Friday, July 11, 2014

Prepare For Another Stock Market Crash?

David Weidner of MarketWatch reports, Dow 17,000 is on the wrong side of history:
Today’s bull market is the fourth biggest since the 1929 crash after stocks have nearly tripled since the financial-crisis low set in early 2009.

But more than any modern bull market, this one stands alone in that it’s squarely out of step with economic growth. It’s being driven higher by just a few wealthy participants and traders who have tacitly, perhaps even unknowingly, agreed to drive prices higher.

The main reason for that is two-fold.

First, low interest rates have made other investments unattractive. The 10-year U.S. Treasury is yielding only 2.58%. Inflation is running at an annual rate of 2%. That makes corporate bonds, certificates of deposit (which yield less than T-bills) and other fixed-income products largely a losing proposition. Those who have been buying bonds have been doing so for safety.

Second, the investing public isn’t really buying stocks. A study by the Pew Research Center, published in May, found stock ownership by households is shrinking, at 45%, down from more than 65% in 2002. Even with the Dow Jones Industrial Average reaching the 17,000 milestone, investors are leaving stock mutual funds, not buying them.

This series of circumstances is unique. Unlike central bankers’ response to the Great Depression, the Federal Reserve has embraced Keynesian economics and flooded the economy with dollars on a scale never seen before. The Fed’s balance sheet has more than quadrupled to $4.3 trillion since 2008.

In short, stocks have become more attractive not because of a surging economy or strengthening corporate profits, but because they are the last-place finishers in an ugly contest. That’s a significant difference with boom markets of the past.

For instance, between 1935 and 1937, the stock market lagged an economic recovery. U.S. gross domestic product rose 10.8% in 1934 and 8.9% in 1935. But stocks only took off in that last year, eventually logging a 132% increase until 1937. In that last year, economic growth was robust, but it came crashing down in 1938. GDP contracted 3.3%, and deflation added to woes, with prices falling 2.8%.

The next long-term bull market occurred from 1942 to 1946, when stocks jumped more than 150%. That isn’t a good comparison, given the nation’s involvement in World War II. But there were some robust years economically. And once again, the market moved along with the economy: a 17.7% growth rate in 1941, followed by 18.9% in 1942, 17% in 1943 and 8% in 1944. Much of the growth was offset by inflation (9% in 1942), but at least investors had a reason to buy.

The first post-war bull market began in 1949 and lasted nearly seven years. Stocks rose more than two-fold as U.S. GDP grew at least 4.1% in each of those years, including an 8.7% growth rate in 1950. The Dow Jones Industrial Average finally passed its 1920s record high in 1954. Inflation was all over the map. Prices rose 8.7% in 1951, but increased at about 1% or lower between 1953 and 1956.

The mid-1980s bull market saw stocks, as measured by the S&P 500, double during a five-year period beginning in 1982. Like the current bull market, gains were made to seem bigger after the S&P 500 dropped to only 102.42 in the summer of 1982. But again, there was economic growth that exceeded historical levels — between 3.5% and 7.3% during the rally — and inflation and unemployment fell during that time.

Some describe the period from 1987 to 2002 as a bull market. Technically, it may be. It rose more than 500% during that span. But the real bull market of this era occurred between the start of 1995 until early 2000. Stocks in the S&P 500 rose 237% as GDP increased between 3.8% and 4.8% annually. Inflation was low, between 1.6% and 3%. Unemployment fell each year, starting at 5.6% and ending at 4%. Yes, some of this gain was fueled by unrealistic expectations about dot-com companies, but there was real economic growth underneath it too.

In all of those periods, the market reflected strong economic trends: solid growth, high or strengthening employment and stable inflation. Only the latter is present today. The unemployment rate is improving, but it’s still a relatively high 6.1%. The best GDP rate produced since the financial crisis was 2.8%. That was in 2012, before the current bull market really took off.

Perhaps, as some suggest, this is a new normal. If so, it represents a disconnect between economic reality and market valuation. More likely, it’s a warped market distorted by the extraordinary measures used to create an economic lift.

As market indexes touch new highs, investors should ask themselves if they’re taking part in a history-making rally, or a rally that is ignoring history.
I think Mr. Weidner raises some good points but he's way off on others. Even with all the quantitative easing the Fed has engaged in, the stock market is a leading indicator of economic activity, not a lagging or coincident indicator. The rising U.S. stock market reflects an improvement in the labor market, even if it's a weak recovery compared to all other post-war recoveries (the effects of the financial crisis will be felt for a very long time).

But there are other reasons to be concerned. An astute hedge fund manager sent me an article by Mark Hulbert of MarketWatch, Another sign the bull market is nearing its end:
Here’s another sign the bull market in stocks may be nearing an end: Companies have dramatically reduced share repurchases.

New stock buybacks fell to $23.2 billion in June, the lowest level in a year and a half, according to fund tracker TrimTabs Investment Research. In May, the total was just $24.8 billion, and the monthly average in 2013 was $56 billion.

That’s worrisome, according to TrimTabs CEO David Santschi, because “buyback volume has a high positive correlation with stock prices.” (click on image below)

How high? Consider the correlation coefficient, a statistic that reflects the degree to which two series tend to zig and zag in lockstep. It ranges from plus 1 (which means the two series are perfectly correlated) to minus 1 (the two move inversely to each other). A zero correlation coefficient would mean there is no detectable relationship between the two series.

According to Santschi, the correlation coefficient between monthly buyback volume and the stock market’s level, for the period from 2006 until this spring, was 0.61. That’s highly statistically significant.

A high correlation also makes theoretical sense. That’s because, when a company announces a share-repurchase program, it sends a strong signal that its management really thinks its stock is undervalued — so much so that it’s willing to put its money where its mouth is. So it’s bullish for the overall market when lots of companies are simultaneously announcing such programs.

To be sure, the monthly buyback data are quite volatile, so two months of anemic numbers don’t automatically doom the market. Santschi, for one, says that, if the slow pace continues through July, “we will become very concerned.”

Hedge-fund manager Douglas Kass, president of Seabreeze Partners Management, relates the slowdown in buybacks to the recent M&A wave. He says that both activities represent the implicit recognition by corporate managements that their internal operations are unable to produce sufficient revenue growth to maintain their stock prices.

Over the past five years, for example, per-share sales growth for S&P 500 companies has been an annualized 2.4%, lagging far behind the 20% annualized earnings per share growth rate. One of the ways in which corporate managers have been able to extract that much EPS growth out of such anemic sales growth, Kass argues, is through share repurchases.

As their share prices become more and more inflated, however, corporate managers become increasingly reluctant to buy them. The logical thing to do instead is buy up other companies, paying with shares of their inflated stock.

That’s what is happening now, Kass argues: “There’s a baton exchange from buybacks into M&A activity.”

And, as I detailed at greater length in my column earlier this week, past M&A waves have all ended with a precipitous decline in stock prices.
I covered share buybacks when I recently discussed CEO pay spinning out of control. The main reason why companies repurchase their shares is not to award shareholders but to inflate the bloated compensation of their senior executives (gotta love modern day capitalism!).

But correlations don't translate to causation and I think it's normal that at one point M&A activity picks up because companies are looking for new sources of growth. What concerns me more is the bubble in private equity. Earlier this week, I discussed private equity's trillion dollar hole where I went over the problems plaguing managers -- too much money and not enough attractive deals.

Valuations have reached nosebleed levels. Zero Hedge reports that the median LBO multiple soared to a mind blowing 11.6x.  Obviously, this can't go on forever as fundamentals will catch up and those paying high multiples will get whacked hard when they do.

Nonetheless, as I explained earlier this week in a comment on when interest rates rise, the main threat in the global economy isn't inflation, it's deflation. If deflation takes hold, interest rates will go lower, pushing valuations up across the board. Of course, if it's a bad bout of debt-deflation, public, private equities, real estate and high yield bonds will get wiped (only government bonds will save you).

Another sign that too much optimism abounds is that short selling activity dropped to its lowest level since the Lehman crisis:
The amount of so-called short interest in the benchmark US S&P 500 index is hovering around 2 per cent of total shares in the index, close to the lowest level since Markit began collecting the data in 2006. In the European Stoxx 600 index, the level is similar at just over 2 per cent, while short interest in the UK FTSE All-Share index stands at less than 1 per cent.

This compares with sharply elevated levels in the years preceding the credit crisis, with the data showing short interest in the US in 2007 hitting a high of 5.5 per cent. The Markit data does not take into account all changes in stock indices over the period.

Buoyed in part by injections of cheap money from central banks, including the Federal Reserve’s asset-purchase programme, leading stock markets have continued to rise this year after enjoying strong gains in 2013, forcing some hedge funds to cut their short bets to avoid being squeezed.
I think a lot of hedge funds are getting killed shorting this market which is why they're scaling back their short bets. David Einhorn of Greenlight Capital wrote about it. “It is dangerous to short stocks that have disconnected from traditional valuation methods,” Mr Einhorn told his clients earlier this year. “After all, twice a silly price is not twice as silly; it’s still just silly”.

Finally, Jennifer Ablan of Reuters reports, Carl Icahn says 'time to be cautious' on U.S. stocks:
Billionaire activist investor Carl Icahn said on Thursday that it is time for U.S. stock market investors to tread carefully after the run-up on Wall Street.

"In my mind, it is time to be cautious about the U.S. stock markets," Icahn said in a telephone interview. "While we are having a great year, I am being very selective about the companies I purchase."

U.S. stocks fell on Thursday as concerns about the financial health of Portugal's top listed bank gave investors a reason to cash in recent gains. The S&P 500 fell as much as 1 percent at one point before sharply rebounding, to close down -0.41 percent at 1964.68.

Icahn has been pressuring discount retailer Family Dollar Stores Inc to sell itself. On Thursday, Family Dollar said its profit fell by a third as it cleared inventory ahead of planned store closures and competition intensified.

Icahn, Family Dollar's largest shareholder with a 9.4 percent stake, wants the company to sell itself to rival Dollar General Corp to help them cope with stiff competition from big-box retailers such as Wal-Mart Stores Inc.

Icahn said: "The leadership, to say the least, is questionable at Family Dollar and it's been that way for many years. Howard (Levine) might be a nice guy but he is far from the right leader for Family Dollar."

Icahn added: "We believe Family Dollar and Dollar General should merge as they would make for perfect partners. It is obvious that Family Dollar, especially in light of its record and the looming competition on the horizon, could use a partner.

"However, unfortunately, the announcement of Dollar General Chief Executive Rick Dreiling's retirement is a setback to an activist player like us that would like to accelerate this process but it doesn't mean it is insurmountable on a long-term basis" with regards to a possible merger between Dollar General and Family Dollar.
Two things came to mind as I read this article. First, Carl Icahn should come to Montreal and talk to Larry Rossy, founder of Dollarama, and gain some real insights on how a successful dollar store is run.

The second thing that came to mind is why is Carl Icahn following David Tepper yapping about why he's nervous about U.S. stocks? Haven't I told you overpaid gurus to shut up with your self-serving proclamations on where stocks are heading? Stop scaring retail investors and show us your book. We're not interested in your words.

Now, to be fair to Icahn, he didn't say get out of stocks. He said he's nervous and thinks investors should be selective with the stocks they purchase. I agree, pick your stocks and sectors carefully or risk getting slaughtered in this environment.

In mid August, I'll be covering quarterly activity of top funds, going over the holdings of many hedge fund gurus. Below, I provide a snapshot of the Q1 holdings of Icahn Associates (click on image):

As you can see, Icahn is heavily invested in a concentrated portfolio, with Apple (AAPL), CVR Energy (CVI), Actavis (ACT), Chesapeake Energy (CHK), Ebay (EBAY), Netflix (NFLX) and Transocean (RIG) all being among his top holdings (he doesn't look too worried about a crash).

Every day, I scan the U.S. stock market and look at who are the top YTD performers, 12-month leaders, and stocks making 52-week highs. I like what I see. There are plenty of great stocks in all sectors. Look at the performance of Blackberry (BBRY), Alcan Aluminum (AA), Agnico Eagle Mines (AEM), ConoPhillips (COP), Haliburton (HAL), Novartis (NVS) and Under Armour (UA), just to name a few (I would remain long in some and take profits in others).

Below, Bloomberg View Columnist Barry Ritholtz and Bloomberg’s Jonathan Ferro discuss what’s behind the global equities selloff on Bloomberg's “Market Makers.”

And is the S&P about to take 30 percent dive? Marc Faber, the editor and publisher of the Gloom, Boom & Doom Report, says the global economy does not support current valuations and the market may bypass a meaningful correction and go straight to a crash.

I would ignore these stock market bears waiting for a severe correction. Everyone is nervous but I stick with my outlook 2014 and viewed the big unwind in Q1 as another buying opportunity.  I still like biotechs (IBB and XBI), small caps (IWM), technology (QQQ) and internet shares (FDN). By the way, I particularly like Twitter (TWTR) and tweeted people to load up on it when it fell below $30 several weeks ago (stay long).

My personal portfolio remains in RISK ON mode, heavily invested in small cap biotechs like Idera Pharmaceutical (IDRA), my top holding at this moment (very volatile and extremely risky). I personally couldn't care less what Carl Icahn, David Tepper, Marc Faber or anyone else has to say on why they're "nervous on stocks." We haven't reached the melt-up phase in stocks yet, and when we do, it will make 1999 look like a walk in the park.

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