In Part 1 of The Big Idea, we covered the framework for using a Big Idea, and some of these trends over the past 20 years. To recap, Big Ideas are useful in that they provide a vast number of “trading ideas” over time. Knowing that 2003’s loose monetary policy would eventually lead to an overheating economy was helpful early on – especially when many homebuilders were trading at a P/E of 5 with 5% dividend yields.
It was easy to like them from the long side back then (not so much in 2006); but, that doesn’t mean that getting a Big Idea correct is a license to ignore our Momentum and Signal work. The Big Ideas, after all, only provide the Context, which is step one in our Context – Momentum – Signal process.
Fundamentals as the Context
So, now, let’s talk a bit about where markets and the economy currently are, and what that portends about the next Big Idea.
- Stock Market – We’re six years and two months into the bull market in stocks. The average bull market since 1932 lasted, on average, 56 months versus today’s 74. Now, maybe today’s extraordinarily loose monetary and fiscal policy accommodation (i.e. spending money we don’t have) will extend the bull even further. If you think so, based on valuations, one would have to contend that they’ll remain high, given a lack of profit growth. But, if you look at any mean reverting ratio (CAPE, Tobin’s Q, profit margins, etc.) stocks are near other major peak levels. Below we show a chart of Tobin’s Q Ratio going back to 1900 (courtesy of dshort.com and hussmanfunds.com), which shows stock values relative to underlying net worth.
The Wolf read a report recently that said, stocks weren’t too expensive because they were below peak valuation levels hit in 2000 and 2007 (Two of the most expensive markets ever, which proceeded 40% declines). Let’s just say stocks aren’t cheap today in a normal economy, much less an adverse one in the future, as shown by the Median P/E chart below (courtesy of davidstockmanscontracorner.com). And, most CEOs are buying back stock and investing for growth – typical action at the top of a cycle. Why is it that CEOs are always cutting capacity at economic bottoms and adding it at tops? I guess they are trend followers too.
- Bond Market – Treasuries have been in a bull market since 1982. 30-year Treasuries reached their lowest yield ever earlier this year. That makes them as unattractive on a yield basis as they’ve ever been, and shorter term notes and bills are in a similar state. Now, as we’ve written before, we think the bond bubble is in junk bonds, not Treasuries. In fact, should risk assets sell off, we’d err on the side of Kyle Bass who said many Treasuries could end up trading at negative yields for a short period of time. Suffice to say, these bonds are only attractive in the sense that they don’t carry as much risk as the stock market. A bad year in bonds is similar to a bad month in stocks. The time to sell bonds is likely just after the Federal Reserve announces QE4, but that’s for another post.
- US Economy – We live in a tale of two worlds today. With one in three people on government assistance of some sort (not including SS & Medicare) there’s a significant portion of the US population that is unable to fend for themselves financially. The reason we don’t see breadlines the way they did during the Great Depression is that today’s hungry use EBT cards. Yet, GDP and asset markets have been acting like everything is all right. How long can corporations continue to grow
earnings when sales, and their customers, are deteriorating? While the headline unemployment figures continue to drop we have a troubling chart on the left. It shows the official number along with the U-6 (includes “marginally attached” workers) and the Shadow Stats Alternate, which also adds back in the “long term discouraged workers (chart courtesy of www.shadowstats.com). Here you can see the effect of the low labor force participation rate, which has driven the official number down of late.
Big Ideas of the Future
OK, so that’s the background. What comes next isn’t knowable. But we can examine possibilities and assign probabilities to those outcomes. Then, we watch for signals that the markets give us to determine how to adjust the likelihood of each scenario.
As The Wolf sees it there are really three distinct possibilities:
- “Everything is Awesome” – The Goldilocks economy continues, and the global economy gradually inflates, and grows, its way out of the current over indebtedness. Particularly helpful in this scenario would be the discovery of various technology such as cold fusion for unlimited, free energy; perhaps the “Limitless” pill allowing for a quantum leap in productivity, or the Chinese increasing its debt levels to spur economic growth, in its version of the US’s “1932 gold confiscation (i.e. Attempting to spur inflation by debasement).”
- “Back in Black” – In this scenario, the economy and stock market pull back, in a “pause that refreshes.” The next bear market in stocks retests the old highs from 2000 and 2007 before turning back higher. This would be similar to the 1987 stock market crash, which occurred exactly at the halfway point of the 1974-2000 advance. In other words, the ’87 crash was a 40% decline within a secular bull market. Somehow, suggesting a 40% decline in the stock market today qualifies you for a free tinfoil hat, or membership in the flat earth society, today. Most likely, after the big pullback, there would be an inflationary boom, or continuation of the current “crack-up boom” if you prefer. Under this scenario, asset owners do well, but the benefits of the boom are concentrated in the hands of the few, while the many continue to struggle.
- “Enter Sandman” – 2015-2020, “Junk Bond Bubble Bursts” – This is The Wolf’s most probable scenario. As quickly as capital flew in (see Market Growth chart from troweprice.com), it flies out causing liquidity issues for junk bond issuers who need to rollover debt (see chart from www.doubleline.com/ ). Problems in the weak credit market spillover into the high grade corporates, which are themselves overvalued according to Jeffrey Gundlach of Doubleline.
This is the “take your medicine scenario.” Governments, people and corporations understand they’ve been living beyond their means. Bad debts are written off, incomes fall, asset markets collapse and the economy contracts. Because incomes collapse, new businesses (like the sharing economy) focus on economizing (home gardens, ride sharing, repurposing). In a Depression such as this, because our economic lives are less fruitful, people focus on experiential entertainment. And, this returns a focus to what’s really important in life: family, friends, healthful living (rather than “Keeping Up with the Kardashians,” professional sports and gluttony). This scenario is economically painful; but, ultimately it’s inevitable, and it’s actually restorative.
The Back in Black and Enter Sandman scenarios seem most probable, with a combined likelihood of say 80%. We can leave the extra 20% to be split between Everything is Awesome and scenarios your author hasn’t contemplated. We are confident in this statement because contrary to popular belief, the business cycle isn’t dead, and monetary policy has a fleeting, not lasting, impact on economic growth and asset prices (just ask the Japanese).
So, what are the signs to look for in differentiating between the scenarios? I’ll suggest the 200-day moving average for the stock market. That’s a late indicator, but moving to cash when prices fell below it would have prevented major losses in the bear markets of 2008, 2000, 1987, 1974 and 1930-32. For the traders in the crowd, I’ve always felt the Investors’ Business Daily’s Big Picture does a great job of identifying distribution days as a warning of major dislocations and bear markets. Anytime they list “Market in Correction” in that column, preparing for some big risk event, given the extent of our debt problems, makes a lot of sense.
Another good leading indicator is the credit markets. Many of you may wonder why I harp on and on about the Junk Bond Bubble so much. It’s because credit markets are “smarter” than stock markets, and credit typically leads. So, a skyrocketing CCC credit spread, which we’ve covered before, and a declining price of energy junk bonds, are the early warning lights that another credit contraction has started. Many say that the energy junk bond sector is too small to have a major impact on the economy. Recall that the same thing was said of the subprime housing market in 2007 (remember it was “contained“). Regardless from where it comes, we think that a credit contraction is going to lead to the next recession and bear market in stocks, and it likely has already begun if the CCCs are to be believed.
We will keep an eye out for you, and alert you to any developing details.
The time zone we reference on our charts is Pacific Standard Time. Therefore, the U.S. cash market opens at 6:30 AM PST and closes at 1:00 PM PST.