Preston Pysh

BY PRESTON PYSH

1 January 2016

So anyone that has listened to our podcast knows that I’ve been a bear on the stock market since the end of February 2015. The main premise for my opinion was a few factors that I’m going to outline throughout this article. As the stock market closed out 2015, the US equity market ended at 17,425 on the DOW Jones. This was 814 points lower than when I made my first video warning investors of the potential risks in the current economy (published on 26 FEB 2015). Here’s the video if anyone wants to see it.

Although there’s no way of knowing if a full-on stock market crash will occur this year, I do believe US stocks will close lower at the end of 2016 than they open. Here are some of the reasons why.

The Current Position in the Credit Cycle

One of the most important and fundamental building blocks of investing is the understanding of spending and credit cycles. When an economy is growing and performing well, citizens are spending money. Although that sounds simple and obvious, it’s an idea that leaves even the most astute economic thinkers befuddled when economic downturns occur. The most important driver of this spending is the expansion and contraction of credit (or money) within an economy. As many might immediately suspect, the credit expansion and contraction is highly manipulated by the central bank. For the United States, the Federal Reserve has been manipulating credit cycles since it’s inception in 1913.

The reason the FED adjusts the supply of money is to stimulate the economy when times get tough and to also ensure American’s have jobs, predictability, and sovereign order. In order to ensure this civil order, the FED will increase the amount of “money” when times are bad and tighten the “money” when times are good. Now, I quoted the word money because many people think money is simply the stuff in their wallet. Unfortunately for most people, money is more complex than they realize. In fact, most money is actually credit. Since real dollars and credit spend the same way, many people don’t realize that the FED is manipulating the supply of money by adjusting the amount of loans and borrowing in the system. Although this idea has many more complex ideas and concepts, it’s important to at least highlight the premise and principal of my argument for why I think 2016 is going to be a bad year.

If you would like to learn more about spending, money, and credit cycles, please watch this video to get a much better idea of where this framework originates. If we can understand when a credit cycle has reached it’s expansionary limits and begins to contract, we can do a much better job of anticipating stock market risks because we now understand when dollars are going to become less available and difficult to capture by businesses. When credit is tightening, business have less money to capture, which reduces their annual revenues and subsequently their net incomes. Since high yield bonds (or junk bonds) typically demonstrate the largest price swings (for fixed income assets) during a credit cycle, I’m going to depict the credit cycles in the chart below.

When we look at the market today, one can see how the high yield bond market is starting to demonstrate the initial signs of tightening. Making things even more obvious is the fact that the US FED as begun to raise interest rates for the first time in almost a decade. This occurred in the middle of DEC 2015 and is an obvious signal that monetary conditions are becoming more difficult for American businesses. Now there are many critics that say the FEDs rate increase was only .25% on the over-night federal funds rate and it won’t have much of an impact on the overall performance of the economy, but I think this opinion might be short sighted. There’s a great article by a Dr. John Hussman that outlines quantifiable reasons why the FED’s recent move is much bigger than most realize. In short, Dr. Hussman is saying that a massive pool of zero-interest cash (created from the unprecedented amount of quantitative easing), created enormous yield speculation (in stocks), while dramatically reducing the quantity of interest bearing riskless assets (the bonds the FED purchased through QE). By reversing this QE path, the FED is effectively plowing itself back into the 2009 timeframe with respect to the risk it applies to volatile assets like stocks. Here’s a link to the full article so you can see the deeper analysis he has conducted. As a side note, when Japan was in a similar situation years ago (years of zero percent interest rates, quantitative easing, and an attempt to raise rates by 25 basis points), their central bank needed to loosen monetary policy within a few quarters later. Stocks got crushed.

One of the biggest factors for me turning into a bear 10 months ago was the amazing correlation I saw between Quantitative Easing (QE) and stock market price growth. For anyone that doesn’t know what QE is, it’s simple. The central bank effectively swaps cash for financial assets on the open market. If you want a more colorful description of QE, check the bottom of this article for fun story I provide (it’s in the p.s.s) For this past credit cycle, the financial assets the US FED purchased were bonds. When the FED did this, to the tune of almost 2 trillion dollars, the prices in the bond market became drastically warped. This was not a free and open market. This was a highly manipulated market that forced the yields on bonds through the floor and prices to epic levels. So when the FED finally decided to stop this multi-trillion dollar initiative in OCT 2014, I became very skeptical on the continued growth in stock prices. To demonstrate the correlation I’m referring to please look at the chart below that Doug Short has produced. Doug’s website (which has some amazing graphs, can be found here).

In the chart above, the green sections graphically demonstrate where the US FED was adding cash to the system through QE. You’ll notice a unique S&P pull back after the 1Q of 2010 and in the middle of 2011. Additionally, you notice the market has effectively been flat since the FED stopped QE at the end of 2014. Something important to note is that during this past credit cycle, the FED has lost it’s ability to ease monetary policy simply through lowering interest rate. In the past 80 years, the FED has always been able to increase spending in the economy by lowering rates, but during this past cycle, the FED was only able to stimulate spending by lowering rates and conducting enormous amounts of QE (or liquidity injections). The reason this is occurring is because the US (and the rest of the world for that matter) is experiencing the tail end of a larger credit cycle that’s been brewing since the end of the Great Depression. The primary reason the long term bubble was created was due to the enormous amount of spending that occurred during WWII, and the drastic amount or credit expansion that occurred to pay for the debts in the decades that followed. This was conducted by a drastic expansion of the money multiplier, or reserve ratio, from the 40’s through the 80’s. Anyway, this isn’t a history lesson, but it’s an important highlight so folks understand why the FED used QE during this past short term credit cycle, and why they will use it again (at an even more drastic level) during the coming down-turn.

 

When the credit cycle reaches a peek and starts to contract, stock markets can still grow and expand for a few quarters or years. This is especially true when yield spreads between bonds and stocks are still wide. This occurs because investors are still willing to “chase” higher yields in equities opposed to lower yields in fixed income. This kind of cycle typically involves central banks continuing to raise interest rates until stocks and bonds reach parity with their subsequent yields. In today’s situation, I don’t see that happening. The reason I think the stock market is already starting to trend down is because the FED has already polarized rates to a level that makes yield spreads accross asset classes unacceptable. When an investor has the option of investing in the stock market at a 3-4 % yield or a 2.5% yield in government bonds (at zero risk), the choice is fairly obvious. Why chase a percent or two for all the downside risk. Additionally, I think the stock market is going to struggle going any higher because the duration of the current credit cycle is already very pronounced.

 

One of the more interesting clues for determining the top of the credit cycle (or money expansion) is looking at corporate profit margins.

When we think about how stocks are valued and priced, one of the most fundamental ideas is that higher premiums are paid for businesses that have an expanding profit margin. When a company demonstrates prospects for a growing net income and efficiency to produce profits, investors are willing to pay a premium for ownership. Consequently, when businesses demonstrate a failure to increase margins and effectiveness, a discount is paid to own the security. When we look at the chart above, we can graphically see how profit margins have been a leading indicator of upcoming recessions. When we look at the margins for the end of 2015, the trend doesn’t look promising.

 

When we think about the credit cycle from a domestic lens, we must remain vigilant for the international perspective and impact on potential spending and “imported” capital. Although I’ve been talking specifically about the US credit cycle, there are numerous other variable at play that can potentially impact the bigger picture. When we think about the international markets and currencies, it’s important to remember that the US dollar impacts about 60%, or more, of the world’s currencies. This is because so much debt is denominated in US dollars and international currencies are peg to the dollar. When we think about the impact this has on domestic companies, a strong dollar means US businesses suffer because our materials and labor become more expensive to export.

Additionally, when the dollar gets stronger, international borrowers have a harder time repaying their obligations. When we think about the ramifications this has on the deeply suffering commodities industry, many concerns arise. First, commodities have been crushed over the past year and a half. Oil specifically has seen its price decrease more than 60%. Other commodities aren’t much better. When we think about the enormous amount of borrowing that has taken place in the energy sector since 2009, many might be floored to know the figure is in the trillions. To make matters worse, much of the borrow was denominated in dollars and the capital expenditures in that industry are among the highest of businesses worldwide. This one example highlights a much bigger issue for the world economy: if US companies start to contract due to external drag, the decreased amount of spending becomes self-reinforcing and it has a compounding impact around the world. To demonstrate this idea, look at how interconnected the US equity markets are with the rest of the world’s markets. When you look at this chart, you can see two very distinct global credit cycles.

 

So instead of continuing to quantify why I think the stock market is about to have a bad year in 2016 (because I could write a book), I would rather layout some actionable events/plays for the coming year.

 

What I think will work in 2016

Cash for the first half of the year. First I think US stocks are going to go down in 2016 based on the reasons I explained above. The primary premise for my argument is that I think spending will continue to contract due to the growing shortage of dollars in the system (due to QE ending and FED raising rates) and the international pressures being placed on the strong dollar. I also think that numerous industries are highly leveraged and the spreads between fixed income and equities will continue to narrow. As that occurs, more and more people will sell theirs stocks due to the lack of yield compared to risk free investments. If this is true, cash is likely a safer position than stocks. Cash will protect your principal and avoid any loss. If the market contracts by 10% in 2016 and you’re holding cash for the entire year, congrats, you just beat the market by 10% (over 80% of mutual funds can’t beat the market annually, so cash might be a very smart play). Now, let’s say you’re a more aggressive investor and winning isn’t enough – you must destroy the market. If that’s the case, you might want to contemplate shorting the market. You could potentially look at a Proshares index that shorts the S&P500. A ticker for doing that is: SH. Many people, including myself, wouldn’t call this investing. I would call this speculating.

 

Maybe Oil. I think this industry and sector is going to continue to get punished as long as the dollar is strong and fierce competition exists. Many of my friends are invested in the oil sector because prices have dropped so much and the market price is closely parallel to it’s production cost. They are obviously playing the sector for the long term (which is smart), but I think they are getting into the position a little to early. The reason I’m not following their lead is due to opportunity cost and my expectation for better prices in the future. First, I think oil companies are not representing their future sales accurately. When you look at the chart below, you can see that a majority of the industry is still using $70 to value their future sales.

In my opinion, this is drastically out of scope with reality. Yes, the prices will return to $70 in the future, but not for many of the companies that will go bankrupt before getting there. Until analysts and investors come to the realization that current market prices are using a fairytale estimate in 2016, I’m not touching oil stocks. My opinion is this realization is coming soon, and when it does, I’ll become an avid buyer of the companies with really strong balance sheets (or an energy ETF). Right now, I expect that to occur in Julyish of 2016, but who knows. Circumstances change and so will my opinion. I’ll continue to watch patiently as this sector matures. I’ll be sure to tell everyone on the podcast when I take a position. As a quick note of interest, in December 2015, Billionaire Carl Icahn and Boone Pickens discussed their opinions on oil and specifically it’s timing. I’m with Icahn. The best part of the conversation begins at the 11:30 minute mark.


Maybe Commodities. In addition to investing in energy (maybe later in the year), I also plan on taking a position in commodities. The reason I’m paying close attention to commodities is I think it’s going to be a fantastic place to invest once the dollar, and other fiat currencies, begin to weaken. My expectation for the first quarter of 2016 is that the dollar will continue to be strong. The reason I feel this way is the FED is tightening and I believe there may be a run on liquidity by the end of 2016. If this occurs, the FED and all the other central banks will need to devalue fiat currencies in a major way. When that eventually occurs, commodities are going to do exceptionally well because they represent a finite supply of inventory (assuming demand remains somewhat stable). If central banks ease at the level I expect them to move, the value of commodities will skyrocket and you’ll see the opposite price movement we have seen over the past two years. Assuming interest rates remain uncharacteristically low (which I fully expect), this position might even be something worth leveraging in order to increase the magnitude of the return. I think this is going to be one heck of a play once commodity demand is stable and central banks ease like crazy. I have this same opinion about gold and silver and I plan on taking positions in stocks that cover those metals during the same period of time.

 

Not High Yield Bonds. I think we are on the cusp of a horrible year for high yield bonds. With the FED starting to raise rates and the enormous amount of junk debt in the energy/commodities industry, I think high yield bonds are going to have an enormous amount of sellers in 2016. Although I don’t view short positions as investing, it’s speculation, I think a short position in junk debt will perform really well in 2016. Since junk debt doesn’t move with the same vigor and volatility of equity prices, this short might make more sense for people that want better returns than cash but less volatility risk than an S&P500 short.

What famous billionaires are saying right now

Finally, I think it’s important to highlight what a few financial billionaires are doing based on the current market conditions.

 

Warren Buffett (personal net worth 66 billion) – Although Buffett conducted a massive purchase this past summer, his recent activity has been fairly stagnant. As of last quarter, Berkshire Hathaway is sitting on 66 billion dollars of cash. The company’s cash position has been growing over the past year while his common stock positions have been decreasing (by over 10 billion). Many people think that because Buffett conducted a few billion dollar purchases this past summer, he’s still a bull on the market moving forward. I think this idea has a lack of appreciation for the difficulty Buffett has striking deals that actually make a difference in his portfolio. Due to his sheer size, when he has a shot at bagging a big company, he often has to take the shot, despite to average terms and values.

 

Billionaire Carl Icahn (net worth 21.3 billion) – September 2015, Carl Icahn made the following video telling the world that danger lies ahead and the best position is probably cash.


Ray Dalio (net worth 15 billion) – Here’s a 60 minute video of Ray Dalio talking about how he thinks the FED is making a fatal mistake by raising rates. He believes they are only looking at the US short-term cycle and not accounting for international forces and a firm understanding of the 75 year credit cycle that is in the process of deleveraging. He believes US equities have preasures to move lower.


Stanley Drunkenmiller (4 billion) – Here’s a video of Stanley Drunkenmiller talking about how he thinks the market might have peaked in July of 2015 and that he’s currently a bear for 2016.


Anyway, I hope you’ve enjoyed reading my opinions. Hopefully it’s helped you think about your current portfolio and armed you with intelligent questions to ask your professional money manager. Happy investing!

~Preston

P.s. As usual, I want to hear why my analysis is wrong. If you’ve got some comments or questions about this post, be sure to leave it here on our forum.

 


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