Bear Market

Forget 'red balloons', StreetTalkLive's Lance Roberts expands from his recent visualization of Bob Farrell's investment rules to six more market mavens with insights into money management and being a successful investor. What you will find interesting is that not one of them promote "buy and hold" investing for the long term - probably because in reality it doesn't work.

As the markets once again approach historic highs - the overly exuberant tone, extreme complacency and weakness in the economic data, bring to mind Bob Farrell's 10 investment rules.  These rules should be a staple for any long term successful investor.  These rules are often quoted yet rarely heeded - just as they are now. Farrell became a pioneer in sentiment studies and market psychology. His 10 rules on investing stem from personal experience with dull markets, bull markets, bear markets, crashes and bubbles. In short, Farrell has seen it all and lived to tell about it. Despite endless warnings, repeated suggestions and outright recommendations - getting investors to sell, take profits and manage your portfolio risks is nearly a lost cause as long as the markets are rising.  Unfortunately, by the time the fear, desperation or panic stages are reached it is far too late to act and we will only be able to say that we warned you.

The ongoing message from the mainstream media, analysts and most economists is that the economy has turned the corner and we are set for substantially stronger growth in the coming year.  While that sounds great on the surface the economic data has yet to hint at such a robust recovery.  What is worrisome is that CNBC has started using the term "Goldilocks economy" again which is what we were hearing as we approached the peak of the market in early 2008.  As David Rosenberg pointed out in his morning missive: "Maybe, it's just this:  so long as there is a positive sign in front of any economic metric, no matter how microscopic, all is good.  After all, you can't be 'sort of in recession' - it's like being pregnant... either you are or you are not." The bottom line is that ex-artificial stimulus, and other fiscal supports, there is little in the way of an economic recovery currently going on.  In order for the economy to reach "escape velocity" it will be on the back of sharply rising employment and wages which are needed to prime consumer spending.  This is not happening as the the gap between wages and rising cost of living continues to drive the consumer to shore up that shortfall with more debt.  

By bailing out banks and targeting equity prices, the central banks are exacerbating the misallocation of savings/financial capital to historically overvalued corporate equity. What happens when central banks make credit cheap and abundant? All that cheap money chases scarce productive assets. The yields on assets drop, and speculative "risk-on" assets are boosted into bubbles. Even as corporate profits have skyrocketed (does the trajectory look sustainable? up almost 300% in four years?), equity valuations have risen apace, keeping yields at historically low levels. Anyone who claims "stocks are cheap" would do well to study these charts...

There have been several articles as of late discussing that the next great secular bull market has arrived. However, the reality is that this cycle is currently unlike anything that we have potentially witnessed in the past.  With massive central bank interventions, artificially suppressed interest rates, sub-par economic growth, high unemployment and elevated stock market prices it is likely that the current secular bear market may be longer than the historical average. No matter how you slice the data - the simple fact is that we are still years away from the end of the current secular bear market. The mistake that analysts, economists and the media continue to make is that the current ebbs and flows of the economy are part of a natural, and organic, economic cycle. If this was the case then there would be no need for continued injections of liquidity into the system in an ongoing attempt to artificially suppress interest rates, boost housing or inflate asset markets. From market-to-GDP ratios, cyclical P/Es, misconstrued earnings yields, and the analogs to previous Fed-blow bubbles, we appear near levels more consistent with cyclical bull market peaks rather than where secular bear markets have ended.

Profits and leverage are locked in a deadly embrace. There is a time-honoured tradition in statistics: whipping the data until they confess. Bullish and bearish equity analysts are equally guilty of this practice. It would seem that statistical conclusions are merely an ex-post justification of a long-held prior belief about equity markets being cheap or overpriced. Clearly, consensus, notably among sellside analysts, is bullish. GLG's CIO Jamil Baz presents the bullish view before discussing the bearish counterpoint - consensus disregards leverage. In the short term, it is clear that central banks need to entertain the illusion of viable stock market valuations by pulling rabbits from a hat. But as high-powered money reaches ever higher levels, the probability of accidents looms large.

From the close on Dec 28th (pre-fiscal-cliff), the Dow is up over 7% (for its best January since 1994), the long bond is down 3.3% in price, gold is up marginally and the USD is down marginally. From around November 2012, the current in stocks is eerily reminiscent of the same run from November 2011's dip and co-ordinated easing. It would appear that if 2011/2 was the world normalizing to ZIRP, 2012/3 is the world's central banks fighting currency wars with their ever-expanding balance sheets (and while Europe won last year in stocks, the ECB's fading balance sheet is leading its stocks to underperform a renewed Fed expansion). Credit markets are notably not buying this risk-on move (and nor is VIX) in January but JPY-cross-based carry is leading the way, so the world better hope that no one doubts the BoJ's ability top unilaterally 'win' the currency wars. Energy and Healthcare are the month's winners as JPY loses 6.4% on the month and EUR gains 2.7% against the USD. ES clung to VWAP into the close. with a second down day in a row

There has been an burst of exuberance as of late as the market, after four arduous years, got back to its pre-crisis levels.  Much has been attributed to the recent burst of optimism in the financial markets from: better than expected earnings, stronger economic growth ahead, the end of the bond bubble is near, the long term outlook is getting better, valuations are cheap, and the great rotation is here - all of which have egregious holes. However, with the markets fully inflated, we have reached the point that where even a small exogenous shock will likely have an exaggerated effect on the markets.  There are times that investors can safely "buy and hold" investments - this likely isn't one of them.

If corporate earnings have topped out, what will push the stock market higher? The usual answer is "central bank intervention," but history suggests that in the long run, the market eventually correlates to corporate earnings. Earnings up, market up; earnings down, market down.

Ironically, the very success of stock market manipulation only thins the market of legitimate participants and thus increases the probability that risk that has been suppressed for years will erupt uncontrollably. That the stock market is manipulated is no longer in question. One explicit goal in the Fed's zero-interest rate policy (ZIRP) is to drive capital into risk assets such as stocks. That is a first-order, transparent policy of manipulation, i.e. a centrally managed policy aimed at managing markets to meet a key central-planning goal: creating an illusion of prosperity via an elevated stock market and the resultant "wealth effect" for the 10% who own enough stocks to matter. Indirect manipulation is hidden from public view lest the rigging of the market taint the perception that a rising market is "proof" that Federal Reserve and Administration policies are "succeeding." Indirect manipulation is achieved via Federal Reserve quantitative easing operations, unlimited liquidity and lines of credit to fund bank speculations and masked buying of market futures. This multilevel manipulation creates a Boolean either/or for any Bear market: either it is a planned "panic" that profits the banks or a systemic failure of the orchestrated campaign of market manipulation.

As unemployment rose toward 10%, the January 1975 cover of Ramparts magazine blared: The End of Affluence: The Last Christmas in America. (TLCIA). Now statistics are echoing that last great recession: rising prices for essentials, systemically high unemployment and stagnant wages. So how does a society deal with the End of Work when it also means The End of Affluence, even for many of those with jobs? How does government deal with declining tax revenues and rising interest rates? The death throes of the debt-based consumerist lifestyle are already visible beneath the glossy propaganda of "rising revenues this Christmas season." The Fed is desperately attempting to re-inflate the debt bubble by lowering interest and mortgage rates and buying up all sorts of semi-toxic/impaired debt. What the Fed dreads is the reality we all feel and see: fear of the future due to diminished wealth and shaky incomes.

It must be pointed out that gold is certainly no longer the bargain it was at the lows over a decade ago (at which time Warren Buffett undoubtedly hated it just as much as today). This is by no means akin to saying that there is no longer a bull market in force though. What seems however extremely unlikely to us is that the long term bull market is anywhere near to being over. After all, the people in charge of  fiscal and monetary policy all over the globe are applying their 'tried and true' recipe to the perceived economic ills of the world in ever bigger gobs of 'more of the same'. Until that changes – and we feel pretty sure that the only thing that can usher in profound change on that score is a crisis of such proportions that the ability of said authorities to keep things under control by employing this recipe is simply overwhelmed – there is no reason not to hold gold in order to insure oneself against their depredations.

"what you realize is that the lessons of ’08 will actually result in a much quicker process, a process that I would describe as a “black hole” if and when there is the next financial crisis.... Nobody in America has actually seen, or most people probably can’t even contemplate, what an actual loss of confidence may look like. What I’m trying to struggle with as a money manager, who really seriously doesn’t like to lose money, is how to protect our capital and how to think about the next crisis."

If you want to send a roomful of 100 wealth managers into an icy chill, have Russell Napier address them. Napier’s presentation, “Deflation in an Age of Fiat Currency,” is thought-provoking, and the precise polar opposite of investing as usual. US stock markets aren’t cheap, not by a long chalk. Napier, like us, favors the 10-year cyclically adjusted price / earnings ratio, or CAPE, as the best metric to assess the affordability of the market. At around 21, the US market’s CAPE is near the top end of its historic range. The S&P 500 stock index currently trades at a level of around 1400. Napier believes it will reach its bear market nadir at around 450, driven by a loss of faith in US Treasury bonds, and in the dollar, by foreigners.

We have long been pounding the table on what in our view is the biggest detriment to any future growth for not only corporate America, but the entire US (where, sadly, government investment IRRs just happen to be negative - a fact that most won't understand until it is too late, especially not self-anointed economic wisemen whose only solution to everything is "do more of the same" yet who thought the utility of the Internet would be eclipsed by that of the fax machine): the complete lack of capital expenditures at the corporate level, and lack of (re)investment spending. It turns out that, however, that there is more to the story, and as the following chart from SocGen's Albert Edwards shows, not only are companies using up what actual free cash flows they have for such stupid stock boosting gimmicks such as harebrained M&A (just look at the recent fiasco between HP and Autonomy to see how rushed M&A always ends), and of course buybacks, but they are now levering to the hilt to do even more of this. The last time they did this? The golden days of the credit bubble.