Are credit measures the best metrics for predicting stock market moves?

There were a number of financial articles I found intriguing this week, particularly centered around the following:

“The net effect of these investor groups is that they together shed $1.1 trillion of shares (included in these categories, and spread over them, are ETFs). But the $1.1 trillion of shares that these investor groups shed over those five years was overpowered by $2.95 trillion of share buybacks over those five years.

You can read the whole article if you’d like the charts and such, but it’s an interesting phenomenon to think about. Investors actually pulled 1.1 trillion out of stocks while corporate buybacks flooded 2.95 trillion in, resulting in a massive bull market as buying outpaced selling by 1.9 trillion.

Most investor classes have been bearish because they are trained on classic valuation models, and no matter how you slice it the idea of a “new normal” of slower growth does not justify P/E ratios that are way above average.

So will the stock market plummet? It’s tempting to think so. However, a very interesting podcast on RealVision by Brain Reynolds explained an interesting phenomenon.

After the problems with Detroit pension funds, remaining labor groups have been increasingly pressuring politicians to fill pension shortfalls. State and local taxes have been rising and putting larger amounts of money into these funds. The funds are typically expected to make returns around 7%, and they attempt this by throwing ever more money into leveraged forms of corporate debt.

This corporate debt goes more and more into stock buybacks. 2018 had a record $800 billion in corporate buybacks, and I’ve seen predictions of $1.2 trillion for 2019. If that holds true, stocks have no option but to tear higher.

Brian Reynolds explained that when credit markets start to freeze up, the cycle can quickly turn to panic like in late 2018, yet the market will be tearing higher like a switch has been turned on once the credit thaws again.

In such a market, credit is by far the most important indicator. Credit creation spills over into all asset classes, flooding the stock market with liquidity so it will blindly tear higher only to let it drop in a panic when credit creation drops to a smaller level.

So what credit metrics are there? Well, the primary ones tend to be the yield curve, such as 10 year bonds vs 1 year, and bond spreads, such as corporate debt vs government debt. These can be problematic indicators however when central banks around the world try to directly manipulate these measures.

I tend to think that the volume of credit creation is the key here, and a manipulated rate is not a reliable indicator. That begs the question, what do we use? I’m not sure if ordinary investors like me can access more direct information. Some things that might help however include:

1. Overall debt levels, perhaps found from various articles… make sure you sell if they stop rising.

2. Central bank policy – the Fed can talk more dovish, but I’m nervous about stock price declines until they lower rates and switch back from reducing the balance sheet to enlarging it.

3. Technical Analysis on the S&P 500. This may actually be your best bet because the way the money flows which drive the price work differently in a low-liquidity selloff than a high-liquidity rise. Thus the way the price itself moves may be the best tell, as these patterns will help determine direction. If the credit creation switch is turned on, that will show and likely last between a few months to a couple years before being switched off again.

Caution: this is not the same as saying buy the dips … buying the dips in this market will actually be dangerous. It is saying buy when you have confirmation of the loose credit trend continuing and sell when you see signals of credit tightening.

I’m no expert in technical analysis and I can’t tell you what price signal will work – I can only suggest you find what metrics fit the trend in the last 5 years and ride them through until we eventually hit another regime change in what drives the market. This regime change could involve the slowdown in the rest of the world affecting the US, but I think it will more likely be driven by politics, when politicians are driven to find other economic levers to mess with.

Buena suerte, and as always I hope this gives you something to think about.

—– Some afterthoughts —-

It occurred to me that there was a recent regime change we need to think about… expansionary fed policy was the main driver, leading to credit spillover into stock buybacks, until 2018. After that the Fed tightened policy, and the rest of the world started responding to the tighter credit and going dow.n

Then the tax change was the next policy lever pulled which highly incentivized corporations to “repatriate” dollars – many of which were used for stock buybacks. That’s why we see record stock buybacks going forward for now. That begs the question of how long can it last?

Of course the money going in to fill the pension funding gap is pouring in as well – but if this money comes from local taxes while credit is tightening and world growth is slow, we’re bound to hit a recession which would spook the markets.

This leads me back to my original thought which was wait for the fed to actually reduce rates toward 1% before hitting a high conviction bullish outlook. Until then think cautious … when the steady climb starts to turn be ready to cut and run until you see a solid base forming. Be prepared for prices to drop as fast as they did Jan-March 2018 and again Sept-Dec 2018.

I don’t think this tax change repatriation spillover will be as steadily reliable as QE spillover in driving stock markets higher … it could be more high intensity but short-lived as companies rush to take advantage of the tax law before it can be changed. Also keep in mind that the money allocated to stocks will be dispersed over more high profile IPO’s this year. This will be a drag on the overall market because it will absorb money allocated for stocks (most of which is invested blindly and bluntly ETF-style). Essentially, if Uber is valued at $10 billion, then the IPO will pull $10 billion which would have been allocated to other stocks – acting the same as if $10 billion was pulled from stock ETF’s.

Anyway, I didn’t want to rewrite yesterday’s post but I though this was important enough to mention.

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Why does an inverted yield curve indicate recession?

There’s a lot of discussion about the importance of this classic indicator for recessions, so let’s take a look at what it typically means.

A yield curve inversion represents a tightening of credit in the economy due to a collapse in loan demand.

Banks borrow short and lend long, making their business model hard to operate. Insurance companies, pension funds, etc are also steady buyers of debt.

This buying power overcomes the demand for loans as businesses don’t find the need to expand. Buying overpowers selling, pushing down the yields of mid ranged debt.

Less borrowing and spending means less money cycling through the economy – ultimately reducing overall earnings. Cost cuts are the natural response of companies to reduced earnings, which feeds the cycle more.

Note that it is actually the collapse in credit demand which leads to a recession – the inverted rate is merely an indicator of this. If central banks supported the yield curve it would merely mask the signal, it wouldn’t actually increase credit demand. Also note that the slowdown following this drop in credit demand doesn’t have to become a technical recession, though it does mean things are slowing.

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What drives the markets?

We’re about a decade into an amazing bull run the stock market, with valuations climbing ever higher. I often hear questions on different nuances, almost always of course dealing with the way to earn the quickest or best returns.

In order to understand what drives returns, the most important thing is understanding flow of capital. You need to understand why money is piling into an asset and why you should expect this to continue. This may sound simple or obvious, but most people don’t think of things that way at all – they look too much into the underlying asset or the headline news. Most financial articles you read are nothing but noise – they take the most recent stock move and tie it to a recent headline. This is easy journalism which provides an endless amount of analysis to sell, can sound somewhat convincing at a surface level because it reflects something you’ve already heard and many are talking about, but really tells you nothing about what’s going on beneath the surface.

In order to understand flow of capital, I’ll start by introducing a number of investment strategies. Investing is as much art as science, and there are many ways to play it. Regardless of your strategy however, it takes patience, discipline, and conviction in your approach. I’ll list a few approaches and then brush into my view of things.

Passive investing / ETF’s:

Most funds today are passive rather than active, so I’ll start there. A passive fund, like an ETF, will blindly throw money at a benchmark allocating based on price. If a stock doubles in price, it’s weight in the index effectively doubles, and more money is allocated there as a result. Valuation is thrown out the window, as markets are assumed to be efficient in pricing. Downside protection is thrown out the window, as diversification is assumed to be adequate because you hold all the shares in the index. This strategy is a great way to minimize management fees, as very little oversight or research is required. However, I tend to believe that this strategy going mainstream will simply drive valuation to wilder cycles than ever before. When money piles in over time all seems well, but when this influx halts or reverses it could easily overshoot valuation to the downside. Most investors in this area tend to be momentum driven by nature, and will reallocate away when their gains don’t meet expectations, creating a self-feeding cycle lower.

Value investing:

For active managers, some focus in valuation. This tends to offer more downside protection, as reduced price can generate more interest rather than the reverse. However, there are many so-called “value traps” out there that seem to offer good valuation for years but simply don’t show the gains of momentum stocks leaving you with sub-par investment returns. Please understand though that value investing is by no means a dead end, it just isn’t a panacea – a good value investor should be able to explain not only why valuation metrics are good, but what catalyst is expected to drive valuations higher and approximately when this is expected to play out. Without the why and the when – or the signs to watch for – how can you keep the discipline to hold the investment until it gains? How do you know if it will ever gain?

Technical analysis and investing:

People often see the simplistic side of this approach- “the such and such stock price shows a classic formation which indicates movement to the upside with resistance expected at this price level”. It’s not quite that simple… traders who are successful with this style of investing often focus on a specific market and find what works there. They might look at oil for example and follow a number of indices they find relevant which often include currency fluctuations and trends energy users (like airlines and commercial freight). They also pick a time range that tends to be short term … some are measured in hours, some in days, weeks or months but typically not much longer than that. The big advantage to this approach is that you always have something to work on, and you have relatively steady ways of quantifying your success and value, so many active fund employees invest this way.

Macro investing:

The idea here is that you try to find the overall trends in the market and invest accordingly. Is the dollar strengthening, putting pressure on gold an emerging markets? Will bond yields continue to rise or fall and who will gain as this happens? Note that political events can affect this, but it is primarily related to identifying cycles … what type of market are we in, what are the primary drivers, what are the signs that the cycle is shifting, and so on. This is what I’m personally most drawn to, but it has a major drawback … there isn’t always something great to invest in. I like using the ocean as an analogy here… technical and momentum investors try to follow the waves, making something on each one. Value investors pick a few surfers in hopes of finding a good one for the team and trusting him to make it. Macro investors focus on the tides. This can be powerful, but you might have to wait a while before the tides are really moving.

Back to the original question – what drives the markets?

Over the last decade, we have had unprecedented easing of central banks worldwide. The federal reserve is perhaps the most important player, but the amount of easing by the European Central Bank, Bank of Japan, and Central bank of China has been much heavier. The result has been a flood of new money to “invest”, almost like a dam opening up to make the river flow bigger. In addition, capital conditions for global investment have eased like never before.

This has lead to what I like to think of as the “everything bubble”. Housing has effectively become a global investment asset instead of a place for workers to live. Whatever it is that big funds pour money into – stocks, bonds, real estate, etc – have soared while wage inflation stayed low. This has a number of implications including the worldwide political instability we see, but I’m going to focus on markets.

In a sense, the markets now are really simple, but more patience is required than ever which can be excruciating. Essentially, the flood of central bank money has been driving markets ever higher in a way that far outpaces other drivers. Right now it has simply become a story of one ratio: the quantity of money allocated to investments compared to the quantity of available assets to invest in.

Take a quick look at recent events in this area. The Federal Reserve began to tighten in two ways – reducing its balance sheet holdings while increasing interest rates. The US dollar began to strengthen. This put a lot of pressure on emerging markets, so they all had to tighten central bank policy in response. Emerging market assets slumped in value. The BOJ, ECB, and bank of China slowed or stopped their easing measures so that their currencies wouldn’t drop too much. The US dollar is still the worlds biggest reserve currency and the biggest currency for international trade, so these entities cannot just let their currencies slip.

Then the tax cuts went through allowing big international corporations to “re-patriate” their overseas cash holdings without the big tax penalties of the past. This money flooded into stock buybacks and US treasuries. The US market didn’t see a taste of the liquidity drying from the world until mid 2018, but the move was relatively mild (though somewhat larger in the most crazily valued tech names). Markets don’t move in a straight line however, and the low in December was followed by a new wave of money. The Federal Reserve even spoke dovishly in January to help keep valuations high. Worldwide markets aren’t seeing the same gains however, and even gold has been under pressure as money has flowed into US dollar denominated assets.

However, the Federal Reserve is still reducing its balance sheet and other central banks are still waiting before they ease further. Also, the US budget deficit is higher than ever. This that means that the money flow from central banks isn’t raising the level of money allocated to investments, while the amount of investable assets – in the form of US treasuries – is still increasing. That is an outward tide which warns of lower valuations ahead. Be patient my friends and hold more money aside for a time when valuations are better.

How do you know when to stop waiting? Simple. The Federal Reserve will start loosening the floodgates again. Once asset values go down enough to spook the banks and politicians, the Federal Reserve will lower interest rates and then start to increase their asset purchases again.

Don’t try to be clever and front-run this process. The magic is in going with the tides, not anticipating a future move before other investors. Let the Federal Reserve reduce rates to 1% before you become really bullish, otherwise you’re fighting upstream, it’s really that simple – and the patience required will be excruciating.

In the last down cycle back in 2008, I made a big mistake that I don’t want to repeat. Valuations were getting better and I was all in before that crash in fall 2008. I witnessed a massive margin call as the CEO of Chesapeake lost his shares and pushed the stock below $12 a share. I knew this was a crazy good buy but I couldn’t do anything! If I sold my existing holdings it would take a few days before Ameritrade would let me re-invest the money, and even if I had money to transfer in there was a waiting process. A few days later the stock was back over $25. The bottom of the market hit in March 2009 and I couldn’t keep investing because I knew my days of working in my HVAC construction job were numbered. This time I want some money to allocate for crazy bargains if they happen. Also … the central bank turned the market last time just as it will this time. When that happens, if last time is a guide, the US market will pick up first while emerging markets lag for a year or two. Then emerging markets will skyrocket as risk-on once again dominates.

Good luck everyone, and remember- the key to correctly applied patience in investing is to know why you expect a move higher and you give yourself signs to watch for. Without that you’ll be subject to the folly of losing patience prematurely (like I did with emerging markets back in 2010), or blindly being patient in a “value trap” that never seems to go anywhere.


How to Save Capitalism

I just finished reading Tepper’s book “The Myth of Capitalism,” which is a thought provoking work on the hazards of monopolized industry and the importance of anti-trust.

The book’s main premise is that the cornerstone of capitalism is competition.

Worrying signs:

For nearly two decades now, less small businesses have been created than destroyed through closing or acquisition.

In 2014, the largest source of employment for US workers was very large corporations, a mantle long held by the small businesses sector.

Median workers have seen little to no wage growth for decades while the cost of living (rent, food, fuel, and other modern necessities like college tuition and health insurance) have been skyrocketing and benefits have been continually watered down.

Our economy is growing fragile. Localized events, like the hurricane in Puerto Rico, caused massive shortages of Saline, which is the base fluid of IVs in hospitals. It is relatively easy to produce, yet all our production is concentrated. This is the case for many industries, some of which are already completely outsourced. As a result, our entire economy is more at risk to natural or geopolitical shocks.

Political instability is increasing worldwide as the wealth divide grows while workers are increasingly over-educated and under-utilized. Income inequality is accepted and even embraced by the middle class if people see a clear upward path. When their hard work goes unnoticed and the system is seen as rigged, this sentiment becomes poisoned.

A note on socialism vs communism:

We are already in a period that will see significant political change. The anti-communist rhetoric is still a powerful voice in politics, but the mainstream parties have twisted this message in a way that is increasingly dangerous. They relentlessly equate socialism with robbing the productive and handouts to the lazy, while strategically ignoring the centralization of power in our system.

Centralized decision making is the cornerstone of communist government. The Soviet Union was lambasted for having a feudalistic command-and-control economic system, NOT for being a workers paradise.

Popular social reforms like social security, progressive income taxes, Medicaid, food stamps, and so on should never be confused with communism. If this subterfuge continues while large corporations are allowed to centralize our economy at the expense of the average voter, then there is an ever-increasing danger that a real communist will be elected and large swaths of our economy will be nationalized.

Suggested measures

1. Watch for and regulate portals.

Monopolies typically involve the control of key portals between many suppliers and many consumers. The SEC needs to carefully watch for these portals and actively regulate them to either spread control or eliminate the outsized profit.


A small number of firms buy all of the produce from US farmers and supply all of the grocery outlets. Most farmers in a region have only one large buyer for their goods, which then supplies all of the large chain grocery stores. These could be broken up along with large grocery chains to create smaller competing firms.

Amazon owns the biggest portal for online retail. They also act as a large warehouser/retailer. Their online portal should be severed from their retail engine so that they can’t systematically compete with and crush and small retailer encountering initial success on their website. Similarly, Google Search is a very powerful portal which should be severed from all of their other businesses so that they can’t just take over or replace any online company with a good idea at their whim.

2. Passively discourage monopolies through taxes.

A special monopoly tax should hit all company profits when market share hits a threshold such as 10%. This should scale up and become quite large as market share approaches 100%. This cuts the rewards of monopolization and encourages investors to put more money into smaller firms.

3. Watch for and combat industry collusion.

Whether it’s a small number of firms who follow the “price leader” or powerful investors cross-holding shares of all major competitors in an industry, the SEC needs more direction and leeway in this area.

4. Create fertile soil for small businesses to start up.

The cards are clearly stacked against startups. A few things can change this such as the following:

– Increasingly use business size exemptions in regulations (targeting gross revenue and/or number of employees)

– Create special tax breaks for small businesses and make them permanent

The idea here is that an ordinary person could quit his day job and make a comfortable living in the private sector on his own. If successful, he will have the means, experience and basic structure to allow him to scale up operations. If successful this would bring a wave of innovation while empowering the individual worker – a real win-win.

5. Allow small business employees to enjoy the retirement and health care perks typically reserved for large employers

There is no reason to hold back 401k’s from small business employees just because their employers lack the size and clout to avoid getting fleeced by the few large 401k providers. I strongly believe annual caps to IRA’s should be eliminated entirely and replaced with total value caps. $5,500 a year won’t get me far in retirement, and a $1 million retirement account balance is way beyond reach for a median employee today. Same story with health care – a small company employee should be allowed the same choices and subsidies as his corporate counterpart.

I’m going to stop here, but I hope this gets you thinking. The future doesn’t have to be a dystopian nightmare of control and obedience- it can be a golden age of individuality and innovation. I’m happy to say I’m optimistic on that score.

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If you could change the system…

How often do you find something in our political system that doesn’t make sense and should be changed?  For me it’s all the time, and its especially frustrating in that most of modern politics focuses on completely different things.   I can’t expound on all of these ideas in a readable post, so I’m just going to make a list of bullet points with minimal description.  Hopefully you find this thought-provoking.

·         Deal with our monopoly/oligopoly problem

o   Most industries in the US are dominated by a small number of firms.  We have the same number of publicly listed companies that we had in the mid 1970’s with an economy that is 3 times larger.  This causes a number of problems, but fortunately there is a book by Jonathan Tepper called “The Myth of Capitalism” which clearly lays this out.

o   Ideas to fix this include using the SEC to break up large companies, making many reporting regulations size dependent in order to give small business a break, or even special taxes on companies based on market share (perhaps a special tax starting at 10% market control that starts small and gets very high as you approach 70% market control)

·       Lawsuit reforms

o   People have agreed for a long time that litigation is out of control. Many of the problems in our society stem from this, as proposed solutions fall apart due to a shift in liability. It curtails our freedoms as trampolines, merry go rounds, diving boards, and other things are no longer available. It creates a tremendous burden on business owners, particularly pressuring smaller medical practices to shut down or merge operations with a larger practice.

·         Hazardous waste disposal

o   Recycling programs have been very successful in getting people to separate out bottles, cans, paper, and other recyclable materials – yet many household items like batteries, fluorescent bulbs, paints, cleaners, oils, acids and so on contain chemicals that should not go to landfills, yet they end up in regular trashcans.  For small-time contractors its often worse as they make very little money per project and are expected to pay much larger sums than big competitors to dispose of hazardous waste. 

o   The solution here is simple: aim to make hazardous waste disposal as easy and convenient as recycling.  It should be totally free with local government collection centers, possibly paid for by taxing the initial sale of the items they collect.

·         EPA Reform – taxes over controls

o   The EPA needs to have the authority to tax to a small extent.  Many times, production of hazardous waste is a byproduct of modern society that can’t be avoided.  Currently, they try to address issues with direct controls on emissions limits of certain things, but this is often an inefficient approach that tries to limit the excess production of one thing with the direct control of another.  To put it simply, I’m merely suggesting that this policy lever would be useful.

·         Subsidize Fruits and Vegetables

o   We hear about the “obesity epidemic” all the time, yet healthy options always cost more.  Lower-middle class people in modern society live in crowded places with roommates – they often don’t have their own kitchens and refrigerators, and they find it cheaper and easier to stick with low cost fast food.  Look at any of the value menu items, however, and they are all carbs, beans, cheese, and cheap meats with no more than a sprinkling of iceberg lettuce.  Healthier choices always cost more, or at the very least are equivalent (example – get a “salad” instead of a “sandwich” at subway and you forego the bread but pay the same for the same quantity of meats and greens).  I think it should be subsidized to the point where that extra garden salad costs no more than that extra dollar for the bag of chips, particularly at low-end fast food places. 

·         Student Loans

o   Tuition has been rising in leaps and bounds while median incomes go nowhere.  Loans have become easier to get for larger amounts, and college degrees are required for more jobs than ever – many of which never required degrees in the past and don’t pay any more than they used to.  This system is very damaging to our youth, it delays and often prevents family formation, and it really needs to be addressed.

·         Affordable Housing

o   Watch the classic “It’s a Wonderful Life” and Pottersville resembles most city living today – with people paying more to rent in crummy, over-crowded housing than they paid to own a home in the “Bailey Park” alternative.  The reason is simple – housing costs have skyrocketed while median incomes went nowhere.  After the last housing bust, wall street was invited to purchase single-family homes in rental schemes for the first time – leading to a large “recovery” in housing prices that went beyond the prior peak in national terms.  Rental units are often dominated by a small number of large firms with monopoly level pricing power.  This issue needs serious attention. 

·         Federal Reserve Policy Tools

o   Current policy tools of the federal reserve are interest-rate manipulation and quantitative easing.  Both of these push money into the system by expanding debt and driving up asset prices.  These tools destabilize the system by making the rich (asset owners) ever richer while wages go nowhere, while ordinary people find retirement and large purchases ever further from their reach, and debt loads increase exponentially.   

o   Other tools I’d propose:  The ability to make direct payments to every citizen (show your social security card at a bank to redeem) which would increase consumer spending while allowing consumers to pay off debt, helping to stabilize the system.   If you don’t like that idea, perhaps allowing the federal reserve to create a “government infrastructure spending” fund which could then help much needed public improvements get built while creating jobs.  Perhaps you allow banks to borrow at a “penalty rate” so that credit would not freeze up completely yet it would not manipulate asset prices so much … my main point here is that the current tools are counter productive.

·         Government shutdown policy

o   Our current shutdown policy was set in the late 70’s and started hitting from the Reagan era onward.  It focuses all of the penalties on a small set of people from low-level government employees, to government contractors, to national parks and related businesses while the actual officials feel no pressure at all.  Whether its something as mild as freezing pay of elected officials (they’re all rich anyway) or as extreme as a cloture type system where they are literally locked in the building and remain in session until they agree on something (and the president can only veto if he’s locked in there too) – I’m not sure what the answer should be.  The current setup needs to change though.

·         Patent Reform

o   Patents should be about innovation rather than preserving monopolies.  I believe that very strict limitation on the duration of patents should be enforced … no patent lasts longer than 30 years.  If you cant make money with a 30 year exclusion, you wont be funding the project anyway – and it would unleash an enormous wave of innovation as all of that locked away knowledge would become a free public resource.  Limits like this would also curtail the efforts of “patent trolls” which don’t really innovate so much as patent everything possible in order to take control of any possible benefits that others find.

·         Wall street regulation

o   Leveraged Buy-Outs should be illegal because they take money from current stakeholders and give it to the party doing the takeover.  A company like Sears or Toys-R-Us for example would get loaded with debt that was only used to pass its control from the current owners to the new hedge fund – greatly diluting the claims of pension holders, current debt holders, and other stakeholders such as employees.  It’s a transfer of wealth plain and simple.

o   Stock buy-backs should be illegal and actually were until 1983.  They were once considered stock price manipulation, and they generally are as they load a company with debt for a rise in stock price that often proves temporary.  This can help an exiting CEO or a hedge fund with options contracts, but it actually harms the other stakeholders including debt holders, pension fund holders, and employees.

o   SEC operations.  We often hear that the “SEC is asleep at the wheel” as they allow all sorts of financial frauds to take place, often with much warning ahead of time.  Forensic accounting is an area that some short-sellers specialize in … they uncover active frauds while shorting the stock.  Unfortunately many of these active frauds are allowed to continue long after they are exposed.  The SEC needs to take these more seriously.

I’m running a bit long so I’ll stop here, but I hope that reading this will get you thinking on how the system really needs to change rather than being distracted by the latest political media fad.

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Is it a good time to go short?

Going short is always a risky bet.  The easiest way to do it as an amateur is to buy put contracts, allowing you the right to sell a stock at a given price.  If the stock drops below target, the put option has value.  If it stays above the strike price and you hold it until expiration, it becomes worthless.

I decided to make a small wager this morning, and my plan is to show what I’m thinking and why.  One blunt confession – I have not learned the tricks of the trade for technical analysis though I’ve been meaning to start.  That sets me at a disadvantage, but I’ll explain my reasoning and can judge whether its worth anything.

My bet: Purchased 5x put options of TOL June 21 puts at $1.75.  1 contract = 100 shares so the cost is 5x100x$1.75 = $875.  Options have both time value and intrinsic value.  This purchase has no intrinsic value because it is out-of-the-money, but it’s time value is significant.  If the stock stays above $32 for 6 months, then the time value will slowly drop to zero and the intrinsic value is worthless.  If the stock drops below $32, then I make money on controlling 5×100 shares, making the intrinsic value $500 for every dollar below $32.  I can exit the trade at any time by selling these options (note exercising them early is an option, but it would mean getting only the “intrinsic value” and giving up the “time value” remaining in the contract.)

Okay, enough basics.  Here’s my reasoning…

  1. In my previous post, I explain how we’re in danger of starting a bear market.  This is because the strongest buying forces of the past have dried up.  Force 1 = central banks are either slowly tightening or holding steady but not easing.  The Fed leads the pack here because other countries run into trouble if their currency falls too much too fast vs the US dollar.  Force 2 = corporate stock buybacks following the tax law change, which I believe have run their course.  If the recent rally fizzles and falls, it could be another leg down.
  2. Housing sales have been falling dramatically nationwide, particularly in the West.  Many other countries have been experiencing similar declines.  US data stopped in November because of the government shutdown.  Two months of US housing data will hit the market soon, and I expect it to continue its trend of YTD declining sales.
  3. The Federal Reserve is about to issue another press conference.  Much of wall street expects more dovish signals, but I believe Powell will surprise to the negative.  My guess is that he will hold the interest rate steady, but continue the gradual balance sheet reduction at the same pace.  I think he will talk more about normalization and a plan to return to holding only US treasuries, and shedding off the mortgage backed securities over time.

In short, the buying pressure we’ve been used to is repressed because central banks aren’t pumping more money in, and I have a couple potential short-term catalysts to get people worried about housing.  Toll Brothers is the largest homebuilder, so I expect them to get hit a bit.

You’ll note that my reasoning here is primarily macro – which is my main field of interest.  I have gaping holes on two fronts – no serious technical analysis and no serious fundamental or balance-sheet analysis on the underlying company.  I am unlikely to fill these holes in the future, as I work at a computer all day and spending more time on the computer when I return home is difficult.  I’m primarily a long-only investor, but I enjoy learning and trying new things – so I put in a wager that I can easily part with and yet still be interested in.

One last thing I should say before I sign off here … I have been following and I’ve come to like his balance of financial news across different countries and markets.  His biggest focus is housing and autos, where he has the most experience, data, and insight.


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What are the markets doing? Where do we go from here?

I’ll save you time and start with my conclusion.  My explanation (which I actually wrote first) will start below.

In summary, here is how I see things:

  1. Right now stocks are fighting the tide as central banks of the world are comparatively tightening.  Much of the money from central bank easing ends up in the stock market, and this buying power is drying up.
  2. As the stock market begins to decline, investors will start to ask questions like “does my investment make sense” or “how low can this go.”  In order to answer those, they dust off their valuation models and start using them again.
  3. As valuations become more important, the bear market gains momentum.  Valuation models that were stretched are pared back considerably.
  4. Central banks will see declining asset values and think about easing.  If economic growth slows, then zero-interest-rates, negative intertest rates, and QE (money creation) will be back on the table.  The tide of investment money will start to flow back in to investment markets.
  5. Investors will initially be wary and stick to valuation models.  They may look to alternate markets like gold or commodities for diversification.  Ultimately when stocks start to rise again, the concept of valuation will be slowly pushed aside and the up-cycle will start again.

Now back to the beginning:

It has certainly been a volatile year, with markets starting at a peak around 2,830 in Jan 2018, dropping to a low around 2,588 in Mar, then rising to a new peak of 2,930 in Sep, dropping to a low of 2,415 in Dec, then rising to 2,633 today.

The last 5 years have seen a great run in the US stock market, with the S&P 500 pulling from 1,860 in 2014 to close at 2,633 today.  That’s a 41.5% increase or about 8.3% per year.

US GDP had a low of 1.6% in 2016 with an estimated high of 2.9% anticipated for 2018 – for an average of 2.4% per year – so that doesn’t quite explain the growth.

S&P per-share earnings (which are quite volatile) have been (2.11-15.42+9.27+16.21+21.77)/5 = 6.8% per year, so that doesn’t completely explain it either.

I’m going to jump past this and just explain my narrative here…

I believe that we are in what is called the “everything bubble”, where excessive QE by the central banks of the world has led to asset price increases in nearly every investable market – from stocks and bonds to real estate.

Using the ocean as an analogy, the central banks of the world have been pushing money into the markets like crazy, causing the tide to come in and price levels to rise.  There are always waves, but the effect of the waves is negligible compared to the effect of the overall direction of tide.  What we’re beginning to see is that the tide is starting to head back out.

The Federal Reserve started the tightening cycle and took it the furthest, both with interest rate increases and balance sheet reductions.  At the beginning of this cycle, two things kept the S&P 500 rising higher – the large US tax cuts, and the money created from foreign central banks finding comparably attractive yields in US dollar assets.  A lot of corporate foreign earnings were also “repatriated” and used to fund record corporate stock buy-backs.  The US dollar started rising considerably since the Federal Reserve began to tighten.  This has pressured emerging markets quite heavily, especially those with large amounts of dollar-denominated debt.  Emerging markets had to respond with considerable interest rate hikes and still saw their currencies head lower – we saw the most news of this in Argentina and Turkey.  The European and Japanese central banks kept their low rates, but stopped easing (you may remember hearing about the “taper tantrum” when the US stock market started to turn as QE was slowing years back).  China has reduced credit growth considerably as well, leading to a slowdown in a number of different areas such as Chinese domestic auto sales.

Remember that as long as central banks are holding or tightening, you’ll be fighting the tide by buying in.  This won’t change until central banks are spooked into easing again.  In the meantime, there is significant danger that valuation will come into question.  I’ll explain…

During a bull market – particularly one driven by easy central bank policies, but any will do – valuation is continually edging higher.  Investors start throwing money in because they see things going up and they don’t want to miss the boat, so valuation models become ever more strained and price-to-earnings ratios soar.  Throw in some new technology and narrative replaces valuation entirely.  In the dot-com bubble prior to 2000, internet stocks soared to incredible highs as price-to-sales replaced price-to-earnings because it could justify negative earnings for fast-growing companies.  It ultimately crashed 90% when valuations became important again and people asked how much these things could really expect to earn.  Many companies with negative earnings died off completely because they could no longer get funding.

Compare that to today… a small number of tech stocks dominate the S&P.  Amazon has an enormous market share and P/E, but it doesn’t earn much and its pricing power is low.  If it raised prices by 10%, watch sales switch to other websites from eBay to  Netflix was valued more than Disney at its peak, even though it has negative cash flow while Disney owns much more valuable content along with theme parks, hotels, major motion pictures, and a whole product array to follow them.  Tesla was valued more than GM even though it was a niche high-end EV producer struggling to make a more affordable EV while GM had international operations and a large robust product line.  I could go on but you see my point – investors going back to earnings valuation models could lead to much lower prices going forward.

Note that I picked on Tech because it was easy, but the “rising tide” lifted valuations and stretched valuation metrics everywhere.

On this note, there is one more really important trend I want to mention … the rise to dominance of ETF’s.

ETF’s – exchange traded funds – offer you both diversity and liquidity.  You can by and sell shares tracking companies in the S&P 500 and pay very little in management fees, getting your safety from diversification.  Sounds great, right?  But does it work?

Look back at the price jumps over the last year and you can see that the S&P itself can be quite volatile.  Also, consider that bear markets can take it down significantly – like the last one with a high above 1,550 in 2007 and a low below 700 in 2009.  But that is only part of the story.

ETF’s work by blindly throwing money at stocks in an index based on valuation.  Netflix is valued as much as Disney – allocate the same percentage to each.  Don’t worry about valuation, the market will sort itself out, right?  But what if everybody does that?  What if nobody is looking at valuation and it just gets more and more out of whack?  Normally if a good stock crashes too far, active value investors will pile in and create a floor.  If the stock is dominated by ETF-holders then the dropping price simply means less should be allocated to it, leading to more selling, which can reinforce itself considerably causing a significant undershoot in valuation before the few remaining value investors can start to reverse the tide.

In short, the structure of an ETF will allocate the most money to what is overvalued and the least to what is undervalued, helping you on the up-side and crushing you on the down-side.  By contrast, a good actively managed fund will aim to avoid out-of-whack valuations, which gives you less of a gain going up but a lot more protection going down.

One last thing to worry about … bond ETF’s.  High-yield bond ETF’s are popular because they offer a decent return and safety through diversification, but they have a considerable unseen danger called “liquidity mismatch”.  High yield debt is considered relatively illiquid because low amounts trade, so large sales can be difficult and move the price a lot.  If something spooks the holders of these ETF’s – such as the high-yield rate increases typical in an early bear market – investors can just sell and the fund has to cash them out.  If enough investors sell, then these ETF’s are basically forced to sell this below value to pay out those investors.  This dollar value of the ETF drops and either more people sell which could collapse the fund, or the fund stabilizes but never recovers because the fund-holders were forced to eat some of those losses when the high yield debt was sold below value.  If you individually hold a number of bonds, then you can just hold them to maturity and most likely keep the principal when these bonds pay out – but as an ETF holder you effectively lose that ability.  The credit risk – that of the individual bonds defaulting – is actually not increased in an ETF because an environment where defaults start happening is much more likely to cause a run on your “diversified” ETF fund, whereas splitting between 5-10 bonds on your own should at least get you the average rate of payoff (a 10% default-rate for high yield is considered extremely high).  However, it will likely net you better because an ETF blindly throws money into everything whereas anyone picking individual bond issues will likely show some discretion on what seems credit-worthy.  For example, the record sale of 100-year bonds to Argentina in 2017, which collapsed in value the following year, would seem a crazy deal for an individual to purchase, whereas owning some of it in a “diversified” emerging-market government bond ETF with an 8% yield would seem to make a lot of sense. (Note that Argentina didn’t default on these yet – my point is that picking your own 5-10 bonds is not that difficult and even a novice would be somewhat discerning).

I hope I gave you some food for thought. Have a good night.

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