Can you handle the truth about gold investments?

Takeaways: Buy gold now.

Yes, right away. The price is at a 5 year low, after correcting by 40% from its peak in 2011, erasing about half of the run-up over the last decade. That’s a bargain – unless the trend proves broken, which there are good reasons to assume it’s not (China hoarding, production costs, negative interest rates, money printing, flight to safety coming etc.).

gold price 1994-2015 

Buy an ETF for speculative purposes (GLD for exposure to the gold price, GDX for gold producing mines, GDXJ for smaller, more speculative and exploration oriented mines), and physical gold to hide at your BOL, as insurance against the break down of society (not my preferred choice).

Gold bottoming out? It should be.

gold apr 23 2015

 

There is gold and cocaine all around us

– so close, yet so far

Twelve percent of annual gold production reaches its final destination in minuscule amounts in electronic devices.

That gold is just as inaccessible as the cocaine in money bills. It takes a couple of thousand of dollar bills just to make one single party line. Similarly, refining the micro grams of gold found in cell phones and other electronics just isn’t worth the trouble.

coke in bill

Even if Colombian pesos probably have a higher cocaine content, the smallest bill (1000 pesos) still costs 40 US cents. Even at 5x the cocaine “contamination”, the cost per line would amount to 160 USD. Gold in devices has the same characteristics.

Is that a gram?

Good as gold?

Nota Bene: This is not a comprehensive overview of everything about gold. It’s bits and pieces of my perspective on gold and gold investments. Further, it’s not a recommendation to buy or sell anything. Anything.

Warning: Gold is more or less intrinsically worthless. You can’t eat it, can’t sleep in it or under it, it can’t warm you and it’s almost useless as an industrial metal. You can wear it but be prepared to lose a limb or your life over it.

gold for consumption

Okay, so you can eat it, it just doesn’t contain any nutrition

 

Gold has got ONE thing going for it – it’s eternal

What’s the fuzz about? Gold is eternal and limited. In addition it’s solid, heavy and pretty. It’s malleability makes gold ideal for jewellery (and apparently, clothes and oversize dildos as in this video with Swedish pop group Army Of Lovers).

All gold was made billions of years ago in supernovae and neutron star collisions. It’s practically indestructible as well as impossible to produce artificially.

Gold utility

army of lovers gold dildo final

A fun side story is that the genius behind the group (2) went to the same business school as I did. He has also released a philosophy/psychology book at my publishing company, Hydra. Also fun is that the girl (1) in the picture (and group member) lost to me in court after refusing to pay back a loan I granted her when she wrote another (Russian cook) book at Hydra.

Why gold instead of shells, pearls, qualified work hours, MIPS, BCAA (protein), energy (1 joule, e.g., or 1 kWh), potable water, arable land, dollars or bitcoins?

Even if gold itself is worthless, using it as the base for transactions provides a lasting unit of account that can’t be diluted by producing more or lost due to destruction. If you want more gold, you have to dig it from the ground and refine it, which costs about as much as gold on the market does. The cost of producing gold increases over time due to inflation and increased difficulty in extracting gold.

Pearls and shells are fragile and volatile. Dollars can be printed (even if central bankers promised to neutralize the extra dollar once the crisis is over).

Bitcoins are a bit like gold, but can be destroyed by solar flares or EMPs – and it can’t be used as jewellery or electronic circuits. Bitcoins, unlike gold, face competition from other cryptocurrencies that can be constructed by anyone that so desires. What if Bitcoin is the MySpace, Nokia or Altavista of cryptocurrencies? Where is the Facebook, Apple or Google?

Meat Wallet

meat in big wallet good as gold

-not very practical

Actually, my own favorite among the alternatives is essential amino acids, due to the undeniable intrinsic value. Their biggest problem is the needed bulk per transaction. Another problem is the volume needed to back the sum of all transactions. There can never be enough protein around for that – just the promise of delivery if needed. Perhaps water is the answer after all. Or energy. Then again, (long term) storage is an issue.

 

Why buy now?

The price has fallen by 40% in USD, despite mad money printing since the peak in 2011, despite intense hoarding by e.g. the Chinese central bank (albeit not yet disclosed, but probably later this year. My guess is that China has expanded the country’s official reserves by at least 5x) and despite extreme increases in asset prices such as stocks and bonds (and Swedish real estate).

China’s gold hoarding

china gold hoarding

 

When should you own gold?

  • during inflation
  • during or after money printing
  • during hyperinflation (caused by falling production due to speculation and malinvestment in the preceding money printing boom)
  • in turbulent times – e.g., war

 

Who should consider owning gold?

  • Billionaires, dynasties: one atom of gold will stay one atom of gold no matter how you hide it. Gold might be the only way for a dynasty to protect its wealth over time. It’s not about returns it’s about stability.
  • Central banks, governments: pure fiat money has never worked for long. To prevent a collapse or to restart after the death of money a base is required and the most trusted base since gold was first discovered, 7-10k years ago, is gold
  • Doomsdayers: just note it has to be physical gold, hidden from governments, armies, fellow citizens and others
  • Speculators: okay, they don’t really need gold, but they are included among buyers at this point. Contrary to dynasties, speculators don’t care about gold per se or its insurance qualities.
  • Insurance: As part of a quattro stagione portfolio, as a hedge vs. stocks or consumer prices (cf ratios gold/dow, gold/CPI, gold/oil)

 

Why not gold now?

Again, gold is inherently worthless.

 

Valuing gold

What is gold actually worth? Ballpark?

Hello! Am I invisible? Nothing!

 

Okay, here is a stab at gold valuation:

There is about 200 000 tonnes of mined gold in the world. At current prices that’s worth 7.2 trillion dollars or pretty close to the amount of physical money floating around. However, it’s just a tenth of a wider money definition (M3=75tn).

What if all money had to be backed or replaced by gold? Easy, gold would have to be at some 12 000 USD/oz, rather than the current approximately 1200 USD.

In contrast, what’s a dollar worth? Well, the paper isn’t worth much and neither is the 28 ug of cocaine locked in the fibres of an average dollar bill (FYI: 99% of bills in London contain cocaine). The U.S. Fed has some 8000 tonnes of physical gold in its vaults. That’s enough to back less than 10% of the physical currency in the US and around (less than) 1% of its M3. China probably has a similar amount and thus a much better coverage, albeit still negligible as backing for its currency.

gold

However, the power of taxation should mean something… It’s just that that power and value have been diluted by existing debt, as well as promises of pensions etc. that the USD is “backed” by a huge negative net value. Hence, the Bitcoin cryptocurrency is a better bet than the USD, despite having no intrinsic value or backing whatsoever.

Of the main contenders for money, dollars and Bitcoins get disqualified pretty quickly. The only thing Bitcoins have going for them is that they are much better than dollars and other fiat money.

Energy and water sound fine on paper, but there is at least one good reason why gold has won that battle the last 10 000 years. Storage (and stability – water goes bad and energy dissipates. Just as with proteins you only have the promise of delivery left and if you die that goes away, while gold remains).

Another theoretical valuation approach

Gold currently makes up about 1% of investment portfolios. To achieve significant diversification effects that should be at least 5%, and probably rather 10%. Some advocate multiples of that – at 25% (the Quattro Stagione strategy).

Even to just get to a more conservative 5-10% average portfolio weight, either other assets have to plunge dramatically (-80-90%), or gold would have to increase in price by some 500-1000%. Once again the evidence points to 10 000 USD/oz, give or take a few thousand. Well, if it weren’t for the fact that gold is worthless, that is.

Most likely there will be a combination of falling prices for stocks and bonds and a rising price for gold, as the sellers of other assets park their wealth in the safe haven of gold. Thus, even if you want to stay long stocks, you could hedge that position by adding gold. Everybody can’t go full retard as I have (both buying gold and shorting stocks).

Chartist’s view point to 5-6000 USD/oz

gold bear trap

 

My first hand experience with gold is limited but rewarding

Have I put my money where my mouth is? What is my actual experience in investing in gold, except reading about it for my entire career?

I bought a batch of gold ETFs (gold price as well as junor and senior gold mine funds) and single stocks (single senior gold mining stocks) a few years ago, after the post 2011 gold price crash, and sold them at a 25% profit after just a few months.

Then I bought again about a year and a half ago, this time just the senior gold mine ETF and a gold price ETF. The reasons behind buying at that point were:

  • The price had fallen by 40% (just as low as when I bought the first time)
  • I expected turmoil, and consequently flight to safety (to gold)
  • I expected weakening peripheral currencies, e.g. the SEK, due to weaker global trade and not least a weakening Chinese economy
  •  I expected a stronger USD (flight to safety, US investors selling foreign assets)
  • Money printing (fear of inflation, rising asset prices overall, gold/dow ratio coming back)
  • Covert central bank hoarding being disclosed (foremost China)
  • Diversification, including something benefiting from money printing
  • I wanted to be anti fragile (if there was a crash or other problems, I wanted to benefit from it)
  • Peak gold production?
  • Refill coming at the Fed?
  • Gold becoming competitive vs. negative interest rates

peak gold

 

So far, I only got the stronger USD part right. Nevertheless I am up by 20% on the second gold trade (thanks to the USD/SEK development), and I obviously expect much more to come. My current gold exposure is about 0.5-1m USD.

Please note that buying gold is pure speculation. It doesn’t produce any return. Actually it runs up a bill just owning it.

I simply hope to offload my paper gold to a bigger fool within a few years.

Since I don’t own any physical gold directly, I have no insurance against real and lasting trouble such as war or severe capital controls. Without returns or insurance qualities, only speculation remains.

 

Summary: buy gold now

Apocalypse, no? I’m not much for doomsday scenarios, so I’m gonna go with paper gold, for short term (1-5 years) speculative purposes, rather than physical gold buried at my BOL as insurance for when Game Of Thrones becomes reality.

Buy the ETFs GLD (gold price 1:1) and GDX (senior/large gold mines). Make it at least 5-10% of your portfolio, or a full quarter as part of your Quattro Stagione.

Stay away from GDXJ, unless you really like to gamble with your money. I made good returns on my GDXJ the last time round, but I still don’t want them this time. The same goes for single stocks like Goldcorp (GG) and Agnico Eagle Mines (AEM). There is nothing wrong with them, and I bought them and profited from them in the previous round, but I’d rather diversify away the company specific risk. I currently own GLD and GDX.

Why? Winter is coming.

gold cap 2

Seriously? China is hoarding gold, stocks and bonds are due for a collapse or at least a serious correction, while gold is due at least a bounce after its 40% correction since 2011. In addition, gold is the ultimate debt-free safe haven in a world of monetary madness and crazy leverage upon leverage.

gold just do itJust do it

 

It’s different this time – can you profit from it?

PICTURE: It's different this time

Summary: It’s different. You’re screwed.

PICTURE: It's different this time

This is what you’re getting into: Endless bearish rambling of historical market performance over various half and full cycles. In short: you’re screwed.

Graphs galore: You’ll also via several charts, learn how things are different this time – and not in a good way. Debts, profit margins, sentiment, volumes, algo trading, money printing, inflation, price moves, global synchronization, junk bond issuance, stock buy backs, valuations, fiscal and monetary stimulus in the U.S. and abroad are all at historical extremes. Normalization or a full pendulum swing would spell disaster.

Central punks: At the heart of it all sit the central banks, not least the Fed, and their financial repression, pushing savers into overpriced risky assets and inflationary consumption behavior. Zero interest rates have papered over unsustainable debt levels and hollowed out the economy through malinvestments. What’s left is record folly on all accounts, sometimes seemingly appearing to support the house of cards it really is, but is tantamount to having run over a cliff (but not yet plunged) or lifting yourself by the hair.

No silver lining: I offer no solutions (except maybe the one about creating real value, and the other about how to get 20% return per year and an extra marshmallow), no way out, but to wait and hope it’s not too different this time and that there’ll come a decent investment opportunity down the road

Crazy or delusional – your choice

In the previous post we explored a handful of ways to build an investment  portfolio. 3 out of 4 basically meant throwing in the towel, closing your eyes and just go for it. The fourth takes a delusional mind, thinking it actually is possible to time markets.

Markets will move. Will you?

There is no doubt that markets do move significantly up and down.

Everybody knows markets sometimes halve in value and single stocks fall by 75-90% or go out of business completely. Nobody is oblivious of the fact that markets dropped by around 50% twice in just the first decade this century.

It’s just the timing part that’s difficult. Most resign before the task and simply buy, hoping it’ll work out okay over time – fully aware that there will come a halving in fortune sooner or later. Others, retarded types like yours truly, still believe it’s better to wait for good (better) opportunities to buy, i.e., practice market timing. In particular after 6 years of rising prices.

It’s the ratios, stupid

It’s not that stocks have to go down nominally, it’s the valuation of probable future cash flows that I have a beef with. I can pay a million dollars for a steak as long as I get a billion in monthly pay. Likewise I’m happy to pay 500$ per Amazon share, as long as prospective annual free cash flows average at least 35$ per share.

Stocks and markets fluctuate between cheap and expensive, and I want to buy cheaply even if it means waiting. There is never a hurry to invest. Opportunities will cycle back. Presently, ratios between pay, prices, profits, sales, debt, risk etc. are more out of whack than usual, leading to the conclusion that…

This time it’s different

I’m not joking. It is different. To see how so we first need a little perspective (even if I think 20 years is too little to truly get perspective on the stock market).

Sure, the 2000 peak in S&P 500 was followed by a 50% plunge, and the 2007 peak ended even worse; setting a lower low in 2009 than in 2003. And, yes, for the 13 years between 1996 and 2009 the most important stock market index in the world got nowhere.

However, the market soared gloriously in between: +250% from 1995 to 2000 and +100% from 2003-2007, not to mention the most recent tripling (+200%) since 2009.

7.5% real return per year

A long term investor that got in right before the central bank-propelled rallies started in 1995, was rewarded by a nice and round +350% increase in (real, assuming dividend=inflation) value over just 20 years or 7.8% per year. Let’s call it 7.5% (since actual inflation probably was a little higher than the average dividend yield).

7.5% per year, every year?! Who wouldn’t want that kind of return? Let’s buy some shares right away!

Just a little note of caution: that return was achieved from trough to peak (presumably) over two and a half cycles. It also took us to the current extreme and utterly unsustainable situation (see more below about how it’s different this time). For the complete two cycles 1995-2009 the annual return was ‘just’ 2.5% per year over 14 years.

Can you really get 2.5% per year over a cycle?

Hey, 2.5% is still much better than current interest rates, let’s go, I’m calling my broker now. (I’m obviously talking to an idiot that just can’t get that the 2.5% return was still predicated on buying at the 1995 generational bottom, albeit selling at a bottom too). There are no guarantees whatsoever you’ll get as good a return as 2.5% per year over an arbitrary cycle.

The Retarded Hedge Fund Manager Karl-Mikael Syding SpreZZaturian

Before you make the call, let’s look at negative half-cycles first, just to get a feel for the “worst case” scenario. From the peak of 2000 to the second trough of 2009 the total return was a negative 57% or 9-10% real fall per year for 9 years.

If we happen to be near a peak right now and we experienced a similar 1.5 cycles, your 100 would be worth 43 in the year 2024. Obviously it could be even worse, considering the height of the current peak and that the downturn in 2009 was cut short by remarkable political interventions that will prove hard to repeat.

From there (2024) you would need an increase in value by (at least) 133% just to get back to your 2015 par value of 100. That might be done in 5 years time (just look at 1995-2000 and 2003-2007, as well as 2009-2015) but could also take longer (if investors have wisened ever so little over time and don’t fall as easily for bubble blowing the next time round).

Assuming a historically impressive 10% return per year from 2024, it would take 9 years, i.e. until 2033 for you to get back to your current 100 (if we are near a peak now and history repeats, and you then get 10% per year for 9 years in a row). All numbers in real terms and assuming dividends equal inflation.

Are you ready to wait until 2040 for zero returns?

If the economy would slow compared to trend, or inflation or interests rise, making dividends dry up somewhat your outcome would be worse. And, in case you lost track, that would take us to a new peak and you would be required the wherewithal to sell at that peak after 9 strong years in a row just to bag ZERO return between 2015-2033. Well that is if we even get a 133% appreciation after 2024, AND that the fall from now to 2024 is as ‘mild’ as the 2000-2009 bear market. We might have to go through yet an entire 7-year cycle (2038-2040?) to get to or above the 2015 par value.

Uhhh, you’re so damn negative. What about a peak in the year 2022, what would I get between now and then?

Well, you got nothing between the peaks of 2000 and 2007, despite 2007 being a new all time high, inflated by irrational hopes on the BRICS (Brazil, Russia, India, China and South Africa) – such a peak that it had to be followed by a plunge of 60% in the S&P 500, before the largest money printing (and not least very shady new banking accounting legislation) effort in history managed to turn things around.

And you got nothing (actually a negative return) between the troughs (i.e., full cycle) of 2003 and 2009.

Even buying at bottoms is no guarantee for profits

Yes, true story, even if you bought perfectly at the bottom of 2003, you would have lost money by holding on to your investments for 6 years (I just hope that hypothetical investor didn’t buy anything at higher prices in between).

Today’s peak (if that’s what it is – hint: it is) stands 1/3 higher than the 2007 peak, and since 2007 a lot of things have changed (for the worse)… and I am coming to that in a bit. Hence, it would be quite a stretch to hope for the next peak to surpass the current one, considering how ridiculous circumstances are right now.

Buying at peaks all but guarantee no profits for a long time

My best guess is that, peak-to-peak 2015-2022 will produce a flat to negative return (and possibly much worse if inflation takes hold – not unreasonable given the ubiquitous money printing). But the next peak, in 2030-33 just might reach today’s level :D ! Ahhh, is that a smile I see on your face? Even that, however, would take a creative mind, so let’s aim for 2040 instead. :(

If nothing else, perhaps the pre-singularity reverberations (immense advancements in technology and productivity) will lift stock prices to new highs by then. Or money won’t matter at all, but let’s not assume things will be that different just yet.

But, but, but, you said it was different; it sounds as if you’re expecting exactly the same kind of crashes as after 2000 and 2007.

No, it is different. Just much worse. Here’s how:

As brief as I can be: Very particular and unusual circumstances and set of factors have converged and resonated, to elevate stocks to today’s levels (I will soon get to the point of how it’s different – see charts below).

These conditions are not likely to be repeated for a very long time, thus ruling out consecutive epic peaks like the last three (2000, 2007 and 2015), delaying and diminishing coming peaks (2024, 2032, 2040).

Quite to the contrary, these simultaneous overshoots will undershoot, possibly synchronized, to create a generational bottom before normalizing (meaning, recovering from the bottom, but not approaching bubble-like peaks for a while – you really shouldn’t count on every peak being the stupidest bubble ever).

I don’t care if I sound like a broken record. This is how I see it, and if I don’t tell it, then who will? Sure, I’ll play the mentally challenged for some time, but I’d rather look like a fool before the event than after.

Buy stocks if you want, there could be 2% in it per year until 2030 or so

-if that peak turns out as insane as this one

Also, I don’t mean to discourage anybody from buying stocks (yes, I do). I just want to set the record straight, to make sure you know what it is investors actually got from the market historically and under which conditions.

It’s all to easy to see nothing but the recent 200% surge (20% per year for 6 years), or 7.5% annually since 1995, and extrapolate from there, despite even veteran buyers from 15 years back just got 2% per year on average by holding on all the way up to today.

Bull talk: +3.5% per year until 2023 – any takers?

One bullish note, before moving on to the “this time it’s different” charts: If you start buying carefully now, and throughout the downturn and recovery, you might achieve an average price 25% below current levels by the time we hit the next peak (well, if it reaches the current crazy levels).

That’s not too bad; it could amount to +33% return over let’s say 8 years, or 3.5% per year. Just don’t be fully invested right now, but aim for averaging over the full cycle (remember you have already abandoned all hope of timing cycles, so don’t expect to think differently at the bottom).

Everything that’s different

Finally, here it is – everything that’s different.

Debt

All that really needs to be said is that there is more debt and credit sloshing around than ever before. Sooner or later the piper needs to be paid, and there just isn’t enough assets to go around. Once selling starts, the higher the debts the worse the eventual fall.

Stock purchases are financed with debt. NYSE margin debt is at its all time high (downturns in levered long trades do not bode well – selling begets forced selling and so on). Margin debt has tripled since 2009 and is higher than the peaks of 2000 and 2007. Is anybody paying attention?

nyse margin debt until January 2015

Money printing has lifted spirits and leaked into markets in an unprecedented manner. Fed’s balance sheet has quintupled since the last downturn commenced. That’s 3.7 tn dollars extra. There is a long way down for both the economy and stock markets, if the monetary support wanes (keeping it up is also risky; inflation, dollar crash, import and other trade issues).

fed balance sheet 2015

Japan has truly gone full retard (“if 20 years of QE doesn’t do it, let’s try harder…”)

Fed and other CB balance sheet

Household debt and corporate debt are also at highs, leaving total debt at dizzying heights How does 60 tn USD sound (3.5x GDP)?

total us debt 2015

debt to gdp

There is nothing wrong with debt in itself. As long as the debt is used to finance productive investments that return more than the cost of debt (risk adjusted) you should borrow.

However, when interest rates are close to zero, investors, politicians and entrepreneurs turn to ever lower quality projects and the ratio of value-destroying malinvestments increases.

Corporations are issuing more “high yield” junk bonds than ever and they are using the money for stock buybacks and other poor investments. This practice is building a house of cards of stocks with elevated valuations and companies with high debt that can’t be serviced at normalized interest rates.

Interest rates

They have never been lower. In many places interest rates are even going negative now. What’s really different is that it’s happening at a peak of a business and stock market cycle. What’s supposed to happen in the coming downturn?

The downturn surely will exhibit some different features this time, considering the starting point with maximum debt and zero interest rates.

Banks often run into trouble in downturns, in particular after debt binges. Then tax payers bail them out, adding to the national debt. This time that would occur on top of already record high debt – levels that many already consider unsustainable.

interest rates 3000 years uk interest rate 1694-2013

Can this situation with zero interest rates last? What incentive does anybody have to save (which is needed to invest)? Hardly anybody wants to save and many are led to speculate/malinvest, eroding the real base and growth potential of the economy.

Even the Japanese have stopped saving. That’s different this time. Instead the BOJ has to buy all the debt the Japanese treasury issues.

jap saving ratio

Here is what has happened everywhere:

Bailouts and ever lower interest rates created the impression of very low risk. Investors consequently piled on more risk, pushing up prices on assets (like the stock market). This in turn made stocks seem like the only game in town, almost forcing everybody and their dogs (not my Ronja though) to abandon zero interest bank accounts and treasuries in favor of stocks, pushing the market even higher.

Low interest rates, easy loans (car loans, student loans, mortgages) also fueled consumption despite stagnant wages (the median wage is still at the 1998 level in the U.S.). Hell, you wouldn’t want one idle cent at a zero interest account when everybody else were making big bucks on Apple shares, so you went out and bough a couple of iPhones and some Apple stock. Everybody did that.

Real Median Household Income

This has made sales and profits look better, has caused corporations to hire more people (poorly paid, and part-time, but still hired) and push down official unemployment numbers. With a job it’s easier to get a loan and shop more…

So, low interest rates have made fundamentals (sales, profits, employment) look better while at the same time pushing up valuation multiples (P/E 10 has gone to 17) of those fundamentals through debt financed buybacks and panicked investors feeling left behind.

 

In the background debt has silently been piled on debt – unnoticed due to near zero interest rates, and borrowed money has been used for consumption and poorly considered investments that will turn sour when interest rates rise or consumers become more fearful.

The climb to the peak continues, as long as risk aversion is low, as long as returns are positive, as long as interest rates are low, as long as debts can be serviced (requiring a solid job market and low interest rates or at least rising stocks).

A system fraught with fingers of instability

The lower the interest and the higher the debt (both are at new historic extremes) the more sensitive the system. The more uncertain and poorly paying jobs (stagnant wages since 1998, albeit higher than 2009; real underemployment at the highest level in decades) and the more interest rate dependent the economy (debt financed consumption, debt financed companies and projects), the more sensitive the system.

Underemployment is at highs:

underemployment

Usually debt ratios are low and interests rates high before a downturn. In a slowdown interest rates fall, mitigating the debt burdens. Some debtors still default but thanks to the low starting point the resulting debt level isn’t disastrous. This time it’s very different:

Leaving new monetarism and extreme QE aside, any little thing could topple the current situation. Falling stock prices could trigger an avalanche of stop losses and more sell orders.

If investors demand higher interest rates to buy treasuries (as they rightly don’t like the money printing that’s eroding the dollar’s value), the government would need to tighten its budget and lay off people. Squeezed consumers (living off loans) would spend less due to lay-offs and higher interest rates, causing the private sector to streamline (more lay offs…).

Did I mention the market didn’t care about easier money the last two market crashes? (charts from Hussman, showing how the Fed eased all the way down)

fed easing and market plunge fed easing and market plunge 2

Corporate profit margins are at all time highs. Over the last few hundred years, profit margins have been strongly mean reverting due to competition and wage cost/disposable income dynamics for costs, sales and profits.

Picture: Real profit margins over time

Right now automation and cheap loans (fueling consumption, i.e. sales, and reducing borrowing costs for the companies themselves) have enabled more sales and higher profit margins from fewer and cheaper employees. In addition, banks are the biggest beneficiaries of all, since they make their living on debt and there is record amounts of it to go around now.

Actually, the digital era that started in earnest 20 years ago, but accelerated further 8 years ago with the milestone product the iPhone, has meant faster churn among the Fortune 500 companies (companies leaving the list), not to mention much higher brand disaster risk (the risk of a 20% drop in brand value in a single quarter over a period of 5 years). This should mean less barriers to entry, more competition, less pricing power, lower margins over time, shorter company and production life spans. This sounds really stupid right now (at current record high margins), but corporate margins should undershoot their average level significantly going forward.

Google, Apple and Amazon might seem invincible and eternal right now but so did Steinway and Kodak at one time.

Valuations are higher than ever (median P/E, EV/EBITDA, P/S, e.g.), based on record high margins expected to last forever, based on low interest rates and only very low-yielding direct projects left on the table all but forcing money into stocks instead (at any price, to not be left behind). Oh, and record buybacks as well (debt-financed at record low interest rates).

Median PE

 

Picture source

When growth falls, profits undershoot, interest rates normalize, buybacks dry up and the public’s penchant for stock market speculation diminishes, valuations are likely to undershoot too. Well, they have to unless the historic average has shifted upward permanently.

It’s different (right now). That doesn’t mean it will continue to be – it usually doesn’t

Valuation charts

Picture from zerohedge

 

Chart from Hussman that shows probable forward looking annual returns:

hussman weekly comment stock valuation march 2015

All lines ending in 2015 project the expected annual return over the coming 10 years 2015-2025. Right now it’s around 0% total nominal return per year, meaning the S&P 500 index is expected to be lower in 2025 than today and the difference made up by dividends. The line ending in 2005 at around 8% is the actual 10-year average annual return over the 10 years 2005-2015. That’s about twice the projected level of 4%. Historically such unexpected overshoots have been followed by periods of undershooting the projection. A repeat would mean much worse returns than the projected 0% per year, over the coming 10 years.

As you can see, debt and interest rates infiltrate every corner of the economy and feeds on itself, giving rise to more consumption, higher profits, more speculation & buybacks and higher valuations, while undermining the real economy (lower growth potential ahead) with negative return malinvestments and speculation instead of innovation, investments and production. 

Forward Price Earnings ratio is at highs

SPX forward PER

At some point between the current extreme and a future point, it’s possible that the economy, sentiment, sales, profits and valuations all undershoot at the same time.

If not, it’s bad enough if they normalize at the same time. Heck, even if only one variable normalizes or undershoots over the coming 3 years, stocks are in for a deep dive. In fact, if markets were free to find the clearing price for interest rates, the other variables would normalize automatically

How did we get to this extreme situation, where all important variables have ended up in la la land?

  • The Fed’s money printing and ZIRP (zero interest rate policy) have fueled both profits and various forms of speculation, driving reported unemployment lower, profits higher and valuations higher
  • Bail-outs causing moral hazard (excessive risk taking since you’ll book the gains and tax payers the losses).
  • Algorithmic trading (most don’t care about absolute levels, meaning stocks can drift arbitrarily far from fundamentals)
  • Record world participation: China, Japan, the US, UK, Europe, Brazil, Russia – every major economy is stimulating their economies at the same time. The developing world is more important than ever thanks to two decades of high growth. The flip side is that the entire world is facing the same problems at the same time. The strong comeback 2003-2007 depended on the BRICS (not least infrastructure [stimulus] spending in China, Brazil’s and Australia’s commodity boom and Russia’s oil bonanza). That trick is spent now. That’s what’s different this time.

Stock market volumes are dominated by algo trading, HFTs. Some estimates point to 70-85% of all stock market trades being done by autonomous computer programs. Measured as the number of placed (and withdrawn) orders it’s more like 99.99%. It’s not real money out there, don’t try to make sense of what’s happening. It’s just machines playing games with each other.

Much of the remaining 15% real money trading will disappear too if/when algo trading collapses. Despite all computer based trading, volumes are shrinking. And try to fit the 15% real money in these charts:

volume stockcharts

 

NYSE-Total-Volume6 NYSE-volume-chart seeitmarketcom volume

A week ago, one HFT firm (A) filed a suit against another one (B). The suit was based on firm B’s market manipulating algos hindering firm A’s algos from manipulating markets in its desired fashion.

As another example, a few years ago a person was charged with tricking a market manipulating algo into making mistakes that the person thus benefited from.

We can see the HFT presence in the record high frequency of “market breaks” when exchanges crash.

Other different or ominous developments:

The oil price collapse

oil price 5 years

The Baltic Dry collapse to all time lows

Baltic Dry 522

Record bull advance (length, height). There is a limit to how long investors can become more optimistic every day.

Rally is long in the tooth

US macro surprise index

On the bright side (no irony) the US economy can only surprise less negatively going forward

macro surprise

Record low number of negative investors

-that’s why stocks have been able to climb so far. Bears have converted to bulls. But it’s no indication of further increases – quite the opposite.

bears 20150216_bears

Record weak China house price development

china house prices

Record high junk bond issuance

Of course companies issue as much junk bonds they can during this search for yield phase. Wouldn’t you? It’s basically money for free. Some saturation can however already be discerned – signalling increasing risk aversion which often is followed by plunging markets.

Junk bond yield signals are not so different

hy credit and spx 18 marh 2015

This chart is simply too stupid. Nobody is that crazy:

buy and sell

The USD (DXY index)

Paradoxically getting stronger but first and foremost more mobile – be careful when currencies move faster than usual.

Oh, it’s different

To summarize, it’s different alright; much worse, volatile and inherently unstable than earlier pre crash episodes. In short, it’s the worst time ever to invest. Hussman’s chart below shows (vertical lines) when his thoroughly back-tested ‘ensemble’ of valuation and timing methods have signalled strong sell. Q1 2015 is worse than ever.

never been worse time to invest

Taxes next?

The Fed can’t keep funding the deficit, since the dollar would collapse sooner or later – causing all sorts of hell (imported inflation, energy crisis, trade wars). They can go on for a long time, but not indefinitely.

Hence, either inflation erodes savers’ money in order to get debt/gdp under control, or increased taxes will have to deal with the primary deficit problem – unless the U.S. wants to default (unthinkable?).

Perhaps increased taxes (they are at lows), or cut in welfare spending (unlikely), will be the proverbial straw on the camel’s back? Well, better that than revolution or war as Paul Tudor Jones warns.

What to do?

I’m waiting. Shorting and waiting, hoping the fall won’t be too cataclysmic or different (or take to long to get going, which could be the same thing).

If you can’t stand waiting, I unfortunately have very little comfort or advice to offer (see previous post for some more or less desperate possibilities).

Build real value:

  • Have fun and live now, before the feces hit the air conditioner. Happiness is real.
  • Invest in yourself (skills, experiences, fun) – prepare for the next round
  • Build a business, a real business – not speculation. Make other people’s lives better and you’ll make a profit.
  • Make sure your debt is strategic, not just built on hopes of eternally low interest rates. Amortize, fix the rate for 5-10 years, use the money for real value building investments, not a bigger house or consumption.
  • If you feel you must invest, buy something others don’t. Look among the losers and the small, not the hyped giants. Imagine you buy the entire company and take it private, actually getting its cash flow, not just hoping to sell the stock at a profit to a bigger fool.

Stocks, bonds, metals, commodities – forget it, you simply won’t be long term enough to stand the downturn that most likely is just around the corner. If you are thinking about being fully invested NOW, you most likely will be all out 50-60% down from here.

Silver lining

There is always a silver lining. If you can handle waiting for a normal time to invest, you should get 10% per annum for quite a while after that. Markets almost always dip below levels that promise that kind of returns for a decade.

If you are lucky enough to wait out an epic bottom (don’t hold your breath though – even if I think that’s exactly what’s coming) you could get twice that for several years.

If you can be different, if you can wait, you’ll get two marshmallows instead of just one. How’s that for being optimistic?

Are you too ‘smart’ to short the market? Then do this

Unlike most smart investors, financial pundits, TV commentators…

 

…and not least my eloquent friends at Wall Street Playboys,…

 

I do time the stock market, and I don’t shy away from making my recommendations or investments public.

 

Right now every fiber in my body screams to short the stock market:

  • Risk aversion is on the rise (seen in general market dispersion, chaotic and nervous intraday patterns, loss of trend uniformity, increasing High Yield spreads) and any little event could topple that first crucial domino that sets off the rest. The whole market is nothing but an unstable pile of fingers of instability.
  • The rally is extremely long in the tooth and some robot traders could just as well take that as a cue to try the downside (NB: 80% of the trading is automated robot trading)
  • Oh, did I mention the US stock market is the most expensive it has ever been (on some measures, and just 10-20% below the epic peak of year 2000 on others)? Swedes hoping for a safe haven in dear old Stockholm should note that the OMX index usually mirrors the US indices perfectly in downturns, no matter if OMX lagged a little before.

The stock market in a nutshell (pic from Hussman)

Why you should short stocks

Directly from Hussman, just as the picture above: The yellow shaded areas show points where credit spreads might be defined as “rising.” For simplicity, I’ve shaded all points where credit spreads had advanced 90 basis points from their 6-month low, and were greater than their 150-day moving average. Observe that the steepest losses we’ve observed in the S&P 500 in recent decades have been concentrated during those periods of objectively widening credit spreads. I’ll say this again: low and expanding risk premiums are the root of abrupt market losses.

The purple shading identifies only a subset of those points that also match the market return/risk profile that we currently observe (basically identifying recently overvalued, overbought, overbullish conditions that were then joined by deteriorating market internals or widening credit spreads).

 

But, I get it, you just don’t want to short the market. It seems immoral, dangerous, unnatural… You’d rather just wait for a good buying opportunity – and you don’t want your money to sit idly on a zero per cent bank account meanwhile.

You could copy my strategy, which is to slowly accumulate investments that have already become somewhat cheap (but, as always, risk becoming cheaper, much cheaper, further ahead) and trade others opportunistically (I like gold and currencies, since they don’t really have ‘intrinsic values’ like stocks. That makes it easier to disregard the dangers of picking unknown pennies in front of an unknown bulldozer)

 

So, what am I doing exactly? I mean, I have retired, I am officially a retarded hedge fund manager. I could live splendidly off of my capital for the rest of my life. However, as the retard I am, I want to prove that I am right. Just saying I said so afterward simply isn’t enough. I want to make some money too.

 

Except for my big short (which is waaaaay under water) on the Swedish stock market, this is what’s currently in my direct financial portfolio (except apartment, pension funds, private companies like the publishing company and the floating sauna company, russian art etc.)

 

  • Software as a service: A convertible loan and a sell option in a Human Resources software company – if things look okay, I’ll convert to shares and later use the sell option, if they look really good, I’ll convert and keep the shares for a while. If things turn really ugly, I’ll end up with a large mansion in the countryside
  • Cash at the bank (dry powder)
  • Loans to friends (not that dry gun powder, but perhaps I’ll get to call on these when the time comes – at least they stick to regular amortization schedules)
  • Gold (albeit “paper gold”) SPDR Gold shares ETF – gives me some USD exposure as well as some insurance against Yellen’s next move (+21% so far on this trade)
  • Gold mines (senior = actually producing gold) Market Vectors Gold Miners ETF – like above but with more juice (+24% on this trade so far)
  • USD 3x leverage – I halved my position in the USD yesterday (75% profit in a year) but still have a fair amount left. The Swedish Krona, SEK, usually falls in times of trouble. If China falters probably doubly so due to Sweden’s export dependency to Asia. The USD on the contrary, despite all its shortcomings, is the safe haven of first choice for most investors (incl. americans themselves selling foreign assets). The Fed might even consider raising rates this year which I can’t see any other central bank doing.

Smaller investments and speculative short-time bets (oil):

  • Creditsafe – small unlisted credit service company, provides credit quality information on companies and private individuals
  • Oil (Brent) 5x Leverage (entered today )
  • Peptonic medical – oxytocin pioneers (very small investment)
  • Opus – small investment (testing services and testing equipment mainly for the auto industry – hopefully a secular growth story, the share price has recently halved and that’s why I stepped in. However, the shares will likely fall a lot more before this is over)

 

My suggestion to you (except shorting stocks) is:

  • Invest in a business (your business perhaps?) or learning a skill
  • Keep cash ready for opportunistic buying in the case of a (flash) crash
  • Think outside your geographic region (stocks, currencies)
  • Slowly, slowly accumulate stocks that really excite you and have become forgotten by other investors that chase a shrinking pool of rising large caps
  • Consider buying things like gold or oil, but do your homework first, don’t just follow my lead