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Here’s Why Investors Should Be Worried About Waning Risk Appetites

I’ve spent a lot of time here and on social media drawing attention to the waning risk appetites in junk bonds and leveraged loans. What I haven’t done is fully explain why I think it’s so important to pay attention to. In short, all of the markets, whether you’re talking about stocks, bonds, commodities or currencies, are all interrelated and cyclical. What’s happening in the commodity markets has implications for currencies and vice versa. What’s happening in the bond market has implications for stocks and so on and so forth. Right now it looks to me, from the action in many of these markets, like the overall upcycle could be close to peaking and rolling over.

Why do I focus so intently on risk appetites? Because risk appetites are the main driver of the overall cycle. When investors are eager to take on more risk, riskier companies are more able to finance their endeavors. When investors become risk averse, it becomes harder for these companies to finance and those who overextended themselves during the upcycle face the prospect of failure during the downcycle.

This is why the Fed has made it perfectly clear that one of the goals, if not the main goal, of quantitative easing was to stoke risk appetites because this provides a boost to the credit markets. Hopefully companies use the easier credit to spend, invest and otherwise stimulate the economy. (In the current cycle, a lot of that money went to things like stock buybacks, though, so the direct impact on the economy wasn’t as great as the Fed probably hoped).

So the fact that risk appetites for high-yield bonds and leveraged loans are waning so rapidly should be a worrisome sign for all kinds of investors because it means the main driver of the cycle is now waning. Now consider the crash in the price of oil and other commodity weakness which is a deflationary sign. And also consider the surge in the dollar, or crash in foreign currencies depending on your geography, which could cause all kinds of problems for the folks who borrowed too much money in dollar terms. And finally consider the plunge in sovereign bond yields, including treasuries, in developed nations around the globe, a clear sign that not only inflation but future economic activity, here and abroad, may not be as robust as we thought a few months ago.

All of these signs are flashing red for both the economy and the markets, in my humble opinion. And at the very least, the drying up of liquidity in the high-yield and leveraged loan markets will have a negative impact, and possibly a very large one, on mergers & acquisitions, LBOs and buybacks, three significant sources of demand for equities. All in all, it looks to me like the boom in risk appetites which has driven the markets higher over the past five years could be in the process of reversing and the major implication for the markets is not bullish.

Related reading:

Bloomberg: Leveraged Loan Funds Seen Plunging 40% After Record Year

FT: Falling Oil Price Poses New Thread To Banks

Bloomberg: Carl Icahn Calls Junk Bonds A Bubble

Dr. Ed Yardeni: The Energy Bubble

Bloomberg: Hedge Fund Manager Who Remembers 1998 Rout Says Prepare for Pain

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Everything But The US Stock Market Has Already Peaked

The new Z.1 report came out today so let’s update many of the indicators I’ve been sharing here over the past few months. What should be worrisome to market watchers here is that we now have a host of significant indicators that look like they may have formed important peaks and begun to roll over. We will need to see at least a couple more quarters worth of data to be sure but this is certainly something to keep an eye on.

First let’s take a peek at Warren Buffett’s favorite valuation yardstick. (See “How To Time The Market Like Warren Buffett” for a look at one way I use this indicator.) It actually peaked last quarter and saw a small retracement in Q3. This indicator is 83% negatively correlated with future 10-year returns in stocks (the higher the reading the lower forward returns) and its current reading implies a -0.88% annual rate of return over the coming decade. The 10-year treasury at 2.2% looks fairly attractive in comparison.

fredgraphNext we can take a look at the household percentage of financial assets allocated to equities. This indicator is even more negatively correlated to future 10-year returns at about 90%. It has also pulled back just a bit from the peak it made in Q2. Its current reading implies a forward return of about 2.8% per year over the coming decade, slightly better than the 10-year treasury.

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Finally, comparing the current level of the S&P 500 to its long-term regression trend we can see that the only other time in history stocks were this overbought was at the height of the internet bubble. This measure is not quite as highly correlated to future returns as the other two but at 74% it not that bad, either. It also looks at the largest data sample of any of them so I believe it’s worth including. At its current reading it suggests stocks should return just 0.74% per year over the coming decade.

Screen Shot 2014-12-11 at 1.35.10 PMBlending the three forecasts together we get a 0.89% annual return forecast for the stock market over the coming decade. A straight comparison to 10-year treasuries at 2.2% shows them to be the more attractive of the two asset classes right now. Hell, even 5-year treasuries are paying 1.6%, nearly double our model’s forecast.* All in all, this looks to be the second worst time to own equities in history.

Still, the stock market’s uptrend remains in tact as all of the major indexes currently trade above their 200-day moving averages. But as I’ve noted recently there are plenty of signs that the trend is not as healthy as bulls would hope. The advance/decline line, new highs-new lows and the percentage of stocks trading above their 200-day moving averages are all diverging fairly dramatically from the new highs recently set in the indexes. This is a serious red flag.

And now that our market cap-to-GDP and household equities indicators have possibly peaked, along with high-yield spreads (inverted), margin debt and corporate profit margins, there seems to be a very good possibility that the uptrend could be tested in short order. In fact, when I go back and look at the times when all of these indicators peaked around the same time over the past 15 years or so they coincide pretty neatly with the major stock market peaks:

Stock Market Peak Q1-2000 Q4-2007 ???
Market Cap-GDP Peak Q1-2000 Q4-2007 Q2-2014
Household Equities Peak Q1-2000 Q2-2007 Q2-2014
Margin Debt Peak Q1-2000 Q3-2007 Q2-2014
High Yield Spreads Peak (Inv) Q3-1997 Q2-2007 Q2-2014
Corporate Profit Margins Peak Q3-1997 Q4-2006 Q3-2013

So the uptrend may still be in tact but I think we have a plethora (yes, a plethora) of evidence that suggests its days may be numbered. Foreign equities have mostly given up their uptrends over the past few months and commodities, led by the oil crash, look even uglier. How much longer can the US stock market swim against the tide?

Note: I’ve received many questions over the past few months since I first posted, “Seeing The Forest For The Trees,” about just how to go about doing this and here’s my recommendation if you don’t want to own stocks right now: Hold cash. It’s not sexy but it’s dry powder.

Now if you want to earn something rather than nothing on your cash and you’re worried about interest rates rising (and it seems everyone is) you can easily build a ladder of individual bonds rather than just buying a bond fund. The difference between owning a fund and owning bonds individually is when you own bonds directly you can decide exactly what maturities you are comfortable owning and you can always hold them to maturity if interest rates move against you. A bond fund, on the other hand, doesn’t give you that sort of flexibility.

Here’s how I would consider setting up a bond ladder right now if your goal is wait for a better buying opportunity in the stock market. Simply divide your investable funds into five equal buckets. Then invest each bucket into 1, 2, 3, 4 and 5-year treasuries, for example (you may want to choose shorter or longer durations based on your own goals). So if you have $50,000 in our example you would just buy $10k of each maturity. If the 1-year bonds mature before you find a better place to put the money then reinvest the proceeds into 5-year bonds again (as your original 5-year bonds will now be 4-year bonds and so forth). This way your blended yield on the bonds should come pretty close to the 0.89% our model suggests stocks should return without any of the heightened risk in owning equities right now.

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5 Reasons You Should Avoid Bank Stocks Right Now

Josh Brown, blogger extraordinaire, wrote a post the other day about the breakout in the financials which argued that investors should overweight them. All due respect to Josh (who I think highly of), here’s 5 reasons why I think that’s a bad idea, especially in regards to the bank stocks:

  1. The yield curve has been falling all year and lately more like a brick. Because banks borrow at the short end and lend at the long end this always leads to pressure on profit margins. That’s why, until this year, banks’ share prices were so sensitive to changes in the curve. I don’t know why their share prices haven’t noticed yet this time around but I’m thinking it’s just a delayed reaction:sc-14
  2. The default cycle is about as low it can possibly get and now looks to be turning upwards again. The 40% crash in the price of oil over the past few month raises the real prospect of rising defaults in the energy sector. Canadian and Texas banks are especially vulnerable and their share prices have taken a hit recently. But if there’s one thing we’ve learned from the financial crisis it’s that these things are never isolated. They are all closely and inevitably intertwined.
  3. Everyone and their mom is overweight the banks and has been for quite some time. And if everyone already owns them where’s the incremental demand going to come from to push prices even higher or at least faster than the broader market? That’s a tough question to answer.BAML Allocations Nov 14
  4. What if these breakouts everyone is watching are nothing but a head fakes? False breakouts are one of my favorite chart patterns to trade because they are visual evidence of the crowd become overly euphoric for something. They are a text book example of price getting ahead of fundamentals (exactly where I think the banks are today). The resulting fall back to reality of sentiment usually brings with it a pretty dramatic price reversion, as well. (JPM, C, WFC all look vulnerable to me and BAC is merely working on a double top.)sc-15
  5. They are impossible to value. If the companies themselves can’t even determine how much money they made or lost in a given quarter how can anyone else be expected to? In fact, since FAS-157 was repealed (or “relaxed”) who knows if they’re even solvent? You just can’t possibly “invest” in something you can’t begin to understand (but speculate away; that’s your prerogative).

Ultimately, I think the banks might be the most vulnerable sector to a cyclical downturn and there are plenty of signs (global economic weakness, interest rates, commodities and bond market risk appetites) we could be headed in that direction fairly soon.

Disclosure: I am short financials.

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This Is Probably The Second Worst Time In History to Own Stocks

This stock market is now the second most overbought, the second most overvalued and most most over-leveraged market in history.

Overbought: My friend, Dana Lyons, recently posted the chart below which shows the S&P 500 in relation to its exponential regression trend line. The only other time in history stocks were this “overbought” (traded more than 90% above the long-term trend) was back at the height of the internet bubble.

tumblr_nfel6euWDb1smq3o4o1_r1_1280

Chart via JLFMI

Overvalued: A glance at the chart below, of Warren Buffett’s favorite valuation metric (total market capitalization-to-GDP), clearly shows that there was also only one other time in history when stocks were priced so dearly as they are today: 1999.

fredgraph-2

Chart via FRED

Over-leveraged: Finally, investors have never been so highly levered to equity prices. Even 1999 can’t compare with today’s aggressiveness. As the next chart shows, net free credits (cash minus margin debt) in brokerage accounts have never traveled so far into negative territory as they have now.

NYSE-investor-credit-SPX-since-1980-2

Chart via dshort.com

I think it’s pretty pointless to debate whether this constitutes another “bubble” or not. Label it however you want. But it’s hard to deny that this is, at the very least, the second most unattractive time to own equities in history. In other words, this is probably the second worst time in history to own stocks.

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Here’s Why The Long Bond Could Be About To Blast Off

I always love hearing people say things like, “interest rates are so low they can’t go any lower!” That’s the sort of superficial thinking that gets investors into trouble and provides opportunities for those willing to look a bit deeper.

So let’s take a look and see if that’s actually true – that rates are as low as possible right now. Taking a quick look around the world at other developed nations it’s pretty plain to see that our bonds, even at a meager 2.3%, offer pretty incredible relative value:

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The UK is paying a fairly comparable 2%. But Germany pays less than 0.8% and Japan’s minuscule yield is hardly worth mentioning. In fact, borrowing for next to nothing in Yen and then converting to dollars and purchasing long bonds (called a “carry trade”) has been a “no-brainer” (another kind of thinking that can get investors into trouble) for a long time now.

The question that comes to my mind when I look at this chart is, “why couldn’t our rates go as low as the UK, or Germany, or even Japan?” Maybe I’m just not imaginative enough but I can’t think of a bulletproof reason our rates should find a floor at current levels.

What’s probably even more important to consider is the fact that the Fed’s Quantitative Easing activities have dramatically reduced the supply of these bonds and because they are reinvesting the proceeds of maturing bonds that will remain the case for quite some time. And what happens when you dramatically reduce supply while demand holds fairly steady? That’s right! The price goes up. This isn’t rocket science, folks.

Then consider the fact that demand has been muted because portfolio managers (and individual investors) have absolutely hated these things for at least the past year. They haven’t been this underweight since 2007 right before long bonds went on an epic 50% run over 18 months:

BAML Bonds Nov 14

Chart via Fat Pitch

I’ll remind you that long bonds have been the best performing asset class so far in 2014 despite this meager demand from portfolio managers. It’s pretty amazing to consider that they still consider them their favorite short idea:

iiKhZBiGSMpIChart via Bloomberg

Imagine how they’ll do if portfolio managers and individual investors decide rates aren’t going higher any time soon and so they shouldn’t hate/short them anymore. Not to mention the potential for a “flight to safety” out of high-yield, leveraged loans or even stocks. Ultimately, I can see the distinct possibility of a real blowoff type of move at some point.

And wouldn’t that be the most fitting way for this epic bull run to end?

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See also: “The $400 Billion Bond Mismatch Keeping Bears at Bay” -Bloomberg

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A Conversation

Imagine a financial adviser* approached you with an investment opportunity** without telling you specifically what it was. And right up front he tells you it’s likely to generate a zero to negative return over the coming decade. What would you say?

I imagine any investor with any common sense would respond by saying something like, “why in hell would I want to own something that will generate a zero to negative return over 10 years?!

And the adviser would likely respond with: “Well the outlook for other asset classes over the next 10 years is no more attractive than it is for this one.”

Common sense investor: “Well if it’s going to return zero or less wouldn’t even a savings account do better? Why not just own safe fixed income instruments? We can ladder them so we don’t have too much interest rate risk or opportunity cost. And it’s plain to see that plenty of asset classes offer returns better than zero over the coming decade. Why not just own them?”

Adviser: “There seems a reasonable likelihood that inflation will accelerate at some point over the next decade, and this asset class is a good hedge against inflation.”

Investor: “Okay. If runaway inflation is the only reason to own it wouldn’t TIPS or precious metals provide a better hedge considering this asset class’s extremely unattractive valuation?”

Adviser: “I have learned the hard way that market timing is very difficult and is generally a terrible idea. It’s better to just own this asset class all the time regardless of its prospective return.”

Investor: “Okay. So you’re saying you’re not confident in your ‘prospective return?'”

Adviser: “No. We’re confident. We have a variety of valuation measures that are highly correlated to the future 10-year returns of this asset class and they all say the same thing: that it’s very highly likely to return zero or less over that time frame.”

Investor: “So you’re saying that you have proven valuation measures that have been highly accurate in forecasting the return of this asset class for decades but you don’t think they’re very useful.”

Adviser: “That’s right.”

Investor: “Gotcha. I’ve got an even better deal for you. How about I sell YOU an investment that returns nothing over the next 10 years? That’s better than negative right? I’ll take the money and put it into risk-free treasuries, keep the difference between what they pay me and what I pay you (nothing) and then pay you your initial investment back at the end. How much would you like to buy?”

Adviser: “Only my employer (major bank) and the Fed can play that game, I’m afraid.”

*Thanks to Henry Blodgett for playing the “adviser.”

**US Equities

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It Pays To “Think Different” About Apple’s Stock Price

About 10 months ago I wrote that I thought Apple was worth $114 to $128 per share (split adjusted). That day the stock closed at $72. Today it closed at $116, 60% higher. So this morning I sold it. Here’s why:

Fundamentally, the company has gone from being very undervalued to fairly valued in a very short period of time. (Note: Carl Icahn, who is a lot smarter than I am, says the company is worth $200 per share. I just don’t know how much of this is salesmanship/optimism and how much is cautious analysis.)

I know, I know, Apple is firing on all cylinders and will probably continue to do so. iPhone 6 is selling like hotcakes even before we get into the holiday shopping season. New products are in the pipeline and Apple Pay will probably be huge for the company.

But how much of this optimism is already baked in to the current valuation? At 5 or 6x cash flow, almost none of this was priced in. At nearly twice that valuation today I’m not so sure. Ultimately, at the current price I no longer have a margin of safety. Should the company stumble, and I’m not saying they will, there’s no reason the stock couldn’t go back to the $80-95 level (where I’d probably buy it back).

Screen Shot 2014-11-21 at 12.18.53 PMAnd this is where fundamentals and sentiment get blurred. Clearly, investors don’t quite love the stock as much as they did during the summer of 2012 (will any stock be that loved ever again?) but they no longer think Samsung is going to eat the company’s lunch. So I wouldn’t say sentiment is super-frothy but a 60% run in 10 months tend to inspire at least a little euphoria and StockTwits sentiment has reflected that for some time. 90% of the messages on the site tagged with Apple’s ticker are bullish. That’s a pretty crowded trade.

As for the long-term trend, clearly it’s still bullish. But there are some signs that it may be getting exhausted. DeMark Sequential sell signals are now triggering on multiple time frames. A daily 13 sell signal registered at today’s open while another 9 sell setup triggered a couple of days ago. All this means is we are seeing a cluster of trend exhaustion signals currently:

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The weekly sell signal won’t trigger until the Monday after Thanksgiving but this time frame gives us a good look at the action over the past couple of years. The stock famously peaked in the summer of 2012 before losing roughly half its value into the spring of 2013. The stock has since rallied back and broken out above that prior high (taking the major indexes with it). A simple 1.618 Fibonacci extension projects a target of roughly $122.

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Interestingly, that 2012 peak was accompanied by a completed monthly DeMark 9 sell setup. Last month the stock triggered a monthly 13 sell signal off of that same setup. The risk level for this monthly signal sits at roughly $121. Coincidentally, that’s also the risk level for the daily signal. So according to DeMark Sequential analysis on multiple time frames, the stock could continue to run to $121-122 to test these risk levels and complete the 1.618 Fibonacci extension on the weekly chart.

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From where I sit, however, the stock has pretty much reached fair value, sentiment has shifted positively once more with investors nurturing great expectations for the holiday season and the parabolic move over the past few weeks has triggered a flurry of sell signals. So I’m not saying this is the top. I’m just saying I’ve had my fun and the risk/reward equation no longer appeals to me.

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