When the tech bubble collapsed in 2000, many popular stocks found their market prices gutted. For example, Cisco lost 86% of its market cap, while Amazon fell over 90% from $107 to $7. Losses like these decimated investor portfolios. In 2008, it happened again. The average diversified US stock fund fell a whopping 38%. The S&P 500 lost 50% by March 2009, and investors with more than $200K lost more than a quarter of their savings on average.
Recently, Hussman pointed out on Twitter that the most overvalued 10% of stocks in 2000 lost 80% of their value in the bear market that bottomed in the fall of 2002. Hussman added ominously, “Currently, every remaining decile (1/10) of S&P 500 components trades at a richer [price-to-sales ratio] than in 2000.”
In other words, 90% of US equities are more expensive right now than they were at the peak of the dot-com bubble. By implication, the inevitable bear market will be a lot more painful than the 2000-2002 rout that took the benchmark S&P 500 Index down 49% and the Nasdaq Composite Index down 78%.
Why bring up these bad memories? Because as we get closer to the end of this bull market, whenever that be, we see many investors are wondering two things: 1) will “whatever’s next” be as bad as 2000 and 2008; and 2) if so, is there a way to avoid it? No one knows exactly when this bull will finally run out of steam or how far it will fall; yet, there are signs we’re approaching an inflection point.
1. An Aging Bull Market
Our current bull market began on March 9, 2009. It turned ten years old this past March, which makes it the longest bull market on record. In fact, as of March, this bull was 122% longer than the average bull market length of 54 months.
2. Elevated Valuations
In simple terms, we believe the stock market is overvalued. Below is the respected “Buffett Valuation” (based on Warren Buffett’s fondness for this metric, calling it “probably the best single measure of where valuations stand at any given moment”). It compares the total value of the stock market to a country’s GDP. As of the time of this writing, the US Buffett valuation is about 1.3, meaning the stock market is about 30% larger than the entire US economy. Historically, markets start getting in trouble when this ratio passes 1.0. If you’re wondering, the ratio hit a top of around 1.1 before the 2008 crash.
Since the lows of last December, the markets have climbed ignoring weakening economic growth, deteriorating earnings, weak revenue growth, and historically high valuations on “hopes” that more “Fed rate cuts” and “QE” will keep this current bull market, and economy, alive…indefinitely.
Many are dismissing currently high valuations under the guise of “low interest rates,” however, the one thing you should not dismiss, and cannot make an excuse for, is the massive deviation between the markets and corporate profits after tax. The only other time in history the difference was this great was in 1999.
The Truth About Wall Street Research
For many years, I have counseled clients to disregard mainstream analysts, Wall Street recommendations, and even MorningStar ratings, due to the inherent conflict of interest between the firms and their particular clientele. Here is the point:
- You are NOT Wall Street’s client.
- You are the consumer of the products sold FOR Wall Street’s clients. Major brokerage firms are big business. I mean, really big business. As in $1.8 trillion a year in revenue big. The table below shows the annual revenue of 40 of the largest financial firms in the S&P 500.
When it comes to Wall Street profitability, the most lucrative transactions are not coming from servicing “Mom and Pop” retail clients trying to save their way into retirement.
Wall Street is not “invested” along with you. Wall Street “uses you” to generate income.
This is why buy and hold investment strategies are so widely promoted. As long as your dollars are invested, the mutual funds, stocks, ETF’s, etc., brokerage firms collect fees regardless of what happens in the market.
This is why “buy” ratings are so prevalent versus “hold” or “sell,” as it keeps the client happy. Below is a chart of 4642 rated stocks ranked by the number of “Buy,” “Hold,” or “Sell.”
There are just 2.8% of all stocks with a “sell” rating.
Do you believe that out of 4642 rated companies, only 129 should be “sold?”
You shouldn’t.
But, for Wall Street, a “sell” rating is not good for business.
The conflict doesn’t end at Wall Street’s pocketbook. Companies depend on their stock prices rising, as it is a huge part of executive compensation packages.
Corporations apply pressure on Wall Street firms, and their analysts, to ensure positive research reports on their companies with the threat that they will take their business to another “friendlier” firm. This is also why up to 40% of corporate earnings reports are “fudged” to produce better outcomes.
The chart below is from the survey conducted by the researchers, which shows the main factors that play into analysts’ compensation. It is quite clear that what analysts are paid to do is quite different than what retail investors think they do.
The question really becomes “If the retail client is not the focus of the firm, then who is?” The survey table below clearly answers that question.
Yep, there you are. At the bottom of the list.
Fed Update
Quantitative Easing (QE) is a Keynesian tool to stimulate the economy when the economy is weak and to pull it out of recession. We are now using QE to try to continue economic strength and expansion, leaving no safety net for the economy when it eventually does weaken. Last Friday, the Fed announced it is starting up QE again after stopping for the last five years.
The Fed is in QE mode because there is a problem with liquidity in the system. Given the Fed was caught “flat-footed” with the Lehman bankruptcy in 2008, they are trying to make sure they are in front of the next crisis.
The Reality Is The Financial System Is Not Healthy
If it was, we would:
- Not still be using “emergency measures” to support banks for the last decade. (QE, LTRO, etc.)
- Not be pushing $17 trillion in negative interest rates on a global basis
- Have reinstated FASB Rule 157 in 2012-2013 requiring banks to mark-to-market the assets on their books. (A defaulted asset can be marked at 100% of value, which makes the bank look healthy.)
- Not need to reduce liquidity requirements.
- Not need $60 billion a month in QE.
US – China Trade Agreement
The US and China reached a partial agreement Friday that would broker a truce in the trade war and lay the groundwork for a broader deal that Presidents Donald Trump and Xi Jinping could sign later this year.
As part of the deal, China would agree to some agricultural concessions, and the US would provide some tariff relief. The deal under discussion, which is subject to Trump’s approval, would suspend a planned tariff increase for Oct. 15. It may also delay — or call off — levies scheduled to take effect in mid-December.
So, who won? China.
- China gets to buy agricultural and pork products they badly need.
- The US gets to suspend tariffs.
Who will like the deal?
- The markets: the deal removes a potential escalation in tariffs.
- Trump supporters: Fox News will “spin” the “no deal” into a Trump “win” for the 2020 election.
- The Fed: It removes one of their concerns potentially impacting the economy.
By getting the “trade deal” out of the headlines, this clears the way for the market to rally potentially into the end of the year. Importantly, it isn’t just the trade deal providing support for higher asset prices short term:
- There now seems to be a pathway forward for “Brexit.”
- The Fed is injecting $60 billion a month in liquidity into 2020.
- The Fed has cut rates and is expected to cut again by year end.
- ECB is back into easing mode and running negative rates.
- Fed and ECB loosening capital requirements for banks. (Because they are so healthy after all. *Sarcasm*)
The Bull Case For 3300
- Momentum
- Stock Buybacks
- Fed Rate Cuts
- Possible Brexit Deal
- Trade Deal
However, while the case for a push higher is likely, the risk/reward still isn’t great for investors over the intermediate term. A failure of the market to make new highs, given the amount of monetary support, will be a very bearish signal. We will be watching closely.
Ray Dalio: The Next Logical Steps In A Classic Dangerous Journey
Why You Should Read: This report continues Dalio’s Three Big Issues outlook I previously shared with you. His vision appears to have grown darker in the last few weeks, due, specifically, to reports the Trump administration may get more aggressive in limiting US-China capital flows. To Dalio, this further confirms the 1930s parallels he sees. Not a comforting viewpoint, but it is important to consider.
Key Points:
- As previously described, three big forces are converging in a way unseen since the 1930s: large wealth and political gaps, limited central bank stimulus ability, and a rising power challenging the existing world power.
- In the past, these events led to capital flight and then capital controls. Recent proposals suggest we may now be inching toward similar moves.
- Countries increasingly must choose whether to align with the US or China. Time is on China’s side in this long-term struggle.
- Trump allies, like Steve Bannon, openly state that US capital is enabling the Chinese challenge, and they are considering many ways to limit it.
- Dalio believes some kind of fiscal-monetary policy coordination will be needed to stimulate further economic growth, since conventional monetary policy has lost its effectiveness. Success is not guaranteed.
Bottom Line: In interacting with Dalio, he said the 1930s were different in one respect. Back then, the problem was unemployment. Now it is under-employment. People have jobs but remain frustrated at their living standards. The problems are slightly different, but they are still big problems. I like that Dalio is looking for solutions, even when I think some of them won’t work.
America’s Corporate Earnings
America’s corporate earnings have stagnated since 2012, and only share buy-backs have kept earnings per share rising since that time. See next three charts. (You can find more information here.)
Yet, earnings per share have risen dramatically since 2015.
Non-financial corporations’ borrowing to buy back their own shares is why earnings per share have skyrocketed, therefore, pushing up the S&P 500 share index.
The US consumer is 17% of the global GDP, bigger than China’s whole economy.
Market Data
- Leading the world. Most of the ways the US has been surprising the world have not necessarily been the good kind. When it comes to economic reports, though, the US had far surpassed other regions, to one of the most extreme extents ever.
- Black cross. The 50-day average crossed below the 200-day average on the Dow Transports, an “ominous” signal for stocks.
- Earnings slump. Standard & Poor’s is estimating that operating earnings among the 505 companies in the S&P 500 index will decline from where they were a year ago, the worst result in several years.
- Small business retreat. The NFIB organization surveys small business owners on an array of aspects about their businesses and outlooks. The latest results for September show that among 9 different metrics, sentiment peaked a year ago and just hit a multi-year low.
- Small slump. The IWM small-cap fund has been suffering one of its worst stretches in a decade, with ETF traders consistently pulling money from it over the past three weeks. Options traders have also been paying up for the protection of put options.
- Individual investors won’t buy into this market. The latest AAII survey showed yet another drop in optimism. Over the past 20 weeks, the Bull Ratio has dropped to the 2nd-lowest level since the financial crisis.
- High-low death cross. The net percentage of securities on the NYSE hitting 52-week highs minus those sinking to 52-week lows has been dropping, with some recent days dipping into negative territory.
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