It is impossible to discuss the markets without playing the “What’s the Fed going to do next?” game. As you don’t need me to point out, that topic has been beaten into a bloody pulp by every pundit worth the label.
Even so, because of the Fed’s outsized influence—much of which is psychological—I guess one can’t avoid the topic.
In my view, the Fed won’t raise rates for at least a year—but if they do, it will be by a token amount.
Any more than that and they will kill the economy, blowing a hole below the water line of global stock and bond markets in the process.
At which point the Fed would have to reverse the decision, damaging their underserved reputation as an omnipotent institution and revealing the august body for what it actually is: a room full of academics with almost no real-world experience and zero idea how to extricate themselves from the ZIRP-world they and their predecessors have created.
Once the Fed is revealed for the cadre of empty suits it is, the economy will seek equilibrium based on the facts and not the fantasy that the Fed can meddle the economy of the United States—and by extension, the world—back to health.
I suspect the likely outcome of an end to the Fed’s Reign of Error would involve a waterfall collapse pretty much across the board.
Raise Your Hands if You Want Higher Interest Rates
That said, we humans have a strong fondness for matters of faith, and I see nothing on the near horizon that may threaten to cause the masses to rebuke the Fed’s undeserved reputation.
When you get right down to it, no one really wants higher interest rates. Sure, savers would like to earn more interest on their money, but even the most ardent yield hounds don’t want to see the housing, stock, and bond markets simultaneously eviscerated.
And no one wants to pay more for their credit, especially given the towering levels of debt hanging over individuals, corporations, and governments. In the case of the latter, the list of somewhat delayed but inevitable consequences of higher interest rates is not pretty—including soaring deficits, cutbacks in government services that will not be appreciated by the recipients of those services, and, of course, higher taxes.
On the topic of debt, one might assume that a lot of that debt would have evaporated in the 2007/2008 crash, and it temporarily did. But in a world with borrowing costs near zero, it didn’t take long for the mullets to once again begin snapping at the bait of cheap money.
As the chart here shows, since the fourth quarter of 2007 the world has piled on another $53 trillion worth of debt. (Thanks to John Mauldin for bringing this chart to my attention.)
A glance at the data reveals the big growth in debt since 2007 comes from the government, a clear indicator of the growing role of the government in the economy. In no way is this healthy. It doesn’t end well.
Regardless, with no constituency (outside of Austrian economists) hoping for interest rates to be set entirely by the market, the odds are good the Fed won’t raise by more a 25bps—a toe in the water—until 2017 and maybe beyond.
This prediction is supported by the fact that the US is now firmly on the rails and speeding toward the presidential election. The Fed would be loath to skew the outcome by destroying the economy. We may even see the next wave of quantitative easing, though it is hard to visualize how the Fed could lower rates further without setting off an overt currency war.
While no one can predict the future, I believe it is reasonable to base your investment decisions around the assumption that today’s low rates will persist for at least a year.
The New (Temporary) Normal
What can one say about the US market? For starters, it is unquestionably overpriced. You can begin to understand just how overpriced by considering that between 1912 and 2015, the DJIA Index averaged 2,647. As I write, it stands at 16,735.
However, when you look at the Dow on a P/E basis, it’s not as overvalued as it appears. In 1990, when the DJIA began its parabolic rise, the average stock in the index traded at a P/E of about 15. Today, it trades at 20.
(To help you keep this stuff in perspective, here’s a link showing the average P/E by year stretching back to 1871.)
Dividend yield is another useful indicator of stock market valuation. Sticking with the historical perspective, here’s a 100-year chart.
Though you Senderos are a sophisticated lot and already know this stuff, to be complete I will mention that the dividend yield is the price an investor is willing to pay per dollar of dividend. The lower the dividend, the poorer value of the underlying stocks because it means you are paying more for less.
As you can see in the chart, for most of the last 100 years the dividend yield bounced somewhere between 3% and 6.5%. You can see the trench going into the crash of 2000 where the dividend yield fell below 2% for the first time ever. The dividend yield as I write is still a toppy 2.6%.
So, based on 100 years of dividend yield history, the market is expensive. But based on the past 10 years, you might say it’s a “new normal.” How long the market can persist at these levels of overvaluation is anyone’s guess because the actions of the Fed over the last 20 years have stranded us in uncharted waters.
A quick but relevant aside. Two days ago, I revisited the performance of two blue-chip stocks my daughter selected in January of 2014 as part of her educational curriculum. Just for giggles, I made the exercise tangible by investing $1,000 in each of the picks.
The two companies were about as blue as blue chips get—Walmart (WMT) and Coca Cola (KO).
So, how did they do over the past 21 months?
With dividends, $1,000 invested in Coca Cola would have returned a whopping $26.
Worse, staunch Walmart is off 16.30% over the period, so a loss of about $160.
So much for widow and orphan stocks as a safe haven.
Inevitable, But Probably Not Imminent
Given the fact that the Fed’s faith parade is still passing down Main Street, I can’t see any imminent reason for the stock market to crash. Even so, should some lad shout aloud about Yellen’s lack of clothes, things could turn on a dime.
However, per above, while the market is overvalued, it is not dangerously so.
To help us define “dangerously,” consider that when the Nikkei started its swan dive from its all-time high in 1989, the P/E ratio of the average stock was 78.
To give you a sense of just how big the bubble in Japanese stocks was, consider that at the height of the dot-com boom, the hoopleheads were lining up to buy the S&P at a P/E ratio of 40, about twice where it is today, but still half that of the Nikkei.
In addition to high but not yet insane valuations, it is worth remembering that there are few ports big enough to handle the trillions of investment dollars in search of a return. While the US bond market has the size, with yields at next to nil and the hint of an eventual rate increase in the air, it’s nothing to get excited about, and so people aren’t.
Supporting that contention, despite concerns about stocks, the latest data show net outflows from taxable US bonds funds running at $7.5 billion a week. While that is high, it’s not really anything to get excited about, because we are talking about a $2.3 trillion sector. Still, based on how investors are voting with real dollars, the trend is not positive.
In fact, the only mutual-fund sector with positive inflows is money market funds. Along with Treasuries, the money markets can handle the volume, yet as neither offers a positive inflation-adjusted yield, anyone investing in them is doing the equivalent of throwing their hands in the air and surrendering.
So, where does a gal invest today for a return?
Not So Much “Where,” But “How”
In my view, the stock market is probably your best bet for a return, but only if approached with forethought and discipline.
While everyone’s circumstances and tolerance for risk will differ, in the hopes it will serve some useful purpose, following are some of the ways I deal with our family’s investments.
1.Focus on value. Despite the low price of the volatility trades (VIX, VIXY, etc.), there is a lot of volatility in the market just now. That allows you to zero in on stocks selling at a great value and use stink bids to buy them even cheaper. Or, better, sell a put option so you get paid for buying the stocks if and when they fall. If the stock doesn’t fall, you happily pocket the premium—thank you very much.
2.Don’t be afraid to speculate. Successful speculating is all about calculating risk, and the only way to do that is to carefully study the target of your speculation to assure yourself there is significant unrealized value in the position.
Unsuccessful speculation happens when you read or hear about some exciting sure-fire way to make 1,000% on your money and you rush in without further due diligence. You should know exactly why you are entering each trade and the conditions that will cause you to sell or buy more.
3.Don’t follow a lot of stocks. The portfolio I manage for our family has a total of about 20 positions. More than that, and it gets impossible to keep in touch with why you own them, which is precedent to knowing when to sell them.
4.Don’t fight the trends in motion. Earlier, I mentioned the trend for flat interest rates. Another trend in motion is for weak resource prices.
Yes, the cycle for precious metals and related stocks will come around again, but when it does, you’ll have plenty of time to get positioned. Sure, you might miss the first 10% of the move, but as long as you are paying attention, you’ll have time to jump on the up elevator.
Accepting that the sector is likely to remain weak for a while makes now an ideal time to familiarize yourself with the better junior resource companies out there.
The reason to be doing your homework now is because when the junior market blows up, as it certainly has over the last few years, the quality properties slip out of the fingers of the weak players and into the hands of the seasoned professionals who understand there is a time to reap and there is a time to sow. When the cycle comes around again, as it will, those pros will build new companies around the marque properties—or use them to breathe new promotional life into existing ones—and make fortunes in the process.
The key to big returns is to hitch your wagon to the proven management teams because they are the ones quietly picking up the best properties on the cheap. One easy starting point for your research is to google members of the Explorers’ League, the organization I started when I took over Casey Research back in the day.
In order to be inducted into the Explorers’ League, a person has to have been responsible for discovering or developing a minimum of three economic mineral deposits. That is an exceptional feat, given most people in the business retire without a single economic deposit to their name. You can access the list of Explorers’ League honorees by following this link.
Let me add a quick caveat. Not all of the Explorers’ League Honorees are angels and sometimes they strike out just like mere mortals, so don’t rush blindly into their deals. That said you can trust that as the new wave up in resources unfolds, many of the better projects will coalesce around them.
You can also play trends on the downside. For example, in the energy sector I continue to successfully use Seadrill (SDRL) as a trading sardine. It’s currently selling for about a quarter of its book value and, though revenues are falling along with the rest of the energy sector, it makes money hand over fist. I don’t think the energy sector is going to recover for at least a year, and as a result every rally in energy stocks will continue to be quickly followed by a hard beat down.
When that happens, Seadrill will get smacked down with the rest… allowing me to buy it at a fraction of its underlying value. Invariably, within a week or two, oil ticks up and the spring under Seadrill’s price releases. My latest trade was from $5.70 to $6.60 when I sold, a 15% return in less than a week. In time, I hope I’ll be smart enough to hang on to my position as energy finally turns the corner and Seadrill heads back towards its 52-week high of $26.00.
I guess what I’m saying is, to succeed in markets these days, it helps to make the trend—up and down—your friend.
5.Be a cautious contrarian. In recent months, the narrative in the mass market media has been almost 100% that China is a disaster. That alone should alert you to a possible contrarian opportunity. Personally, I’m convinced the China story is closer to the mid-point than the endpoint, so I view every pullback in the market as an opportunity to leisurely build positions in companies such as BABA, CEO, and CHL, among others. These are the companies providing the backbone to China’s transitioning consumer economy.
The chart below shows that the excess in the Chinese market of recent years has been largely washed out. Sure the stocks could go lower, but I don’t think they’ll stay down for much longer.
It really comes down to whether you think the country with the world’s largest population and the world’s fastest-growing economy has seen its best days. If you think the trend toward China becoming the world’s largest consumer economy is over, then by all means follow the herd and ignore the opportunity. Personally, I am a buyer at these levels.
6.I try very hard to be disciplined. There is a saying that investment profits are made not when you sell, but when you buy. I have worked hard to overcome the natural impulses and emotions we humans are born with. Nowadays, I set a specific target entry price on every investment, and unless something fundamental changes, I won’t pay more. Likewise, I set a sell price, or a stepped-up chain of sell points, and almost never deviate.
Just yesterday, I had a long-standing sell order filled for a third of one of my long-term core holdings—Pretium Resources (PVG). I could see the market coming to my price last week, but I left the target price alone. After the target was hit, the price continued to rise, and I couldn’t help feel like I had lost something.
Then I reminded myself of the importance of discipline and didn’t give it another thought. For the record, I think Pretium is at least a double from here, but the company is moving into the mine building phase, which is always tricky—so who knows? That said, this is a very large, very high-grade deposit in a very good jurisdiction, so a takeover is a real possibility. If that happens, I still have two-thirds of my position remaining to profit from.
7.Accept that the markets will remain volatile for the foreseeable future. That’s why I never set stop losses. These markets are so volatile, the odds are good you’ll get stopped out of a stock you want to own and then watch it bounce back a day or two later. Instead, I take the attitude that it’s not a loss until I sell and don’t worry if my positions get knocked back with the broader markets.
As long as you are sufficiently cautious in your initial assessment of the upside, then—provided there is no change in the fundamentals—there’s no reason to sell on a dip. (Unless you want to capture a tax loss.)
Additionally, if you embrace volatility, it can be a very good friend. See Seadrill above.
8.Have a sufficient insurance position in physical metals securely stored. I believe having 10% to 15% of your portfolio in the right sort of precious metals always makes sense. By “right sort,” I mean government mint coins or bars from one of the large brands. US Gold Eagles or Johnson Matthey bars are immediately liquid, which is very much not the case for numismatics or, worse, the “modern rarities” sleazy dealers love to promote because of their high mark-ups.
With the disclaimer that I have an ownership position in the underlying company, I would urge you to give the Hard Assets Alliance a close look. It uses the latest technologies and processes to streamline the process of buying, selling, and storing metals internationally. It is a very well-managed organization with highly competitive pricing and a very solid trading platform that, with a click, allows you to store your metals in some of the world’s safest vaults.
9.Diversify. While I don’t think it’s imminent, there’s no question the market bubble could find a pin on any given day. Therefore, I think it is important to diversify between asset classes as well as between political jurisdictions.
For our assets, we have a manager who invests in a more traditional portfolio. Then, separately, we have a trading account I run that follows the strategies discussed here. We also have an international trading account, which is largely invested in the Kohinoor Core Fund, a hedge fund specializing in “Black Swan” strategies.
We have physical metals securely stored in vaults (not in our house!) in the US and internationally, and we have an allocation to real estate for personal use and for rental income, also diversified internationally.
If I have it right, any two markets could pretty much collapse and we’d still be fine. You can’t ask for more than that.
Finally, I would mention that given the tenuous nature of the world we live in, it may be appropriate to start thinking long-term in regards to things like savings and expenses. Living here in Argentina, our cost of living is a fraction of what it would be in the US, even though the quality of life is in my opinion much higher.
On that topic, during our recent stay in Vermont, I was shocked at how expensive eating out has become. A relatively modest meal for four in a decent restaurant can set you back a couple of hundred dollars, three or four times more than a better meal would cost you in the best restaurant on the plaza in Cafayate. Copious quantities of excellent wine included.
In today’s manipulated economy and manipulated markets, you aren’t going to be able to park money in CDs or money markets and pocket a decent return. Therefore, in order to keep ahead of the steady erosion of inflation, you are going to have to invest. By which I mean, you’ll have to participate in equity markets.
While there is a chance that there is still some juice in long bonds—which you’ll collect if the economy does slip back into recession—all things considered, investing in bonds provides almost no return in exchange for taking on the risk that the influence of the Fed on interest rates may wane and rates will head higher.
Another alternative for those of you looking to earn a yield is to participate in peer-to-peer lending networks such as Lending Club. While I haven’t dipped my toe into this particular pond, I have spent time reading up on them and know several people who reliably pocket 8% or better each year with very little effort. You can limit your risk by establishing more stringent credit requirements for the loans you’ll make, and by building a portfolio of dozens or even hundreds of small loans.
However you approach today’s markets, at the end of the day you need to decide on what rules best suit you and stick to your guns. One simple test is that every time you feel emotional about any investment, sit down until the feeling passes.
Summing up, I’ll borrow the old Rolling Stones refrain, “You can’t always get what you want, but if you try sometimes you might just find you get what you need.”
Hope this is helpful.