Quick Disclaimer
The following is a transcript of recorded content. Please note, these transcripts are not always perfect and may contain typos. If you notice any major mistakes, please feel free to report them by opening a Technical Support ticket under the Help menu at the top of the screen.
Full Transcript
Chris Martenson: Welcome to another Peak Prosperity podcast. I am your host, of course, Chris Martenson. Here is the question: Have the equity markets stopped? I know that question is on everyone’s mind, but the real action, as always, is in the bond market, where we might ask the very same question: Has the bond market topped? As I have been fond of writing and saying recently, if you loved rising equities coupled with falling yields, you're probably going to hate the opposite. There are a lot of reasons, fundamental, technical, and related to marked-to-market sentiment to suspect that the fun ride of every higher equity and bond prices is over, at least for a while.
Today, I am pleased to be speaking again with some of the team at New Harbor Financial. That is Mike Preston and John Llodra, who will help us understand today how a disciplined approach to investing can make all the difference when markets wander into extreme territory. Before we get started, I’ll make it clear that Peak Prosperity has a commercial relationship with New Harbor Financial, one in which fees are shared on referred accounts. It is important to note that this arrangement does not result in any increased fees charged to the end customer. You are charged the same as if you walked in through the front door. All the details in this arrangement are provided clearly in writing during the referral process if we get to that point.
Welcome, gentlemen.
John Llodra: Thanks for having us today, Chris.
Mike Preston: Thank you, Chris.
Chris Martenson: Great. So let’s start from the outside in – Fed policy, and I guess everything is hinging on Fed policy. Certainly the Fed governors or chairmen or people open their mouths and the markets swoon or gyrate or up and down, all of that. But really, what the Fed is trying to do is prop up all the prices of financial assets, including real estate if it can, to create this wealth effect. From where I am sitting, it looks like – what are we, six years into this experiment? There’s not a whole slew of really convincing data that the Fed has been successful. Tell me how you see this world today.
John Llodra: I will be happy to kick us off with that topic. The Fed has done a lot of talking about their objective to jump-start the economy through job growth and GDP growth and whatnot. Really, from our perspective, it has been a very thinly veiled guise for incenting folks to flood into risk-based financial assets. In effect – and we do not what to beat this to death – we actually have a game here in our office. Once in a while, we will turn on CNBC and see how long we can get before someone mentions a Fed, usually in a bullish positive light.
We actually think the Fed has done potentially tremendous harm to the function of the financial markets. It really comes down to the fact that they have become such a huge factor in frankly one of the largest markets in the world – the bond markets, U.S. Treasury, and mortgage-backed bond markets. And, have had the effect, through both their purchases of bonds and their near 0% interest rate policies, of driving interest rates down and prices up on bonds over these last several years such that the forward return has been assumed to be quite pitiful for most investors.
What that has caused is folks to essentially flood into other risk based assets – like stocks, like high-yield or junk bonds, like real estate – and basically get bullied out of safer assets that many folks believe they should be in. We think there has been a huge amount of artificiality priced into markets like the bond markets. Consequently, we feel that almost in a mirror-image kind of way, there has been a huge amount of artificiality priced into things like the stock market. Think about markets and equilibrium, most are going to flood from one asset class to another when the return prospects are greater in those other asset classes. So if you essentially have cash earning zero, in a macro sense, the Fed’s policies have caused folks to flee into other asset classes such that their risk-adjusted return prospects have also been driven to zero. So, almost uniformly, we feel that most, if not all, asset classes have been driven to essentially zero or near-zero perspective returns from this point in time.
Chris Martenson: So here we are with poor returns, at least on a risk-adjusted basis. And looking at the market action recently, we have seen both equities falling and bond prices falling at the same time, and no real action in the dollar to sort of support or explain those moves, so they seem real. The question becomes, have the markets topped, and where are we in this cycle? We are pretty long in the tooth in this particular bull market advance. What are your views there? Is it time to become more defensive than usual, or is this the time to become really defensive?
Mike Preston: I will take a shot at that one. It would be hard for us to find a money manager that would actually have the credit to go out and say the market has topped. Frankly, we thought the market was risky a year ago, and it kept grinding higher day after day, month after month. We do think the market is at or near a top, as we said there in August of 2013 – mid August. The market went up to around 1707 on the S&P. Currently it is right around 1655. The market probably has put on a top at that level. Of course no one can guarantee that to be the case. Even if the market goes higher than its previous high at 1700 or so, it is unlikely that these gains will be durable. It is unlikely that these gains will be able to be kept by most people, and that is really the point.
We as money managers want to take risk when risk is likely to be appropriately awarded by durable gains over the long-term. When I say long-term, I mean over a period of several years – a full market cycle, if you will. So, when answering that question, we really have to build a case. The case that we are trying to build is, should we be bullish, or should we be bearish? Is this a time to take a lot of risk, even leveraged risk – going long to stocks, or that is betting stocks are going to go up? Or, should we be pulling back or pairing back our risk by moving more and more into cash? In building that case, really, we have to take a look at a lot of different sets of data. There is really good people out there putting together really good data that is not hard to find – from your site to some of the other sources we are going to give due credit to here in just a minute.
The bearish case has a lot of data available that you can look at the hard and fast numbers and say geez, you know, things aren't as rosy as CNBC would like us to believe. On the flip side, the bullish argument, it is hard to find concrete data to back up the markets going higher from here. So really what I would like to do is just spend one minute or so defining secular stock-market cycle.
When I say secular market cycle I’m talking about 10-20 years in length. Here, there is a good source called Crestmont Research. It is put together by a man named Ed Easterling. It is crestmontresearch.com. There are lots of neat charts and graphs on there. There is a number that we use and we find useful. He puts together a nice graph show in secular stock-market cycles over a long period of time. You can see by looking back over the last 100 years or so that stock markets alternate between bull markets (that is, markets going up) and bear markets (markets going sideways to down). They alternate every 10 or 20 years. So really, between 1900 and 1920 was a bear market, only ended after World War I. Then 1920-29 was a large bull market. And 1929-1945 was a 16-year bear market. And 1945 all the way up to 1966 was a wonderful bull market. The 1950s actually showed a gain greater in the stock market than the 1990s showed. Then 1966-1982 was a secular sideways bear market, and 1982-2000 was once again a bull market. So it is kind of an on/off type thing.
Between 2000 and now, 2013, we have been in a secular bear market. The question on the table here is, are we at the end of a secular bear market? The S&P has gone nowhere literally in almost 14 years, with two declines of 50% along the way. So the real question is, are we about to break out into a brand-new secular bull market here? Or are we simply midway or more along the path of a secular bear market – one that could have declines of 40-60% or even 70% lying ahead? We think, for a lot of different reasons, we are still on the secular bear. A lot of folks out there are saying the opposite. CNBC and the financial press think the secular bear market is over. We’ve heard people say this is like a 1982-type moment, that the secular bull is back. And, we do not think it is.
Chris Martenson: Let’s talk about some of those fundamental factors that really will support the defensive in this particular point in time. I will say that the one piece of evidence I have heard on the bullish side goes something like this: The Fed won’t allow the stock market to go down, which is shorthand for saying that the Fed stands ready to print as much as necessary to keep prices elevated.
But that’s not a really fundamental value sort of a play to speculate whether the Fed is going to dump more money in or not. Let’s talk about these fundamental factors for a minute. What do we have? Earnings come up all the time. Corporate earnings are at all-time highs, and there are projections that they are going to go even higher.
John Llodra: I’ll take the handoff there. So yeah, if you look at these cycles that Mike referred to, there are very clear signposts that one can look back at and say, these were glaring indicators that told us we were in the neighborhood of the end or the beginning of a given bear or bull cycle. Some of the most reliable signposts that one can look at are valuations – how expensive as a function of earnings are stocks, individual stocks, or the market in general, and also things like interest rate or inflation trends. So, let’s say, each of those in turn. One of the most common metrics that folks will toss out in terms of measuring the valuation of the market is the so-called PE ratio – price-to-earnings ratio. Pretty simple concept; the numerator in that fraction is the price of a stock or a price of the stock market in general – like the S&P 500 – and the denominator, the “E”, is the earnings of the company or the market in general.
So, it sounds simple enough, but the devil is in the detail. The “E”, the numerator, is where most of the mischief happens. If you put an “E” under there, an earnings that is misleading or artificially high, you are going to come up with a PE ratio that is misleading low, leading one to conclude that the market is undervalued. The market has room to go up from here. That is really where much of the mischief has happened of late. If you look at corporate earnings right now, it is somewhat of a conundrum to most folks, but they are at very much peak levels. If you look at over a long period of time, clear as day, corporate earnings have risen over time. That’s why the stock market has risen over the last century plus with very strong results.
But just as certain as that long-term rising trend has been a pretty defined and cyclical pattern piece and troughs around that trend line. We happen to be right now in an area that is one we call a peak of that cycle. Most analysts will use a single year of earnings estimate, usually Wall Street’s forward operating estimates that are generally high and biased to the high side. If you use a peak number in that denominator, you are going to come up with a much lower PE ratio than is reality.
Professor Robert Shiller of Yale came up with a pretty simple but novel way to adjust for that. It is the so-called Shiller Adjusted PE ratio, which looks at the prior 10 years and averages those and adjusts them for inflation. And when you do that, you smooth out the unintended effects of that cyclicality in earnings. So if you look at where the Shiller Adjusted PE Ratio has been in these major bull and bear market cycles in history, basically, shrewd durable bull markets start with a Shiller Adjusted PE Ratio in the 5-10 range. And they typically end and a new bear market begins when the Shiller Adjusted PE ratio reaches 20-25, in that ballpark. Right now we are between 24 and 25 on the Shiller Adjusted PE ratio.
So, valuations have been a very clear indicator of major market bottoms and tops. We are about as extreme on evaluation as we have ever been, with the exception being the Tech Bubble of 2000 where the Shiller Adjusted PE’s got up to about 46. Not too many folks are willing to say that was logical or will ever be repeated again. On a valuation standpoint, we are very much on the high end of history, which usually coincides with the beginning of a new bear market rather than a new bull market.
We can talk about things like interest rates and inflation, just quickly. Inflation – right now we have somewhat moderate, stable inflation. In fact, that is much to the Fed’s frustration. They want to stimulate a little more inflation than they are getting. But, history is showing that when you move from a period of stable inflation to either high inflation or low inflation – meaning deflation – that has tended to be a horrible time for the stock market. So either way, the Fed seems to be worried about two scenarios here: deflation and longer-term inflation. Either of those moves has traditionally been associated with very horrible results in the stock market.
Chris Martenson: In there, you mentioned something else, which was the interest-rate trends. That is certainly something that has caught my attention a lot lately, because you want to talk about the things that the Fed wants and does not want. The interest-rate trend, which has been worldwide – watching the long-term interest rates of those ten-year bonds and higher in a bunch of sovereign nations have really risen a lot since – depending on which country we are talking about, it is early May to early June. So it has been a couple of months. It is a fairly durable phenomenon, at least by recent standards. And it has gone so far that people like Pimco have tweeted out that that’s it. We hit a long-term secular low in interest rates and what was that, maybe 1.6 on the tenure? It was somewhere in that zone. And that’s it. So they are just heading up from here.
Talk about the relationship of interest rates and stocks or equities in this case.
Mike Preston: Sure, I’ll offer a quick response to that Chris. The ten-year note, the world watches the yield on the ten-year U.S. Treasury Bond. It really drives the interest rates on so many very important vehicles, not the least of which is home mortgages. Last year, in roughly August of last year, the ten-year bond yield bottomed out at 1.39%, about 1.4%. And most recently, as I look at it right now, it’s at 2.8%. So that is an increase. It is really almost a doubling, actually, if you look at it that way. It really literally is a doubling from about 1.4% to 2.8%, or to put it another way, an increase of 1.4%.
This has had the effect of driving mortgage rates up over a point. Average mortgage rates now are up around 4.6%. They were in the mid 3%’s not too long ago, maybe about six months ago. As interest rates rise, it essentially is toxic for the economy and the stock market, because business owners and consumers are less likely to borrow and reinvest. Homeowners are less likely to borrow and build that addition or move to a bigger home. Companies are less likely to borrow and finance the purchases of other companies, even investing in new plants and equipment. So, it’s just something that everyone is watching. It is something that we are watching closely. Frankly, it is one of the hostile syndromes that John Hussman – another person that we admire and read quite closely. He has a site, hussmanfunds.com – he talks about a toxic syndrome, a more dangerous syndrome in the stock market, and one of those is interest rates rising quickly over the past six-month period. That’s exactly what we are seeing.
This is a huge warning flag. You are right, Bill Gross tweeted the other day, he said we have got no one to sell to but ourselves. All assets are inflated. So, certainly it has got us very, very cautious and very defensive.
John Llodra: Chris, just adding to that quick, so many of the fairly unsupported bullish arguments have been well, because bonds are yielding so little, stocks represent the best game in town. Now the interest rates have picked up – still moderately, but significantly relative to where they were – that argument starts to lose some weight. In fact, looking at where the ten-year bond is right now, just a tad bit under 2.9%. If you look at some work done by folks like John Hussman that Mike just mentioned, and GMO (Grantham Mayo van Otterloo) – a big money manager based out of Boston – they both have very good reliable track records in projecting perspective returns in the stock markets. John Hussman estimates that ten-year forward returns in the S&P 500 are roughly right in line with that 2.9% that ten-year bonds are currently priced to yield. GMO actually, for the seven-year horizon, actually projects a negative return for most stocks.
All of a sudden, the modest pickup in yields on bonds really challenges the perspective return prospect for things like stocks. So they are no longer the slam-dunk best show in town relative to artificially low bond yield.
Chris Martenson: We saw that virtuous cycle on the way down in yields where the lower yields went, the more attractive stocks became. So really that was a plus, with all the ample liquidity provided by the Fed, et all. You had a really virtuous cycle where both bonds and stocks went up, and of course that was on the Fed game plan and other central banks’.
So here we have the opposite where we are seeing, on some of these days, red on stocks and red in bonds at the same time. So there is all this selling going on. That clearly says something about market conditions and whether there is enough liquidity to be supplied really to keep everything elevated where it is. And potentially, the answer is no at this point.
One of the things that I think the Fed has been counting on is this idea of this wealth effect that we started out this podcast with, and this idea that the stock market, it is the same thing as the economy, right? As long as equities are rising, I guess the tail will wag the dog and the economy will follow along. Do you take exception with that?
John Llodra: Your recent piece a couple days ago very eloquently spoke to that. If you look at where the rubber meets the road, jobs recovery, look at GDP growth. You know, it is clear that after five to six years of intervention here, the results that we are so somewhat sought and promised are not being delivered. We are having pathetic rebounds and job recoveries and GDP growth. So I think the evidence speaks for itself.
The reality is that most folks forget that the stock market is a forward-looking machine, if you will. Let’s not forget the stock market began rallying back 2009. We have had a pretty long rally here. And for folks to now be saying if the economy starts to get better, that means the stock market will go higher. A lot of that possible future improvement is already more than priced into the gains and the stock market over the last several years since the 2009 low.
Most folks fail to realize that to stock market usually rebounds when economic news is getting worse, not when it is getting better. We think that story is more than played out to an excessive level. Even with the improvements in the economy, we are likely to see a major pull back in the stock market.
Chris Martenson: Well, buy the rumor, sell the news is an operative phrase that I learned to trade by. Meaning, the stock market is there projecting if the economy is going to recover, and then when it finally does, it has already priced that all in – it has already bought that rumor, and the news itself may or may not be what you are hoping for. If the Shiller Adjusted PE’s are right, boy, you know –
unless you are expecting us to go back to 2000 levels on the Nasdaq and get price earnings that are in the 40’s and 50’s, you know that is where you are going to get a market doubling. Otherwise, we are going to have to have the earnings really double.
And of course, they are at not just highs, but at levels that have really never been recorded before on a percentage base of the economy. All of this hinges all of the euphoria around the fundamental side on the bull case hinges on the economy really taking off. And each successive GEP release is eh, you know, 1%, 1.5%, eh, you know, this is not taking off. So, that part is not happening.
Well, those fundamental reasons I think are – you know, that is one thing you guys are looking at. The sentiment is something I used to track when I was trading. Tell me how you track sentiment and what you are seeing there.
Mike Preston: Sentiment is really overwhelmingly bullish across the board, and there is a number of different ways to track it – no really exact science. There are a number of polls out there, like National Association of Investment Managers and the AAII poll. A number of these and more polls of investment managers are showing really record complacency, really record lows in the number of bears. When I say lows in number of bears, I’m talking about people that think the stock market will go down. The respondents of people that think the stock market will go down are less than 30%, just to throw out an average number. So there is really a dearth of pessimism. Really, stock markets take off and launch into the multi-year secular bull markets in social environments that are washed in pessimism. They do not take off to new secular bull markets when everyone is bubbly with optimism. There really are not that many people that are negative or paying attention to the data that should make them be negative on the stock market.
Investment managers – you can just take a poll of them, and again there is a lot of different data that you can look at there. Simple things, even just like magazine covers, for instance. Magazine covers – on April 22nd, on Barrons’ cover there was a bull jumping on a pogo stick. He had jumped right over a bear who was cowering in the background, and it said Dow 16,000 on the cover. There have been a lot of these types of magazine covers lately.
This is not an environment that you want to see, really. If you're a bull, you really want to see negative covers. Generally, when you have got magazine covers that are so positive you have a social mood – and that’s really what we’re concerned with, is social mood – you’ve got a social mood that has reached a peak in terms of optimism.
When social mood changes and then reaches a realization phase that maybe things are not as great as they thought they were, that’s when you get very fast, very vertical elevator type drops to the downside that are unexpected. So that’s what we are concerned about.
Chris Martenson: One of the things I track, Mike, is also looking at the New York Stock Exchange level of margins – margin meaning that people, investment managers, others have gone out and borrowed money in order to go along or invest in stocks. From my point of view, by the time people have already borrowed to go long on stocks, they have probably done all they can do, or they do not have much further to go in that run. Are you tracking that, as well?
Mike Preston: Yes. Margin debt is very near record levels, at or above where we were in 2000 and 2007. It is not enough for many speculators to be 100% invested. They want to be 200% invested, betting on the stock market going up or more. That is generally a terrible time to be investing for the long term. I’ll just go through some of the things we are looking at. Insider selling – I’m talking about corporate insiders – they are selling almost 10 shares, 9.2 shares at last check; they are selling for every 1 that they are buying of their own company’s stock. There are reasons that corporate insiders sell, of course, and they might just need the money for something else. But when you get almost a 10:1 sell-to-buy ratio, it is something to really pay attention to.
Interestingly, there is one sector of the stock market that is nearly the opposite of that, and that is gold and silver miners. Corporate insiders at gold and silver mining companies are buying ten shares for every one that they are selling. That is pretty interesting, in light of a gold and silver mining sector that at its worst was down almost 70% year-to-date this year. It was a brutal bear market for that group. But those insiders are doing the smart thing, at least in their eyes, and buying stock.
Really, this time is different, as John, I think, mentioned earlier in the conversation. Everyone thinks this time is different. You know, they say the Fed has got our back. This is probably going to go down as being called the Fed bubble or the Bernanke bubble, very similar to the housing bubble of 2006 and the tech bubble of 2000. As quickly as other things, stock equity mutual funds have record low cash, down to about 3% of holdings. Typically they hold 5 or 6%, but the last couple of months they have been down around 3%. There have been record retail in-flows of cash into equity mutual funds over the last couple of months as well. And, you couple that with everything else we are talking about, valuation and so forth, it paints a really disturbing picture.
One last thing I might mention is the volatility. The volatility of this market has been very low. The volatility is measured by something call VIX. Recently that went under 12, which is right near a multi-year low. It just shows how much complacency there is. This market does not move a lot day-to-day. Sometimes it is like watching paint dry. But, it is that exact type of market that sometimes is the most dangerous. It just kind of lulls people to sleep. In the midst of the hostile environment that we are in, it has us a great deal in cash and just kind of sitting on our hands and waiting for better opportunity.
Chris Martenson: All right, well, let’s talk about if we peel back the covers on equities for the moment. You peer in there and look at what is going on. You mentioned what happens when you look into insider selling, if you peer under the covers. And note that gold and silver miners, for some reason, they are buying ten for every one they are selling. When you peel back the covers, what are you seeing in there technically that might support a bearish versus a bullish case?
John Llodra: Much, much on the sentiment side of things and technical side of things. If you look at the gold and silver miners, they are almost the exact opposite of what is going on in the broader stock market. There has been no more unloved asset class than the gold and silver miners over the last couple quarters. When you think about markets in general, they operate on the simple laws of supply and demand. You know, frankly, if there are more people wanting to buy than wanting to sell, then the price has got to go up to tease out more sellers, and vice versa. If more people are wanting to sell than people willing to buy, well, the price has got to drop to entice more buyers to come in.
If you look at technical and sentiment readings on the gold and silver miners, almost uniquely they have been in rock bottom levels rivaling the negative sentiment that we observed both in that sector and in the broad stock market in general back in the depths of the decline in 2009. So, frankly, we are just seeing lots of signs of an exhaustion of sellers in that sector. From a technical standpoint, technical analysis really comes down to trend following and momentum strategies. Don’t ask the question of why are things going up or down, but are they. And what are buyers and sellers doing to carry on those trends?
Basically, there have been lots of signs that some of the selling pressure has abated in the gold and silver miners. We’ve seen at least in the near term here a quite sizable balance off the bottom, and almost the opposite is what we are seeing in the broad stock market at this juncture.
Chris Martenson: What is it you are seeing in the broad stock market there, in terms of the technical factors?
John Llodra: It is very early. We are not willing to say the top is today or last week. Topping processes usually take time. But, what you start to see in broad topping patters in the stock market is a lot of different things, but one very hallmark sign is a narrowing of leadership. If you can almost imagine, you know – obviously we see the news every day, the S&P 500 did this or the Dow Jones Industrial Average did that, that talks about the index in general. When you look underneath those indices, though, and look at how individual stocks and those indices are behaving relative to the direction of the index, what you oftentimes find at major tops is that fewer and fewer stocks are trending higher while the index itself is going higher.
In very extreme events, you might have a small handful of stocks carrying an index higher at the same time that more and more stocks under the line of that index are turning lower. We are starting to see that in some things. For example, for the last couple of years there has been record low dispersion between different sectors of the economy in terms of stock market return. That has basically spoken to the fact that it has been an all-risk-on or all-risk-off – mostly all-risk-on – environment for the last few years.
We are starting to see some dispersion. There actually are some sectors that are starting to outperform or underperform other sectors. That is a sign that there is not this uniform bid being placed under all stocks of every stripe. We are starting to see things like the often-talked-about Hindenburg Omen. We are not particularly watchers of that one indicator, but that speaks to the same time many stocks are making all-time highs and there are also a large number of stocks making new lows. It speaks to dispersion, a faltering of many stocks at the same time, and that fewer stocks are carrying the market higher. Those are just some of the things.
One analogy we like to use in technical analysis is that of a rubber band. The markets generally stretch in either direction like a rubber band would. They oftentimes overstretch in either direction too much, and over time things revert back to the mean – meaning the rubber band snaps back to the center point, if you will. If you look where stock markets have been across the board for the last several months, and in fact even the last couple of years, uniformly they have been very much overbought statistically on the upside, meaning they have stretch
