Investing, Markets

This Indicator Is Still Flashing A Bear Market Warning

The NYSE just released the margin debt numbers for March and, considering the rally in stocks we’ve seen, it wasn’t much of an uptick. In fact, the nominal level of margin debt remains well below its 12-month average.


The 12-month rate of change, which is pretty tightly correlated with stocks’ same rate of change, is also still negative.


Now this sort of a downtrend in margin debt doesn’t always lead to a bear market but let’s put it into some context. Not only is margin debt now in a downtrend, it’s coming off of the highest absolute (top chart) and relative (chart below) highs ever seen.


And if you think if margin debt as a simple indicator of potential supply and demand for stocks (when borrowing is low there is great potential demand and vice versa), this should have you worried about another bear market. And the statistics bear this out.

When margin debt has reached relative extremes it has been a very good indicator of, in the words of Warren Buffett, broad investor, “fear and greed.” To demonstrate, when financial speculation relative to the overall size of the economy has been very low, forward 3-year returns have been very good and vice versa.


What’s important to note today is that margin debt is now in a downtrend and its massive relative size suggests returns over the next 3 years will be very poor. In other words, based solely on this one measure, buying stocks today presents investors with a great deal of risk for very little potential reward.


Fighting Bullish Spin With Data And Analysis

I came across a blog post today over at Dash of Insight. Normally, I enjoy checking in with Jeff’s thoughts here and there but today I have to take issue with something.

In “expensive misconceptions,” he likens a chart of John Hussman’s with things like the Baltic Dry Index and the Hindenburg Omen ultimately concluding these are all nothing more than opportunities for investors to indulge in confirmation bias.


Specifically, he takes issue with the chart in question (above) by writing:

“I have a simple question for you: Could you step up in front of a group of people and explain this chart? If not, why do you believe it? A smart and influential guy presents something that you cannot really evaluate. Why is this a sound basis for your decisions?”

In other words, because “you” (read “he”?) can’t explain the chart, it is simply not valid. To be clear, Jeff makes no attempt to even understand the chart or the concept behind it let alone pose any counterargument to it at all, at least not anywhere in this post.

So let me help him out here by explaining it. This chart is a visual representation of Warren Buffett’s famous words: “The price you pay determines your rate of return.” In fact, this chart is a very close cousin to what Buffett has called, “the best single measure of where valuations stand at any given moment.” That is, the total value of the equity market in relation to GNP, essentially a price-to-sales ratio for the broad stock market.

It’s very simple, actually. When investors have paid high prices in the past, as indicated by the total value of the country’s equities relative to the country’s economic output (including foreign sales generated by domestic companies – one popular critique of the Buffett Yardstick is that it doesn’t account for this), they have received meager and even negative returns over long periods of time, as indicated by the forward 12-year returns on the chart. Conversely, when investors have been able to buy stocks at relatively low valuations, their returns have been very good over the following decade or more.

Furthermore, this negative correlation between valuations and forward returns is statistically very high (greater than -90%) and backed by 65 years worth of data. The Buffett Yardstick, as Hussman demonstrates, has been nearly as good as his own version at forecasting forward returns and is backed by roughly 90 years worth of data. Both charts, and the data and reasoning behind them, clearly demonstrate and validate the concept that, “the price you pay determines your rate of return.”


The only “expensive misconception” here is failing to understand this iron “law of valuation,” as Hussman calls it. Investors who are willing to believe they should reasonably expect wonderful returns regardless of the price they pay will inevitably be introduced to this law over the course of their investing lifetime, as countless others have been in the past. Just ask anyone who bought stocks in 1929, 1937 or 2000, the last three times stocks reached current valuation extremes, according to the Buffett Yardstick.

Finally, I find it terrifically ironic, and perhaps enlightening from a sentiment standpoint, to see Jeff end the piece with this:

“The insightful investor fights spin with data and analysis.”

Because, at least in this instance, it appears he’s fighting robust data and analysis with nothing but spin. In fact, Jeff may be indulging in a bit of confirmation bias of his own:

Confirmation bias, also called confirmatory bias or myside bias, is the tendency to search for, interpret, favor, and recall information in a way that confirms one’s preexisting beliefs or hypotheses, while giving disproportionately less consideration to alternative possibilities. -Wikipedia

“Less consideration to alternative possibilities”? How about none at all?


What Separates Extraordinary Investors From All The Rest?

This post is an excerpt from the most recent edition of The Felder Report PREMIUM:

What separates truly extraordinary investors from all the rest? It’s simple: They are extraordinarily discriminating.

I talk to a lot of investors. Every one of them is looking for that next, great trade. They’re researching, studying charts, reading annual reports and analyzing financial statements, whatever their process calls for, and they should be scouring the markets like this. You can’t expect to reap the rewards of any activity without first sowing the seeds in this way.

The one distinction, however, I notice between average traders and investors (and I’ll use them interchangeably here though they use very different methodologies) and really good ones is average traders put on far more trades than the really good ones do. I’m talking ten times as many trades, at least. Average traders put on trades all the time. They believe they really are capable of finding that many good ideas on a regular basis.

“Charlie and I decided long ago that in an investment lifetime it’s just too hard to make hundreds of smart decisions…. Therefore, we adopted a strategy that required our being smart – and not too smart at that – only a very few times. Indeed, we’ll now settle for one good idea a year.” -Warren Buffett, 1993 Berkshire Hathaway Letter to Shareholders

Really good traders, in stark contrast to all the others, are far more patient. They don’t put on a trade simply because they have an opinion about something or worse, someone they respect has an opinion about it. No. They wait for the perfect setup – the setup that they have profitably taken advantage of time and time again. Until it arrives, they do nothing.

“One of the best rules anybody can learn about investing is to do nothing, absolutely nothing, unless there is something to do…. I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I do nothing in the meantime…. I wait for a situation that is like the proverbial, ‘shooting fish in a barrel.’” -Jim Rogers, Market Wizards

Now this is a lot harder than it sounds. And that’s exactly why the average trader can’t do it. It’s hard to watch potential trades go by and not act on them, especially if they would have been profitable – it’s hard not to kick yourself. And there’s something specific to the American work ethic where we feel lazy if we’re not constantly trying to accomplish something.

“I always made money when I was sure I was right before I began. What beat me was not having brains enough to stick to my own game – that is, to play the market only when I was satisfied that precedents favored my play…. There is the plain fool, who does the wrong thing at all times everywhere, but there is the Wall Street fool, who thinks he must trade all the time.” -Jesse Livermore, Reminiscences of a Stock Operator

Once you’ve found a system, though, that suits your own personality and proves its worth over time, you learn to sit back and wait for everything to line up before you pull the trigger. And I can’t emphasize enough how infrequently this happens. Great investors probably only pull the trigger once for every one hundred opportunities they look at. For some, it’s even less than that.

“Only maybe one or two times a year do you see something that really, really excites you. And if you look at what excites you and then you look down the road, your record on those particular transactions is far superior to everything else, but the mistake I’d say 98% of money managers and individuals make is they feel like they got to be playing in a bunch of stuff.” -Stan Druckenmiller, Speech at the Lost Tree Club

You might just say extraordinary investors are the snobbiest of all the snobs in the marketplace. They turn their nose up to almost everything they see. It’s only on that very rare occasion when something comes along that is so attractive that they simply can’t not buy it that they finally give in. This extraordinary patience and discipline is exactly what leads to the extraordinary returns that set them apart from the rest.

Economy, Investing, Markets

We May Have Just Witnessed A Generational Peak In Corporate Profit Margins

Over the past few years I’ve written a fair amount about the record-high levels of corporate profit margins. I’ve been focused on this topic because corporate earnings are one of the most popular ways to value equities thus the sustainability of record-high profit margins should be an issue of great concern to investors. If profit margins revert to historical averages, earnings-based valuation measures investors are using to justify investment in equities today could quickly go against them making stocks appear much more expensive than they do currently. And this process may now be underway.


To the point of mean reversion in profit margins, in the past I have referenced the words of a pair of investment legends. Jeremy Grantham has called profit margins, “the most mean-reverting series in finance.” And back in 1999, Warren Buffett explained why:

In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. In addition, there’s a public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems—and in my view a major reslicing of the pie just isn’t going to happen.

Both of these two gentlemen clearly believe, and very strongly, that corporate profit margins have an equilibrium. They can rise above or fall below that equilibrium but the very nature of capitalism, along with its social contract, will force an inevitable reversion to the mean.

I believe there are three major factors behind the recent bubble in corporate profit margins. First, and most obvious, is the simple trend in interest rates over the past 35 years or so. As rates have fallen to lows not seen in many generations, debt has become much less costly, especially when you also consider that corporate spreads on top of these ultra-low rates have also fallen to ultra-low levels.


Second, corporate taxes as a percent of income have been falling for a long time, as well. Recently, this may be due in large part to the growth of tax avoidance strategies, mainly those involving relocating corporate headquarters to tax havens.


Third, labor costs have also been falling for quite some time. Much of this may be due to the trend toward automation and, perhaps far more so, the offshoring of labor over the past several decades. This falling corporate cost is very apparent in the labor share of income numbers that many have discussed recently, including Paul Tudor Jones.


These three secular trends have provided a tailwind for profit margins for a long time now. However, they may be reaching, or have already reached, their full potential and begun reverting. In terms of interest rates, the Fed Funds rate has essentially been stuck at zero for seven years now. Corporate spreads hit rock bottom almost two years ago and have been reversing course ever since. Furthermore, after a long period of deregulation in the banking industry that saw lending standards loosen considerably, it appears that regulation is making a sustained comeback and the effect will likely be just the opposite.

Politically, corporations are finding it increasingly difficult to defend their use of tax avoidance schemes. Politicians have been squawking about this for a long time but it now appears as if they are ready to actually do something about it. More and more companies are reporting growing political risk in this regard as new legislation is being introduced in a variety of countries to combat it.

Finally, the trend toward offshoring looks to be in the process of reversing as overseas labor costs rise and companies focus more and more on the potential quality and branding benefits of, “reshoring.” Google trends shows a surge in the popularity of this search term in recent years.

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So I agree with Grantham and Buffett that profit margins are very likely to continue to revert to their historical mean, driven by the natural forces of capitalism, and its social contract. And this will most likely be seen in either the rising cost of debt, taxes or labor, or perhaps all three.

In the short-term, history suggests the current profits recession very likely will lead to an economic recession accompanied by a bear market. In fact, profit margin peaks regularly lead major stock market peaks and profit margins peaked this cycle about four years ago already. In addition, the recent fall in earnings and profit margins is already beginning to damage those earnings-based valuation measures. The S&P 500 now trades at its highest price-to-earnings ratio since the bull market began even as the index remains well off its recent price highs. And profit margins still could have a long way to fall before even reaching their average level since 1950.

Longer-term, if these new secular trends working against profit margins are to remain in place, earnings growth will be much harder to come by for corporate America than it has been over the past few decades. And there are plenty of signs it is already becoming very difficult for them. Corporate cash flow has essentially been flat for the past five years. At the same time, more and more companies recently have resorted to financial engineering via buybacks, non-GAAP reporting and even outright fraud. My guess is this is all in an attempt to make up for broadly slowing organic profit growth due the these secular tailwinds shifting to headwinds.

Should these shifts actually turn out to be longer-term secular trends, they pose a great risk to equities in both the short-term and the long-term. Falling profit margins and rising valuations (as earnings fall) make for a pretty bearish one-two punch for the stock market. I can’t imagine investors being very eager to pay higher valuations for companies growing more slowly. That equation usually works in reverse. And there’s no reason I can see to expect these challenges to corporate profit margins to let up any time soon.

Charts, Investing, Markets

This Is STILL The Worst Possible Environment For Stock Market Investors

The latest Z.1 data was released yesterday showing that, as of the end of the year, the stock market was still very overvalued, investors were still overly bullish and the S&P 500 was still very overbought relative to its long-term regression trend. In other words, this is still the worst possible environment for equity investors.

Let’s start with Buffett’s favorite valuation yardstick, total equity market cap relative to GDP. It still shows the broad stock market to be more highly valued currently than any other period during the past 60 years outside the peak of the dotcom bubble.

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The percent of household assets allocated to stocks is also hovering near record highs, suggesting investors have rarely been more bullish than they are today.

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Even more interesting from a sentiment standpoint, however, may be the ratio of household equity holdings to money market funds assets. This ratio is just off its all-time high set during the second quarter of 2015. Yes, this is likely due to seven years of ZIRP but it’s hard to argue that investors haven’t completely bought into the TINA argument over that time.

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Finally, the S&P 500 finished the month of December 82% higher than its exponential regression trend line. This is roughly where it stood in the Fall of 2007 just prior to the financial crisis. (It is also roughly the level attained just prior to the crash of 1929, as well, though this is not pictured in the chart below.) The only time it’s been higher than this is, you guessed it, during the height of the dotcom bubble.

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When you combine these three signals (not including the money market fund ratio) we get a blended forecast of 1.33% for the broad stock market annually over the next decade. Since 1951 this model has an 89% correlation with forward 10-year returns so it’s something worth paying close attention to. Compare that prospective return to the 2% offered by the 10-year treasury note and it’s hard to argue that stocks currently offer adequate reward to offset their much greater risk.

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What’s more, the S&P 500 in December closed beneath its 10-month moving average signaling a long-term trend reversal.

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At the end of 2015, stocks remained very overvalued, over-bullish and over-bought and the trend had reversed to the downside. None of this has changed in the 70 days since. And in the past, this setup has led to some of the worst bear markets we have ever seen.

Ultimately, equity investors currently face the very real prospect of another massive potential drawdown in hopes of achieving an annual return less than the “risk-free” rate. That’s not a risk/reward equation that should get anyone excited about owning stocks right now.