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StockTwits Q&A

Last week I did a question and answer session over at StockTwits. I thoroughly enjoyed it and sincerely hope it helped a few folks. Here’s a teaser:

We’ve written about Jesse Felder before. In-fact, we’re giving away $1,000 to the charity of your choice if you get this question right. Business Insider has a post up about this story too – Felder is growing his beard out until the next 10% correction. We recently sat down with Felder and talked about his beard, and thoughts on the next 10% correction:

Check out the highlights over at my Tumblr: jessefelder.tumblr.com

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Playing Defense In The Stock Market Right Now Doesn’t Make You An Idiot

I’ve taken some flak recently for my persistently bearish views of the stock market over the past year. Rightfully so. I’ve been dead wrong. And with a record level of bulls it should come as no surprise that they’d like gloat.

But I’d like to make a few things clear. First, I’m not a perma-bear. Far from it. I was rip-snorting bullish on stocks back in early 2009 when it was very painful and lonesome to be such. And when the broader stock market presents investors with another good buying opportunity I won’t hesitate to get bullish again.

Second, just because I “worry top down” that doesn’t prevent me from successfully investing “bottom up.” I was very bullish on Apple a couple of years ago when it was also painful and lonesome to be such. I also turned very bullish on Herbalife earlier this year. Even if these trades were fully hedged they would have crushed the S&P. My worries are also one reason I’ve been bullish long bonds, another trade that has crushed the stock market.

I really find it funny that stocks are the only asset class where if you don’t own them – and today that means owning the index – when they go up you’re an idiot. What about those who didn’t own gold in the 2000’s? Or those who didn’t short financials in 2008? Or those who haven’t owned long bonds over the past few years? Why aren’t you an idiot for missing these trades?

Right now there’s a zeitgeist. It’s a mantra among investors that if you don’t own stocks 100% of the time you’re a loser. To me this is asinine. There have been plenty of times throughout history where owning stocks was a loser’s game and today has all of the makings of another one. And the zeitgeist, itself, is compelling anecdotal evidence of that!

One of the best rules anybody can learn about investing is to do nothing, absolutely nothing, unless there is something to do… I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up… I wait for a situation that is like the proverbial “shooting fish in a barrel.” -Jim Rogers in Market Wizards

I look for compelling risk/reward setups. That’s my personal style and it works for me. As I see it, the current risk/reward equation for owning an equity index fund is all risk and no reward. And some very smart people agree with the idea.

Ultimately, I still believe it’s time to play defense:

Marks became bearish on “riskier debt markets” way back in 2004. Just because he was three or four years early does that make him an idiot? Of course not. Did playing defense cost him performance during those years? Yes. But was it worth it? Absolutely. Playing defense was critical to surviving the financial crisis.

Knowing when it’s time to play defense versus offense is critical to staying power in this game. I’ve been through a number of cycles now in my career. I’m not going to simply decide one day to ignore the risks I see just because they haven’t materialized over the past 12 months. I don’t need to own an S&P 500 index fund to make money when there are plenty of other far more compelling ways to do so.

And the single reason I continue to share my bearish views on stocks is that I truly care about trying to help long-term investors avoid another painful lesson. In fact, that’s exactly what I’ve been doing here for nearly a decade now.

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I’m Hearing A Lot Of Smart People Use “The Four Most Dangerous Words In Investing” These Days

Let me begin this post by saying that the three sources I quote here are among the handful of voices on social media and the financial blogosphere I respect most. This is also why I’m especially concerned about this new trend.

What worries me is that I’m now hearing the “four most dangerous words in investing” from some of the smartest guys in the game. Each of the arguments I’m going to look at represent some version of “it’s different this time” in relation to overall stock market valuation.

I’ve made the case for months now that stocks are extremely overvalued. In fact, I believe there is a very good case to be made that while we may not have another full-fledged tech bubble on our hands, the broader stock market is just as overvalued today as it was fifteen years ago, at the peak of the internet bubble.

To counter or to justify this idea, some very smart people have gotten very creative. First, Alpha Architect recently ran a post on valuations determining that, “the stock market isn’t extremely overvalued.” It’s “normalish.”

However, and they do acknowledge this in the post, they are looking at today’s valuations in relation to the history of just the past 25 years. The problem with this is that the past 25 years represent the highest valuations in the history of the stock market so, obviously, today’s valuations will look much more reasonable when framed in that light.

In acknowledging the limitation of using just the past 25 years, however, the author of the post questions whether, “market conditions 100+ years ago may be different than they are today.” In other words, ‘it’s different this time’ so those historical measures are no longer be relevant. To their credit, they recognize, “this sounds a bit like the ‘new valuation paradigm’ thinking that prevailed during the dotcom boom when valuations went crazy.” Still, they are putting it out there for less circumspect investors to rely upon.

Similarly, my friend Jesse Livermore of Philosophical Economics recently posited in a terrific piece that there are very good reasons justifying the persistent high valuations of the past 25 years.

Should the market be expensive?  “Should” is not an appropriate word to use in markets.  What matters is that there are secular, sustainable forces behind the market’s expensiveness–to name a few: low real interest rates, a lack of alternative investment opportunities (TINA), aggressive policymaker support, and improved market efficiency yielding a reduced equity risk premium (difference between equity returns and fixed income returns).  Unlike in prior eras of history, the secret of “stocks for the long run” is now well known–thoroughly studied by academics all over the world, and seared into the brain of every investor that sets foot on Wall Street.  For this reason, absent extreme levels of cyclically-induced fear, investors simply aren’t going to foolishly sell equities at bargain prices when there’s nowhere else to go–as they did, for example, in the 1940s and 1950s, when they had limited history and limited studied knowledge on which to rely.

My problem with this line of thought is that it assumes that human beings have essentially begun to outgrow the behavioral biases that have ruled them throughout a history that encompasses much longer than just the past century. We have seen “low real interest rates” and “aggressive policymaker support” in the past. See Ray Dalio’s excellent letter on 1937 as an analog for today’s economy and markets. So this argument really hinges upon, “the secret of ‘stocks for the long run’ is now… seared into the brain of every investor…. For this reason… investors simply aren’t going to foolishly sell equities at bargain prices when there’s nowhere else to go.”

In other words, we have entered a new era where human beings have fully embraced “stocks for the long run” for the long run and without reservation so cycles will be muted and valuations remain elevated for the foreseeable future. Never mind the fact that the recent history of the financial crisis may contradict this idea. I think the burden of proof for this argument lies squarely with its author. I have my doubts. In fact, this sounds strangely similar to Irving Fisher’s famous line just days before the 1929 crash, “stock prices have reached what looks like a permanently high plateau.”

Finally, Alex Gurevich wrote a fascinating think piece over the weekend on the Fed, the economy and how they relate to stocks and bonds. While I truly appreciate following Alex’s thought process (as I do both of the previous authors’), it’s his case for owning stocks that strikes me as a clear rationalization of extreme valuations:

Singularitarians (such as Ray Kurzweil)  believe that we are on the brink of explosive self-acceleration led by computers designing better computers, which design better computers even faster, and rapidly surpassing every aspect of human intelligence. Singularitarian philosophy is migrating out of the province of science fiction writers into the  mainstream, and can no longer be ignored by long horizon investors… The idea of economic singularity allows me have a clear and consistent theory of unfolding events. I can be positive on stock market without being scared of valuations.

I don’t dispute the awesome idea of singularity. It seems inevitable and inevitably beneficial for society (though some very smart people would disagree). What I dispute is the idea that singularity should justify high valuations.

As I tweeted this morning, it reminds my of Warren Buffett and Charlie Munger on the awesome innovation of air conditioning and air travel. These things were miracle innovations that dramatically improved the lives of human beings but did they justify abandoning tried and true investment methods developed over long periods of history? In retrospect, the answer is obvious. Amazing innovation is truly inspiring but it shouldn’t inspire you to overpay for a simple stream of future cash flows that have been very easy to value accurately over very long periods of time.

Ultimately, only time will tell if it is, in fact, “different this time” or if history will rhyme once again and today will only represent another stanza in the poem it’s been writing for centuries. With all due respect to these three very wise market philosophers, my money is on the latter.

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Why The Buyback Binge Is Not As Bullish As You May Think

As Bloomberg recently reported, stock buybacks are now running at over $40 billion per month. With margin accounts already maxed out and households along with the largest sovereign wealth funds already “all in,” buybacks now represent the single greatest source of demand for equities.

On the surface, this should give investors great comfort. Stock buybacks may be the most effective way for companies lacking growth opportunities to enhance shareholder value. Look a little deeper, however, and this fact should give investors pause. Why? Because companies may be the worst market timers there are. They routinely set buyback records at major market peaks and buy only a tiny fraction of that amount at major bottoms.Screen Shot 2015-03-17 at 12.46.35 PMChart via Factset

How can that be? Shouldn’t the companies be in the best position to most accurately estimate their own intrinsic value and future prospects and thus most effectively buy low and sell high? Yes BUT companies are far more capable of buying back stock when cash is plentiful – when money is easy to borrow and profits are high.

The time when money is easy to borrow and profits are high, however, usually coincides with high equity prices. When money is hard to borrow and profits squeezed like during a recession, stock prices are usually much lower but companies are not in a position to take advantage. Buybacks, then, are very highly correlated with corporate profits and bond market risk appetites.

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Right now companies are spending fully 95% of their profits on buybacks and dividends. As I recently wrote, profit margins peaked over a year ago. And aggregate corporate profits are expected to decline over the next two quarters for the first time since the great recession. It’s hard to imagine companies being able to maintain near-record buyback levels amid this pressure in profits.

But they can still borrow money to buyback shares, right? Well, borrowing power is also tied to profits and investors’ willingness to buy their debt. I have also written recently that bond market risk appetites peaked last summer and have diverged from equities ever since. Should this trend continue, it would not be supportive of continued buybacks.

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All in all then, just like margin traders, households and the largest pension funds on the planet, the greatest source of demand for equities right now may also be maxed out.

A version of this post first appeared on The Felder Report PREMIUM

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Why The Smart Money Is Beginning To Worry About The Downside

A month or so ago, I was struck by Ray Dalio’s comments at Davos. He seemed fairly concerned and the major media outlets didn’t really pick it up.

“It’s the end of the supercycle. It’s the end of the great debt cycle.” –Ray Dalio

What does this mean? I think the simplest explanation is that over the past several decades we’ve gone from a nation of savers who paid cash for things including homes and cars to a nation of spenders who use debt like mortgages, car loans and credit cards to pay for things.

And it’s not just on the consumer level. It’s also happened at the corporate level.

“Corporate debt was $3.5 trillion– in 2007, arguably a period and– many would describe as bubbly. It’s 7 trillion now. So it’s gone from 3.5 trillion to 7 trillion. As you know, most of that mix has been in more highly leveraged stuff, Covenant-Lite loans– high yield, that’s where the majority of the rise has been. And if you look at corporations have been using it for, it’s all financial engineering.” –Stan Druckenmiller

Government debt has also grown to multiples of GDP around the world. But it can’t keep growing forever.

“In the past 20 to 30 years, credit has grown to such an extreme globally that debt levels and the ability to service that debt are at risk, relative to the private investment world. Why doesn’t the debt supercycle keep expanding? Because there are limits.” –Bill Gross

The debt boom over the past few decades has been a big economic stimulant. It reminds me of the steroids era in baseball. You take a great player, put him on the juice and he becomes a record-breaking home run machine.

But what happens when he comes off the juice? Have you seen a picture of Mark McGuire or Sammy Sosa lately? They are shadows of their former selves. Now that rates are zero and everyone has borrowed as much as they possibly can debt is no longer the super-stimulant it once was.

“The process of lowering interest rates causing higher levels of debt, debt service and spending, I think is coming to an end.” – Ray Dalio

The steroid era is over. So what are the implications for the economy and the markets?

“The implications are much lower growth, less inflation, lower interest rates, and less profit growth.” –Bill Gross

These are all symptoms that we’ve already witnessed since the financial crisis, right? Slower economic growth has been partially masked by rising asset prices and the wealth effect. Slower profit growth has been masked by the “financial engineering” Druck mentioned above. But that doesn’t change the fact that we are now facing a post-steroid era for the economy.

“We brought consumption forward and issued one giant credit card for the past 30 years. Now the bill is coming due. Investors need to get used to low returns, and low growth, inflation, and interest rates for a long time.” –Bill Gross

What’s probably most troublesome about the whole situation is that now that rates are zero or negative, debt levels have reached their maximum capacity and asset prices are already inflated (and spreads flattened), central banks no longer have the ability to ameliorate an economic slowdown by easing monetary policy.

“Central banks have largely lost their power to ease… We now have a situation in which we have largely no spreads and so as a result the transmission mechanism of monetary policy will be less effective. This is a big thing… So I worry on the downside ’cause the downside will come.” –Ray Dalio

With corporate debt levels twice what they were before the financial crisis, the covenants on much of that debt weaker than ever before and liquidity in the bond market disappearing, the next downturn could present a unique challenge for the Fed. And their traditional tool to address these sorts of challenges is now essentially impotent. No wonder Dalio is worried.

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