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The Federal Reserve's concerted
action continues to induce a rally in stocks that has endured for
far longer than we believed it would. However, the Fed's goal to
create and build wealth has not been achieved. If it had, we would
be in the midst of a boom and jobs would be plentiful. We predicted
the Fed would not "taper" and they have not. However, we are now
in a lose-lose situation. If the Fed tapers at any point, stocks
will be crushed. If the Fed does not taper, stocks will eventually
reach such unsustainable levels that a crash will be the most likely scenario.
Dollar Trading Volume (DTV) is on track to register
its third highest reading in stock market history. After the peak
of $65 trillion in 2010, DTV fell to $63.5 trillion in 2011 and to only
$52.7 trillion last year but is now roaring along at a pace that will take
it to nearly $56.7 trillion this year.
The business of the nation is no longer steel,
no longer cars, no longer manufacturing at all. It is no longer computers
nor semi-conductors. And even though health care costs now approach
17% of our gross domestic product (GDP), nothing comes remotely close to
the business of stocks.
At the current rate, transactional velocity as
represented by DTV amounts to more than 2.8 times total stock market capitalization
and nearly 3.5 times our GDP. Every day, the economy generates an
average of roughly $45 billion in business. During the holiday season,
which is responsible for the lion's share of retail, that number probably
doubles. However, stocks trade only on weekdays and an average of
$225 billion is traded daily, five times as much as GDP.
There is no business bigger than stocks.
In fact, as seen above, the current situation is a replay of what occurred
in the Roaring Twenties ending in 1929, the Tech Mania in 2000 and again
as the housing mania peaked in 2007.
This is the third stock mania
in 13 years.
A streak of madness never
Manias historically are once in a lifetime events.
The inevitable collapse is typically accompanied by long memories and those
that were burned stay away, possibly for the remainder of their
lives. As an illustration, your Editor's father was a stock broker
in 1929. After the crash, whatever stock he had left was tossed into
a safe deposit box, where it resided until 1968. This is a true story,
a portio of which was offered by your Editor to Nelson DeMille for his
book Gold Coast (see page 46). The anecdote about the shares
of Amerex Corp. is true.
Amazingly, despite a 50% drubbing from 2000-2002,
many people were eager to forget and another mania developed not only in
housing but in stocks. But the second mania collapse has led to a
complete metamorphosis of the stock market, an arena in which investment
has become meaningless. Stocks trade only for the moment. Since
the long term is of no consequence and holding periods have been cut to
the quick, valuations are unnecessary.
Stocks can trade at any level, it does not matter.
Our stock market has been overwhelmed by high frequency trading (HFT).
Many positions last no longer than the time it takes to read this sentence.
Many bids and offers last no longer than the time it takes to punctuate
the end of this sentence.
It's all absurd, bizarre, and
as a result, prices are a fantasy.
As you will see below from
our article on July 22nd,
stocks remain greatly overvalued....
as they were in March 2000
and October 2007....
a stubborn streak of overvaluation.
The following was the lead
article in our September 16, 2013 issue.
Theory: derivatives aid economic growth and are
responsible for economic growth that would otherwise be difficult to achieve.
Wrong. Adherents of the theory are plentiful in the field of the
dismal science known as economics and they are nearly universal in
their beliefs when proponents come from the banking and brokerage
industries. However, theory is defined as speculation and conjecture
based on assumptions drawn from limited knowledge. A theory that
has been proved is no longer theory, it is fact. The theory that
derivatives are responsible for economic growth have long ignored the obvious;
they do not provide better economic growth. In fact, they hamper
economic growth. We will hope to show you overwhelming evidence in
today’s rant, and make no mistake, this is a rant. Over the last
few years, we have been acutely aware of what we see as irresponsible stances
of the financial industry, those committed to protect investors (such as
the SEC) and by the Federal Reserve Board to hide all the facts.
The experience of recent years is now officially
meaningless. In the first quarter of 2013, notional values of derivatives
rose 3.8% from the end of last year to achieve a new all time record high
of $231.6 trillion. If the pace continues for the remainder of the
year, notional values will soar 16.1% for the year and add another $35.8
trillion to last year’s tally.
Above, our featured chart compares the country’s
Gross Domestic Product (GDP) with total notional values of derivatives
as reported by the Office of the Comptroller of the Currency’s (OCC) category
listed as “insured U.S. commercial banks and savings associations.” This
is the number we typically report every few months in the newsletter, but
it is important to note that even the $231.2 trillion shown in our rightmost
bar pales in comparison to the tally for the category of the top 25 bank
“holding” companies. How much? Glad you asked. That total
is currently $296.8 trillion, an amount equal to 17.6 times our GDP and
15.6 times total stock market capitalization.
As it turns out, derivative madness was only briefly
interrupted by the financial crisis and has resumed an ugly trend destined
for ignominy, a stubborn streak, if you will allow. The certain outcome
of ignominy is foretold by the comparison you see on this page. Over
time, more leverage, more credit and methods to accommodate leverage and
credit have proliferated. We are now a society living not only on
borrowed money but very likely on borrowed time as well.
From the very beginning of the long inclined path
on our chart, there was no proof that the increased use of derivatives
would aid economic growth. The OCC’s very first data point was for
1991, when notional values of derivatives were a mere $7.34 trillion, equal
to 1.2 times GDP and 1.8 times total stock market capitalization.
However, when we match notional values up against the 5-year growth rate
in GDP, we see a trend exactly opposite to the common wisdom. The
widespread acceptance of derivatives was entirely based on wrong assumptions.
Below, the 5-year rate of change for GDP has been
declining (with brief exceptions) for 21 years, since the data commenced
and concomitant with the accelerating use of derivatives. While we
have no doubt that derivatives and especially leverage have potential to
temporarily boost economic growth, the attendant risks are gigantic.
The three year rally in longer term economic growth into 2006 was punctuated
with a massive one year increase of 29.6% in notional values of derivatives.
The two year increase into 2007 was 63.2% and by 2008, the three year increase
was 97.4%. The rest, as they say, is history. While the 5-year
growth rate of GDP was enabled to climb to as high as 5.8%, the attendant
risks kicked in and proved there can never be a free lunch.
From our standpoint, the nation is rapidly being
painted into a corner from which escape is less likely with each new brushstroke
by the Federal Reserve, Congress and the Administration. It’s almost
as if they are all clueless, led by the nose by a financial industry that
cares solely about its own. The banks, exchanges and the brokerage
industry have also completely transformed the capital raising functions
of the equity market by reducing the long term to microseconds. As
we have shown so many times previously, the proliferation of high frequency
trading has afforded privileges in which the public cannot participate
and which favors institutions to the detriment of the public.
Derivatives have also favored institutions to the
detriment of the public, by having the very substantial advantage of bailout
possibilities. In fact, at this point in time, it is clear that the
situation has become so onerous that there is no doubt that way too many
institutions are indeed, too big to fail. If one goes down, the potential
harm to the remainder of the system is too great and the risks too dire
to entertain, thus another plunge into the chasm will be “fixed” the same
way as before. The banks and brokers know this. The exchanges
know this. There is no impetus to change or rectify or ameliorate
the same kind of risks that placed the nation of the verge of the abyss
in 2008. Thus, it will happen again. Thus, in a worst case
scenario, the bailouts will happen again. Thus, the public will again
be punished as the worst of double standards is allowed to endure.
Below, notional values of derivatives for the top
25 commercial banks account for 93.2% of all derivatives. While all
on the list benefit, clearly the top four are in a league by themselves.
Ironically, as John Crudele commented in the September 7th NY Post, “The
real-life costs behind the JPM ‘Cult of Jamie” are substantial. When
you add up all the costs to JPMorgan via fines, losses under Jamie Dimon’s
tenure, it adds up to $28.2 billion over five years. But don’t fret
about Dimon or JP. While the company must indeed replenish the lost
capital and for the nonce will have less capital to earn more capital or
to lend for small businesses to help the economy, they can nevertheless
take a tax deduction that will result in $7 billion less for the government.
Even more hysterical is according to Crudele, “the Federal Reserve is actually
financing this $28 billion, since JPMorgan can borrow from the Fed’s window
to pay out these fines.” Crudele also comments, “There has not been
one clawback of anyone’s bonus, and from what was reported, last year’s
bonuses were crazy-good. And it seems the word on the Street is, 2013 bonuses
will be the same crazy-good.” You can see the article at http://bit.ly/19uQOY3.
The purveyors of derivatives in mass quantity have
more on their plate than you may care to know. See http://bloom.bg/12JCJVs.
Bear in mind, that’s $100 billion less to lend for small businesses to
help the economy, but undoubtedly some of the amount will be countered
by tax deductions. Will there be clawbacks? Sure. And
if you believe that, we have a bridge to sell you. More can
be found at http://bloom.bg/15hCBA7
and also at http://bloom.bg/14ceFYP.
While not all of this activity is directly attributable to derivatives,
there is a pattern way too strong for us to deny. Obviously, JPMorgan
figures prominently in our analysis, since they alone account for 30.3%
of all notional values in derivatives. Years of observation and analysis
lead us to the conclusion that this new rapid expansion in notional values
of derivatives has again led to a vast increase in systemic risk and has
dramatically impeded economic growth.
We will be very lucky if the
consequences are better than last time.
The following article is reprinted
from our July 22, 2013 issue.
In the final analysis, stock prices are supposed
to be based on valuations. A company that has had an improving earnings
stream and regular dividend increases theoretically should be valued higher
than an unproven entity with only potential but of course, in reality,
it doesn’t work that way. Fear and greed rule the stock market and
the implementation of greed fits the many ways participants may estimate
“potential.” In the case of Amazon (AMZN), we have a company that
began operations 18 years ago (was it really that long ago?) and seems
destined to never trade at what should pass for a normal price/earnings
ratio. Despite growing to $61 billion in revenue, AMZN’s current
price is equivalent to more than 96 times projected earnings for the fiscal
year ending December 31, 2014. Stratospheric P/E multiples like this
are indicative of greed on a grand scale.
Of course, overvaluation is not limited to AMZN
and we have also mentioned Netflix (NFLX) in the same category of egregiously
overvalued companies. NFLX currently trades at a price equivalent
to 86 times next year’s projected earnings. Why not cite current
P/E multiples? Okay, we will. AMZN’s is infinite since there
are no earnings. NFLX’s P/E is 649. Clearly, this does not
make us feel any better about their valuations, but high P/E multiples
do not automatically go hand-in-hand with immediate price declines, even
when valuations are extreme for the entire stock market. However,
when valuations are stretched for a lengthy period, say ten years, it’s
usually a different story. High P/Es are likely to spell doom for
even the best and most dynamic bull markets. At center, we see the
current chart for a ten year average of P/E ratios made popular by Robert
J. Shiller in his book, Irrational Exuberance (see www.irrationalexuberance.com/).
The current 24.51 reading has been matched (or nearly so) only in the Roaring
Twenties mania that ended spectacularly in 1929, the broad market secular
peak for stocks in 1966, and the mania beginning in the late 1990s.
Although the 10-year average has remained quite high for most of the period
of the last 18 years, it has not changed the requirement that stocks must
eventually trade at a fair value from a historical perspective. The
two huge declines into the 2003 and 2009 bottoms are also plainly visible
in our chart and are evidence of the inevitable necessity for fair valuations.
Dating back to 1880, the median
Shiller P/E has been 15.88 and the mean 16.47. The mean represents
close to a one-third decline in prices from today.
Is it possible?
Who would have thought that
prices would have been halved into both the 2002 and 2009 bottoms?
Yes, it is possible.
Even a modest retracement to
a Shiller P/E of 20 would cause a lot of consternation and this is precisely
what we expect.
[EDITOR'S NOTE: AS OF NOVEMBER
4, 2013, THE SHILLER P/E WAS 24.86]
A portion of our lead article
in the July 22, 2013 issue is reprinted below.
If you wish to see the entire
article, please see the FREE TRIAL banner on our home page.
Dow 15,000 In May 2016
Despite the two manias and subsequent major stock
collapses from 2000-2002 and 2008-2009, there is still a huge contingent
of permabulls who believe that the long term always sees substantial gains.
Nothing could be further from the truth.
We have long been labeled as permabears, and again,
nothing could be further from the truth. Lest we be misunderstood,
we need to clarify our position. It’s inconceivable that anyone could
have been more bullish than your Editor in July 1982, a month before the
super bull market began, or in December 1987, the day before stocks took
off and never looked back, and again in January 1998, just before the invasion
of Kuwait. But too much has transpired in the last 15 years and this
is a completely transformed stock market. We believe the capital
formation system is threatened by how the stock market has metamorphosed
into a machine to profit exchanges, banks, brokerages and mechanical trading
systems, all with extremely short term horizons. Nothing matters
beyond a microsecond.
It is no wonder that the public has not returned
and we believe that as long as the arena favors the few over the many,
the investing public will not return and we will all be the poorer.
Wealth in terms of market capitalization is meaningless without the public’s
There are also technical reasons for our bearish
stance and you see perhaps the best perspective above, representing annualized
returns for stocks over all 20-year rolling periods since 1917. The
twin manias mentioned in the first sentence of our article have had a pronounced
and outsized effect on the overall average return for stocks over the last
century. For 78 years until 1995, stocks as measured by the Dow Industrials,
returned 4% per annum, a benchmark that was once widely considered as the
standard. Since the twin mania produced stunning gains, a newer generation
has been influenced beyond all reason and believes there is a new standard
of perhaps 7% or even 8% gains per year. However, reversion to the
mean is a powerful and valid concept, especially in the current environment,
where economic growth has slowed from previous decades and is expected
to remain under pressure for years to come.
Thus, we are convinced that our line, currently
sporting gains of 7.32% annualized over 20-years, will decline to
the historical average of 5% at some point, and perhaps even the 4% “standard”
seen for the 78 years until 1995.
If the Dow simply moves sideways
the 5% level will not be achieved
until late in May 2016.
If we are headed to the 4%
historical standard of yore,
the wait for normalcy will
end in February 2017.
Of course, the reversion need
not last that long if
prices decline say, to Dow
The 5% benchmark would be achieved
as soon as June 2015.
The 4% benchmark would be achieved
in late January of 2016.....
[The remainder of this article
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The typical four year bull cycle has already
been exceeded by seven months. The cyclical bull market is on borrowed
time. It is difficult, if not impossible to forecast a peak while
the Fed feeds $85 billion per month into the financial markets, but at
some point, not only will the break come, it may be as bad as the prior
two bear markets that erased fully half of all stock market wealth.
We consider the levels mentioned below to be
extremely conservative, amost bullish in the face of what we see as phenomenal
risk ahead for the nation.
The stubborn streak of high
prices, overvaluations and derivative madness is likely to end as it did
in 2000 and again in 2007.
15,709 /// SPX 1780 /// Nasdaq Composite 4000
Worst Case Scenarios
12,471 /// SPX 1420 /// Nasdaq Composite 3150
Correction Target - Dow 14,551
to Risk Ratio: Extremely
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