Today is the 25th anniversary of the launching of the Vince and Larry crash test dummy public service campaign, and donated artifacts are welcomed at a ceremony at the Smithsonian American History museum in Washington, DC.
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Desperately Seeking A Margin Of Safety

Back in 2000, I had one of my best years as an investor. You may remember that year marked the peak of the greatest stock market bubble in history. Anyhow, while everyone and their mom was buying internet stocks I was loading up on the exact opposite.

One of the unique things about that time was that the bubble was really concentrated in the technology sector. Outside of that there were some great values to be found in the old “bricks and mortar” types of companies.

I found a couple of those great values in Abercrombie & Fitch and Washington Mutual. I think ANF was trading around 8 times earnings despite the fact that it was still growing pretty fast and had incredible returns on new stores. And this was back when WaMu was still just a boring old thrift trading for 5 times earnings. When investors finally gave up on the high flyers they took refuge in names like these and both ANF and WaMu soared.

In 2007, things were very different. Although valuations didn’t get anywhere near those 2000 levels, there was even more pain felt as a result. There just wasn’t really anywhere to hide during the financial crisis as everything seemed to get hammered to the same degree.

Today’s market feels like a combination of these two and it honestly worries me. We currently have even higher valuations than we did in 2007 – in some cases, even higher than in 2000 (median price-to-sales ratios at all-time record highs). And the overvaluation feels just as pervasive as it did in 2007, maybe even more so (note record “median” valuations, not “mean”).

In other words, the diving board (valuation) is higher now and there’s even less water (pockets of value) in the pool than there was.

This is why I’ve spent so much time researching ways to avoid the next major bear market. Because I think it’s gonna be a doozy. So I think it’s probably wise for most investors in US stocks, at this point, to switch from buy-and-hold to a trend-following approach. Still, this assumes that the selling window, when it comes, will be wide enough and open long enough for everyone to casually exit through which is not always the case.

An alternative or complementary solution I’ve spent some time looking at is a “global value” approach. I got turned on to Meb Faber’s work a few months ago and I think this idea of his has so much merit, especially for investors in US stocks right now. There may not currently be those pockets of value within the US stock market that will help to weather the next storm but there are pockets around the world that may fit the bill.

Do yourself a favor and go read Meb’s book. It just might help you manage the next market meltdown.

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Two Similes

A couple more thoughts on “The New Wolves of Wall Street“:

  • The main reason for using index funds is to reduce costs. If that’s the case then why add a high-cost advisory fee on top? Doesn’t that defeat the entire purpose?! If asking your stock broker if you need to trade something is like asking the barber if you need a haircut (to steal a Buffett line), then an adviser pitching index funds with a fat advisory fee is like a barber telling a bald guy, “okay, you can shave at home but keep the regular checks coming, okay?”
  • Many of these advisers will say that just because they’re using index funds doesn’t mean they’re not providing valuable advice. It’s true that some are but some will argue that you pay them to close the “behavior gap.” In other words, “you pay me to protect you from yourself.” To me this sounds a lot like, “I’m the wiseguy who provides protection in this neighborhood. If you don’t pay me how can I keep you safe?”
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Profit Margins And Major Stock Market Peaks

The chart above plots corporate profit margins as a percent of GNP alongside the Wilshire 5000 Index. I ran it because I was curious to look at profit margin cycles and how they relate to stock market cycles.

It’s probably an understatement to say that the current bull market has had a strong profit margin tailwind. Margins in this cycle have surged to all-time record highs. This has amounted to what could be considered rocket fuel for valuations, which are now, according to some measures, as stretched as they have ever been:

Looking back through history, it’s interesting to note that each of the major peaks in the stock market over the past 40 years has been preceded by a peak in profit margins.

In 2007, the stock market peaked about four quarters after profit margins did. In 2000, stocks peaked about ten quarters later. Stocks peaked about eight quarters after profit margins leading up to the 1987 crash. The only outlier I found (I admit it’s a small sample size) was the 1973-74 bear market where profit margins and stocks peaked simultaneously.

How is this relevant to today’s market? Well, profit margins peaked this cycle way back during Q3 of 2011 (eleven quarters ago) but they never really dropped much until Q1 of this year.

I have argued that a reversion in profit margins poses the “dominant risk” to stocks. Now that they seem to be reverting, we will soon find out if that’s true.

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“The Dominant Risk For Wall Street” May Be Manifesting In Small Caps

A good deal of attention has already been paid to the growing divergence between small cap and large cap stocks so far this year. The former have seen a small decline while the latter have risen about 8%. But I’ve seen very little commentary regarding WHY this might be happening. Of the many divergences the market has seen recently I think this one may be the most significant as the small caps could be the “canary in the coal mine” for the broader market.

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It all comes back to what I have argued amounts to a bubble in corporate profit margins. Jeremy Grantham has used a 2-standard deviation event as one benchmark for a bubble. Using that definition, it’s hard to argue that profit margins are not currently in a bubble.

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Warren Buffett also weighed in on unsustainably high margins back in 1999:

In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. In addition, there’s a public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems—and in my view a major reslicing of the pie just isn’t going to happen.

Note that margins are now nearly twice the 6% level that Buffett considered a long-term upper threshold. Now I haven’t heard him say anything about current levels of profit margins (and I’d love for somebody to ask!) but I think his logic is still valid. At some point, the pendulum will have to swing the other way and profits will revert to some extent.

Like the price divergence between small and large caps, the forces behind the scenes here have also been the subject of much ink. It’s that 99% versus the 1% thing. You see over the past few years as the economy has slowly recovered in the wake of the financial crisis companies have seen their revenues grow but have been reluctant to add to their employee base. The result is that a larger and larger portion of these revenues fall to the bottom line. This goes on for a period of five years and, voila! Record profit margins. The 1% (owners of these companies) celebrate while the 99% stagnate.

Until now…

There are signs recently that this dynamic is shifting. After all, you can only milk your current employee base so much before they become overextended and your product or service suffers or you can’t meet the growing demand, etc. At some point in the recovery or expansion process you have to start adding employees AND paying your current employees a little better in order to retain them.

And it’s beginning to look like this is exactly what’s starting to happen. As the BLS reported a couple of weeks ago, job openings are improving pretty dramatically. July saw a 22% gain year-over-year. And as we learned today, real wage growth spiked in August by the largest amount in years.

This is fantastic news for the 99%. It looks like more jobs and better pay are finally on the way. And it’s exactly the result the FOMC, with their albeit super-blunt tools, have been trying so hard to create. As Pimco’s Paul McCulley writes:

But as Martin Luther King intoned long ago, the arc of the universe does bend toward justice. And as I wrote in July, I think it will do so with the Fed letting the recovery/expansion rip for a long time, fostering real wage gains for Main Street. This implies that the dominant risk for Wall Street is not bursting bubbles, but rather a long slow grind down in profit’s share of GDP/national income.

But do bubbles usually unwind in a “long slow grind down”? Maybe. But sometimes they burst. Either way, this is not so good for the 1% and those record-high profit margins. And we’re seeing this happen already in what area of the market? You guessed it – the small caps and “middle market” companies. Sober Look reports:

While over 50% of [middle market] companies are seeing revenue growth, the fact that over 50% are experiencing EBITDA declines suggests margin compression. For the sixth consecutive quarter, more middle market companies experienced EBITDA declines than gains.

It’s been six consecutive quarters now that these smaller companies have experienced, “margin compression.” UBS recently confirmed this data noting the recent plunge in EBIT margins at small cap companies.

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Chart via Business Insider

Make no mistake, this epic stock market rally has been built on the back of this profits boom. It’s been the source of much of the earnings growth we’ve seen and inspired investors to bid valuations to what has historically been rarified air. Should profits decline it would mean already extended valuations are even more inflated than they currently appear and would remove a major underpinning of the bull market.

What I worry about even more, however, is the amount of risk that has been assumed recently based upon the expectation that profit margins will remain at these record levels indefinitely. As Sober Look recently reported, leveraged buy out valuations are at heights not seen at any other time during the past 14 years. More importantly the amount of debt in relation to targets’ EBITDA is also at a record:

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Chart via Sober Look

If EBITDA at more than half of these companies is actually declining now these multiples will soon look even more inflated than they already do and the massive amount of debt used in buying them is at risk even greater risk of becoming unsustainable than it originally appears.

Speaking of the “massive amount of debt,” It’s important to note that the volume of leveraged loans has far surpassed it’s highs of 2007…

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Chart via Dallas Fed

…and the risk controls embedded in these loans has fallen dramatically as covenant-lite’s share of overall issuance is now twice what it was prior to the financial crisis.

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Chart via Dallas Fed

So it looks as if we may have more built up risk on the debt side of things than we did prior to the financial crisis. If margins are actually beginning to revert, as the small cap/middle market is suggesting, at 2-standard deviations above their long-term average, they potentially have a very long way to fall. And with so much risk betting against this possibility the fallout could be dramatic.

Perhaps this is why spreads have finally begun to widen just a bit over the past few months in the high-yield market.

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Chart via Charlie Bilello

All in all, this is clearly a very complex system with various intermarket relationships. But we are seeing some signals that point to the fact that the Fed may be close to achieving it’s goals of increasing employment and wages. While this is good news for the labor force, it’s bad news for companies and investors because the resulting margin compression would remove the main driving force of this bull market along with causing potential problems (defaults) in the high-yield bond market. So keep your eyes on the small caps; there are big implications in that divergence everyone’s looking at.

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On The “Sioux And The Buffalo”

My recent piece, “The New Wolves Of Wall Street,” struck a nerve. I think it taps into both advisers’ insecurities and investors’ worries about not getting what they pay for. Good. That’s what I was going for.

Before I follow up on that piece, though, let me make a couple of things clear. First, there are some truly wonderful advisers out there. My experience, however, tells me they are more the exception than the rule. As WSJ’s Jason Zweig tweeted this morning many, “treat clients like Sioux treated the buffalo.”

Second, I’m not criticizing either the RIA model or index funds right now (though these aren’t without their own problems). All in all, they are a net positive for individual investors because they reduce conflicts of interest and bring down costs. I’m focused on the problems that arise when you put the two together.

Ultimately, this discussion is focused on the massive underperformance individual investors experience in their own portfolios on a consistent basis:

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Most pundits like to blame this on the fact that individual investors are just “dumb money.” Indeed, there is a “behavior gap” that causes investors to become euphoric with the crowd and buy at the wrong time and then panic in the midst of a bear market and sell at precisely the wrong time. This is human nature.

What the wolf doesn’t want you to know, however, is that he’s just as much to blame for your underperformance as your caveman brain is (see “Where’s Wall Street’s Blame In The Buy High Sell Low Game?“). In fact, even if he does a perfect job managing your natural instincts along with his own, he’s going to cost you big time – like half of all of your profits over the long run, big time.

So the problem as I see it two-fold. Both the “behavior gap” and obscene fees are significant contributors to the problem of massive underperformance. Addressing the first part is a good start. But ignoring the second part or – even worse – pretending, as an adviser, to pursue a low-cost approach while charging predatory fees is counterproductive, at best.

In fact, I’ll take it a step further. An adviser who is recommending passive index funds should not charge a “management fee” at all. Management fees are just that – fees for managing investments. If you’re not managing investments – you’re just overseeing a passive portfolio – you don’t deserve a management fee. Period.

Investment advice like this is valuable, though. Investors deserve to be educated about how their biases screw up their investment plans. And I think there’s a huge opportunity for advisers interested in doing this the right way.

Investment advice like this should be compensated just like all the other “advice” given by professionals out there – attorneys, accountants, therapists, etc. – on an hourly rate. Get paid for the advice you’re giving. Nothing more – nothing less. What would you say to your CPA if, instead of his hourly rate, he asked you for 2% of all your money every year for the rest of your life just for doing your taxes?

Too many “advisers” simply gather assets, charge their management fee for a one-time recommendation and then just ride the gravy train. And can you blame them? Under a management fee structure this is the overwhelming financial incentive. They maximize their profits by bringing in as much money as possible to charge a perpetual management fee on and then do as little management or advising as possible.

If advisers were compensated for the time they spent actually advising rather than the amount of assets they gathered then that’s how they would spend their time. This would much better align investor needs with adviser incentives. And it would also help keep human advisers relevant in the era of the robo-adviser. Somebody’s going to see the light here and seize this opportunity, I’m sure.

Still, I believe that the vast majority of investors are capable of overcoming the “behavior gap” on their own. They certainly don’t need pay an annual tithe to have it managed for them. My hope is that this helps inspire them to help themselves. And there are some wonderful role models out there like Stephanie Mucha.

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The New Wolves Of Wall Street

Wall Street is in the midst of some pretty massive change right now. And I’m talking about Wall Street as it relates to Main Street. I’m talking about how individual investors are being courted (hunted) and cared for (killed) by the new wolves of Wall Street.

Brokers have now become an endangered species as the model has been attacked on two sides by fee-only investment advisers (aka, RIAs) and discount brokers advocating a DIY approach. And now there’s a third entrant attacking both the brokers and RIAs: robo-advisers. All in all this evolution is good for investors as it ultimately brings down costs.

But don’t underestimate greed’s resilience and its willingness and ability to adapt. As they say, “the more things change, the more the stay the same.” Many brokers are making the switch to RIAs. In fact, they’re doing it in droves (witness the growth of the likes of LPL Financial). Changing your title and even your business plan, however, won’t magically turn a wolf into a sheep but it does make him harder to identify.

Make no mistake. There are plenty of wolves left on Wall Street. They just don’t call themselves wolves anymore. In fact, they do everything in their power to look like innocent, cuddly sheep. They setup as RIAs now. Many even preach a low-cost, passive or index-based approach to investing, aligning themselves with the likes of Burton Malkiel, Warren Buffett and Jack Bogle, some of the most respected names in the business.

It’s the ultimate hypocrisy. You see, while they preach a low-cost approach and may actually use low-cost products like index ETFs, they’ll charge you an arm and leg for the privilege – as much as 2% per year. As Meb Faber put it, “you’re a predator if you’re charging 2% commissions and or 2%+ fees for doing nothing.” I’m sure the wolves, who normally brag about ‘eating what they kill,’ would take this as a compliment. Meb continues,

Anything more than 0.5% or so on top of fund fees is either paid a) out of ignorance, which is not always the investor’s fault or b) as a tax for being irresponsible.  For the latter I mean a fee to keep you out of your own way of chasing returns and doing something stupid, much in the same way someone pays Weight Watchers or any other diet advice program when you know what you should be doing (eat less, exercise more).

I’d say that anything more than 0.25% for “managing” a passive portfolio of index ETFs these days is obscene (it’s not even really “managing” if it’s passive – more like “overseeing”). And there are plenty of advisers charging nearly ten times that amount. And what’s the money for? What are you paying these fees for year after year? Because if the funds themselves do all the work and merely need to be rebalanced a couple of times it might take 15 minutes per year.

At the end of the day, you’re paying for the pleasure of their company. And that 2% fee might not seem like much but it really adds up over time. As Albert Einstein famously said, “compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” Over 40 years, on $100,000 initial investment, that 2% fee you’re paying compounds into roughly $2 million. Even Kate Upton‘s company is not worth that much.

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That chart above shows the growth of $100,000 over 40 years assuming a rate of return of 9.68% for the index fund (the return over the past 40 years) and 7.68% for the investor paying 2% to his adviser. The DIY guy ends up with a little over $4 million and the guy with the wolf, I mean adviser, ends up with a little less than $2 million. That’s right, the wolf ends up eating over half of your profits.

So when I call these fees “predatory” or “obscene” this is why. Wolves preaching a low-cost, passive approach and charging these fees represent the height of hypocrisy – or the height of greed – take your pick.

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Taking A Shine To The Gold Miners, Part Deux

(If you enjoy reading my blog please subscribe to The Felder Report via email and follow me on Twitter @jessefelder.)

Three months ago I published a short piece titled, “Taking a shine to the gold miners,” and the ETF subsequently jumped a little over twenty percent. Recently, however, it has given back a good chunk of those gains and I’m once again intrigued by the trade.

Now I’m not going to try to make the fundamental case for owning gold. You can find great arguments being made on both sides of that debate (see “The Great Gold Debate“). Either you believe that gold is a unique store of value or that it’s just a shinier metal than most. What I’m interested in right now is the technical picture and general sentiment towards the asset after a three-year bear market that has seen the precious metal drop, in dollar terms, nearly forty percent.

On a long-term time frame gold is testing a pretty important uptrend right now. Actually, it’s fallen below the uptrend but I’ll be looking for a monthly close below the trend line and/or the 10-month moving average (both around 1275) to determine that the uptrend line is officially broken and there’s a lot of time left in the month of September for it to rally back and close above.

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The MACD lines at the bottom of the chart are also getting very close to turning higher. Notice they last crossed down back in early 2012 which turned out to be a great signal to get out if you owned any gold at the time.

Looking at the gold ETF on a weekly time frame (a chart I posted at the end of last year on my public StockCharts chart book), it’s clearly breaking down out of a bearish pennant but key support lies just below at the 61.8% Fibonacci retracement around 113.68 (roughly 1200 for the precious metal).

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So the metal is at a crucial juncture right here. Can it hold the monthly uptrend and the weekly 61.8% retracement level? Time will tell.

Should they both manage to hold these key leves, the best way to play it may be through the gold miners ETF. A look at the weekly chart here shows a potential variation of a head and shoulders bottom with a DeMark 13 buy signal. Technically, you could argue the price action is either basing for a reversal or flagging before continuing lower.

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But at the bottom of the chart I’ve included the ratio between the miners ETF and the gold ETF. After underperforming the metal for the past three years or so the miners have recently begun to outperform. If their underperformance back in 2011 was a warning signal that gold’s bull run was coming to an end (and it was) this recent outperformance could mean the bearish trend of the past few years may soon be ending, as well.

And a longer term look at the ratio between the miners and the metal (at the bottom of the chart below) shows the miners have not been this cheap relative to the underlying metal at any point during the past twenty years.

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Finally, not only are portfolio managers extremely underweight the precious metals right now, individual investors have pretty much abandoned them, too.

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While the so-called dumb money gives up on the trade, the smart money is getting aggressive on the long side. George Soros nearly doubled his position in the gold miners ETF last quarter to over two million shares. He also bought call options on the gold ETF equivalent to about 1.33 million shares.

For those of you who fall in the gold bug camp, the technicals and sentiment may finally be aligning in your favor once again. Stay tuned.

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