Investment Strategy

Is there an “everything bubble”?

Buenos Aires, Argentina

The G20 summit begins in Buenos Aires tomorrow. The lockdown has truly begun, as security forces are deployed across the city. Train services will start to shut down this afternoon.

World leaders have started showing up with their retinues. The Saudis and French are already here, arriving yesterday. Most of the rest are expected to show up today (Thursday) or tomorrow morning. As I type, Air Force One is taking off in Washington D.C., whisking the US president southwards.

Protestors will show up too, both the usual local groups and some overseas brethren (and sistren…lest anyone is offended). The “mardi gras for malcontents” will soon commence. For more about the G20 “bunfight for bureaucrats”, see my musings from earlier in the week (“Buenos Aires prepares for G20 lockdown”).

In the meantime, I’m working on my latest report for OfWealth 3D Stock Investor. This month’s recommendation is a profitable, dividend-paying media company trading with a price-to-earnings ratio (P/E) of just 7. It went through a period of poor profit performance, but has now returned to growth. As a result, I think it’s extremely cheap and provides loads of price upside (50% or more). If that sounds like your kind of thing, you can find out more here.

Finding such opportunities means a lot of deep-dive analysis, which is time-consuming. So I’ll keep my comments brief today, and share an article written by my friend Nick Giambruno for International Man.

As you’ll see below, Nick believes we’re in an “everything bubble”, and the end result will be a major stock market crash. As regular readers of my thoughts will know, I also see some major risks around the world (see here).

Those risks warrant a relatively conservative portfolio allocation. But I’m not as pessimistic as Nick. There are certainly some bubbles around – such as big US tech, big growth (e.g. Amazon), and bonds in Japan and most of Europe.

But, as I’ve shown before (see here), I believe most of the US stock market isn’t that expensive. That said, some non-tech/growth sectors are pricey, if not exactly in bubble territory. I’m thinking of many big, mature, low/non-growth consumer staples and consumer discretionary stocks with P/Es well above 20. Things like Coca-Cola and McDonald’s.

(Incidentally, Coca-Cola sits within the consumer staples sector, whereas McDonald’s sits with the consumer discretionary sector. Apparently, fizzy sugar water is more of a “need” and a processed meat sandwich is more of a “want”. Go figure.)

Nick makes one specific point where I have a different view. He highlights that the Cyclically-Adjusted Price-to-Earnings ratio (CAPE) for US stocks is at a highly elevated level (around 31). This is factually correct, although I’ve identified at least seven factors that artificially skew the current CAPE ratio to the upside.

It’s going to take some detailed analysis to unpick it. But my early take is that the true CAPE may actually be pretty close to its median level since 1971. Which is to say, the period since the dollar completely left the gold standard and truly became fiat money.

That median is around 19, which is 39% below the reported figure. If I’m right, this is another indication that US stocks actually aren’t as expensive as headline figures suggest. But I need to do more work on it.

Outside of the US, stocks look pretty reasonable, even cheap. The MSCI Europe index has a P/E around 15. That’s neither cheap nor expensive. The MSCI Japan index trades at 13. Emerging Markets trade at 12 (although there’s a big range within that, at the individual country level). Overall, there’s plenty of value to be had, for those prepared to hunt for it.

On the bond side, US Treasury bonds are still pricey but not bubbly. The 10 year bond yields 3%, which is far less inflated than when it yielded just 1.4% in July 2016. The current yield is still slightly on the low side relative to inflation, meaning bond prices are slightly high, but it’s not what I’d call a bubble. (On the other hand, I wouldn’t go near European or Japanese bonds.)

Other stuff that looks un-bubbly includes things like gold and other precious metals, and commodities (e.g. oil, uranium, soybeans, wheat).

So, while I believe there are plenty of bubbles about, I no longer think we’re in an “everything bubble”. However, I also think that it pays to keep an open mind, which is why I want to share Nick’s article with you today. He makes many good points, and gives an interesting historical perspective. I hope you enjoy it (and, as always, feedback is welcomed).

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com


Is there an “everything bubble”?

by Nick Giambruno for International Man.

I think there’s a very high chance of a stock market crash of historic proportions before the end of Trump’s first term.

That’s because the Federal Reserve’s current rate-hiking cycle, which started in 2015, is set to pop “the everything bubble.”

I’ll explain how this could all play out in a moment. But first, you need to know how the Fed creates the boom-bust cycle…

To start, the Fed encourages malinvestment by suppressing interest rates lower than their natural levels. This leads companies to invest in plants, equipment, and other capital assets that only appear profitable because borrowing money is cheap.

This, in turn, leads to misallocated capital – and eventually, economic loss when interest rates rise, making previously economic investments uneconomic.

Think of this dynamic like a variable rate mortgage. Artificially low interest rates encourage individual home buyers to take out mortgages. If interest rates stay low, they can make the payments and maintain the illusion of solvency.

But once interest rates rise, the mortgage interest payments adjust higher, making them less and less affordable until, eventually, the borrower defaults.

In short, bubbles are inflated when easy money from low interest rates floods into a certain asset.

Rate hikes do the opposite. They suck money out of the economy and pop the bubbles created from low rates.

It Almost Always Ends in a Crisis

Almost every Fed rate-hiking cycle ends in a crisis. Sometimes it starts abroad, but it always filters back to U.S. markets.

Specifically, 16 of the last 19 times the Fed started a series of interest rate hikes, some sort of crisis that tanked the stock market followed. That’s around 84% of the time.

You can see some of the more prominent examples in the chart below.

Let’s walk through a few of the major crises…

• 1929 Wall Street Crash

Throughout the 1920s, the Federal Reserve’s easy money policies helped create an enormous stock market bubble.

In August 1929, the Fed raised interest rates and effectively ended the easy credit.

Only a few months later, the bubble burst on Black Tuesday. The Dow lost over 12% that day. It was the most devastating stock market crash in the U.S. up to that point. It also signaled the beginning of the Great Depression.

Between 1929 and 1932, the stock market went on to lose 86% of its value.

• 1987 Stock Market Crash

In February 1987, the Fed decided to tighten by withdrawing liquidity from the market. This pushed interest rates up.

They continued to tighten until the “Black Monday” crash in October of that year, when the S&P 500 lost 33% of its value.

At that point, the Fed quickly reversed its course and started easing again. It was the Chairman of the Federal Reserve Alan Greenspan’s first – but not last – bungled attempt to raise interest rates.

• Asia Crisis and LTCM Collapse

A similar pattern played out in the mid-1990s. Emerging markets – which had borrowed from foreigners during a period of relatively low interest rates – found themselves in big trouble once Greenspan’s Fed started to raise rates.

This time, the crisis started in Asia, spread to Russia, and then finally hit the U.S., where markets fell over 20%.

Long-Term Capital Management (LTCM) was a large U.S. hedge fund. It had borrowed heavily to invest in Russia and the affected Asian countries. It soon found itself insolvent. For the Fed, however, its size meant the fund was “too big to fail.” Eventually, LTCM was bailed out.

• Tech Bubble

Greenspan’s next rate-hike cycle helped to puncture the tech bubble (which he’d helped inflate with easy money). After the tech bubble burst, the S&P 500 was cut in half.

• Subprime Meltdown and the 2008 Financial Crisis

The end of the tech bubble caused an economic downturn. Alan Greenspan’s Fed responded by dramatically lowering interest rates. This new, easy money ended up flowing into the housing market.

Then in 2004, the Fed embarked on another rate-hiking cycle. The higher interest rates made it impossible for many Americans to service their mortgage debts. Mortgage debts were widely securitized and sold to large financial institutions.

When the underlying mortgages started to go south, so did these mortgage-backed securities, and so did the financial institutions that held them.

It created a cascading crisis that nearly collapsed the global financial system. The S&P 500 fell by over 56%.

• 2018: The “Everything Bubble”

I think another crisis is imminent…

As you probably know, the Fed responded to the 2008 financial crisis with unprecedented amounts of easy money.

Think of the trillions of dollars in money printing programs – euphemistically called quantitative easing (QE) 1, 2, and 3.

At the same time, the Fed effectively took interest rates to zero, the lowest they’ve been in the entire history of the U.S.

Allegedly, the Fed did this all to save the economy. In reality, it has created enormous and unprecedented economic distortions and misallocations of capital. And it’s all going to be flushed out.

In other words, the Fed’s response to the last crisis sowed the seeds for an even bigger crisis.

The trillions of dollars the Fed “printed” created not just a housing bubble or a tech bubble, but an “everything bubble.”

The Fed took interest rates to zero in 2008. It held them there until December 2015 – nearly seven years.

For perspective, the Fed inflated the housing bubble with about two years of 1% interest rates. So it’s hard to fathom how much it distorted the economy with seven years of 0% interest rates.

The Fed Will Pop This Bubble, Too

Since December 2015, the Fed has been steadily raising rates, roughly 0.25% per quarter.

I think this rate-hike cycle is going to pop the “everything bubble.” And I see multiple warning signs that this pop is imminent.

• Warning Sign No. 1 – Emerging Markets Are Flashing Red

Earlier this year, the Turkish lira lost over 40% of its value. The Argentine peso tanked a similar amount.

These currency crises could foreshadow a coming crisis in the U.S., much in the same way the Asian financial crisis/Russian debt default did in the late 1990s.

• Warning Sign No. 2 – Unsustainable Economic Expansion

Trillions of dollars in easy money have fueled the second-longest economic expansion in U.S. history, as measured by GDP. If it’s sustained until July 2019, it will become the longest in U.S. history.

In other words, by historical standards, the current economic expansion will likely end before the next presidential election.

• Warning Sign No. 3 – The Longest Bull Market Yet

Earlier this year, the U.S. stock market broke the all-time record for the longest bull market in history. The market has been rising for nearly a decade straight without a 20% correction.

Meanwhile, stock market valuations are nearing their highest levels in all of history.

The S&P 500’s CAPE ratio, for example, is now the second-highest it’s ever been. (A high CAPE ratio means stocks are expensive.) The only time it was higher was right before the tech bubble burst.

Every time stock valuations have approached these nosebleed levels, a major crash has followed.

Preparing for the Pop

The U.S. economy and stock market are overdue for a recession and correction by any historical standard, regardless of what the Fed does.

But when you add in the Fed’s current rate-hiking cycle – the same catalyst for previous bubble pops – the likelihood of a stock market crash of historic proportions, before the end of Trump’s first term, is very high.

That’s why investors should prepare now. One way to do that is by shorting the market. That means betting the market will fall.

Keep in mind, I’m not in the habit of making “doomsday” predictions. Simply put, the Fed has warped the economy far more drastically than it did in the 1920s, during the tech or housing bubbles, or during any other period in history.

I expect the resulting stock market crash to be that much bigger.

All the best,

Nick Giambruno

Editors note: This article was originally published by International Man.

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