The Current State of Stocks

          About one week ago, I completed the June Special Report which is titled “Mid-Year Market Update:  What to Consider Now for Your Money”.

          This week’s holiday issue of “Portfolio Watch” is a preview of that Special Report.

          As I have often stated, the potential problem with a time-sensitive special report written 3-4 weeks before delivery, is that so many things can change by the time the delivery happens.

        The June Special Report examines the state of many markets and offers a forecast as to where they go from here.

          Interestingly, the stock forecast offered seems to be playing out already.  Here is a bit from that report which can be ordered next week for those with an interest in reading the entire report.

          Last year, when we forecast a high probability of a stock market correction, we pointed to a commonly used piece of fundamental data, something known as “The Buffet Indicator”. 

          The Buffet Indicator is actually a measure of the total value of stocks as compared to economic output.  Put another way, this indicator is a measure of market capitalization (the total, combined value of stocks) divided by Gross Domestic Product (total economic output).

          Last year, we published this chart, noting that the indicator showed that stocks were extremely overvalued.

          There are three important points of reference on the chart.  The first is the calendar year 2000 when the Market Cap to GDP indicator stood at 159.2%.  That means that in approximate terms, the total value of stocks was about 1.6 times the economic output of the United States.

          From those levels, stocks fell more than 50%.

          The second important reference point is in 2007 when stocks peaked just prior to the financial crisis.  At that point, stocks were valued at 110% of US economic output.  From that point, stocks once again fell more than 50%!

          Then, late last year, the Buffet Indicator rose to 216%, a level never seen previously.  The total value of stocks was more than twice the total economic output of the United States.  At those levels, it was easy to predict a stock decline was inevitable.  As a side note, for stocks to return to the historic average of the Buffet Indicator, they would need to fall 70% from those lofty levels.

          As of this writing, we have now seen about a 20% correction.

          Technically speaking, as long-term readers of our newsletters and special reports know, we called the top in the market in December.  While forecasting where stocks go is dangerous business in an artificial economy abundant with newly created currency, it seemed like a December 2021 top was likely for a couple of reasons.

          The chart above is a chart of an exchange-traded fund that tracks the movement of the Russell 3000, a broad stock market index

          There is another technical indicator that we use to potentially detect major turning points in the market.  While the indicator itself isn’t unique, the way that we use it is unique.

          The indicator is something called a MACD, often pronounced, “mac – dee”.  It is a technical indicator developed by Gerald Appel in the 1970s.  MACD is an acronym that stands for moving average convergence-divergence.

          The MACD is often used with a daily or a weekly chart to determine trend changes.  The chart above is a weekly chart and the MACD indicator has been drawn across the bottom of the chart.

          The MACD indicator has two lines moving up and down across the bottom of the chart.  These lines, one orange and one blue occasionally cross each other.  It is these crossovers that many traders use to trade and determine potential trend changes.

          The orange line on the bottom of the chart is drawn by taking the 12-period moving average of price and subtracting the 26-period moving average of price.  If you look closely at the labeling on the right-had side of the MACD indicator, you’ll see a zero line.  When the orange line crosses the zero line, it is at that point that the 12-period moving average of price and the 26-period moving average of price are the same. 

          Here’s what one can discern using a moving average of price:  the 12-period moving average of price is the market’s consensus of value over the 12 periods.  On the chart above, which is a weekly chart, the 12-period moving average of price is the market’s consensus of value over the past 12 weeks.  The 26-period moving average is the market’s consensus of value over the past 26 weeks.

          When the orange line on the chart above is over the zero line, it tells you that the 12-period moving average is higher than the 26-period moving average.  That means that if the moving average of price over the past 12-periods is greater than the moving average of price over the past 26-periods, the market may be bullish.

          The blue line on the chart is a 9-period average of the difference between the 12-period moving average and the 26-period moving average. 

          When the orange line on the MACD chart crosses over the blue line to the upside, it means that the trend may be turning positive or bullish.  When the orange line crosses over the blue line to the downside, it means the trend may be turning negative or bearish.

          This indicator, like any other indicator, is far from perfect.  In a market that is not solidly trending, the MACD line and average line crossover can lead to false signals.

          Notice also within the MACD indicator above, there are some vertical lines drawn.  These vertical lines are known as a histogram.  They plot the difference between the MACD line (the 12-period moving average line minus the 26-period moving average line) and the average line.

          On a longer-term chart, like a monthly chart, the ‘ticks’ up or down of these lines can signal a strengthening or a weakening market.

          Looking at the chart above, I’ve drawn a downtrend line on the chart.  Notice how far the current price (as of one week ago) is from the down trend line drawn on the right-hand side of the chart.  If this Exchange Traded Fund (IWV) doesn’t close over about $253 (from a present price as of this writing of $225), the trend will remain down.

          That means that stocks could rally by up to 12% or so from here and not change the primary trend from down to up.  Last week, stocks made up half that gap.  I look for the trend line to hold and the downtrend to remain intact.

          That means stocks can rally from here by another 5% or more without a trend change occurring. 

If you or someone you know could benefit from our educational materials, please have them visit our website at www.RetirementLifestyleAdvocates.com.  Our webinars, podcasts, and newsletters can be found there.

The Recent Stock Bull Market – Real or Nominal?

          The double top theory for stocks that I suggested at the end of 2021, is looking like the right call at this point.

          Stocks suffered their worst week since March of 2020 last week despite a 4-day trading week. 

          As I have been suggesting here each week, when stock gains are largely attributable to an artificial market environment created by easy-money policies, a correction will have to ensue.

          My February special report will be an analysis of stocks.  Look for an opportunity to get the report in the February issue of the “You May Not Know Report”.  (If you’re not a subscriber, call the office to request a complimentary copy – 1-866-921-3613)

          Given the dismal performance of stocks last week, ironically after I wrote about and offered evidence of a bubble in stocks last week, I thought it would be appropriate to dig into this topic a little more deeply.

          But I want to examine this topic from a different viewpoint – the effect that currency devaluation has on stock prices.

          Long-time readers of “Portfolio Watch” have seen this analysis in a similar form in the past, but the analysis is important to understanding what is largely behind the stock bull market.

          This analysis requires that we define two terms – nominal and real.

          Nominal is defined as ‘in name only’.  When I say that stocks increased nominally, I am stating that stocks increased in name only.

          Real is defined as an actual thing, not imaginary.

          The most recent bull market in stocks has been in nominal terms not real terms.

          Here is an excerpt from the February Special Report to explain.

Stock analysts rarely discuss the key relationship between stock prices and currency devaluation.

Simply and succinctly stated, as currency is devalued stocks priced in that currency rise in price.  This increase in the value of stocks due to currency devaluation is nominal rather than real. 

The same currency devaluation or inflation that causes the price of groceries to increase also causes the price of stocks to increase.

Let’s look at an example to make the point.

This is a chart of the Dow Jones Industrial Average going back to 1971.

An initial perusal of the chart has one concluding that the Dow reached a level of about 12,000 in 1999 at the peak of the tech stock bubble and a high of about 14,000 at the market peak when the Great Financial Crisis began in 2007.  Presently, the Dow has reached about 36,000 at the high.

Nominally speaking, since 1999, the Dow has risen in value by about 300%, from about 12,000 to about 36,000.  But what did the Dow rise in real terms?

There are many different methods that are used to calculate the inflation rate.  There is the official CPI or Consumer Price Index, as well as more accurate alternate, private-sector inflation calculation methods.

The official inflation rate as measured by the CPI is very manipulated.  Alternate measures of inflation offered by www.ShadowStats.com or The Chapwood Index offer better, more accurate inflation estimates but the most accurate measure of inflation is determined by looking at the purchasing power of gold.

It’s been said that a loaf of bread priced in gold costs exactly the same today as it did during the Roman Empire more than 2000 years ago.  For more than 5000 years and throughout most of history, gold has been money.

To determine the real performance of stocks, it is helpful to price stocks in gold rather than US Dollars.

In 1999, when the Dow reached a level of 12,000, an ounce of gold was around $250.  To price the 1999 Dow in gold, one would take the value of the Dow (12,000) and divide by the price of gold per ounce ($250).  That math has us concluding that the Dow was 48 because it took 48 ounces of gold to buy the Dow.

Let’s fast forward to the present time.  The Dow was recently 36,000 while gold’s spot price was about $1,800 per ounce.  The same math has us buying the Dow for 20 ounces of gold.

Gold, over that 20-year time frame, has been constant.  An ounce of gold has not changed over the last 20 years, 100 years or even 5,000 years.  It is a constant metric.  An ounce of gold is the same today as it was at any time historically.

When one looks at the performance of stocks from this perspective, pricing stocks in gold, stocks have actually declined by more than 58% since the tech stock bubble of about 20 years ago in real terms.

Priced in US Dollars, stocks have rallied more than 300% since the tech stock bubble.  However, when priced in gold, stocks have fallen more than 58%!

From this analysis, one can conclude that the rally in stocks since the tech stock bubble has been in nominal terms rather than real terms.

          A loss in purchasing power causes inflation in consumer items and asset prices – that perfectly explains what we are now experiencing.

          The Fed is now painted into the proverbial corner as, at this point, it seems the financial markets have begun to unravel.  This piece discussed in the February “You May Not Know Report” newsletter explains. (Source: https://thebaddaddy.com/the-rock-and-the-hard-place/)

          Inflation or depression, the authorities are trapped.

          They should know this but are drunk on hubris, blinded by money-printing, schmoozed by lobbyists, and too busy insider-trading to care. If they understood this predicament, they’d have retired years ago.

          The real problem? In the DC halls of power and its feeder universities, they don’t understand economics. Instead, they parrot dogma dressed up in complex math to justify central planning and fiat money.

          Models that actually work (from the Austrian school) are ignored or obfuscated because they don’t consolidate power into a crony, captured system.

          Inflation or depression, how did we get here? Ludwig von Mises explained (in 1949)-

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

          US stock and bond markets are in an epic bubble, and can only be propped up with more money-printing. But that will cause the prices of beef, milk, eggs, rent, and energy to soar.

          The inflation genie is out of the bottle.

          To put her back in, they need to stop the easy-money policies, but that will crash the markets, a cascade of debt-deflation (like 2008) that also torpedoes the real economy.

          So, which will it be, inflation or depression?

          It’ll be an epic tug-of-war as they try to thread the needle. They’ll tighten this year until things start to break, then panic and turn the money spigots back on.

          I believe that this excerpt is spot on.  Inflation followed by deflation, as I’ve discussed often is the only possible outcome at this point.

If you or someone you know could benefit from our educational materials, please have them visit our website at www.RetirementLifestyleAdvocates.com.  Our webinars, podcasts, and newsletters can be found there.

My Thoughts on Stocks as We Begin a New Year

Last week, stocks touched their all-time high levels from November completing a “Santa” rally.  At this point, it remains to be seen what this means.  Since my long-term stock trend-following indicators are negative, I’d have to bet on a double top, which is a bearish pattern, but time will tell.

January is typically an important month in the markets.  Stock performance in January often accurately forecasts stock performance for the year.  I will continue to monitor and comment.

On the topic of stocks, commentator Harris Kupperman compared some stocks in the current market to a Ponzi scheme.  There are many publicly traded companies that have never made a profit that continue to exist via capital raises from investors.  Obviously, you don’t need to be a seasoned, savvy market analyst to realize this is a game that is only temporary.

As someone who has been around markets and analyzed them for a while, what we are presently seeing in markets is eerily reminiscent of market behavior and stock valuations as the tech stock bubble of about 20 years ago peaked.  Except this time around, the collective behavior of market participants is even more erratic and more irrational.

I think back 20 years to a company called pets.com.  The company was in the business of selling pet supplies online.  The company launched its business with a Super Bowl commercial featuring a white sock puppet.

Pets.com raised $82.5 million in an initial public offering, selling its stock for $11 per share.  Nine months later, having never turned a profit, the company declared bankruptcy, as its share price, plummeted to 11 cents.

As Yogi Berra famously proclaimed, it’s déjà vu all over again.

Here is a bit of what Mr. Kupperman had to say on the topic last week (Source:  https://wolfstreet.com/2021/12/26/the-problem-with-ponzis/)

Over the past few years, I’ve been highly critical of the Ponzi Sector. This is a whole grouping of companies that has no ability or desire to ever become profitable. Instead, these businesses have focused on rapid revenue growth because the stock market has rewarded them for this growth—especially if there are no profits. In reality, stock promotion is the core business of the Ponzi Sector—it allows the companies to raise capital and fund unprofitable growth, while insiders dump stock at insane valuations. Now, as the Ponzi Sector equities go into free-fall, a problem has emerged.

Let’s look at Peloton, the overpriced clothes rack with a built-in iPad. We just witnessed the best possible 6-quarter environment that the company will ever experience. The whole world was locked down, gyms were closed, and work was canceled. People literally sat at home, bored out of their wits, armed with massive government stimulus checks, fixated on buying products. Despite every possible tailwind, Peloton lost $189 million in the year ended June 2021. As the stimmies wore off, losses exploded to $376 million in the most recent quarter. If this business cannot make money in this perfect environment, what is the operating environment where it earns money?

Investors will say that the goal at Peloton is to lose money on the hardware and make it back on the subscription product. Sure, I can see how investors may fixate on the growing subscription business, but this is a fad fitness business, churn will be high and accelerating now that gyms have re-opened. The expected monthly annuity will underperform, and marketing will always be necessary to bring in more customers.

If you cut SG&A and marketing to a level where the annuity business revenue stays constant, this thing probably still loses globs of money or at best ekes out a small profit. Could you put this into run-off and harvest some residual value from the current membership base? Of course, you can, but that residual value is a tiny fraction of the current valuation. Instead, management is fixated on continuing the Ponzi Sector model of subsidizing consumers to grow revenue.

Unfortunately, the market psychology is changing and the whole Ponzi Sector is melting down—just look at the ARK Innovation ETF [ARKK], which is a well-curated basket of the largest listed Ponzi Schemes. As inflation accelerates, the market is losing patience with unprofitable growth that never seems to inflect.

          The ARK Innovation ETF contains many technology and innovation stocks that have negative earnings.  Two examples are Teladoc and Zillow.

We’ve gone over this in the past, but it’s worth a refresher here. Ponzi Schemes are inherently unstable. They’re either inflating or detonating. They cannot exist in a state of equilibrium. Once past the peak, they tend to unravel rapidly, as many participants know it’s a Ponzi Scheme and dump when the shares stop rising. The collapse is then accelerated by corporate action.

When a Ponzi is appreciating, stock option exercises can fund the business. Once below the exercise price, there are no cash inflows from options. Instead, you need to issue equity to fund the business. Except, there’s a shrinking pool of investors who will buy into financing at a value-destructive company.

You see, investors want to believe that there won’t be another financing in a few quarters. They’ll want spending to be reined in. They’ll want a path to profitability.

Except, when you cut spending, growth collapses, yet the business will still be nowhere near profitable. When it was growing fast, it was easy to claim you were the next Amazon and profits don’t matter. When you’re not growing, or even shrinking, what exactly is your justification for losing money? It’s a typical death-spiral conundrum. Burn capital to show profitless growth, or cut spending and show smaller losses while the business shrinks.

Returning to Peloton, I get that there’s a loyal customer base and I’m absolutely convinced that there’s a residual business here on the subscription side. However, it’s likely to be a few hundred million of shrinking annual cash flow per year. Put a mid-single-digit multiple on that and what do you have? Exactly!! The stock could drop 90% and still be overvalued.

As a result, no one wants them to shrink towards profitability. Instead, investors are demanding that Peloton use the proceeds of down-round financings to incinerate capital, trying to outgrow the problem. Except, they likely cannot outgrow the problem as everyone who wanted a Peloton has one by now. Spending on growth will have diminishing returns. Yet, what choice do they have, besides losing more per unit and hoping to make it up in volume?

I remember seeing a similar problem in 2000 and into 2002 as internet companies tried to continue their prior growth, buying banner ads, convinced that if they could just show revenue growth, eventually the shares would recover, allowing them to issue more shares and fund more unprofitable revenue. As investors grew tired of this, the down rounds were more drastic, until the companies ran out of suckers and the businesses were wound up.

The same will happen to everyone in the Ponzi Sector. First, they’ll try and out-grow the problem by throwing equity capital at it, then they’ll resort to cost cuts, which will send revenue growth negative, which will make it even harder to raise capital and fund losses. Once investor psychology changes and no longer rewards profitless market share growth, the feedback loop only accelerates the problems for these companies.

The most recent capital raise by Peloton at $46, is indicative of how painful this will be. The shares are now at $39 and everyone who bought at $46 is underwater. Do you think they’ll step up as aggressively for the next down-round?

What if the whole Ponzi Sector is doing down-rounds at the same time? Will there be enough suckers to fund all of these Ponzis? They’ll all need someone to cough up more capital in a few quarters.

Now, I’m not saying Peloton has done anything illegal or immoral. I singled it out because it doesn’t seem to fit the model in most people’s minds of a Ponzi, yet it is. Many of the most successful Ponzi Sector stalwarts have been well-loved consumer products, led by people who genuinely believe they’re improving the world. Investors rewarded them for growing fast, so they did. Now, patience is running thin. Especially when investors are losing money on multiple Ponzi Sector investments simultaneously. Logic says that Peloton cannot grow into profits, it needs to shrink its way there, but that’s going to be a nasty and highly dilutive journey.

            At the outset of this week’s “Portfolio Watch”, I compared the current stock market conditions to the stock market conditions that existed 20 years ago at the time of the tech stock bubble.

          Longer-term readers of this publication know that I often use Warren Buffet’s favorite stock market valuation measure when looking at stock valuations.  It’s the market capitalization to gross domestic product ratio which takes the value of all stocks and divides it by economic output.

          The chart below uses the Wilshire 5000, a broad stock market index in the analysis.  Notice from the chart that in 2000, at the tech stock bubble peak that we have been discussing the market cap to GDP was about 150%.

          That simply meant that the total value of stocks was about 150% of the total economic output.

          At the time, that level of stock valuation was a historic high given that the average valuation of stocks over time had been about 65% of the total economic output.

          Fast forward to the present.  Stock valuations are now more than 200% of economic output or about three times the long-term historic average.

          While there may be some additional upside in stocks, for many investors the downside risk far outweighs the reward potential.

If you or someone you know could benefit from our educational materials, please have them visit our website at www.RetirementLifestyleAdvocates.com.  Our webinars, podcasts, and newsletters can be found there.

About Stocks and Bonds

          The stock market highs of November have not yet been taken out and my long-term trend-following indicators continue to become more bearish.  At this point, a “Santa” rally looks less likely especially given the Fed’s recent statements about accelerating the taper or slowing the rate of currency creation.

          As the longer-term readers of “Portfolio Watch” are aware, I believe the Fed’s taper talk is just that.  The math doesn’t lie; the federal government cannot fund its deficit spending without currency creation.  While the Fed may taper officially, liquidity will have to be made available in order to close the budget gap.

          Of course, common sense dictates that this process of currency creation will have to cease at some future point.  When it does, it is my belief that a reset will have to occur that will affect many assets including stocks and real estate.

          Both stocks and real estate are in a bubble in my view.

          David Stockman, former budget director, penned an article last week that examines just how extended stocks likely are.  Here is a bit from Mr. Stockman’s piece (Source:  https://internationalman.com/articles/david-stockman-reveals-the-truth-about-the-stock-market-and-what-it-means-for-you/)

The fundamental consequence of 30 years of Fed-fueled financial asset inflation is that the prices of stocks and bonds have way overshot the mark.

That’s why what lies ahead is a long stretch of losses and investor disappointment as the fat years give way to the lean.

These will hit hard the bullish investor herd and aggressive buyers of calls who can’t imagine any other state of play. They will be shocked to learn — but only after it is way too late — that the only money to be made during the decades ahead is on the short side of the market by buying puts on any of the big averages: the FANGMAN, S&P 500, NASDAQ 100, the DOW and any number of broad-based ETFs.

The reason is straightforward. The sluggish, debt-ridden Main Street economy has been over-capitalized, and it will take years for company profits and incomes being generated to catch up to currently bloated asset values. Accordingly, even as operating profits struggle to grow, valuation multiples will contract for years to come, owing to steadily rising and normalizing interest rates.

We can benchmark this impending grand reversal on Wall Street by reaching back to a cycle that began in mid-1987. That’s when Alan Greenspan took the helm at the Fed and promptly inaugurated the present era of financial repression and stock market coddling that he was pleased to call the “wealth effects” policy.

At the time, the trailing P/E multiple on the S&P 500 was about 12X earnings — a valuation level that reflected a Main Street economy and Wall Street financial markets that were each reasonably healthy.

The US GDP in Q2 1987 stood at $4.8 trillion and the total stock market was valued at $3.0 trillion, as measured by the Wilshire 5000. Back then, Wall Street stocks were stably capitalized at 62% of Main Street GDP.

Over the next 34 years, a vast unsustainable gulf opened up between the Main Street economy and the Wall Street capitalization of publicly traded stocks.

During that three-decade period, the Wilshire 5000 market cap rose by 1,440% to $46.3 trillion. That’s nearly four times the 375% gain in nominal GDP to $22.7 trillion.

Accordingly, the stock market, which was barely three-fifths of GDP on Greenspan’s arrival at the Fed, now stands at an off-the-charts 204% of GDP.

If we assume for the moment that the 1987 stock market capitalization rate against national income (GDP) was roughly correct, that would mean that the Wilshire 5000 should be worth $14 trillion today, not $46 trillion. Hence, the $32 trillion of excess stock market valuation hangs over the financial system like a Sword of Damocles.

In fact, we believe that the gulf between GDP and market cap has been growing wider and more dangerous since the Fed sped up money printing after the Lehman meltdown. To wit, since the pre-crisis peak in October 2007, the market cap of the Wilshire 5000 is up by nearly $32 trillion, while the national income to support it (GDP) is higher by only $8 trillion.

The stock market’s capitalization should be falling, not soaring into the nose-bleed section of history. After all, since the financial crisis and Great Recession, the capacity of the US economy to generate growth and rising profits has been sharply diminished. The real GDP growth rate since the pre-crisis peak in Q4 2007, for instance, is just 1.5% per annum, which is less than half its historical trend rate of growth.

Back in October 2007, the stock market’s capitalization was 106% of GDP and in just 14 years it has soared to the aforementioned 204%. So even as the growth rate of the US economy has been cut in half, stock market capitalization has doubled.

Given that the stock market has gotten way, way ahead of the economy, the longer-range implication is a long spell during which financial asset prices will stagnate or even fall until they eventually recover the healthy relationship to national income.

Looking at this from a different angle, the current $46 trillion market cap of the Wilshire 5000 would not return to 62% of GDP until US GDP reaches $75 trillion. At an average of 3.3% per annum increase in nominal GDP since Q4 2007, it would take 38 years to get there!

That’s right. The massively over-valued stock market is currently capitalizing on an economy that might exist by the year 2060… if all goes well.

            Mr. Stockman offers a terrific perspective on where stock valuations have moved since the Fed began the ‘temporary’ policy of currency creation.

          Real estate has followed a course similar to the course tracked by stocks.

          The Case-Shiller Housing Index is the commonly used metric of housing values.  The chart illustrates housing values for the past 25 years.

          Looking at the chart, one can see the decline in housing values at the time of the financial crisis.  The index fell from 200 to about 150. 

          Notice that housing values began to increase in earnest after the Fed began quantitative easing.  Since that time, housing prices have nearly doubled.

          And, as inflated as housing prices were at the time of the financial crisis, they are far more inflated presently – they are about 50% higher than they were prior to the collapse that began in 2007.

          Of course, as we have demonstrated many times in the past if real estate and stocks were priced in gold rather than depreciating US Dollars, one gets a completely different perspective.  In 2007, gold was about $650 per ounce.  Today, the spot price of gold is about $1800.  That’s an increase of about 275%.  Priced in gold, both stocks and real estate have declined in value which one would expect given the massive levels of debt that exist.

          The reality is that the US Dollar and every other fiat currency around the world is no longer an accurate metric when examining economic data and asset pricing.

If you or someone you know could benefit from our educational materials, please have them visit our website at www.RetirementLifestyleAdvocates.com.  Our webinars, podcasts, and newsletters can be found there.