What’s an investor to do when the market won’t cooperate?

What is an investor who follows the Austrian school of economics supposed to do with a market that has traded in a narrow range for almost two years and refuses to bend to the reality of falling profits and a slow economy? After all, we may already be in a recession, as Peter Schiff thinks, but the market is clueless.

A couple of posts ago I wrote about the fetish with randomness that afflicts mainstream economics and finance. One result of that fetish is the dogma that no one should try to time the market; just pick good stocks and stay with them. The high priests ridicule those of us who make any effort at looking into the future.

How not to predict the stock market

Investing expert Bert Dohmen said that “Looking at earnings, dividends and P/E ratios in order to predict future stock prices are all a waste of time” in a recent Forecasts & Strategies email issued by the economist Mark Skousen. The email continued:

Dohmen explained, “If a P/E were meaningful for predicting future price performance, why is a stock like Facebook selling at a lofty P/E of around 90, and Amazon with a P/E of 300, both still highly recommended and rising, while other stocks, like Apple, with a low P/E of around 10, [are] declining and down 35%?”

He added, “Analysts tell us that ‘earnings’ are the most important thing affecting stock prices. Really?! Well, corporate earnings in 2015-2016 have had the largest decline since the crisis in 2009, but the DJI and the S&P 500 are within about 1% of making new record highs.”

Then Dohmen asked the all-important question, “So what is the major determinant of stock market trends?”

Of course, the answer is “future earnings.” Stock prices are always based on the forward-looking views of investors. That’s why high-priced stocks such as Facebook are selling for 90 times earnings. It also explains why Amazon is selling for 300 times earnings and Tesla is selling for $230 a share even though it has no earnings! Investors are upbeat about their future. Meanwhile, Apple is selling for only 10 times earnings because it’s not viewed as a growth stock anymore.

Will we never see another Soros or Buffett?

The Global Guru wrote recently that investing has changed so much over the past two decades that we will never see investors like Buffett and Soros who could earn 30% returns for 30 years.

Nicholas Vardy wrote, “George Soros’ investment track record made him the equivalent of a .400 hitter in baseball.” But then his luck changed:

Soros quietly left the hedge fund scene in 2011, turning his fund into a family office. But his last few years in the game were hardly like his first. Indeed, 2010 was Soros’ worst year since 2002, with his flagship fund up a mere 2.63%. The following year was even worse, with his famed Quantum fund reportedly down 15%.

Central bankers made bull riding necessary for survival

Bull riding has become a lucrative sport for those with the talent to ride, earning the top riders hundreds of thousands of dollars per year in spite of a few broken bones. Central bankers have made learning to ride the leaps and spins of the stock market a necessity since the early 1980’s. Why has the market been so volatile since 1980? Two factors have caused it:

1. End of Bretton Woods and rise of floating FX.

2. End of fiscal policy and rise of monetary policy.

The existing international system of floating rates doesn’t have a cool name like Bretton Woods, but it came about after the death of the former fixed rate system. The Bank for International Settlements (BIS), the central bankers’ bank, doesn’t like what its member banks are doing under the current system. While the media and politicians, especially Bernie Sanders, preach fire and brimstone damnation of Wall Street and condemn it for the Great Recession, the BIS body slams the world’s central bankers:

Macro-Prudential regulations have failed for 90 years

Mainstream economists, excluding those at the Bank for International Settlements, have stuck with their ancient superstition that recessions are random events, each with its own special cause, known technically as shocks that send the economy spinning out of equilibrium. Central bankers and politicians along with the mainstream media have rounded up the usual suspects, bankers, and sentenced them without a trial.

The general opinion seems to be that bankers were either too stupid or dishonest while making loans in the past so they made a lot of bad loans and conjured from hell the worst recession since the Great Depression. The guilty verdict requires that Basel and Washington control even more of the decision making process in what has come to be called “macro-prudential” regulations.

This ratio signals recessions and inequality

In past articles I have reviewed sound models signaling the Fed’s money printing has made the economic expansion unsustainable. Those included Spitznagel’s Misesian Index, Shiller’s Cyclically Adjusted Price Earnings (CAPE) ratio, and others. I just discovered a new one, the ratio of asset prices to income.

I found the ratio in a report on inequality of wealth in the world published by the Credit Suisse Research Institute. Referring to the ratio, the report says on page six:

...the ratio is now at a recent record high level of 6.5, matched previously only during the Great Depression. This is a worrying signal given that abnormally high wealth income ratios have always signaled recession in the past.

Why the Fed won't raise rates

The VIX (volatility index) is in a coma, so most investors are dozing while danger signs about the current stock market pop up. The idea that the Fed causes recessions by raising interest rates has relaxed many investors. Some writers have assured nervous investors that it won’t be until the Fed’s third rate increase that the market will respond.

In this previous post, I used Hayek’s Ricardo Effect to explain that recessions can happen without rising interest rates. Now, Hoisington Investment management adds support for Hayek from a different perspective. In the Quarterly Review and Outlook for the first quarter of this year, Hoisington wrote about the financial histories of nations with over-indebted economies. That history goes back two thousand years, but the US has suffered through four such seizures in the 1830-40s, 1860-70s, 1920-30s and the past two decades. The report offers six characteristics of excessive debt:

Corporate buybacks keep market airborne

The stock market has surged lately and a lot of analysts credit it to stock buybacks by corporations. As the chart here shows, buybacks have reached dizzying heights. Corporations are purchasing their own stocks because corporate profits hit record levels last year and management can find no better use for the cash than to give it back to the owners through larger dividends or buybacks.

As I wrote recently, record corporate profits, the current level of optimism and the low yields on debt justify the current loftiness of the market. This is not a bubble, but most investors are wondering what will shoot down this high flying market? Corporations appear to be the last buyers standing because “mutual fund managers have the lowest cash levels in history and money market fund levels are lower now than in 2007 and near a record low from 2000 relative to the capitalization of the stock market."

Bitcoin won't save us

Libertarians have waxed poetic about bitcoin for years. It pokes a finger in the eye of the state by breaking the state’s monopoly on money and rescues citizens from a rapidly eroding dollar. But aside from the block chain innovation and its potential use in other industries, I can’t get excited about bitcoin. Other than symbolic, what advantage does bitcoin offer?

Say you produce oil field equipment in Tulsa and made a big sale to a production company in Marrakech, Morocco and to make the sale you offered them 90 days of credit. Also, you’re local sales rep made the deal in Moroccan dirhams. So you’re worried that in the 90 days before you get paid that the value of the dirham will depreciate against the dollar (that is, it will buy fewer dollars) and you’ll lose money on the deal.

Assault on the Dollar

The US dollar’s position as the dominant reserve currency is coming under assault from at least three directions. The UN announced in 2009 plans to mint silver and gold coins to be used in international trade. Socialist economist Joseph Stiglitz, a Nobel laureate, chaired the UN Conference on Trade and Development (UNCTAD) said it shows

..a growing consensus that there are problems with the dollar reserve system. Developing countries are lending the United States trillions dollars at almost zero interest rates when they have huge needs themselves... It’s indicative of the nature of the problem. It’s a net transfer, in a sense, to the United States, a form of foreign aid.

Emerging market (EM) countries that hold large amounts of dollar reserves don’t hang onto hundred dollar bills. They use their cash to buy US government debt so that they can earn interest and that is what Stiglitz meant by EM countries lending to the US. When someone needs US dollars, to buy oil for example, the EM central bank can easily sell the US debt and provide the dollars for the exchange.

Armand Dufour of the European Bank welcomed the UN coins. “People have enough Fiat currency options, government and banks cannot intrude on bullion coins – they will have their own inviolable value... If we see a dismounting from the US dollar, as is inevitable in the main view, there will be a strong move to the Oro, which may drive its price up to the point where governments will not allow its circulation; they will try to isolate it.”

In his last statement he is merely echoing Gresham's law that bad money drives out good, meaning that people will hoard the UN money while spending paper money as fast as possible.

Then in a Free Market post, China Takes Aim at the US Dollar, Sean Brodrick reported that the Chinese government is pushing its yuan to be a reserve currency like the US dollar. Brodrick wrote, 

In early April, former Secretary of the Treasury Larry Summers publicly warned: "This past month may be remembered as the moment the United States lost its role as the underwriter of the global economic system."

China’s crime was to launch the Asian Infrastructure Investment Bank (AIIB), to compete with the Asian Investment Bank and World Bank, both led by the US. The US begged its “friends” not to join, but they did anyway. Also, China has initiated the China International Payment System (CIPS) in direct competition for the other international payment system called SWIFT, which is a key support of U.S. dollar hegemony.

Finally there is the BRIC bank in which Brazil, Russia, Italy and China teamed up to replace the International Monetary Fund and World Bank. According RT News,

The big launch of the BRICS bank is seen as a first step to break the dominance of the US dollar in global trade, as well as dollar-backed institutions such as the International Monetary Fund (IMF) and the World Bank, both US-based institutions BRICS countries have little influence within.

Talking heads and bloggers typically respond to news of the dollar’s demise as a reserve currency with hysteria: the dollar will become worthless and hyperinflation will destroy the US economy. However, one of the most important economic lessons that investors need to learn is this:  fear sells. Every politician and media flunky knows this. To paraphrase the great American newspaper editor HL Mencken, politicians and media pundits devote their time to frightening people because people will vote or pay attention to the media only when frightened. 

For some reason known only to God people are not interested in good news. Years ago I read a paper in an advertising journal that described research on themes in advertising that actually work. Researchers tested love, sex, friendship and a dozen other themes in ads and discovered that none of the themes moved viewers except fear, and fear worked well.

Nevertheless, I will proceed with the contrarian view: ending US dollar hegemony will be good for the US in the long run, though it could be painful in the short. Keep in mind that a collapse of the value of the US dollar against other currencies will only affect the prices of imports and exports and imports aren’t a large part of the US GDP. So yes, there will be some inflation. But the value of the dollar for domestic goods won’t collapse. Ceteris parabus, more expensive imports will cause the prices of domestic goods to fall. The prices of both imports and domestic goods can rise at the same time only if the Fed cranks up its money printing machine.

So what is the great advantage that the US gets from its status as the number one reserve currency in the world, the loss of which strikes terror in the hearts of mainstream economists? The chief advantage is that the Fed can flood the world with US dollars and the federal government can borrow and spend far beyond its means with impunity. But is that really an advantage for US citizens? No, it is not! Fed money printing does enormous damage according to the Austrian business-cycle theory. The Fed’s ability to print infinite amounts of money is the single most destructive force in the US.

1. It transfers wealth from the poor and middle classes to the wealthy who work in the financial services industries because the latter get the new money first before prices have risen and the former get it last. 
2. It causes the booms and busts that hurt the middle and poor classes the most. 
3. It destroys manufacturing by eroding the value of funds set aside for depreciation, which makes replacing worn-out equipment harder, and reduces profits by forcing them to pay taxes on inflated dollars. 

Federal spending far beyond its means is not much better. The borrowing required to finance deficit spending causes the trade deficit and loss of US jobs (the reason would require another post) and burdens our children with unbearable debt. So why would any economist consider that being the dominant reserve currency is a benefit to the US? They do so because they’re socialists, like Stiglitz.

Because mainstream economists favor unlimited money printing by the Fed and unlimited deficits by the federal government, there is no one restraining either. Those of us who want a better future for our children have only one hope, that an outside force will come to our aid. Barring a miracle for God, China’s efforts to capture the “benefits” of reserve currency are our best hope.

Without reserve status, US citizens would have to buy gold or yuan in order to purchase imports, but a rapidly depreciating US dollar would make that difficult and force the Fed to show some restraint. Also, interest rates for borrowing by the federal government would rise and be denominated in yuan, so any depreciation of the US dollar would increase government debt by the same amount. That would add more pressure to the Fed to stop printing money.

In short, the US would find itself in a position similar to the PIIGS, Portugal, Italy, Ireland, Greece and Spain after the Big EZ fiasco. None of the PIIGS could print their way out of their problems and the governments could not borrow, so they had to reduce regulations, cut spending and raise taxes to get their economies moving forward. Greece hasn’t been so good at it. Nothing would help the US economy more than similar medicine.

The Indifference Zone

The graph shows the weekly averages for the S&P 500 since October of last year.  The index has been stuck in a trading range between 1990 and 2110 for the past six months. A move to 2200 as the forecast in last week’s post suggested would require breaking out above that range into new territory.

Bulls and bears playing tug-o-war created that range because of their diverging expectations. Bears can become bulls when the market hits a support level near the bottom, and bulls will morph into bears near the top. The great Austrian economist Ludwig Lachmann explained the dynamics of trading ranges in his essay “A Note on the Elasticity of Expectations.”¹

S&P 500 Forecast

While profits in the energy sector cratered in the last quarter, a jump in retail profits of $28 billion in the fourth quarter from the previous year suggests that the S&P 500 will continue to rise. The forecast calls for an average of 2056 for the S&P 500 for Q2 and 2185 for Q3 this year.

In order for the quarterly averages to reach such heights, the index would have to set many new record highs. That could happen if more European and Japanese funds cross the oceans to invest in the US as they flee the destruction of their own currencies by their central banks. However, I’m skeptical. 

Another way to interpret the forecast is as a moving average. In technical analysis, moving averages of varying lengths guide investors timing their purchases and sales. The market crossing the moving average is a buy/sell signal, depending on the investor’s strategy. The graph above shows that the forecast sometimes leads and sometimes follows the market but when the two cross it indicates a turning point. The two lines have shaken hands recently, which could be our turning point for this market.

Housing bubble reincarnated as oil

We took my six-month old grandson to the park this weekend and put him into a baby swing for the first time. He couldn't decide if it was fun or not and took turns crying for a while then laughing for a while. I think of that when I read about the oil bubble.

The Fed has reincarnated the real estate bubble of the early 2000s in the current tsunami of oil. To see how, we need summon the help of the Austrian Business-Cycle Theory (ABCT). The ABCT says that Fed induced interest rates below  the rate that the market would naturally set causes excess borrowing and investment in capital goods industries, not a general over investment, but bad investments in particular industries. The market reveals those excess investments through falling prices that cut into profits, reduce employment and spark a recession in the economy.

Earnings stumble

Despite what mainstream finance and economics teach, the stock market is rational. Two things drive it - profits and risk tolerance, or as they say in finance, the discount rate. Both have advanced the stock market from its lows at the bottom of the latest recession to recent record highs as profit rates and risk tolerance soared so that investors have been willing to pay more for the same profits.

As of the writing of this post, the S&P 500 is down about 3% from its record set on March 2. Some of the selling could have come from profit taking or covering shorts, but much of it is due to concerns about future earnings. Last week I showed that profit rates are at record highs and reasonable investors would assume such rates are unsustainable based on the history. And that seems to be the case as Seeking Alpha's Brian Gilmartin wrote:

Looking at the first half of 2015, analysts are now projecting year-over-year declines in both earnings and revenues for both Q1 and Q2 '15, compared to expectations for earnings and revenue growth for both quarters back on December 31 '14.

How high can profits go?

The market set new records this week. Some of the lift came from the European Central Bank printing new Euros. As the ECB buys bonds, the sellers are buying into the US stock market thinking that it is the safest repository. The ECB printing presses will impact stock markets for six months then, like any drug, the effect will begin to wear off. In microeconomics that’s called diminishing marginal returns.

The graph to the left shows profit rates from US domestic only earnings plotted in blue and labeled “Domestic Profit Rates” with the domestic profits that include foreign earnings plotted in red and labeled "National Profit Rates." The data comes the NIPA tables at the Bureau of Economic Analysis. Domestic profit rates are at their highest since 1965, but national rates are at their highest level on record. The high level of profits, and the records in the stock market in spite of a relatively sluggish economy, emphasizes the growing importance of foreign earnings. 

It's not likely that profits can continue to soar and many market watchers are pessimistic about future earnings. The Financial Times columnist Gavyn Davies reported recently that 

Albert Edwards, the market's favourite bear at Societie Generale, wrote last week that the rte of decline in analysts' forward profit expectations in the US is clearly associated with recession. According to MSCI data, profits downgrades are exceeding upgrades by a net 33 percent at present.

Some of the decline in expected earnings comes from falling oil prices and much of the rest from the rising dollar that reduces earnings from overseas. 

Schwab's Liz Ann Sonders estimates that the forward looking price-to-earnings ratio growth rate has actually gone negative:

Bespoke Investment Group (BIG) calculates the “guidance spread” each quarter, which measures the difference between the percentage of companies raising guidance and lowering guidance; so when the number is negative, more companies have lowered guidance than raised guidance. The spread for the most recent quarter came in at a “ridiculously low” -9.4 percentage points. That was the lowest guidance spread since the final two quarters of 2008, at the end of the financial crisis.

Psychologically speaking, pessimism like that coming out of the financial press is good for the market. If predictions turn out wrong and profits surprise by rising the market will soar.  On the other hand, it's hard to see where earnings growth will come from. Eventually, profits will fall as the Ricardo Effect kicks in and when it does the stock market will collapse as it did in 2000 and 2008. 

Fed loses its mojo

The Dow hit another record high and the Japanese stock market rung the bell for a 15-year high this week following statements by Fed Chairman Janet Yellen before Congress that the she was losing patience. (Actually, she said the Fed would remove the word from its policy statement.) 

Both markets have been helped by the Big EZ's firing up its money presses. Much of the new issue of euros will swim the pond and dry out in the US stock market. Also, margin debt and debt by corps to buy back their own stocks are at record levels. 

Taking the market's temperature

Based on the popularity on my blog of the post The Dao of Investing - It's time to sell, I'm guessing investors are looking for indexes to help them take the temperature of the market. So this week I will revisit an indicator I developed in my book Financial Bull Riding.  

The method for building the index was based on a technique developed by James Estey in his book Business Cycles published in 1950. Estey included a chart of business cycles from 1790 through 1949 in which he plotted economic activity similar to GDP. Armed with dates for business cycle peaks and troughs, he de-trended the data by calculating the average for the series between peaks, then between troughs, then averaging the two series to obtain an average for each business cycle. Then he subtracted monthly figures from the cycle averages. 

China's slow growth omen

Reading the daily economic news in hopes of navigating our location in the business cycle reminds me of ancient priests trying to discern the movements of the gods by examining the contours of the liver of a sacrificed goat. Even the ancients priests understood that the more omens they could combine the better their predictions would be.

Another omen appeared this week when China announced that official China Federation of Logistics’ January purchasing managers’ index (PMI) slid to 49.8 from 50.1. The HSBC and Markit private sector PMI also fell from 49.8 to 49.7. Indexes like these are designed so that any outcome below 50 indicates contraction in the sector. In the worldwide division of capital, China is primarily a consumer goods manufacturing nation that supplies the US and the Big EZ (Euro Zone), which are the world’s largest manufacturers of producer and capital goods.

The Austrian Business-Cycle Theory (ABCT) at its simplest divides economies into raw materials, producer goods and consumer goods. Hayek’s version, employing the Ricardo Effect, says the turning point in an expansion comes when spending on consumer goods increases and the greater profits cause consumer goods makers to stop buying new equipment. That generates a profit crisis among producers goods manufacturers who begin to reduce employment and the recessions begins. The large jump in GDP, which mostly measures sales of consumer goods, in the third quarter was an omen of bad things to come from the producer goods sector. Sales of consumer goods (GDP) fall when enough workers in the producer goods sectors have lost their jobs.

Big EZ's QE Fail

The stock market climbed last week in anticipation of the European Central Bank's announcement of its program to purchase more bonds. The US press has dubbed it the ECB's quantitative easing, or QE. As with the several versions of QE in the US, the ECB's purpose is to reduce interest rates enough to persuade businesses to borrow and expand and consumers to borrow and buy cars and houses. Also, the bank hopes it will ramp up price inflation that will reduce debt.

The bank's QE effort will fail to achieve the goal as did those of Japan and the US. ECB president Mario Draghi admitted as much when he told politicians that credit expansion alone will not rescue Europe without "structural" changes by governments. In other words, Europe's problems are microeconomic, not macro. The structural changes needed include reducing taxes and rolling back regulations, especially rigid labor regulations that make it almost impossible for businesses to divorce employees. Businesses are not investing in the US because of high taxes and job-killing regulations, but the problem is much worse in Europe.

Crude shutdown price - lower than you think

When the Saudis allowed the price of their crude oil to fall, it was reported that the Saudis expected the price to fall no lower than $60 per barrel. The Saudis assumed that the average cost of production in the US shale oil fields was somewhere around $70 and that producers there would not operate for long at a loss. Insiders have said that the Saudis want to reduce competition from high cost US producers and retain their share of the US market, which came to 13% of imports in 2013, the latest figures from the US Energy Information Agency.