Q4 2014 Forecast

Here is my latest forecast of the S&P 500 quarterly averages. The market is quite a bit above what profits would justify, which means the PE ratio is expanding, or to put it another way, people are so desperate for earnings that they're willing to take higher risks. The market is above the forecast as it was in the late 1990's bubble.

Swedes help with timing

Anyone not a mainstream economist has recognized the awesome blindness of the profession to the approach of the latest financial crisis and its impotent policies afterwards. I recently finished a book published last year that not only explains why mainstream economics failed but promotes good economics, the Austrian kind, and provides another tool for telling the future.

Thomas Aubrey, the author of Profiting from Monetary Policy and founder of Credit Capital Advisory in the U.K., consults businesses on how credit creation affects global asset prices. Aubrey begins by detailing the devastation of the crisis on pension funds. Not only did many funds lose money in the crisis, but the low interest rate monetary policies intended to restore the economy have inflicted more damage and will lead to many failing in the future. Aubrey doesn’t mention the life insurance industry, but it and millions of retired people are suffering for the same reasons.

Austrian Bull Riding

Earlier this year Doug French, a senior writer at Agora Financial wrote a nice review of my book, Financial Bull Riding. In case you haven't read the book, this might persuade you to take the ride:

How Austrians Ride the Financial Bull

By Doug French

The single most asked question I get at investment conferences is, “Do you have a list of money managers who invest guided by the Austrian School of economics?” The question is a good one. After all, the Austrian School stands alone in predicting the fall of the Soviet Union and the housing and financial crash.

Anyone with a retirement account has been whipsawed by the stock market over the past few decades. Fidelity’s Peter Lynch told everyone to buy stocks and hold. Everything would work out great. Diligent savers would even end up millionaires, courtesy of an ever-expanding stock market. The efficient-market hypothesis (EMH) provided intellectual support for the idea. The market reflects all information, so there’s no way to beat it, said the economists.

Another Omen - Price to Sales

The first indicator most investors check in order to begin to assess the value of the overall stock market is the price/earnings (PE) ratio, which is currently around 18 and just slightly higher than the 60-year average of 16.3. 

But the PE ratio can change a lot depending on the number of years one selects to calculate the average. For example, the Schiller ratio uses a 10-year moving average and calculates the ratio at 26.3. As the last post disclosed, corporations have been buying back their own stock and that alters the ratio by reducing the number of shares divided into profits. 

Who is buying?

The Dow is back over 17,000 and the S&P 500 topped 2,000 again this week. Who is buying at these nose bleed levels? According to Jeffrey Kleintop of LPL Financial the buyers are individual investors and corporations buying back their own stock (Hat tip to Christopher Rowe, Director of Investor Education at The Oxford Club). 

Currently, there are six notable trends in buying and selling in the stock market. U.S. stocks are being purchased by corporations and individuals; however, foreigners, hedge funds, institutions and insiders are net sellers.

According to data from FactSet, S&P 500 companies bought back about $160 billion in stock in the first quarter of 2014, and are on pace for an amount this quarter that is close to the all-time high of $172 billion set in the third quarter of 2007. Corporations have been decreasing the amount of shares in the market for 10 straight quarters. Over the past year, this has amounted to about 3% of shares outstanding in the S&P 500. 

Why does this matter? Individual investors tend to pile into the market near the top so that they buy high and sell low. Individuals are a small part of the market, so they function mainly as an indicator that the end is near.

Corporate buying is a much larger segment, large enough to overwhelm institutional selling and cause the market to rise. Corporations are borrowing to purchase their own stocks and pump up returns. This deflates the price/earnings ratio by inflating the earnings per share. So while I'm not a big fan of PE ratios as a guide to investing, corporate buy-backs make the ratio even less worthwhile.

But the main problem with corporate buy-backs is that the corporations are borrowing to buy. That pumps up the price of the stocks, makes management look better and in some cases triggers options and bonuses for them.

Kleintop expects institutional selling to continue. So what happens when profits go south and corporations have trouble making the payments on the loans? It will take out the largest group of buyers in the market this year. Most will have to sell the stocks they bought for a loss. That will accelerate any decline in the stock market that follows a bad earnings reporting season.