling site on the planet), Norway has prospered greatly over the past few decades. This has allowed the nation, despite its relatively small population, to build one of the largest sovereign wealth funds in the world. So large, in fact, that the fund now owns 1% of all the equities around the world (including nearly 2% of European equities, making it the largest holder there).

The oil crash has not been kind to Norway. And in order to maintain its spending to prop up it flagging economy, some believe the country may be forced to dip into its sovereign wealth fund. In other words, the fund has gone from being one of the largest buyers of equities in the world to possibly a net seller. Bloomberg reports:

If the government has to withdraw money from its $875 billion sovereign wealth fund, it will be a historical step. It’s either that, or heavily rein in fiscal spending at a time when the country needs it most. The state’s spending could start to outstrip income from oil, which it pours into its wealth fund for future generations.

To his credit, Marc Faber outlined this possibility at the Barron’s Roundtable back in January:

…sovereign wealth funds rose to $6.8 trillion as of September 2014, from $3.2 trillion in 2007. Of that growth, 59% came from oil, gas, and related revenue. As oil prices fall, what will happen to the growth of sovereign wealth funds, which have been buying financial assets around the world? Their funding is going to evaporate, and they might be forced to sell.

Clearly, there are larger repercussions of the oil crash than many currently believe. One of these is that oil-dependent nations, some of the most powerful players in the markets, have already been forced to halt their buying of equities. Considering their buying has been one of the major factors behind the powerful bull market over the past few years this is nothing to sneeze at. What’s more, these massive funds may even be forced into becoming net sellers.

Considering the demographic headwinds facing our stock market right now along with the already extreme positioning of margin traders, it’s hard to imagine any other source of demand being able to make up for the loss of these massive buyers…  or even to just soak up the supply should they become net sellers.

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The Warren Buffett Way To Avoiding Major Bear Markets

A year ago, I wrote a post called, “how to time the market like Warren Buffett,” in which I proposed a very simple market timing method inspired by this passage from the Oracle of Omaha’s 1992 letter to shareholders:

The investment shown… to be the cheapest is the one that the investor should purchase.…  Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought.

The idea is very simple and intuitive: When reliable measures forecast that stocks will outperform bonds, buy them. However, when, on rare occasion, they forecast that bonds will outperform stocks then they should be favored. But how to forecast equity returns? Simple. Just use Buffett’s favorite valuation yardstick, market cap-to-GNP. Right now this measure shows stocks to be about as highly valued as they were back in November 1999.

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What makes this measure most valuable, though, is its forecasting accuracy – which may be what makes it Buffett’s favorite. Below is the 10-year forecast implied by this measure (blue line) against the actual 10-year return for the S&P 500. Notice the red line tracks the blue fairly closely but can overshoot in both directions, overestimating returns during the 1973-74 bear market and understating returns during the dotcom bubble.

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The next chart overlays the 10-year treasury bond yield (red line) against the 10-year forecast for stocks (blue line). The majority of the time this comparison suggests stocks are the better investment. There are few occasions, however, when bonds offer the better opportunity. Today is one of those occasions.

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In my original post, I demonstrated just how attractive it would have been to follow this methodology. Since 1962, an investor who simply had bought stocks when they were more attractive and then switched to bonds when they became more attractive outperformed a buy-and-hold approach and dramatically so (mainly by sitting out a significant portion of the last two major bear markets).

What I think is most remarkable about the chart above right now is, at 3.05% (stocks’ forecast return of -1.07% minus a 10-year bond yield of 1.98%), it is signaling one of the largest spreads between forward returns on record. There are only a handful of quarters over the past fifty years that offered investors a better opportunity to switch from stocks to bonds. In fact, the last time the spread was this wide was during the second and third quarters of 2007, just prior to the financial crisis that led to a 50% drop in the stock market.

Now this doesn’t mean you should sell all of your stocks and run for the hills. Everyone has their own personal investment goals and risk tolerance and that should be paramount in their individual process. A practical way to implement this would be to simply underweight stocks and overweight bonds based on today’s reading. Or if you’re making significant new contributions to your account, maybe you just put those in bonds for now until stocks offer a more attractive opportunity. In fact, that’s probably how Buffett would do it. And though I doubt he uses these measures exactly this way, this sort of process has worked well for him for quite a long time.

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