Tuesday, March 17, 2015

Nowhere to Hide!


John P. Hussman, Ph.D.
Whether or not it is fully appreciated, we are observing extremes in nearly every pendulum of the global financial markets. The situation is likely to be seen in hindsight as one of the broadest points of financial distortion in history. Broadest, because unlike the 2000 peak when technology and large capitalization stocks were more overvalued on reliable measures than they are today.
The median stock price is now more overvalued than in the year 2000.
It’s true that on historically reliable valuation measures that are best correlated with actual subsequent total returns on stocks, the 2000 peak remains the most overvalued point for the S&P 500 in U.S. history, though only about 20% above present valuation levels on those measures (there are certainly many popular but unreliable measures that suggest only moderate overvaluation here). Aside from that 2000 peak, the S&P 500 itself is now more overvalued than at the 1929 peak, not to mention the lesser 1972, 1987 and 2007 extremes. We estimate that the S&P 500 Index is likely to be below its present level a decade from now, though adding dividends is likely to raise the nominal total return to about 1.6% annually on a 10-year horizon.
DYI's  

Estimated 10yr return on Stocks

Using 5.4% as the historical growth rate of dividends and 4.0% as the ending yield.

Starting Yield*---------return**
1.0%-----------------------(-5.7%)
1.5%-----------------------(-1.7%) 

2.0%------------------------1.3%  You are Here!

2.5%------------------------3.8%

3.0%------------------------5.9%
3.5%------------------------7.8%
4.0%------------------------9.4%
4.5%-----------------------10.9%

5.0%-----------------------12.3%
5.5%-----------------------13.6%
6.0%-----------------------14.8%
6.5%-----------------------15.9%

7.0%-----------------------17.0%
7.5%-----------------------18.0%
8.0%-----------------------19.0%

*Starting dividend yield of the S&P500-**10yr estimated average annual rate of return.


Market indicators suggesting a correction is coming: On Black Tuesday Shiller PE Ratio was at 30. Today it is at 26.2 and volatility is back in a big way.

Stocks are incredibly overvalued based on earnings.  While companies like Amazon and Apple blow it out of the water, many others are not.  The current PE ratio is inflated. 
When you evaluate a company looking at price-to-earnings is important.  How much are you willing to pay to get a dollar back?  In essence that is what we are looking at with the PE ratio and right now we are looking frothy:
snp 500
baltic dry index
What this is signifying to us is that the demand to ship goods is low thus pushing prices lower.  The last time we saw a crash like this we ended up with the Great Recession.  Take a look at oil prices:
oil
Oil has collapsed in the last few months alone.  Many were getting accustomed to $100 a barrel oil only to see it drop to $47 a barrel.  The big push for this is plenty of supply with moderating demand.  Then you have OPEC maintaining output to flush out high cost producers and gain market share.  Of course this hit is going to reflect in oil producing countries like Russia, Canada, and Venezuela.
Does any of this sound like a stable market?  Having a system addicted to perpetual debt is not a solution.  It is merely a temporary measure to allow the financial wizards to siphon off real production into their hands.  In housing you had Wall Street buy up many homes driving prices higher and rents higher only to suck away more income from working families.  How is that good?  This was subsidized by the Fed with their negative interest rate policies.  Again, nothing comes for free in this world. 
The S&P 500 has gone up 200 percent since 2009.  A correction is bound to happen and the amount of volatility hitting the system currently is bound to expose some cracks.
Continuing with Professor Hussman
Next, consider the bond market. Unlike 2000, when 10-year Treasury yields of 6.5% still offered somewhere to hide, the present environment offers bond yields to investors that are scarcely higher than 2% in the U.S., with German yields at negative levels even beyond a 5-year maturity. In recent years, yield-seeking speculation has encouraged record issuance of junk debt and “covenant lite” leveraged loans (loans to already highly-indebted borrowers). This is simply a different iteration of what we observed prior to the mortgage crisis, when the yield-seeking security of choice was mortgage debt, and Wall Street’s rush to create more “product” fueled a speculative housing boom as credit was extended to borrowers lacking durable creditworthiness. The current episode is likely to end just as badly, though even more concentrated on the equity market, as a primary object of speculation in recent years has been debt issuance for the purpose of leveraged buyouts and equity buybacks, all of which looks fine only while historically volatile corporate profit margins remain extended at cyclical extremes.
DYI Comment:  Here we go again....Another debt blow off; this time in the junk bond arena. Central bank inspired boom bust cycle.  With interest rates so low on high quality debt especially Treasury securities, there is nowhere to go to for a historically competitive return.  If you believe rates will be moving up soon don't bet on it.  Here is a chart from the Atlanta Fed forecasting GDP growth for Q1 of this year.
Evolution of Atlanta Fed GDPNow Real GDP Forecast
The GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the first quarter of 2015 was 0.3 percent on March 17, down from 0.6 percent on March 12.

   Continuing with Professor Hussman
Again, it’s tempting to think about currencies in simplistic terms, assuming that the quantity of the currency is all that matters for valuation, and therefore that quantitative easing in Japan and Europe, coupled with less accommodative policy in the U.S., should result in unending depreciation in foreign currencies. Just as elevated equity valuations in recent years hasn’t prevented even further speculative extremes, we can’t rule out the possibility that investors will continue to act on a simplistic mindset that results in massive undervaluation of foreign currencies and overvaluation of the U.S. dollar on the foreign exchange markets. Rather, our assertion is that the deviations of prices from valuation norms mean something about subsequent returns, particularly over the complete cycle. Because the present extreme in the global financial markets couples extreme U.S. equity valuations with extreme overvaluation of the U.S. dollar, we view investment prospects for U.S. stocks as even worse from the standpoint of foreign speculators as they are for U.S. speculators (neither can aptly be considered investors at these valuations).
DYI Continues:  Three asset categories that have value for the long term investor.  One: Gold mining companies (Vanguard's Precious Metals & Mining Fund symbol VGPMX) that have been beaten down from peak to bottom around 70%.  A tremendous sell off.  Our model portfolio currently holds 15% as gold stocks have long term potential value, however they are no longer the great bargain of 1998 - 2002 time period.  Dow to Gold Ratio is pricey, as shown in the chart below.
  
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AGGRESSIVE PORTFOLIO - ACTIVE ALLOCATION -  3/1/15

Active Allocation Bands (excluding cash) 0% to 60%
85% - Cash -Short Term Bond Index - VBIRX
15% -Gold- Precious Metals & Mining - VGPMX
 0% -Lt. Bonds- Long Term Bond Index - VBLTX
 0% -Stocks- Total Stock Market Index - VTSAX
 0%-REIT's- REIT Index Fund - VGSLX
[See Disclaimer]

Two:  Oil/gas/service stocks have been beaten down as well and represent long term value.  Oil and gas prices could fall further as the world economy slows or possible outright recession.  Recommend dollar cost averaging only, to lower your cost basis. DYI's favorite, as might have guessed is Vanguard's Energy Fund symbol VGENX.

Three:  The Euro is now undervalued.  The current exchange rate is $1.06 to 1 Euro or almost parity. At the same time Vanguard's European Stock Index Fund symbol VEUSX has a 4.33% yield from dividends as compared to 1.90% for the S&P 500.  Higher dividend yield plus an undervalued currency.  I would only recommend dollar cost averaging as the Euro could drop further( only encouragement to buy more) and an overvalued U.S. stock market that very could bring down world wide markets (including Europe) again encouraging us to continue purchasing.

Tide turning in favour of European stocks after years of underperformance

Euro zone stocks at 50-year low vs US stocks -BoA-Merrill
* Euro STOXX 50 still needs 40 pct rally to reach 2007 peak
* Region offers a better risk-reward -JPMorgan
Happy Hunting 
DYI

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