Posted by Don Martin on Thu, May 09, 2013 @ 03:51 PM
How bad will the bond market crash be?
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Interest rates are artificially low due to the Federal Reserve’s Quantitative Easing (QE). This has made bond prices artificially high. When the economy returns to normal then rates will rise, pushing down bond prices.
A more normal rate for a ten year Treasury might be about 4%, but due to the current climate of low growth and low inflation perhaps 3% is more appropriate. Most bond investors buy something close to the Barclays (formerly Lehman) aggregate index, which has a maturity of 6.6 years and a bond duration of 4.9 years. If the rates in the index go up 1.3% that implies that the index components prices will drop roughly 8%. Contrast this with equities such as the SP500 which may be overpriced by 50% using the PE10 theory, which implies they need to drop 33% in price to reach equilibrium. Rember the 2002 and 2008 stock market crashes where the stock market was down about 45% from the peak.
Investors over age 50 have vivid memories of Volcker’s Federal Reserve raising rates 3% in a single meeting on October 6, 1979, or when Greenspan raised rates 2% in February, 1994. In both cases the bond market prices crashed. However the 3% increase in 1979 or the 2% increase in 1994 were an increase of roughly 20% of the current level of rates at those times. If the Fed raised rates by 20% (of the current 10 year Treasury yield) that would be about 0.36% added on the current 1.80% yield to reach 2.16%, which is hardly scary. If the real yield of Treasuries over a hundred years has been around 2% and inflation is about 1.5% then the ten year Treasury will eventually become 3.5%, resulting in a 12% bond price decline. Assuming an eight year duration, Treasury rates for a ten year Treasury bond would need to rise by 4.1% to reach a level of 5.9% in order to generate a 33% bond price decline. If rates rose that much then stocks would go lower than the forecast that they should drop 33% to a level of about 1000 points for the SP500.
Of course, no one wants to invest in a money losing investment and the risk is significant that eventually rates will rise making bond prices go down. One needs to keep the fear of bonds in perspective and realize that stocks are still riskier than a ten year Treasury.
As the economy moves closer to the bottom for rate reductions then bond investors need to move with an increasing pace into shorter and shorter durations.
The current economic situation has never occurred before where during a time that stocks are high priced bonds are also high priced. Usually if stocks are high then bonds are low priced so one can have a strategy during a normal stock market top that bonds are low priced and are therefore bonds are a bargain that one should buy. In the current era the Fed’s manipulation has destroyed the traditional metrics of the bond market forcing investors to choose between cash with a perceived high opportunity cost or assets such as stocks which I believe are overpriced.
Fortunately the rest of the world (except for Canada, Australia, New Zealand, Scandinavia, Switzerland, Singapore) has worse problems than the U.S. including too much debt and need to export goods at low prices, so they will export their deflation into our economy. The result will be low U.S. inflation for a very long time, which means reasonably low (not super low) U.S. interest rates for another decade. From the start of the Great Depression in 1929 until about 1965 interest rates and inflation (except for 1945-47) were low or moderate.
I have written an article “Treasury bond bubble to burst”.
Investors should seek independent financial advice.
Posted by Don Martin on Tue, May 07, 2013 @ 02:37 PM
Don’t fooled by unemployment statistics
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If the average salaried person lost his job on average every three years and took a month’s vacation while claiming unemployment insurance and while experiencing no problem finding a job that would contribute an erroneous 2.56 percentage points to the unemployment rate. For example if one claims to be unemployed for a month while on vacation that is 7.69% of a year. If this is done every three years then divide 7.69 by 3 equals 2.56. If the natural rate of unemployment is 4.0% and everyone decided to take a month long vacation while listed as unemployed and looking for work the result would be a 6.7% unemployment rate. The current unemployment rate is 7.5%. What if every salaried or wage earning person on average lost his job every two years and took a month long vacation while claiming unemployment. This would contribute 3.85 percentage points to the unemployment rate. If the natural rate is 4% and one adds 3.85% to 4% the result is 7.85%. Of course economists constructed the 4% natural rate of unemployment in part to account for hidden vacation taking while one is registered as unemployed. My point is that such activity is difficult to measure. What is easy to measure is that for college grads there is a full employment economy with a very low rate of 3.9%. Also for the groups “married men” and “married women”, regardless of skills, they also have a low unemployment rate of 4.4%.
The ironic thing is that as the economy gets hotter workers work longer and harder and defer vacations so as to help their employer meet deadlines. Then when the layoff comes its payback time where the unemployed person makes up for a much needed vacation. However if the unemployed person files for unemployment benefits the government statistics imply that someone is unemployed, yet the worker may not feel economic distress and may feel confident that work offers will be available. By contrast, in a recessionary economy a recently unemployed worker would be more rested and more eager to accept a job right away, so by contrast a full employment economy can create a false symptom of unemployment as people who have become newly freed from excessive work dig into a well-earned, overdue vacation.
There was an article in Bloomberg Businessweek “Migrants Stay Busy as Unemployed Greeks Spurn Menial Jobs” about Greek workers who refused to pick fruit and instead the farm owners hired illegal aliens from Bangladesh. So on one hand there is a 27% unemployment rate in Greece and yet the natives refuse farm employment. Is it possible that the modern Welfare State encourages and subsidizes those who register themselves as unemployed? In Ireland some welfare recipient families get over €100,000 (USD $133,000) a year in benefits.
We have a global “welfare state bubble" that creates a false signal of high unemployment which results in the Federal Reserve making interest rates artificially low. This in turn enriches irresponsible Wall Street speculators who borrow using cheap margin loans and buy overpriced stocks so as to participate in “Greater Fool” theory activities like “momentum trading”.
I have written an article about how rising interest rates (related to a reduction of unemployment) will undermine the value of stocks, long term bonds and real estate. See “Improving employment rate to hurt investments”.
Investors should seek independent financial advice.
Posted by Don Martin on Mon, May 06, 2013 @ 09:01 PM
Stocks may recover from crashes but that doesn’t mean they are safe enough to buy
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The news media has published articles claiming that stock market isn’t that risky since it keeps going up or that it isn’t that risky because it allegedly recuperates after a bad crash.
However, investors should remember that the crash of 1929 it took 25 years to recover after adjusting for inflation. For those who bought the Dow in 1966 when it was at a new high of at 1,000 points it would need to go to 7,000 in 1997 to break even after the inflation of the 1970’s, which is a wait of 31 years. And there was no income tax adjustment for the damage caused by inflation, so to adjust for both taxes and inflation they would need to wait even longer. So, yes the market did recover after a bad crash, but only after going through a generation long waiting period.
The Nasdaq went from 5200 in 2000 to 1250 in 2002 and is now at 3,400, so it still hasn’t recovered in 13 years despite all the wonder new tech inventions and huge Apple profits, etc.
The problem with saying that the market always recovers is that in the past 20 years it was partly due to excessive Federal Reserve stimulus which made the market go up too much. Thus looking back over 20 years or less it would seem that stock market risk is minimal, however, there is no guarantee that Fed stimulus will always work or that it will always be available. Human beings (or the germs inside of them) can develop immunity to medicines that used to work; the same can happen with the Fed’s Quantitative Easing zero percent interest policy where it suddenly stop being a help to the stock market.
An analogy is the housing bubble of 1997-2007 where people assumed that because there had been no nationwide real estate crash for 100 years that real estate must be a risk free investment. Precisely because people believed that it created a bubble that led to a horrific real estate and mortgage crash in 2008. Some people still have a property that is worth one third of the original purchase price with a mortgage three times the home’s value.
Never assume that because the market has recovered from previous crashes that it won’t crash again and stay low for a long time. If the PE10 theory is correct then stocks would go down 33% to about 1,000 for the SP and then stock prices would slowly increase at roughly 7% a year, which would mean a decade long wait to recover on inflation adjusted terms for those who bought at the top. That’s a decade when funds that one might have used to buy a house or pay for tuition were simply lost or not available during a depressed market.
Another problem with using a stock market index to say that the market has recovered is the problem of survivorship bias. This is where only the surviving stocks are still in the index and the losers were thrown out and later became worthless or were bought out at fire sale prices in a merger. Thus stock market indexes may not show the true extent of losses suffered by the original members of an index. The majority of the Dow Jones Industrial Average 30 stocks in the past 40 years have been expelled from the Dow as they shrunk in value and size to become unworthy of being in the Dow.
I have written an article “Stock bubble again”.
Investors should seek independent financial advice.
Posted by Don Martin on Mon, Apr 29, 2013 @ 02:30 PM
Will the SP go down to 450 points, a 70% drop?
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A prominent bearish advisor, Albert Edwards, of SocGen predicted that the SP would drop to 450 from its current level of 1596. John Hussman said that since profit margins are 70% above norms then a recession would make the SP’s earnings come in around $75.
My opinion is that the Shiller PE10 (which bullish investors hate) would come to the rescue and keep stocks from dropping much below 1000. The advantage of a 10 year PE ratio is that it averages out the data by using ten years of data so that investors are not distracted by a recession or a temporary boom. Using a PE ratio of 15 and a long term corporate earnings of about $65 or $75 then the SP should be roughly 1,000 and thus it won’t drop down to 450 during a panic. The market tends to fluctuate between 20% plus or minus its intrinsic value so if the intrinsic value is 1000 then it could briefly reach 800.
What the U.S. large cap markets have to offer than can provide stability to the market is that the market is far more attractive and safe than that of other major developed countries and regions. Also the Developing Countries, while they may continue to have higher growth rates, have not made their markets as safe from corruption and cronyism as the U.S. markets are. In addition many Central Banks may try to stimulate their economies by buying foreign securities so as to devalue their own currency and many are allowed by their charter to buy foreign stocks and bonds. This could act as a price support during a hard stock market crash so that instead of falling to 450 the SP only falls 20% below its intrinsic value of roughly 1000, which would be a brief dip to 800.
However, investors should be aware that with each additional dose of Quantitative Easing by the Federal Reserve that the effect on U.S. stocks has diminished. There is the risk that the zero interest rate medicine simply won’t work during the next crisis. This means investors must invest conservatively, avoiding speculative grade assets and move towards "quality" assets. If one is forced to buy stocks then one should invest in the companies with the best quality financials such as stable and growing earnings, low debt, a corporate moat, low to moderate PE ratio, etc. If one is investing in bonds one should avoid junk bonds, except that some participation in junk bonds may be necessary during a period of low rates. If one is forced to buy “below investment grade bonds” then one should invest in or near the highest credit grade in that sector using a mutual fund that demonstrates a conservative attitude towards risk. If someone is contemplating exotic strategies like writing options, buying “Structured Notes” (that act like selling a naked Put option), or trading derivatives these should be avoided as they may have excessive amounts of hidden Black Swan risk.
I have written an article “Black Swans and risk aware investing”.
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Apr 24, 2013 @ 04:03 PM
Will Apple’s stock price crash?
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Yesterday Apple released its earnings report. The profit margin dropped from 46% to 36% in a year, so if the drop continues at this pace then in three to four years margins will be at traditional 9% margin that most companies have. If no sales growth in the future and 15 Price to Earnings ratio then the stock will be trading at $150 in three to four years. People thought when Cisco was $80 a share in 2000 that it would never go down and then it spent much of the next decade in the $14 to 27 range. The nature of tech companies is that creative destruction and the risk of consumers losing interest eventually hits the leaders after several years, making tech riskier than other industries.
Matt Krantz in USA Today had a good article about Apple. Demand for Macs fell by 8% in the first quarter. Future sales of smart phones will be in lower profit margin Developing countries, pushing down profit margins. An interesting chart by Business Insider shows that the growth rate of the iphone is shrinking and is now down to a low rate of growth.
As Apple moves towards a normal profit level and normal stock price this will put downward pressure on the stock market. Last year Apple’s rising corporate earnings were a significant part of total earnings increases for the SP500. As the trend reverses that will hurt the SP500.
The use of borrowed money to pay a dividend so as to avoid tax on repatriation of offshore income is misleading because ultimately real income needs to be used to pay off the debt and that income could come from the foreign subsidiary, so a proper accounting would need to calculate the cost of paying U.S. tax on a subsidiary’s repatriated earnings.
I have written an article when Apple was at $425 on March 4th “Apple going down what’s next?” Today it closed at $405.46.
Investors should seek independent financial advice.
Posted by Don Martin on Fri, Apr 12, 2013 @ 01:32 PM
Will stocks burn investors with a new bubble like in 1998-2000?
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Stocks could go higher but that would make them be very risky. The proper way to invest is to use fundamentals to decide if an investment is priced low enough to justify buying. Currently stocks are too high priced using the PE10 formula and even using current earnings PE.
However, there is the possibility that a bubble in stocks could be developing that would make stocks go up even more. The problem with trying to make money from the bubble is that one would be doing short term trading on speculation that momentum trading will drive prices higher. This is based on the “Greater Fool” theory where one buys an overpriced asset hoping it will go up even more and then one sells it to a Greater Fool. That is very dangerous because when one does that they become brainwashed by the bubble and want to hold on to their stock at the very top. The trouble that it is too hard to spot a top accurately and when it bursts then one may not want to admit they were wrong and sell below the high water mark, so then one might hold on while it drops even more. The way to avoid this problem is to avoid investing in bubbly assets whose main attraction is simply a speculative opinion that other people will make the price go higher.
If one were to try to buy stocks now they would need to view it as speculative and to use stop loss orders and to accept the idea that they could be stopped out at ludicrously low prices during a “Flash Crash” where some stocks dropped 40% in an hour and then later recovered. Or one could try hedging by buying Put options, but the cost of expired Puts might offset the hoped for stock profits.
The situation is vaguely like the 1998-2000 tech stock bubble where the advisors who followed a fundamental style of investing were either bearish or else refused to buy fast rising glamorous stocks and held only lower PE stocks. These conservative advisors were laughed at because they kept their clients from participating in the upward part of the bubble. Once the bubble burst in 2001 then the advisors who advocated a conservative fundamental style of investing were vindicated. The same “movie” was shown again in the real estate and mortgage bubble of 2002-2007.
The common wisdom of advisors is that since interest rates are absurdly low and may remain so for a very long time then one should boycott bonds and buy stocks so as to make a small return. The problem is that if stocks are overpriced then it is wrong to buy stocks. Two wrongs don’t make a right. Just because it is wrong for bond yields to be very low doesn’t mean investors should be like rats in an experiment and take the bait offered by the Federal Reserve and buy overpriced stocks.
The Fed hopes people will flee cash and bonds and invest in “risk assets” such as stocks and real estate. Ultimately when one invests in stocks or real estate it is really a form of participating in a business. An analogy would be if one bought a fast food franchise and personally worked in it and tried to recruit customers. If the reason interest rates are very low is because of a depressed economy then the depressed economy means that the rookie franchise owner won’t be able to recruit customers and may go broke. So by analogy if investors buy a company they should ask themselves what if lack of demand and excess competition makes it hard for the company to make a profit? I trust that a well diversified protfolio publicly traded companies have lots of customers and as a group they won’t go broke but I doubt they can expand their sales and profits in a manner that would justify a continued increase in stock prices. Instead there are reasons to think that corporate earnings will gradually weaken and pull down stock prices.
Corporate profit margins are 70% above normal which is an unsustainable statistical outlier. The best guess is they will revert to the mean. Also PE ratios using PE10 are 50% too high. The combination of falling PE ratio and falling profit margins would be a devastating blow for stocks. If interest rates return to normal stocks will lose a prop that helped prop up their price through the actions of leveraged traders who used low rate interest-only margin loans.
Be prepared for the collective opinion of investors and news media to repeat the mistakes of the 1998 tech bubble and realize that if you hope on that moving bandwagon it may be too hard to hop off without breaking your leg.
I have written an article “Dow’s new high is a dangerous market top”.
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Apr 10, 2013 @ 05:04 PM
The economy is moving towards Full Employment – what are the investment implications?
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The FT ran an article today “Fed early release reveals QE3 debate” which said “The minutes (from the March Fed meeting) show that the Fed was gearing up for a tapering of the QE program at its last meeting, much earlier than markets had expected…”. On April 3 the WSJ said John Williams of the Fed was considering ending the Quantitative Easing (QE) in the summer, which is only 70 days from now.
The JOLTS (Job Opening Labor Turnover) report shows we are almost halfway between bottom and top of previous cycle of 2002-2007; it also shows the ratio of job openings to new hires are at a cyclical top; and the ratio quitters to layoffs is at normal levels.
The economy is moving to “Full Employment”. This means the fed will wake up and end the QE bond buying program much sooner than thought. This will disrupt the investment paradigm that since inflation is low then interest rates will remain low. People forget that the reason interest rates are low is due to the belief that we are trapped in an era of high unemployment and that a temporary emergency exists where the fed needs to have artificially low rates. The fear of unemployment is a much more important reason for rates to be low than inflation. Now that fear will soon go away, resulting in rates returning to normal.
Today Edward Pinto in the WSJ said that when mortgage rates return to the rate typical of the past decade of 6% then either house prices need to drop 25% or wages need to go up 33%.
The effect on investments will be:
- Housing: real estate will stop increasing and become stagnant. With many new rookie landlords some will offer reduced rents to recruit tenants, thus reducing the profitability of rental real estate.
- Stocks: Higher interest rates will compete against dividend paying stocks, thus leading to an outflow of flows from stocks.
- Corporate Profits: This key driver of stock prices will go down by 30% when rates rise, although a growing economy will increase sales, which will offset some of the damage
- Long term bonds: Obviously, rising rates hurt the value of long term bonds.
Some possible contrarian outcomes to the risk that bonds face is that the Japanese Central Bank is determined to do a very aggressive form of QE and devaluation which will provoke Japanese investors into investing in U.S. debt. The Japanese QE program even allows for the purchase of foreign bonds by the Central Bank.
Continued economic risk and crisis in the Euro area and Japan will encourage the world’s investors to use U.S. Treasuries as a parking lot for funds, since institutional investors are far too big to benefit from the $250,000 insured bank CD limit.
The current Fed stimulus may appear to be a repeat of the inflationary 1970’s, but it won’t be. The inflation of the 1970’s was caused by a system set in place in the Great Depression, which was never turned off, which raged out of control in the 1970’s. The system of restrictions of imports, globalization, competition, financing and a general protection of established oligopolies along with powerful labor unions helped to provide a environment that nurtured inflation. The driving force of inflation was an increase in the money supply from bank loans which were facilitated by rising wages given to workers in powerful unions. Today those inflation nurturing conditions don’t exist. Workers are powerless against globalization transferring jobs from country to country to get the lowest wages. Oligopolies like the telephone companies have seen pricing power evaporate. Consumers in the 1970’s didn’t have hardly any discount stores like Costco, or Amazon. Stock broker commissions were fixed at artificially high prices with no price competition allowed, as were airfares.
Interest rates may “need” to go up by roughly 3% due to a recovering domestic economy but foreigners may also need to buy lots of Treasuries. Thus the risk of a huge crash in long term bond prices may not be that significant, although it would be time to move towards shortening portfolio duration. Assuming that long term Treasuries need to have a real yield of 2 to 3% over inflation and that inflation stays in the 2% range then a 4.5% yield on a long term Treasury could eventually happen, (an increase of 1.5%) implying roughly a 25% drop in long term bond prices. This would be less than stocks need to drop to reach a fair value of roughly 1,000 for the SP500. One reason for holding long term Treasuries is that they are a hedge against more crashes in the Eurozone and Japan. To buy a Put option on stocks might cost an annualized 5% for “out of the money” Puts or 10 to 20% for “at the money” Puts. By contrast, one could use long term Treasuries in lieu of a Put option on equities. So perhaps owners of long term Treasuries are justified in holding them because the alternative might be to spend money on Puts on equities. Unlike a Put option that expires in a year, a 30 year Treasury still has value a year later. The principles of investing include diversifying, possibly into things you don’t like, in case you are wrong. Thus owning some long term Treasuries as a diversifier, even if rates may rise, could be justified, as one never knows when a stock crash could suddenly occur, making bonds go up.
I have written an article “Will rising interest rates kill stocks?”
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Apr 03, 2013 @ 06:07 PM
An article in Reuters/CNBC “Fed bond buying could cool this summer, says Williams” mentioned that the Fed’s easy money Quantitative Easing (QE) program could be reduced this summer as the labor market improves. Should you follow the cliché and “sell your stocks in May and go away?”
I have been mentioning this possibility that the labor market may improve. The main reason rates are low is the perception that there is a deep Japan-style Soft Depression with a 14% unemployment rate. But most economic statistics such as sales, GNP, etc. show the economy is close to its old highs of 2007, although about 10% lower after adjusting for five or six years of inflation.
Too many people have found a comfortable niche in the welfare state and thus should not be considered as serious job candidates, so their unemployment should not be used to justify low interest rates. Unemployment is clustered among young people who live with their parents and the least skilled, least educated, lowest paid, both of whom have a conflict of interest in the sense that if they get a job it may not pay more than the benefits they are now getting after adjusting for taxes and commuting.
If businesses could get the same lucrative benefits that some unemployed get then businesses would have an incentive to sell and produce less and the GNP and corporate sales would be lower. Economists need to put less emphasis on unemployment as a gauge of economic activity and realize that excessively low interest rates can create a bubble. Low interest rates already have made stocks go up too much which makes the economy weaker as naïve investors pile on to the rally and end up buying at the top before the next crash.
The unemployed people with good skills and determination will be able to pull off a surprise victory in their job hunt. Eventually as they try harder and acquire more experience and contacts one day they will reach critical mass and breakthrough the barrier to a new career. This progress is hard to calculate. Accounting systems are not designed for things like measuring a company’s human capital or intellectual property, so by analogy government statistics may not be able to detect someone who is “almost” about to find an entry level job. It may take several years for an unemployed person to get admitted to college, graduate, do a free internship, acquire contacts, learn to job hunt, but eventually they will surprise everyone (including bond investors) with a job.
Once investors realize that a major economic shift is occurring then this could cause a panic in both stocks and bonds.
However, inflation is under control and more foreign economic problems mean more foreign buyers of Treasuries and dollars, thus helping to keep interest rates low.
An improving economy helps to modesty upvalue junk bonds by reducing their discounted price that is caused by their credit quality risk. That potential price increase will act to oppose the downward price pressure caused by rising interest rates. There is no guarantee that rising credit quality will be a stronger force than rising interest rates. A low duration junk bond may benefit from rising credit quality more than it would be hurt by rising interest rates, or at least in proportion to the results of a junk bond with long duration.
I have written an article “Will rising interest rates kill stocks?”
Investors should seek independent financial advice.
Posted by Don Martin on Tue, Apr 02, 2013 @ 01:17 PM
A new investing paradigm as the economy returns full employment
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The coming U.S. economic and employment recovery could occur in 12 months and then the Fed would begin raising interest rates, thus damaging stocks. If the unemployment rate goes to the Fed’s target of 6.5% in a year then the Fed will tighten or the bond market vigilantes will wake up and do it for them. Perhaps the Fed will act dumb and let the vigilantes tighten so the Fed can say to Congress “We’re shocked! We had no intention to raise rates!”
The stereotype of a recovery is that it causes inflation. However inflation is primarily a wartime or immediate post-war experience. Today there is a huge surplus of global labor in Europe, Japan and China. New technology of natural gas fracking is creating “peak demand” for oil where the demand for declines as it is replaced with substitutes.
The consequences of a recovery is that a more prosperous population may be less willing to vote for leftist politicians which will enable conservative politicians to offer policies that are slightly more in favor of “hard currency” policies. These policies tend to result in a removal of government stimulus which helps hold down inflation, and boost the dollar, which in turn reduces the impact of inflation. As the U.S. becomes a global investment haven this will attract an inflow of funds that will push up the value of the dollar. As the possibility of a massive deflationary crisis fades then gold investors who feared a hyperinflationary response by the government against deflation will lose interest in inflation sensitive assets. Then gold, TIP’s, commodities will go down. Emerging Markets Central Banks that bought a lot of gold instead of Treasuries starting in 2008 will reverse course, sending the dollar up and gold down. The problems in the EU and Japan have not been solved and will get worse, resulting in more capital outflows into the U.S., so global investors will decide that earning zero percent after inflation in the U.S. is better than getting a “haircut” in Cyprus.
Inflation is caused by commercial banks lending money which increases the money supply. When unions are powerful and there is a full employment economy then workers have plenty of income to use to qualify for and get an inflation causing loan. This is what created inflation in the 1970’s. Today the unemployed when they do get hired will be mainly starting out in low paid jobs and they may burdened by too much debt or have bad credit so they won’t be able to get much debt. Thus the shift into a full employment economy won’t be inflationary.
Thus people should not fear inflation occurring as a result of the coming employment recovery.
What investors should fear is that stocks are priced too high and stocks have been helped too much by ultra-low interest rates. Once interest rates have been removed and corporate profits drop to normal levels then stocks will begin to move down towards intrinsic value of roughly 1,000 for the SP, drop of about a third. As the economy improves and more people are hired that doesn’t always boost profits, instead it raises costs for companies so that their profit margins will revert to the normal level of 6% from the current bubble of 10% of sales. In theory stock prices are a manifestation of corporate earnings, so a drop in earnings will make stocks go down.
Investors should also fear the overconfident investment advisor who assumes that ultra-low rates have a high probability of staying low for years. Since the Fed's policies are radical, unproven, and risky then they could suddenly be canceled if the Fed finds it made a mistake. If these rates return to normal they will destroy leveraged mortgage REIT’s and may weaken the value of dividend paying stocks once investor find they can get a decent return in bonds they may sell high yielding stocks to reduce risk.
I have written an article “Will the Fed tighten too early and cause a crash?”
Investors should seek independent financial advice.
Posted by Don Martin on Mon, Apr 01, 2013 @ 02:28 PM
Don’t be fooled on April 1st or on any day
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April Fool’s Day may be a time for some people to make jokes, but investors should consider the opposite of levity which is to take a serious attitude to avoiding hidden risk. I feel that in modern times investors have not felt the pain of the Great Depression and some have not felt the pain of the great inflation of the 1970’s (where stocks had huge losses on an inflation-adjusted basis) so the typical investor is subconsciously brainwashed into believing that the market has less risk than it really has.
The Greenspan and Bernanke Federal Reserve era has created a myth for the past 20 years that government can bail out “too big to fail” institutions and bail out investors with excessive rate cutting and pump priming.
When society went through the pain of the Great Depression investors learned for the next several decades to invest cautiously, thus they were behaving rationally, giving credibility to the “Efficient Market Hypothesis” (EMH). But in recent decades the lack of fear has made investors irrational, thus leading to bubbles. These bubbles or the risk that the market could become a bubble mean that the market is not efficient and that investors must dismiss the EMH as not applicable for the current era. In order for the EMH to work society must first experience a severe crash with no bailout so that investors will learn how to behave.
The current paradigm is that the market perceives an asymmetric relation between risk and reward where risk is allegedly minimized through bailouts but the perceived rewards have no symmetric cap. This belief system causes investors to overpay for assets, which is wrong. The correct way to invest is to buy and hold at good, low prices instead of doing momentum trading using the “Greater Fool” theory where someone buys an overpriced asset hoping to sell at higher prices to an even bigger fool. Unfortunately if the market is overpriced than “buy and hold” is not applicable as a strategy.
Cheap money from Fed stimulus has created too much margin loan based investing. This has damaged investment correlations so that during a crash, just when you need uncorrelated assets, their prices go down together (thus changing their correlation from uncorrelated to correlated), except for Treasuries.
I have written an article “A solution to high correlation”.
Investors should seek independent financial advice.