The Relentless Rise – October 2017 Newsletter (The Forecast Report)

When you’re dealing with stock market “bubbles” there isn’t much that matters…for a while. Bad news, good news, it doesn’t matter. It’s all bullish, or so it seems. Much of the news as of late has been horrific. Believe it or not, many well-known investors are frustrated by the current state of affairs, but the US markets are painting a different picture with its relentless rise. We have Harvey, Irma, and Maria that have caused massive human suffering, loss, and will cost hundreds of billions of dollars which have been siphoned away from productive infrastructure. We have nothing getting done in Washington as the most recent health care bill was shut down, foreign countries are hacking private servers for sensitive information, a transparent tax bill that, for the most part, is unworkable, the Tom Price shit show, and Trump’s failure in Alabama (Luther loses). The Geopolitical environment is less than stellar as North Korea is becoming more of a problem, Catalonia’s secession from Spain is causing riots and worse, and other European countries are still debating leaving the EU. In addition, Las Vegas was attacked in a mass shooting during a concert that took the lives of 58 innocent people and injured hundreds more. So, what effect did that have on the market? Zero, zilch, nothing, nada.

The S&P 500 has now risen for eight consecutive quarters. It hasn’t seen a 3 percent decline in over 228 trading days (11 months for those counting). This year’s biggest drop in the S&P 500 is the smallest for any year in at least 104 years (that’s as far back as I could pull)! This has pushed investors to be complacent and has created a feeling of invincibility. According to Merrill Lynch, clients have the lowest allocation to cash in at least 13 years. Optimism has steadily increased. Look no further for excessive optimism and machismo than the millennials. According to a survey conducted by AMG Funds, they found that 81 percent of millennial investors (most are too young to have experienced the 2008 stock market bomb) consider themselves “extremely or very knowledgeable” when it comes to their finances, while just 19 percent of experienced investors felt the same way. 10 percent of millennial investors stated that they understand the benefits of diversification (compared to 50% of baby boomers). The majority of the Millennials polled are also piling into some of the most excessively priced ETF’s and cryptocurrencies. There’s no fear. Well, I guess many will learn the lessons of generations past the hard way.

Shaded blue region encapsulates the S&P 500’s relentless rise in 2017

There’s been a lot of financial pundits arguing about the S&P 500’s price to earnings ratio and whether it’s overvalued. Some state it is excessively overvalued and some state it’s high, but not excessively so. The problem with placing your faith in the price to earnings ratio is that it can be manipulated. Yes, the S&P 500 Price to Earnings ratio isn’t incredibly extreme, but there’s a reason for that. Much of the data is hidden due to all the financial engineering that has taken place to inflate earnings and hide the true excessive overvaluation of the market. The suggestion that I received when looking at overvaluation was to take into consideration the Price to Revenue metric, which has been very helpful. You can’t really financially engineer revenue, which makes sense. Grant Williams has a great chart (shown right below) that shows, according to the Price to Revenue metric, that our current market is the MOST expensive ever (by a lot). The chart includes the dot com and housing bubble.

The FED…

Last month the Fed unveiled its balance sheet reduction plan, or in other words Quantitative Tapering plan. To give a simple explanation the Fed is planning to let billions of dollars of maturing bonds roll off its balance sheet without reinvesting the proceeds. Our current quarter will see $10 billion of maturing bonds roll off the Fed’s balance sheet per month. As the quarters go on the amount of maturing bonds that roll off increase. For example, in Q1 of 2018, we will see $20 billion of bonds roll off each month ($60 billion total). In Q2 of 2018 it will increase to $40 billion per month and so on.  In effect, the Quantitative Tapering plan will take increasingly larger amounts of liquidity out of the monetary system as the quarters roll on.  It seems as though the plan could work, right? Oh, but wait. The ECB (European Central Bank) is also planning on reducing its Quantitative Easing program along with the BoJ (Bank of Japan). Even though the Fed stopped their QE program over two years ago, the market has still done well. Why? Because the ECB and BoJ have picked up the slack and then some. The liquidity they have produced is huge and much of that liquidity was invested in the US stock and bond markets because the US has been the best house on a shitty block. So, what happens when global liquidity starts drying up??? Well, if this liquidity has been fueling this relentless rise in the US stock market, which it has, without the liquidity stocks will fall, interest rates will rise, and it will rock the financial markets. So, this is the option the Fed is choosing in the hope that they can bring this market, O’ so gently, back to “normalcy.” But, once the central bankers start to extract this liquidity, no matter how gradual or gentle, you’re still letting air out of a massive bubble in stocks. If history, tells us anything about bubbles there’s no gradual way for it to end. No one knows where the breaking point is of the Fed’s Quantitative Tapering program, but that will be part of the catalyst that will end this bull market along with the ECB and BoJ Quantitative Easing reduction. The next logical question to ask is if the bubble does start to deflate, what will the Fed do??? Well, the last resort when the Fed realizes their Quantitative Tapering doesn’t work is, once again, to create Quantitative Easing Number 4…At that point, the Fed will realize that they are unable to exit from their QE program without inflicting pain on the market. The Fed will be out of “ammunition” and will have to succumb to defeat. This, in turn, will provide the public with the knowledge that the Fed is between a rock and a hard place, is unable to unwind QE, and as a result, the public’s reliance and faith in the Fed evaporates.

Of course, we don’t want this to happen, but the public needs to open their eyes to the fact that this market is being fueled by nothing more than excess liquidity. It’s not increased earnings or profitability of companies. We are seeing market caps skyrocket with no underlying catalyst except new money pouring into the market from excess liquidity. The rise is relentless, but the result of the extraction of this liquidity is going to be really really difficult. You can’t have blind optimism that this bull market is going to keep going forever, but many in the public do. Unfortunately, these poor millennials are going to learn the hard way. It’s hard to blame them. They’re used to low volatility, buying the dips, placing their money in high flyers, and not diversifying. Why would they? It’s worked great so far. This will end and when it does investors need to protect themselves. This is a great time to protect yourself. Low volatility provides some great opportunity to protect your portfolios. This our two cents. Could we be wrong? Hell yes! We have been before, but we don’t plan on getting caught in something that has a high probability of occurring. We can’t know the future, but we can be proactive and plan for it. If you don’t have a plan, you’re going to be reactive. Reactive is never good when your an investor in the market, especially if chaos ensues (see 2008).  Don’t chase prices higher in the hope that a greater fool will buy your positions from you at higher prices. Could we see a slow creep up (or an aggressive push higher) through the end of the year? Absolutely and it wouldn’t surprise us. Will that last through 2018? I think you know where we stand.

We hope everyone stays safe out there and has a wonderful Halloween. I don’t know if any of you dads have the same Modus Operandi, but I can’t wait to raid my kids’ candy stash for a boatload of peanut M&M’s! I figured my one-year-old could do the heavy lifting on helping dear old dad out on his candy addiction 🙂

A quick note, you’ll notice that there are a few links at the bottom of this newsletter. These links lead to some articles that, we thought, were super interesting. Please let us know if you enjoyed them. We plan on keeping them coming along with some other awesome content!

As always, if we can help you or anyone that you know please feel free to give us a call or book a meeting. We always enjoy talking to new folks. Last, please forward this newsletter on to anyone that might find it of interest.