THE LONE BEAR LETTER
Or “WHO ME WORRY?
Carl M.Birkelbach
1/23/2015
Dow:17,672; NASDAQ:4757: S&P 500 2,051
After reading all of the 2015 predictions, I realize that I am one of the few people who have not become bullish on the US stock market. All looks well on the surface, as US GDP growth for 2015 is forecasted to be up 3% to 3.6% and corporate earnings are expected to grow some 9%. Sorry, I just can’t go along with all the hubris, hype and cheer. Current metrics have yet to be a measure for forecasting the future of stock prices with matrixes and algorithms. That’s why bubbles and market crashes are surprises!
In September 1981, I called myself ‘The Lone Bull’ and predicted that the Dow would go up from the then Dow Industrial’s 1000 area to above 10,000. That was fun! However, now, I have to call myself ‘The Lone Bear’ and it is, ‘lonely’. Nobody wants to hear the negative scenario about the United States or world economic conditions. Let’s face it, a Bear Market, could only help Wall Street professionals traders. Everyone else, if you are not prepared, will suffer. Like Pavlov’s dog, investors have become trained for the last five years to ignore setbacks and negative factors. However, all stock market upward cycles come to an end and usually with a surprise. In 2000 it was the dot com bust; in 2008 it was the housing bubble. Both times the markets fell 50%. For the reasons below, I believe that there is a possibility that the downside of this Bear Market could see the Dow down to between 12,000 and 10,750. I hope I’m wrong, and I will update this Lone Bear Letter as conditions dictate.
My bearish scenario centers around three areas of endemic problems that could escalate. I continue to be concerned about 1) the US economy, when all the income growth is going to the top 1%, where some reports show the top 1% in the world own 99% of world wealth and where worldwide ‘deflation’ seems a more likely scenario that inflation; 2) where the negative effects of this economic slowdown and resulting deflation, would expose the vulnerability of the ’high yield’ bond market and therefore the balance sheets of the banks, particularly now that the regulations of Dodd/Frank are being diminished by Congress and 3) and the possibility of disturbances by terrorists affecting world economies. I will offer an Investment Strategy below and continue updates at my bloghttps://investmentstrategiesblog.com/ to cope with what I expect to be, a very volatile environment for stock market investors.
1) Concerns About the US and World Economies.
ALL INCOME GROWTH TO THE TOP 1%
My first concern is about the US and world economies. In the US all income growth in the last 15 years has gone to the top 1% of the economic ladder, whereas wages, adjusted for inflation, are down 4.3%. It is estimated by Oxfam America that the top 1% in the world own 99% of total world wealth and most of that belongs to the 0.01%, as worldwide only 80 billionaires control 50% of the global wealth (they own more than 3.5 billion people in the bottom half). There is nothing wrong with accumulating wealth; however, the excessiveness of wealth accumulation could have a stifling effect on the US and world consumer based economies and could make future economic growth unsustainable. The cause of this great wage slowdown and shifting of assets to the very rich has several main causes: 1) Globalization has forced many American and Developed Country’s workers to compete with worldwide poorer workers, who are willing to accept lower wages. 2) Computers and modern machines are replacing human labor in numerous ways. 3) The rest of the world has become more educated and more highly skilled than the US, which ranks 39th in basic education, according to the latest Social Progress Index. 4) Economic and political power (through political contributions) has been switched away from workers and toward billionaire entrepreneurs, corporations and high paid executives. 5) The very nature of the Internet makes pricing extremely competitive and thereby squeezes profit margins, causing companies to trim work force expenses in order to maintain competiveness. The proposals that the President made at his State of the Union Address on 1/20/15, for ‘Middle Class Economics’ have in my opinion, no chance of passage in the Republican Congress. Because of these factors, instead of all boats rising, this scenario isn’t good for anybody and it is possible that as in the 1930s depression, all boats will sink. After all, how many bars of soap and how many cars can each of the wealthy people buy? These excessive conditions, in my opinion, are taking the breath out of the economy, are shaking its base and have yet to be seen in the metrics.
Under the current circumstances, the middle class in the US is being diminished. Minimum-wage and low paying or part time jobs, do not support a family. Although the official US unemployment rate is under 6%, the unofficial rate including those who have given up looking for work or have settled for part-time jobs, is closer to a 12% unemployment rate. In the lesser developed countries, the middle class is rising. However, in my opinion, the growth of middle-class in Undeveloped Countries cannot offset the economic stresses worldwide that the middle class are enduring in Developed Countries. The unemployment rate in Europe is officially set at 13% and some countries like Greece and Spain have an unemployment rate above 25%. The economic growth rate in Europe and Japan is negative, with China slowing (the slowest growth in 24 years). There once was an old saying that said ‘As General Motors goes, so goes the country. A recent appropriate statement might have been to say ‘As the US economy goes, so goes the world economies.” However, I believe that currently, worldwide deflationary conditions may be too strong for the US economy to pull up the rest of the world. Instead, I believe a more likely scenario is that a worldwide slowdown and deflationary conditions together with the breath being taken out of US consumer economy by all income growth going to the top 1%, will have the effect of stifling US economic growth and thereby accelerate a worldwide economic slowdown. .
DEFLATION NOT INFLATION
In the last days of 2014, the Dow’s shot up 1100 points to a Dow above 18,000 on the news that the Fed would be ‘patient’ in raising interest rates. Analyst, took this to mean, that rates would not go up for a considerable time, some say mid 2015 or later. This Fed announcement temporarily eased investors anxieties, as there has not been an interest rate hike since the 2008 financial crisis. There is a concern, that any interest rate increases, would stifle fragile economic growth. The Fed has done everything it can to cause inflation, including near zero interest rates, and printing money, using quantitative easing (QE), to the tune of 3.5 trillion dollars. Despite this stimulus, the inflation rate in the US is only slightly over 1%. The Fed can handle inflation, because it means that they can pay off debt in the future with inflated dollars, such as they did after World War II. However, deflation is another matter. With interest rates close to zero and as the Fed has already stimulated the economy with QE bond buying, there appears little likelihood that, should deflation raise its ugly head, the Fed is in a position to stimulate the economy with further Fiscal Policy. There also seems to be little possibility that Monetary Policy stimulus would occur, as a conservative view now dominates our Congress. Under a deflationary scenario, tax revenues would drop and deficits would get larger and harder to pay off with deflated dollars. As stated above, I believe the US is going to have a problem with economic growth. The working poor, in my opinion, in the US, under current conditions, cannot support growth of US consumer based economy. As mentioned above, economic growth in Europe and Japan has stopped and growth in China is slowing. We are all interconnected. I have a fear that lower oil prices and lower prices of other commodities such as copper, indicate that world economies may be headed into a deflationary spiral which could have a major effect on the US economy, which could have a devastating effect on bond prices and thereby put bank balance sheets, once again in jeopardy.
2) Concerns About the Bond Market and Bank Balance Sheets
DEFLATION AND DEBT
On the one hand, consumers are reaping the benefits from cheaper oil prices paid at the pump, but on the other hand, investors are weighing whether falling oil prices are symptomatic of deflation in a lagging global economy. Countries like Russia, US States like Texas, energy companies like Schlumberger (which just laid off 9,000 employees) and national oil companies like Petrobras (Brazil), depend upon the high price of oil to sustain their budgets and bond payments. They are in trouble. The 10 year bonds of most countries, on average, yield approximately the nation’s inflation rate. In the US the 10 year bond has fallen to a low of 1.8%, and the 30 year US bond is down to a record low 2.4%. Nations worldwide are trying to stimulate their economies. However, Europe is already in a deflationary spiral even though it is now trying to stimulate its economy. The 10 year German bond is at 0.44% and Japan’s (already facing deflation) 10 year bond is even lower at 0.28%. The low rates are the result of fear of deflation. The European Economic Community’s inflation rate is minus 02%. At the time of this writing, the European Central Bank announced a stimulus plan to launch a 1.3 trillion euro bond buying program, similar to the Fed’s QE program. The influential Mohamed A. El-Erian of Allianz said, “But this is insufficient to deliver a growth breakthrough and comes with the risk of collateral damage and unintended consequences.” Like the decline of the Euro? In a surprising move, Switzerland allowed the Swiss franc to trade freely against the euro. The Swiss National Bank lowered its key interest rate to go into negative territory from negative -0.25% to -0.75%. At this time, there are also negative interest rates on short-term government bonds in Belgium, Denmark, France, Germany, the Netherlands, and Japan. In effect, that’s like charging customers to park their money, instead of paying them interest. Apparently, these countries are trying their best to get people to spend their money and stimulate the economy, instead of investing their money in banks or other cash like assets. The surprise action by the Swiss initiated some very interesting quotes from the CNN Money web site. A representative J.P. Morgan said “It’s a glaring warning sign of deflation.” Nicholas Colas of ConvergEx said “As a Central Bank you have to manufacture inflation, otherwise the wheels come off of the whole construct.” The Swiss franc news caused several foreign brokerage firms to go under and a leading US foreign exchange broker FXCM to have its equity wiped out by the “unprecedented volatility” and is seeking alternative financing. These things can happen unexpectedly fast. Remember Lehman Brothers? Deflation can be a self-sustaining cycle, which may be difficult to stop. As explained earlier, deflation is not good for paying off debt and the world is awash with debt. The world economies are trapped in a world of high debt, low rates and slow growth and this debt is only sustainable at very low rates. The US is not immune. Should interest rates increase because of financial and economic instability and lack of liquidity, there could be a crisis in the bond and currency markets. In the Great Recession, derivatives and mortgage bonds priced to the market devastated bank balance sheets and necessitated a bailout. The oncoming crisis I perceive happening, could even be worse than that Great Recession and mirror the 1930’s Depression.
DEFLATION AND INSTABILITY
Petrobras in Brazil, Pemex in Mexico and Gazptom in Russia, sold billions of dollars of bonds to investors looking to receive high interest rates. Petrobras has $170 billion in debt, making it the most indebted company in the world. Trouble with these nationally run oil companies, could cause worldwide investment growth to slow, leading to other corporate bond defaults. The bonds of non-oil producing countries like Turkey, India and South Africa, have already suffered, as anxieties have caused selling in other emerging markets. Since 2009, $1.7 trillion of emerging market bonds have been sold. The Russian stock market is down 50% and the rubble has crumbled. Russia’s Central Bank had to bailout the Trust Bank. This is the first major lender to fail as a result of the sharp decline of oil prices and the ruble. This will cost the Russian government approximately $2.5 billion and is far more than previously anticipated. Other Russian banks are also expected to need bailouts as a result of the recent crisis. Russia has announced that is going to use its $88 billion reserve in its Sovereign Wealth Fund to help bail out the ruble. An unstable Russia is not good for the world. Other oil-producing nations like Venezuela, Brazil, Iran and Mexico may find that their banks may also need a bailout. Lower oil prices are also having their affect here at home, where Texas, Louisiana, Alaska and North Dakota will have State budget problems and economic slowdowns. Even Saudi Arabia is being affected by lower oil prices, as it takes oil at $104 a barrel to balance their budget, where they have no income taxes.
LIQUIDITY PROBLEMS WITH BOND FUNDS
The problem is further multiplied by public holdings of emerging market mutual bond funds and exchange traded funds, which cannot liquefy their bond portfolios as quickly as the shareholders can sell. The investors who hold these high-yielding funds have immediate liquidity. However, the managers that hold these funds in high-yielding bonds, have far less liquidity. It is said that PIMCO owns close to 50% of many foreign bonds and controls over 40% of the debt issued by the bank of China, 40% of the State Bank of India and close to 30% of some Spanish banks. In some exchange traded funds, like widely held BlackRock, they have 9% of its funds in government owned oil companies. These bonds cannot be sold quickly. The Petrobras, 10 year bond has gone from 6% to 8% and Pemex bonds have gone from 3.8% to 4.8%. The selloff in these bonds could quickly turn into a panic and a domino effect could occur, as managers sell more liquid bonds to meet redemption demands. To some extent the panic has already started. However, its international economic implications have yet to be recognized. ‘Junk Bonds’ can very quickly become the new name for these ‘high-yielding bonds’. Remember, markets hate the lack of liquidity. Our US banks are loaded with bonds and derivatives. If the stock markets worldwide start to decline and short-term money suddenly dries up, there could be unforeseen difficulties dealing with a bond/currency crisis that has the potential to cause panic selling and a worldwide economic crisis.
ELIMINATING and DELAYING DODD/FRANK
Congress is delaying and taking the teeth out of the Dodd Frank amendment. The Dodd/Frank amendment was passed by Congress, to prevent another bank bailout, such that occurred in the Great Recession. A January 10, 2015 an article in the New York Times by Gretchen Morgenson is entitled KICKING DODD/FRANK IN THE TEETH. If you recall Gretchen was the first one that saw the weakness in mortgage bonds before the 2008 collapse. She points out that Congress is seriously weakening the Dodd/Frank amendment and risky bank activities, may once again endanger economics stability. In December, Congress, as part of the budget agreement, reversed part of the Dodd Frank law barring derivatives from being traded in federally insured units of banks. Nobody knows how many derivatives are out there. Estimates range to over hundreds of trillions of dollars. Certainly, there are more derivatives than there is debt. How can this happen? RadioShack for instance has $1.4 billion dollars in debt, with $25 billion in issued derivatives. JC Penney has $8 billion in debt with $20 billion issued in derivatives In addition, a new bill has been put forward on the second day of the new Congress, which chips away at the Volker Rule, which is a regulation, intended to reduce speculative trading activities among federally insured banks. The new bill would give institutions holding ‘Collateralized Loan Obligations’ (CLO’s) two additional years to sell there CLO’S. Like the mortgage pools, that wreaked havoc with the US banks in 2008, CLO’s can pose high risk for banks. The second part of the bill relates to the lucrative private equity industry, which remains loosely regulated. The new bill would exempt some private equity firms from registering as brokerage firms with the SEC. Under securities laws such registration is required of firms that received fees for investment banking activities. Lastly, the new bill limits derivatives information that would reduce transparency and increase risk, allowing Wall Street firms with commercial businesses, like oil and gas or other commodity operations and to trade derivatives privately and not through the clearinghouses. The new legislation represents Wall Street’s attempt to delay or end Dodd/Frank regulations on the banks. The Financial Industry pays over $100 million dollars a year to maintain over 700 lobbyists, to look out for their interests. I see “Big Banks” as public utilities, which have an obligation to serve the public. They cannot do that, if they are not safe.
Under current Dodd Frank rules, US ‘Big Banks,’ known as those that are “To Big To Fail”, are to increase capital requirements. For instance J.P. Morgan Chase Bank, (assets have grown to $2.4 trillion) may have to increase their capital requirements by some $20 billion. A recent report by Goldman Sachs issued on January 5 indicated that the best way for J.P. Morgan (Goldman’s rival) to handle the situation, is to split up the bank. The choice for banks “To Big To Fail” is to either make their balance sheets safer or split up. This is exactly what Dodd Frank rules have been designed to do, which is to decrease the risk to the public. The BIG BANKS are bigger than ever and these rules were to go in effect next year, but now Congress wants to give them a couple more years. By then, it may be too late.
3) THE TERRORIST PROBLEM AND OTHER BLACK SWAN OR ‘BLACK ELEPHANT’ EVENTS
We have all heard of the Black Swan. ‘The Black Elephant’ is similar to the ‘Black Swan’, as it is something we had not expected. However, the differences is, that with ‘The Black Elephant’,it is a problem right in front of us, for all of us to see, but we choose not to see it. (It can also be called ‘the gorilla in the room’ but the New York Times coined ‘The Black Elephant’).
The markets so far have chosen to ignore some really negative factors, which I seem to see so plainly and so far the market just goes higher! I have already explained about the ‘Black Elephant’ effect of investors ignoring the risks of income inequality, deflation, bond defaults, bond mutual fund illiquidity, derivative expansion, delaying Dodd/Frank regulations and the precarious situation of banks that are “To Big to Fail”
I also see a “Black Elephant when it comes to terrorism. The radical Muslim world, has found a new way to terrorize the West. Rather than staging huge terrorist acts, such as 9/11, this new activity of random terrorize acts (such as the Paris attack) and in various places throughout the globe, could destabilize our Western economies. . So far, most of these minor terrorist events seem distant from most of us. However, the events in Paris could happen anywhere: in our local grocery stores or theaters or sporting events. If these kinds of events persist or increase, an economic disruption may occur. Then there is the Big ‘gorilla in the room’ and the ultimate Black Elephant that everyone is thinking about, but not talking about and that is the use of a ‘dirty nuclear devise” by terrorists. Sorry, but in my opinion, I have to mention the possibility of this occurring.
Public unrest is also a concern of mime. In my opinion the riotous activity in such places as Ferguson, is really more ‘social’ than ‘racial’. I am concerned that income inequality may lead to social unrest, which may manifest itself in public outbursts, which could be economically damaging. Lastly, I can’t ignore the effects of global warming on the economy. Last year was the warmest on record with devastating effect in such places as California. The Pentagon has said that they defenseless against climate change and it “presents a clear and present danger’ to the country.
INVESTMENT STRATEGY
The financial industry approves of the Efficient Market Hypothesis Theory (EMHT), which proposes that it is impossible to beat the market by trading in it out and that investors should at all times be fully invested in the market in the aggregate, by owning an allocation of mutual funds, because in the long run the market will go up. The dangerous beauty of this theory is that accordingly, your goals will always be achieved sometime in the future. If you just ‘hang in there’ long enough you will make your money back. This gives investors a false theory of contentment. However, during a very long period between 1997 and 2012, the market was up 50% of the time and down 50% of the time. Also during that period there were two stock market collapses of 50%, one between 2000 and 2003 and the other between 2008 and 2009. The financial industry would have you believe that trying a methodology that uses’ market timing’ is an ‘heretical tactic’. Lately, the EMHT methodology has investors drinking euphorically from the common spiked Kool-Aid trough and believing that the market will just continue to go up and that Bear Markets are a thing of the past. Besides, for those who have a fiduciary responsibility, ‘market timing’, is frowned upon by regulators and the industry. As I said in my opening comment which is worth repeating, “Like Pavlov’s dog, investors have become trained for the last five years to ignore setbacks and negative factors. However, all stock market upward cycles come to an end and usually with a surprise.” My scenario, if correct and if only half right, indicates that this is a dangerous time for investors and in my opinion, is not a time to ‘just hang in there’ and wait out any decline and assume political solutions will upright the ship quickly.
In my opinion, political moves that will solve my negative scenario, will not happen. Since Citizens United, that declared corporations are people (If they are people, they are sociopaths), most changes in government are dictated by donors and election contributions. A recent Princeton study has shown that public opinion has no effect on the outcome of an issue in Congress, whether there is 0% approval or 100% approval, the line of accomplishment is flat-lined. ‘Donor power,’ has taken over the rights of ‘We the people’. Wall Street’s is attempting to delay or end Dodd/Frank regulations on the banks. As mentioned, the Financial Industry pays over $100 million dollars a year to maintain over 700 lobbyists, to look out for their interests. In my opinion, it is an illusion, that voters are being heard. There is a big risk that, since government agencies are not responding to the public, the public may not want to bail out the Banks and their high priced executives, should the need arise again. The Congress, by its inaction of Dodd/Frank is pursuing policies, which I believe, are damaging to the common good.
It is interesting to note that the price of gold is getting some notice, 43 years after Nixon scrapped the gold standard. Gold appears to be reemerging as the centerpiece of a handful of initiatives in Europe, Asia and the Middle East. Russia and China have both made the headlines by hoarding enormous stores gold. In France, politicians are calling for the government to start amassing gold. The Netherlands has asked for its $5 billion of gold bullion, in the vaults of New York, to be delivered to them. Even Islamic states are declaring they want to avoid the financial system of the West, by buying gold. What’s going on here? Holding gold for people and governments reflects the anxieties about the future. Even though it may seem somewhat retrograde to many investors, having gold on hand makes people feel safe. For an analogy of how gold holds its value through volatile economic times, I have noticed that gold sells approximately the price of a man’s ‘good suite’. When gold was at $35 an ounce, believe it or not, a good suite cost $35. Now, a ‘good suite’ will cost about $1,200. If the Fed and world governments peruse an inflationary policy, a ‘good suite’ may cost $10,000 and gold should follow course. However, as I suspect, a deflationary spiral becomes unstoppable, a ‘good suite’ may cost under $500 and gold would probably follow. The point I am trying to make, is that gold holds it buying power and should be considered as an alternative.
I don’t know if, or when, my negative scenario will unfold. I can only say, to me, it is not a time to ‘just hang in there!’ Events can happen suddenly and as a surprise. It is better to be too early than too late.
Carl M. Birkelbach
1/23/15
Investment Strategy Blog 