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How the Market Works

Avalanche: How the Market Works

Posted by kdadmin on February 15th, 2017.

Avalanche: How the Market Works

Have you ever seen an avalanche? How about in person? Have you ever been in one? It is an incredibly daunting thing.

This shot comes about sixty seconds after three blasts were detonated at the top of this mountain. Do you see that three story building in the lower right hand corner? How about the train tracks on the left?

Now imagine if you were a person who had been skiing in that valley, just thirty seconds before this shot was taken. How totally screwed would you have been?

This is what a market correction looks like …

Perspective

I’ve recently taken some heat for not investing my clients in stocks at the top of this trumped up market. Had I done so, I would have been putting them in the valley with no ideas to when the detonations were going to occur. Before the blasts went off, the valley looked like this. You didn’t even know there was a multiple storied building in the middle of the valley, did you?

Avalanche

Imagine that you had thirty seconds to get to that building before the snow engulfed you and violently shook you apart in every direction, literally drowning you in a melee of vaporized snow, ice and bits of rock and debris.

Imagine you made it to the building. How, “NOT WORTH IT” would it have been to have taken the risk to ski in an alluring avalanche zone, only to have nearly been pummeled to death, without warning? Now, imagine you didn’t make it.

Fiduciary Obligation

Let’s be clear about something. I’m a fiduciary. That means I have to look out for my clients’ best interests. I have to put their needs ahead of my own. If that means risking the relationship, and by extension my revenue, in an effort to convey the gravity of their situation, or to get them out of harm’s way, then I have to do it. I have to do whatever it takes to help them.

In other words, I’m simply NOT going to let them go skiing in a known avalanche zone. The end. Especially when there are plenty of other, nice, enjoyable runs that won’t put them at unnecessary risk.

The Trump Trade

When people ask me why I didn’t invest in the “Trump Trade,” I try to give them the avalanche perspective. The fact is that people get complacent at the end of a long bull market. They figure it’s easy to invest. That the risk “isn’t that high.” That they will be able to “see it coming” and “get out of the way” before the market correction wipes them out. It’s simply never true. It’s like this avalanche, they simply couldn’t have outrun it.

Remember 2008? Or 2000? The signs were there to “see it coming” but how few did? We did. In 2007, we saw it coming. We got out of the way. We took heat for it. But when the market was down by over 60% from high to low, we averaged a loss of only 15%. We have learned from our experience and have tried to work out how to avoid even that small loss. We’re using those strategies now.

Up to the day before Trump won the election, mid term corporate bonds and the S&P 500 had generated about the same return (about 5%) over the previous twelve months. Even though the stock market was roughly four times riskier and much more volatile.Since Trump won the election, stocks are up over six percent. Bonds are up roughly 1-2%, depending upon the type. The widely unexpected increase in stock prices since Trump took office has been dubbed, “The Trump Trade.”

The story goes that Trump, and a Republican controlled government, will be good for business. Or so the speculators say. While some of Trump’s policies have the potential to be good for business bottom lines, thereby profits and stock prices. The problem is that other policies have the potential to be atrocious drags on the broader economy. And the success of one requires, to a large extent, the success of the other. Nowwhat has changed for the better in terms of core economic indicators since Trump’s election? Nothing. So, why are stocks up? Hmmm …

Remember when the car manufacturer, Volkswagen, magically had much better MPG ratings than most of its competitors? Even though there was no reason that they should have been better? How did that turn out? Oh yeah, they were intentionally misleading everyone. And had been all along. What happened to their stock price after that? It cratered.

Regardless of your politics, the Trump Trade is pure speculation. Pure gambling. Those who bought in got lucky. They could have just as easily gotten totally pounded. As there was nothing of material merit to propel the stock prices up. Plus, there is a tremendous amount of data that indicates no president or cabinet can overcome broad market trends over the long term. No matter how boisterous his rhetoric might be. Getting policy ideas through both houses of government is not an easy task. And then there’s that wonderful organization called the Federal Reserve, who has essentially vowed to counteract the dangerous growth rate Trump has proposed.

Or, to put it another way, buying into the Trump Trade would have been akin to putting my clients in the middle of that avalanche zone with no idea of when the blasts would be fired. Or if. Or from which direction. Simply put, the current the impact of Trump’s fiscal policies remain pure fantasy and hyperbole. Which is not a solid investment strategy.

Hard Economic Data

I realize that I’ve been pretty hard lined about staying out of the stock market. Here’s why.

Honey and Blood

In order for us to be in an expansionary market (stocks go up), we need rising GDP, consumer demand, inflation, manufacturing, and interest rates. We need substantially dropping unemployment. We’d like comparably low prices per unit of earnings received (PE Ratio). Let’s see what we’ve got.

  1. The stock market’s current Price to Earnings Ratio (at 28.4) is higher than only two other times in history (since 1870), an it’s only 3 points shy of the 1929 high (31.5). As recently as 2009, it was HALF its current value (14.1). Checkout my article, Hi I’m Full Employment: How the Market Works for a refresher on how dangerous this is.
  2. Corporate profits had their sharpest fall since the 2008 recession between September 2014 and December 2015 (from $1.8 Trillion to $1.4 Trillion). They have bounced back to $1.6 Trillion, but they’re still substantially off their high. Stock prices that go up without earnings won’t last long (i.e. the 2000 Dot-Com bubble). Look at the chart above, do you notice how Corporate Profits looked, in comparison to the S&P 500 stock prices, right before the 2008 Recession, and how similar that is to today? What do you think happens next? I’ll give you a hint, it’s not up.
  3. The Federal Reserve is quietly withdrawing money from the market. Quantitative Easing peaked out at $2.1 trillion, it’s now less than $1.9 trillion. That’s a 10% drop. This is NOT a stock stimulus. Notice what happened to Corporate Profits and stock prices when the Feds reduced Quantitative Easing
  4. The Unemployment Rateis within a few tenths of a percent of its lowest point. This means that there is no escalating, unfulfilled demand from lots of new people becoming gainfully employed and consuming at escalating rates. In other words, there is no way for companies to sell more products to more people. To increase their earnings, they need to cut costs. They almost always start with employees. Every time this has happened since 1947, a recession has occurred very shortly thereafter (18-24 months). Have a look at my article, A Simple Rule for Investing in 2017.
  5. Rounding out the data, Real GDP growth rate has fallen from 3.5% in September, 2014, to 1.9% in December, 2016. Consumer demand and inflation are flat. Manufacturing is up in the short term. Interest rates are flat to slightly up. All of this indicates a brewing market correction.
  6. Stock market projections for 2017-2019 are 5-7% cumulative. In other words, at the end of this entire period, the gains are about 2% per year.

So, of the six things we need for a growth market that can sustain rising stocks, we only have one. We only have rising manufacturing. Plus, our Price to EarningsRatio is near all time highs (stocks are very expensive). In other words, this is not a growth market and not a time to buy stocks.

Where Do We Go From Here?

It’s not all doom and gloom. Just because the stock market is unlikely to perform well, for the risk required, over the next few years; there are several other investments that are currently outperforming with far less risk.

Even if the stock market simply stays flat over the next few years (unlikely), or even goes up on a wing and a prayer of campaign rhetoric; it still carries the potential of avalanche level destruction. People forget about this. Just as in the real avalanche, preservation of resources, of capital, of life, is crucial to be able to take advantages of opportunities after the avalanche is over.

If you’re my client, you’ll see those trades and an explanation about it via email, likely within the next few days. If not, well, maybe get out of the valley.

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