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US stocks reach a record…of the wrong sort

The S&P 500 index of US stocks closed at a record level just shy of 1,710 on Friday 2 August. The bulls are on a stampede it seems, and the bovine excrement is flowing through the media. Yet, when adjusted for inflation, the index is still way off past highs. However, it’s supported by weak fundamentals and record levels of speculative debt. Look out below…

US stocks are being propped up on three shaky legs: already high valuations, weak earnings growth and record margin debt (used for speculative trading).

I’ll look at those in turn. But first, here’s a chart which shows the level of the S&P 500 adjusted for inflation, up to the end of May (when the index closed at 1,632).

The peak of the market was in August 2000 at an index level of 2,042
The peak of the market was in August 2000 at an index level of 2,042

$100 would have bought, say, $125 of stuff 10 years ago, in today’s money.

Each point along the line is the price at that time in May 2013 equivalent prices, after adjusting for official price inflation. Since money loses value over time due to inflation this increases past price levels, when stated in today’s money. $100 would have bought, say, $125 of stuff 10 years ago, in today’s money.

So by this measure, the peak of the market was in August 2000 at an index level of 2,042 (see dot on chart). In other words, the “record” nominal level that we just reached, of 1,710, is in fact 16% below the inflation-adjusted record 13 years ago (unlucky for some…).

Of course buy-and-hold investors haven’t done quite so badly as this suggests. They’ve also received dividends along the way. But on the other hand the official inflation statistics are almost certainly overstated (see step 1 of the Wealth Workout report: five essential steps to investment success that you can download here). This means the genuine, inflation-adjusted top of 2000 was even higher than that shown on the chart.

Figuring with an extra 2% of price inflation a year, with compounding, puts it 29% higher at 2,634. That means the recent top is actually 35% below the 2000 peak. How’s that for a 13 year (…so far…) bear market!

So you might reasonably think that means the market is still cheap, with lots of room to the upside.

Not so fast. According to multpl.com the P/E ratio is 19.47, against a long term median (middle point) of 14.51. According to this the market is trading 34% above the long run “average”.

The market is trading 34% above the long run “average”.
The market is trading 34% above the long run “average”.

(The “median” is the value of the middle point in a distribution of data points. For example the 50th largest point in a data set of 100 points. It’s more reliable than the “mean”, which is the sum of all data points divided by the number of them, since it ignores extreme high and low readings. But even so, the mean P/E of the S&P 500 is 15.5, still leaving it 26% above “average”.)

But maybe that’s ok. Lots of people say the US economy is perking up, so earnings should grow strongly and make up for the high P/Es. But again the evidence doesn’t support this.

…S&P had reported their second quarter earnings. Overall earnings were up 1.7%. But once the financial sector is stripped out this changes to a fall of 3.4%.

By 2 August, 393 of the 500 companies in the S&P had reported their second quarter earnings. Overall earnings were up 1.7%. But once the financial sector is stripped out this changes to a fall of 3.4%. Big investment banks have notoriously volatile earnings which depend on whether their market bets have paid off. So it’s instructive to strip them out.

Put another way, real businesses in the real economy are still struggling to grow earnings. One big reason for this is that over half of S&P 500 revenues come from outside the US, and a large part of that half comes from Europe. Much of Europe, especially in the South, remains stuck in a depression. This is likely to provide a drag on US stock earnings for years to come.

But then there’s the really worrying issue: Debt, with a capital “D”. This is perhaps my biggest concern when it comes to US stocks. Specifically, “margin debt”.

Margin debt is money borrowed to speculate on the stock market. Loans are made by brokers to traders. These loans are collateralised using the stocks (shares) and bonds in the traders’ portfolios. This means if the loan isn’t paid back the brokers can seize the collateral. But the brokers will only lend up to a maximum percentage of the market value of those positions, since prices are volatile.

If prices fall and the maximum percentage is breached then the brokers make a “margin call”. In plain language, they ask for some of the money back. Over-leveraged speculators have to raise cash fast, so they become forced sellers. When prices fall hard, a “correction” can quickly turn into a crash if there are enough margin calls and forced sellers.

One way to look at the risk of such a situation happening is to compare the amount of margin debt at different points in time. The New York Stock Exchange (NYSE) publishes monthly figures. The following chart compares the level of margin debt with the level of the S&P 500 up to the end of June (both adjusted for inflation).

Fast increases in margin lending have coincided with stock market peaks - quickly followed by crashes.
Fast increases in margin lending have coincided with stock market peaks – quickly followed by crashes.

Total margin debt actually peaked in April, at $384 billion. In nominal (unadjusted for inflation) terms this was the highest level of debt-fueled stock speculation ever seen in the USA. By the end of June it had fallen back slightly to $377 billion – which is still extremely high. Back in October 2007, before the last crash, it peaked at $345 billion. In March 2000, as the proverbial pin was about to be introduced to the “new paradigm” tech bubble, margin debt was $279 billion. You can see straight away that, in the past, fast increases in margin lending have coincided with stock market peaks – quickly followed by crashes. And we’ve just had one of those fast rises in margin debt.

 US stocks reach a record…of the wrong sort

If you look closely at the chart you can see that the market fell hard slightly after the peaks in margin lending in 2000 and 2007. If the pattern is repeated then the April peak is signalling a sharp fall in the US stocks in the next few months.

On the other hand it could be a pause for breath on the way to higher levels of speculative borrowing, on the way to higher stock prices (before a later and bigger crash).

But consider this. Several commentators have noticed the high level of margin debt in the past few months. But there’s something else that I’ve noticed that I believe is even more important.

…the ratio of margin debt (speculative borrowing) to market capitalisation (total value of the US stock markets) is at a record high.

This is that the ratio of margin debt (speculative borrowing) to market capitalisation (total value of the US stock markets) is at a record high. That’s right, it’s even bigger now than during either of the last two speculative stock market peaks, in 2000 and 2007.

Back in March 2000 the ratio was 1.59%. In October 2007 it was a little higher at 1.67%. In April this year it peaked at 1.86% and by the end of June it was a still high 1.80%.

In other words, the US stock market has achieved a new record. But it’s the wrong sort and not one to be happy about.

This is typical of the modern investment climate. Asset prices are pumped up on ever increasing piles of cheap debt.

Fundamental conditions – such as high valuations and weak earnings growth – are poor, and likely to result in disappointing investor profits. Or outright losses.

And small investors are being suckered into joining the party too late as headlines scream about new “record highs” in US stocks.

Make sure, fellow OfWealthers, that you’re not among the suckers. My advice is to avoid US stocks. The potential returns are not worth the risks. And we could be approaching another major market reversal. Stay tuned…

Until next time,

Rob Marstrand
robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.