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Summary It appears late in the post-QE era to take chances. The Fed has turned hostile to stocks, and Congress is not going to give the President’s party a break by stimulating the economy until after the election. With deteriorating incoming economic data, iffy stock market action, and historically high valuations, above-average cash and near-cash allocations look good to me. Value stocks look safest of all stocks, so long as the underlying businesses have growth prospects over the long term. A note on the tragedy in Paris “Fraternite” a toutes Parisiens and all who are horrified and disgusted by the violence of a few days ago. Bonne chance to the injured survivors, the families of the dead and wounded, and all others who were harmed by the attacks. (Please pardon my poor French.) Already, markets are reacting to the aftermath; from a US economic and markets perspective, not much has changed. In my view, the biggest economic and financial bubble in modern US history has been blown. The way in which its ending plays out strikes me as containing more risk than reward now, especially given the Fed’s bias toward tightening and the split power structure in Washington. Many readers are very familiar with the mechanics of how repeated rounds of QE have distorted both the economy and the markets, but for those who are not, I’ll start this article with a review of how this has occurred and why it has created such a dangerous situation. Introduction – why this is/has been the biggest US market bubble – and the economy has been pumped up as well While stocks get the media attention, the bond market is much bigger and now almost as diverse. And, in the era of quantitative easing, or QE, aka money printing, the cash market is now gigantic as well, though smaller than equities. In any case, if we stick to overt financial assets comprising bonds, equities and cash, we can make some composite of interest/dividend yield and other valuation metrics. If we do that, we can look back the recent period of extraordinarily high, 1929- and 1998-level stock valuations; extremely low Treasury yields; record low “junk” bond yields; and ZIRP for cash yields. We can integrate these into one valuation metric and say that never in US history, at least since 1900, has the combination of all these investable classes been so hostile to new money looking for safe and strong returns. Never, in other words, have yields on financial assets been so low in sync together. This has happened because QE involved the creation of lots of new money that the real economy cannot use. Before the Great Recession, the Fed’s balance sheet, which is the amount of “base money” in the economy by one way of looking at money, was around $0.7 T. Of that, 100% was “in” the economy and none was carried on the Fed’s balance sheet as “excess reserves.” Now, the Fed’s balance sheet is around $4.5 T. Of that, about $2 T is “in” the economy, a gigantic $1.3 T additional dollars that largely has come from the Fed monetizing government debt. This additional injection of spending power initially sent prices of consumer goods and commodities surging, but that ended in 2011 for mysterious reasons. As the injection of money into the economy largely ended, the provision of new money by the Fed via QE 3 as well as the continuation of “QE 1.5” (the Fed’s reinvestment of maturing bonds on its balance sheet via printing new money to make the new investment) continued. QE 3 was the “jump the shark” event. An economy that had stabilized, with markets that were realistically priced, was turned into a frenzy of high-risk investments in shale oil and gas, low-quality IPOs, etc. It was very much a ’90s thing, and in retrospect, it might just have been a 1999-type matter that set up an economic and market downturn. The Fed cannot expect to have added $1.5 T in newly-printed money via the QE that ran from January 2013 to October 2014 to an economy that was functioning in 2007 with only $0.7 T and not create a bubble economy and bubble markets. I believe there is potential strategic alpha here because I suspect that Mr. Market is overlooking the possibility that both the economy and the markets may retrench together as the effects of QE 3 fade, even if the Fed holds pat next month. I believe that many market participants are aware that much of the massive flood of QE money has gone into stocks, bonds and real estate. However, I’m just not sure whether market participants are aware of just how much the economy itself was pumped by federal deficit spending, much of which was “paid for” by the Fed’s printing press, and how much poor consumer and business lending was made due to “free” money. Thus, I pencil in an elevated chance of a 1929-type scenario in which an economy and a market that were pumped up by the Fed spiral downward together as the Fed errs and makes money scarcer at a time where deflationary pressures are already very visible. That’s not a prediction, but with essentially all valuation measures of stocks, cash and bonds so high (as discussed above), where is the margin of safety to ride out an incipient downturn? Absent fundamental staying power in the stock market, I have opted for a more defensive posture. Stocks look toppy My guess is that even with the tailwind of positive seasonality, the short- or intermediate-term investment case for US equities is dim now, at least in the absence of Fed money printing, negative interest rates, or a major economic resurgence in important parts of American export markets. There are six reasons out of many to point to here: Deflation is terrible for stocks if there’s a recession, and it’s bad even without a recession. Stocks are, after all, good inflation hedges. And deflation is hanging around the US economy, even getting embedded into it, spreading beyond energy to more and more sectors. The corporate sales and profit cycle has turned down. The credit cycle is turning; high-yield bond ETFs (NYSEARCA: HYG ) are acting very badly, and Moody’s is comparing the credit cycle to 2009 – a bad sign. The Fed is turning hostile to stocks, and the Republicans control Congress and are going to take no actions to help the economy for obvious political reasons. The simplest barometer of the US economy, retail sales, is in recessionary territory. Stock market breadth is at pre-bear market levels, and the best-acting large cap stocks such as Microsoft (NASDAQ: MSFT ), Facebook (NASDAQ: FB ) and Amazon.com (NASDAQ: AMZN ) have much too high P/ Es and PEGs for comfort. It’s very 1999-2000- ish . Now, a stock market top is a process, and ultra long-term market participants can shrug any downturn off. My view is simply that valuations are high, the economy has been over-stimulated, the markets have been over-stimulated, and decades of market action suggest that better buying opportunities for cash probably lie ahead. Thus, in the matrix of risk versus reward I use, I see too many headwinds for both the economy and stocks as both the monetary and fiscal tailwinds that helped stocks so much in 2009-11 are either gone or have no oomph to them anymore. Cash may not be trash Cash has a lot of virtues here. This is especially true for cash that can go into one of the handful of FDIC-insured online bank accounts that yield close to 1%. Otherwise, 1-2 year T-bills are liquid alternatives. Putting it another way, cash does not cost much, given low dividend yields and high valuations of equities, and low interest rates on high quality bonds. Long-term Treasuries may not be trash, either With inflation staying low, as has been the case for a while in the US, I think of the 1960s and 1970s and think of how irregularly rising inflation kept fooling the experts, including the Fed. Bonds were bad news really from the early 1960s, even before measured inflation increased. Maybe the experts will be wrong about inflation and bonds in the opposite direction a while longer? What’s so bad about getting 2-3% above current inflation, with the certainty of getting my principal back and the speculative chance of capital gains if interest rates move down toward levels seen today in Canada, the UK, or Germany? One reason I ask this question is because studies have shown that the bonds that individuals own are almost all munis or corporates . It is the Fed itself, other central banks and institutional investors that hold Treasuries. The fact that Treasuries are either hated or ignored by retail investors makes them intrinsically interesting to me. Treasuries are really not bonds in the sense of corporates , municipals, or even national bonds of weak credits. The government or the Fed can always print up new money to repay Treasuries. So, Treasuries are cash-like in a sense, but they are cash deferred, with small interest payments to keep investors happy along the way toward repayment of principal. One reason I’m interested in Treasuries is that I view the relative price of gold (NYSEARCA: GLD ) as too high versus comparators such as oil, silver (NYSEARCA: SLV ) and platinum (NYSEARCA: PPLT ). This suggests to me that many market participants are too worried about inflation. Based on historical relationships with the above commodities, gold should be trading well below $1,000/ounce. I thus look at long-term Treasuries (NYSEARCA: TLT ) as variants of cash. Individual stocks One of the lessons from the Internet bubble 1.0 was that patience in holding stocks with strong relative value characteristics was rewarded… eventually. I believe this is an optimal strategy to follow today. One of differences between then and now is that then, all things tech were overvalued. And, in some non-favored sectors in 1999, all stocks were reasonably valued or even cheap. In fact, it was so strange a time that unlike the topping process of 2007-8, back in March 2000, numerous stocks hit their cyclical bottoms even as the NASDAQ and SPY topped out (SPY made a double top in the summer of 2000). That was how distorted the momo traders had made the market. The momo traders have been less thematic nowadays. They will take a favored takeover play in biotech such as Incyte (NASDAQ: INCY ) and bid it to a very high valuation, even with competition coming; and they will take Gilead (NASDAQ: GILD ) and assume that its pipeline will fail and that the company will struggle in its major products. Yet investors will look at a biotech-y company such as Bristol-Myers (NYSE: BMY ) and give it a 30X P/E. Go figure. Since I’m happy to trade but happier to hold an asset of value, I’m very happy to own GILD at a GAAP earnings yield around 11%. Even if owning imputes a higher tax rate, maybe the earnings yield is 10%. That’s attractive and requires a classic one-decision investment strategy: buy and hold. Today, in the tech field, one can look at AMZN or FB and say these have bubble valuations, yet just look at a much less expensive and even more dominant Alphabet (NASDAQ: GOOGL ) (NASDAQ: GOOG ) and say its valuation is quite reasonable. One can then look at Internet stocks ranging from iPhone manufacturer Apple (NASDAQ: AAPL ) and say it’s reasonably valued or even cheap, or one can look at a small number of busted Internet stocks and say they might have some value characteristics. There’s no need to look gift horses deeply in the mouth. Markets get faddish; momo traders do not have deep pools of wisdom underlying their trades. The sense in momentum investing is that, say, a depressed stock starts moving up. Maybe insiders are buying, or experts in the industry. Business is turning strong. So you, Mr. or Ms. retail investor, simply buy the relative strength. OK, that might work. However, at this point, both AMZN and FB have been discovered. The concept of momentum investing as an interesting investment concept is unlikely to work now. Beyond GILD and AAPL, and the occasional other value name in growth fields, another reasonably valued sector is insurers – as boring and non- growthy a sector as one could find. What if the Fed raises interest rates? I’m long long -term Treasuries as a derivative of cash. The investment case is either that ZIRP or near-ZIRP continues longer than the market is pricing in, and/or that at some unpredictable point, stock traders will panic and focus solely on return of principal, not trading gains or confident dividend growth investing. If the Fed raises rates by making money scarcer, that hurts the price of short-term money instruments such as the 1- and 2-year T-bill/note. On the long end of the Treasury market, all Fed tightening since the 1980s have merely sustained the bull market in bonds. Given all the deflationary forces extant today, I think that pattern could continue at least one more time. The stock market is never helped by withdrawal of liquidity, however. Neither is the commodities market, and neither is the junk bond market, which I think of as a proxy for higher-quality equities. What about a US recession? Note I’ve said little or nothing about a recession. When stocks were cheap in the 1947-57 period, recessions barely dented the market. However, when they got expensive, they entered a bear market in 2000 and again in January 2002 when there was no recession. This also happened in 1966 and in 1987, though the 1987 crash was really due to a mismatch between stocks at a P/E around 18X (not crazy) but T-bond rates that had returned to above 10%. Stock prices dropped, interest rates dropped, and the long-term bull market in stocks reasserted itself. My caution about equities is not tied to any specific view of a recession. What matters is how economic growth and inflation will play out in the aggregate over many years; that determines the value inherent in businesses operating today. Concluding thoughts – safe sector investing a focus now What happens between traders from one day to the next is not the theme of this article. I think that we have seen this movie plot many times. Of course, not only do we not know how it will end, it never really ends. The economy and the markets continue on; we all have different goals, risk tolerances, etc. My perspective, though, is that the plot of this market story is that the odds favor a cautious approach. I believe that the immense force of QE 3 has created artificially pumped up markets, and that the massive Federal deficits and dodgy lending practices have combined to produce a pumped up economy. I believe that both incoming economic data and drooping stock market action are consistent with a cautious attitude toward near-term and intermediate-term economic growth. In contrast, I think that excessive fear about Fed tightening has depressed the prices of long-term Treasuries, when they just might be ready for one more extremely surprising surge in price (drop in rates). No certainties exist in the markets, but one of the advantages of additional cash reserves is the ability to only lose opportunity cost if the cautious approach looks, simply, wrong. Thanks for reading this thematic piece. Scalper1 News
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