Financial Industry Rants & Sins, Vol 10

Like David Letterman, I have a top 10 list this week. Funny as that sounds, this is not a joking matter if you expect your portfolio to perform how you want it to perform.

There’s an issue that’s been bothering the hell outta me for several months. If you read my economic blog on seekingalpha.com you’ll see all the details. Time and again I hear, see, or read another financial advisor saying we should always be bullish on the American stock market, because there is absolutely no reason to think that we are in for a correction. Never mind a crash, that would be ludicrous. We heard the same mantra in 2008 before Lehman Brothers and the entire real estate market wreaked havoc, causing contagion around the world.

So with all these self-professed gurus who know how to sell you a moldy, rotten bagel, and they can even convince you to eat it, but don’t understand a thing about business or economic fundamentals, here is why you really shouldn’t be bullish on stocks all the time. Particularly now, with the current state of economic affairs.

Reason 1 — You’ll hear these gurus proclaim “there is still over $12 trillion of investment capital available which is not yet invested in the stock market. Imagine what will happen when all that money comes in!” That’s a really big if, not a when. Conjecture about if people decide to invest in the stock market is not a fundamental reason for the rest of us to invest. It’s just wishful thinking, a pipe dream, and I have to wonder what these gurus are smoking?

Reason 2 — There is more margin debt now than there was before the last crash in 2008. Margin debt means that people are borrowing money to buy stocks, bonds, mutual funds, and any asset they can house in their brokerage accounts. The problem is that if all that debt begins to be called (a demand for repayment) there will be a snowball effect that may cause a 1% decline in one day to morph into a beast of a decline of 50% or more.

Reason 3 — The real reason stocks are still climbing in the face of a very weak economy (GDP is negative, as I’ve noted here) is because low interest rates make it easy for companies like Apple and Google to borrow cash and buy back their own shares. If the easy money dries up, then the price floor that is created with share buybacks will fall out from under the price.

Reason 4 — It is becoming harder and harder for companies to borrow cash because interest rates have gone up, and will continue to rise. Janet Yellen, FED president, has already promised us 3 more rate hikes this year, and according to Yellen we can anticipate at least four next year. Each hike is a minimum of 0.25% (one quarter of one percent). As people must pay more for their credit cards, home loans, car loans, and any other cash they’ve borrowed, it means they’ll have less discretionary spending on tap for things like saving and investing, going out for dinner, big purchases like 74” plasma TVs, and holiday spending sprees. If that will not be bad enough for companies who rely on consumer spending, the very same companies will have higher and higher interest payments on their own debt. That translates into less cash flow and a weaker balance sheet. Stock prices are all about the bottom line, and this will be a very strong negative to stocks.

Reason 5 — The Trump Bump. Since election day stocks have soared. But there has not been a fundamental positive change in the economy to warrant the prolific rise. The bump is based on the hope and dream that President Trump will surely lower taxes for companies and individuals, repeal and replace Obamacare, reduce regulations, and other positive actions that will help the economy. With every day that passes that he doesn’t get his agenda through Congress, it becomes clearer that he faces more and more opposition. And if his own party doesn’t support his agenda, a fortiori, the opposing party won’t either. In fact, this is the first time I can remember that the two parties were united to do something since 9/11.

Reason 6 — Trump is trying to push a strong dollar policy and abolish economic treaties like NAFTA. As the dollar becomes stronger, it will cause imported goods to become cheaper for Americans, and it will also cause foreign labor to become cheaper for multi-national companies. The very jobs that Trump wants to keep in America will become that much more attractive in places like China or India. Also as the dollar becomes stronger, that means it will be more expensive for foreigners to buy American made goods. This will actually increase our trade deficit, forcing reason 7.

Reason 7 — The trade deficit is what happens when we import more stuff than we export. It’s simple subtraction: if we import $10 worth of goods, but export only $8 worth, the deficit is $10 — $8 = $2. The trade deficit is an economic indicator that causes us to expect more jobs to be lost to other countries. Some economists think it is the cause of job losses. I prefer reason 6, that it is actually the symptom of other fundamental causes, like the stronger dollar.

Reason 8 — A stronger dollar means other currencies are weakening. This is particularly problematic for countries like Brazil, Russia, India, Indonesia, China, and South Africa, collectively known as the BRICS. They are emerging markets, which are not fully developed and mature like that of America, Japan, or Western Europe. The problem stems from the fact that much of their business loans are taken from American banks and denominated in American dollars. As the dollar strengthens alongside increasing interest rates, it will become more and more difficult for these foreign businesses to repay the cash they borrowed, hence, more and more likely they will default. Rising defaults against American banks is really bad news for our financial system, because banks are so highly leveraged in their business practice. Rising defaults out of emerging markets may easily cause contagion around the world.

Reason 9 — By virtually all valuation metrics, stocks are not just overvalued, but nearing or already in bubble territory, and the cash flow doesn’t support these dreamy values. One of the best indicators is the infamous Schiller 10 year rolling P/E ratio. Average is around $10-$14 of value for every $1 of bottom line earnings. Stocks are now trading near a $30 clip for every $1 in earnings. The last time it was this high? Right before that financial crisis in 2008. Last time before that? NASDAQ bubble. In fact, the track record of this valuation metric is as close to perfect as you can get, which brings me to reason 10.

Reason 10 — When stocks are hotter than the supermodels in the Victoria’s Secret runway show, I am reminded of the old adage that when everyone else is greedy, you know it is time to be fearful. And when everyone else is fearful, that is the time to be greedy. For the reasons above and many others, I fear that we are at a level of greed that is palpably greater than it was in 2008 or 1999. There are no fundamentals or mathematics to support the adage itself, but when everyone else is irrationally exuberant, you know it’s time to prepare for something big to hit the fan. And that, my friends, won’t pass the smell test.