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Summary Evidence suggests that in many quarters, a “risk on” phase of investing sentiment is afoot. The kinds of risks being taken suggest to me that we are in the later stages of a favorable stock market environment. Nevertheless, the U.S. economy seems to me to be basically sound, which makes a negative market event in the near future relatively unlikely. Still, there are enough ways that a negative market event could be triggered that a level of caution – rather than throwing oneself into the risk-on fever – is advisable. On November 2, 2015, The Wall Street Journal brought us flashing signs that the markets have entered a new “risk on” phase. Cam Hui predicted this a few of weeks ago, and now the mainstream press is confirming the trend. Here is one of Cam’s excellent slides focusing on the markets in 2011 and how fear and greed come and go: (click to enlarge) Cam’s slide shows sentiment in the market yees and yaws has little relation to fundamentals. The Wall Street Journal shows risk on The WSJ’s November 2 risk on coverage included these three Page One articles (Note: The headlines here are from The Journal ‘s print edition): In my opinion, these all are signs that financial markets are taking on increased risks. And usually they would be signs that trouble is ahead. Of course trouble always is ahead-somewhere, some time. To say that trouble is ahead helps very little. The problem for investors is whether the time is proximate and the place is wherever they are invested. But before we get to the ‘when and where” hard part, let’s be sure we understand how risk builds up and how certain kinds of institutions react to the forces that impel risk-taking. The role of international funds flows External debt almost always is involved in the build-up of asset values that crash. Robert Aliber, Chicago Booth School professor emeritus, explains how this works in the sixth and seventh editions of Charles Kindelberger’s classic Manias, Crashes and Panics , of which he is the author. Even if you have read Kindelberger’s earlier editions, Professor Aliber’s opening chapters are worth your time. We can trace external buying of debt, often in currencies that are different from the currency of the country whose entities are incurring the debt, as important parts of the crises in, for example, Latin American debt in the 1980s, the Mexican peso crisis of 1994, the Asian contagion crises of 1997, and the U.S., Ireland, Iceland, Spain and Greece problems beginning in 2007. I ascribe this phenomenon in part due to foreigners’ unfamiliarity with local markets. The foreign money is dumb money, I say. And it goes abroad when it is seeking better yields (and is unable to evaluate the risks properly) or simply has too much cash that it cannot invest at home (Eurodollar recycling by U.S. banks in the late 1970s, for example). I have not convinced Professor Aliber that my “dumb foreign money” theory is correct. He thinks macroeconomic forces are more likely the origin of the international capital flows. Maybe both forces are at work. Whichever (or whatever) the origins, the historical record suggests that we should be wary when we see large international capital flows, especially when the borrower cannot print and does not naturally trade in the currency borrowed. Foreign adventures by domestic players We also know that when certain kinds of institutions that have little international experience open offices and make investments in unfamiliar nations, the jig soon will be up. Within about three years, the flaws in their strategy will begin to appear. The German Landesbanks are perfect subjects for this test because they were established by the state and are owned by the state to serve purposes that became unnecessary decades ago. (I explained this in my book Debt Spiral .) Therefore they are always looking for new ways to make money. The Landesbanks were prominent victims of that tendency in the 2007-2009 market events. They were, if you recall, among the first banks to get into trouble in August 2007 because of their Ireland-based, U.S.-invested SIVs. Punters’ success lauded When the financial press starts lauding the successes that risk-takers are having, such as those that buy out-of-the-money Brazilian and Russian bonds, that is anther sign of trouble ahead because people will emulate the apparent successes at precisely the wrong times. Such games work if you can get out fast enough. But the door is not large, and it closes swiftly. Nevertheless, the WSJ reports that “fund managers are trying to manage those risks by staying nimble, rather than holding positions for an extended period which could be hurt by sudden market downturns.” Good luck. Record bond issuance but not much actual investment The WSJ touts the healthy corporate bond market as a sign of a strong U.S. economy. I do not think the economy is weak, but I do not think the strong bond market is such a good sign. What is the money being used for? It is being used largely for stock buybacks and acquisitions. Using debt for those purposes weakens the U.S. economy over the long term because it makes more companies fragile in downturns. And it tends to support stock market prices at levels that naturally decline when the flood of acquisitions and stock buybacks eases. Debt for productive investment can be a positive, but debt that mostly reduces the float of common stock serves no beneficial purposes that I can see, other than those of management and shorter-term stockholders. It is not something to celebrate as indicative of a strong economy. It is indicative of low interest rates, the reach for yield, and the temptation to replace equity with debt. Deal volume Another sign of a long-in-the-tooth market is deal volume. The deal volume in this case goes hand-in-hand with debt issuance. The deals mostly are designed to reduce competition, which may be good for corporate profits but is bad for the economy as a whole. And it indicates that companies do not see organic growth in their futures, which is not a sign of strength. Most companies do not sell out or pay up to acquire when they see bright futures for their independent selves. But don’t get carried away, please Don’t listen to scare-mongering, however. The FT had a particularly egregious article on November 2, in which the writers explored the possibility of a market meltdown caused by investors fleeing balanced mutual funds because the bond market was going down. That is preposterous stuff foisted by the big banks that want lower capital and the right to trade freely for their own accounts. The FT writers are particularly susceptible to this bilge; I do not know why. Balanced open-end funds are safer than houses, so long as they are not leveraged. The U.S. economy is OK I think the U.S. economy, despite all the negatives that I have listed for the future of capital markets, is OK. Neil Irwin had an interesting piece on The New York Times Upshot site last week in which he said he was undecided about whether the U.S. economy was OK or not. As I read the article, he really came out that the economy, despite all the negative signs, is OK. (If you haven’t read it, it is worth a look.) And that is where I come out. At the end of 2012, I wrote on seekingalpha that I was optimistic about the U.S. economy through 2015. Here we are almost at the end of 2015, and without going into detail here, I remain optimistic for the near future. Continued slow growth seems likely. We seem likely to have neither the great strides in productivity nor the large working population increase that might lead to faster growth. And I do not expect the government to begin any historic spending sprees. But the downside negatives almost all emanate from abroad, and the U.S. economy has been dealing with foreign negatives for the entire time it has slowly recovered since 2009. When, where, how? So much for the easy stuff. When, where, how will a negative market event occur? “Why” is not for us to know. “When where, and how” is hard enough. If I really knew when, where, and how, I would be a very rich man. Since I am not a very rich man, we must presume that I do not know. But thinking about such things concentrates the mind. And if you think about this question along with me, I think you will clarify your own views. The relative status quo could go on for quite a long time. And I do not expect the downside stimulus to come from China in the near future. Even though I think China is in for some rocky times, I think the Chinese government and economy will be able to handle them. I have written about that at nexchange.com, where I publish short pieces weekly. But weak credits have attracted too much money and stock markets are priced high largely because of low interest rates. Both those factors would be quite vulnerable to a material increase in interest rates. But I do not think the Fed is going increase rates significantly. There is no reason to do so. A discursion on monetary policy I do not regard myself as an expert on monetary policy, but so many commentators talk about it without meeting that requirement, why shouldn’t I? I do a lot of reading and even correspond with some macroeconomists. It seems to me that for the Fed to raise rates in order to have room to lower them again when a recession occurs lacks logic. The U.S. economy is in slow-growth mode. If it could stay there for an extended period of time without a recession, that would be a good thing. Therefore monetary policy should encourage continued growth, if possible without encouraging credit bubbles. I take that to suggest a monetary policy that is neutral, by which I mean a policy that permits the market to set rates to the extent possible. If the “natural” rate of interest is about zero, then policy should permit rates to remain near zero. And there is considerable evidence that the natural rate (economists call it the Wicksellian rate) is near (or even below) zero. Why raise the rate artificially, which may cause a recession, merely to have the “firepower” to lower it again? On this subject, let me share an interesting graph from Bill Longbrake’s monthly letter that is published by my friends at the Barnett, Sivon & Natter law firm: (click to enlarge) The chart is hard to read, but the data are important. What they show is that the Fed and some other major forecasters (the BofA and Goldman Sachs forecasters that Bill follows every month) are expecting a Fed Funds rate of 3% or more by 2018. If that is going to happen, then I think bad things are going to happen to the U.S. economy and to the U.S. stock market by 2017. Fortunately, Bill Longbrake disagrees. He forecasts close to a zero Fed funds rate still in 2018, and Bill has a better forecasting record than the Fed. I am sticking with Bill on this, but please recognize that we seem to be in the minority and that our being wrong could have significant negative consequences. What might cause a negative market event? Regardless of what the Fed does, I think we will see is some of the risky bets not paying off, the weak credits being unable to refinance, as well as a rise in bankruptcies and delinquencies that already have been occurring over the last year in the energy sector. Many parts of the global economy have depended on the energy sector to buy their products. They are likely also to experience problems, and it is likely that they, like the energy companies, borrowed heavily to expand their capacity quickly and that their creditors also will suffer. U.S. housing remains expensive. Here is a graph of real house prices through August 2015 from Calculated Risk. (click to enlarge) As you can see, house prices are almost back where they were at the top of the boom in 2005-6, with middle class incomes having barely budged since 1999. As I wrote in a lengthy article back in February 2012, housing cannot lead the economy until house prices are affordable for the middle class. In that article, I saw 1997 as a benchmark year when house prices were still affordable in terms of incomes. But house prices now are even more above the 1997 level than they were in 2012, with barely any progress in middle class incomes. Houses are more affordable than they otherwise would be because interest rates are low and heating oil costs have declined. But house prices remain a problem, and household formation and the healthy consumer expenditures that follow that are deterred by the high prices of houses, as well as by student loan balances, a lower marriage rate, and several other economic and social forces. Some respected forecasters say household formation is picking up. So far, I do not see it. A decline in house prices therefore would be a mixed event. It might stir household formation, but it also might cause another round of foreclosures, particularly on properties that have little equity (which means just about everything financed by the FHA), and it might have a negative “wealth effect”. A big change from my thinking a couple of years ago is that whereas in February 2013 I saw rising capital flows propelling global stock prices higher, I now think global capital flows are reversing. That means liquidity most likely will not continue its upward thrust. These various cautions suggest that the U.S. stock market will not produce large returns over the next year or two. But will something cause a major disruption in the next year or two? I am starting to think that is not likely. I have no better crystal ball than anyone else, but I do not see a catalyst on the horizon. The major suspects would be politically or geopolitically unsettling. For example, both parties in the U.S. have enough dumb ideas that, if adopted, one of them could have negative economic consequences sufficient to cause a recession. Or a trigger-happy president could find reasons to do foolish things. Or the Fed could raise rates at a pace that would knock the value foundation out from under the stock market. I am hopeful that American public officials will see the difficulties and not score an “own goal”. A few days ago, I published A Portfolio for the Next Market Crash-Revisited . In that article, I discussed my February 2013 prediction that a negative market event likely would occur in the next five years and that we are now half way through that period. I concluded that I had not changed my investment strategy as a result of events over the last two and a half years. Even though I am suggesting today that I do not think a market event is likely in the next two years, I remain convinced that, at least for investors over, say, age 50, prudent portfolio management indicates being somewhat protective even while maintaining an optimistic outlook. “Risk-on” may be fine for traders. For longer-term investors, it is best not to be tempted at this point in the cycle. Of course, if you’ve really gotta have that new Porsche Panamera, and you only have a spare $40,000… Scalper1 News
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