The “Rules” of Prediction

The “Rules” of Prediction

As Benjamin Graham, the father of modern common stock analysis, once wrote, “In the short run, the market is a voting machine, and it’s quite clear that the votes are not always cast in favor of value. Still, in the long run, it is a weighing machine.”

For those looking for some excellent reading, we recommend that you obtain a copy of Michaels Lewis’ (of MoneyBall etc. fame) new book, The Undoing Project. It is, in its essence, the background history of behavioural economics. The two fathers of the modern psychology of predictions, Amos Tversky and Daniel Kahneman, took away the “rules” that used to underlie the assumption of the ‘rational man’, so beloved by people like B.F. Skinner, and gave us a whole new way of thinking about how decisions are actually made. The book is written in Lewis’ usual breezy style with lots of personal stuff to remind us that they are/were human, too, but leading to some fascinating insights into the way that we actually think.

At SAC, we do, of course, attempt to predict the future of stock prices and even overall market movements, even though we are very aware that prediction is often more an art form than a strict science. As cited above, however, we do know that in the long run, the market is, as Benjamin Graham pointed out many years ago, a weighing machine. It is the short term that is often the devil in the details when the market becomes a popularity contest, a voting machine. In chapter 7 of Lewis’ book, we found this excellent summary of the prediction process – which would seem to go some way to explain why markets are the way that they are today.

Consider their outline of the “science” of prediction:

  •         People predict by making up stories
  •         People actually predict very little, but stories ‘explain’ everything
  •         People live under uncertainty whether they like it or not
  •         People believe that they can tell the future if they work at it hard enough
  •         People will accept any explanation as long as it appears to fit the facts
  •         The handwriting may be on the wall. It was just that the ink that is used tends to be invisible
  •         People often work hard to obtain information that they already have, and avoid new knowledge
  • People mistake the delay of consequences with the absence of consequences.

This argument is quite popular with investors who haven’t spent much time getting their hands dirty with historical data, satisfied to repeat verbal arguments they’ve heard elsewhere as a substitute for analysis.

  •         Man is a deterministic being thrown into a probabilistic universe
  •         In this match-up, surprises are (or should be) expected
  •         Since the explanations that are invoked following events “fit the facts”, everything that has already happened must therefore have been inevitable. And if that is so, why is it that we can’t see what is inevitable in the future which lies immediately ahead of us?

A Self-Perpetuating Do-Loop

What seems to have happened recently is a sort of self-perpetuating do-loop between market strength and economic expectations. As John Hussman recently observed, “In recent months, the consensus of survey-based economic measures has turned higher, including a variety of surveys of purchasing managers, as well as indices compiled by regional Federal Reserve banks. At the same time, economic measures based on actual activity such real GDP, real sales, consumption, and employment haven’t been nearly as robust, and in some cases have turned lower. This disparity between “hard” activity-based and “soft” survey-based measures has been particularly wide relative to historical norms.

Soft survey-based measures tend to be most informative when they uniformly surge coming out of recessions. In contrast, during late-stage economic expansions, positive disparities in soft measures tend to be false signals that are resolved in favor of harder measures. Sharp downturns in “soft data” can contribute to recession warnings, but they should be confirmed by measures such as slowing growth in employment, real personal income, and consumption. That has been particularly true in recent years, when historically reliable survey-based signals were regularly distorted by swings in expectations about quantitative easing.

The current positive divergence is particularly likely to be misleading. The charts of survey-based measures demonstrate this. What’s striking about survey-based economic measures is that their 5-year rolling correlation with actual subsequent economic outcomes has plunged to zero in recent years (and periodically less than zero), meaning that these measures have been nearly useless or even contrary indicators of subsequent economic outcomes.

What Hussman is saying is that the (soft) survey data that things are getting better and better are reinforcing the bullishness reaction of the stock market. And the bullish stock market reinforces the soft survey data because it is ‘obvious’ that a strong market is indicative of a strong economy. So this is the ‘story’ that supports the observed outcome, a rising market in the face of increasingly poor actual fundamentals.

Now to finish the story, the higher that the market goes and the weaker the fundamentals that support it, the less investors are able to rely on solid fundamental data to build portfolios upon, and the more that they must rely on momentum. That means that “value managers” tend to underperform the market, and, indeed, almost any form of active management tends to underperform as stock selection implies using sound judgement based on hard data, but it is not that kind of judgement that is driving the market today.

Take that a step further, and we have the powerful move to ETF investing (exchange traded funds which mimic some underlying index of stocks, either the overall market or specific groups however defined). ETF investors simply buy the index and everything in it without regard to value, because they have “discovered” that value investing doesn’t work [anymore]. As the self-perpetuating market/survey-based data do-loop continues to weave its magic, we get another self-perpetuation do-loop, namely that investment selection based on “value” is a mugs game: all you have to do is to buy the index, warts and all, no matter what is inside it as it doesn’t really matter.

As investors pour money into Index ETFs, which by definition have to buy everything in an Index, capitalization-weighted of course, the highly priced and highly cap-weighted get more highly priced and cap-weighted regardless of their intrinsic value. It is a virtuous circle if you happen to manage ETFs and a vicious circle if you do not. As a money manager, you cannot avoid buying the ridiculously priced stocks because to fail to do so is to underperform the

ETFs to which you are being compared.

This Time is Different?

Now that the financial and the popular press has seized on this obvious fact, the resultant upwelling flood of money into ETFs essentially does nothing except to distort the values in the market even further. Professional judgement is not needed any longer. The market therefore concludes that the ETF is here to stay, and investors now have an easy, one-decision judgement to make.

One decision investing! How simple can life get? However, before we embrace the concept whole-heartedly, it might be well to inquire, ‘have we ever been there before?’ and what was the outcome? For those of us who have been around this block before, we remember Charlie Ellis’ great landmark book, Institutional Investing, which appeared in 1971. In his book, Ellis noted that if you bought the then-called Nifty Fifty growth stocks, they had (note the tense) outperformed the market for decades, and that therefore all a money manager had to do to outperform the market was to buy those stocks as the core of any and all portfolios. After that, money poured into those stocks. But can anyone guess what happened next? By the bottom of the bear market of 1973-4, the average Nifty Fifty stock was down by some 80%. Many never came back to their previous highs and those that did often took decades to do so.

Of course, we don’t have to go back that far. Just recall 1999-2000 when the internet was going to revolutionize the world and the dot-com stocks went wild. When we criticized the valuation levels of some of these stocks on BNN (then ROB-Tv), we were accused of “not understanding the 21st Century”. But it turned out that it was not the 21st Century that needed to be understood: it was market valuations and balance sheets that one needed to grasp, and after a 2-year bear market which saw the utter collapse of those stocks, suddenly value was back in vogue. Warren Buffett was not dead (as one earnest advisor assured us in the Spring of 2000) after all!

As Tversky and Kahneman discovered in their research, fear of remorse over lost opportunity gains often drives decisions. If the market goes up 10%, and you are in too much cash or too cautious, how annoyed, concerned, and bothered would you be, even though you know that the values that you would have had to be invested in were stupidly extreme – if you only make 3-4-5% instead? Being “left out” is tough to swallow. And it helps to have a willingness to suspend belief in support of the ‘the story’. We observed, for instance, that CP Rail recently had a flat quarter, and the stock is close to an all-time valuation high with no fair market value potential left? Of course, the stock jumped 4% because management assured us that ‘things will get better’. There’s a lot of story-telling without supporting evidence going around these days. It’s all bullish (no ‘T’ in the spelling!).

Plus Ça Change, Plus C’est La Même Chose?:

What Now for the Market?

Valuation extremes require investors to argue “this time is different” – and dismiss the entire history of the financial markets – because valuation extremes have always ended badly. As the saying goes, when everyone thinks alike, no one thinks. Dry powder has considerable value here, not because of the poor return it currently generates, but because of the opportunity it may afford to establish constructive and even aggressive market exposure over the completion of this cycle, at much higher prospective returns than are currently available.

In our North American Value Portfolio, ex the gold stocks which we hold for insurance purposes, the median price/book ratio for the majority of stocks is fairly close to 1.1 times, and the average forward Price/Earnings Ratio about 12 times. This is a far cry from the average price/book of the S&P 500 of more than 2½ times and an average PE of 21.3x. For the SPTSX, the numbers are 1.5 times for the price/book and 18.6x for the average PE Ratio. And we hold some cash because we suspect that sometime in the not so distant future, cash may well be king again.

We continue to hold about 10% of the fund in gold shares. We do suspect that if, as, and when markets are weak (bearish), the Fed will mount another charge to the rescue – as it has since the sudden market collapse in 1987 – and flood the land with money again. The Donald would not have it any other way!  

Will the gold stocks hold up if markets go south? Not entirely, but they will come back earlier and faster than the rest of the market because the Fed is highly likely to have a catfit if markets head south, and they will “do something” (stupid but helpful to gold investors) to head off anything too serious in the way of a decline. Are there any better hedges than golds? Not likely, except cash. The reality of markets is that in weak markets (i.e. bear markets) investors sell their garbage first (the stocks that are plunging) and then the good stocks a bit later (the ones that haven’t plunged so far) because “they didn’t go down, so I took some profits to offset my losses”. Even banks take it on the chin, albeit often not so badly, even if sometimes it feels as if they are as bad as anything else. Investors lose all perspective in bear markets and this one may be quite interesting because all those innocent folks who are investing in ETFs will find out that ETFs don’t mean a thing from a safety point of view in a bear market. Most people don’t have a clue as to what’s inside them, but as they are designed to act like the market so they will get pasted like the market and provide you with no cushion of safety at all.

Hussman concludes that, put simply, investors are in an echo chamber now, where their optimism about economic outcomes drives optimism about the stock market, and optimism about the stock market drives optimism about economic outcomes. Given the deterioration in correlations between “soft” survey-based economic measures and subsequent economic and financial outcomes, investors should be placing a premium on measures that are reliably informative. On that front, hard economic data, labor force constraints, factors influencing productivity (particularly gross domestic investment and the position of the current account balance in the economic cycle), reliable valuation measures, and market internals should be high on that list. The hard economic data tell a much different story than soft survey-based measures, and there is a risk that investors may be setting themselves up for considerable disappointment. The GDPNow projection from the Atlanta Fed for first-quarter 2017 GDP growth has dropped to a projected annualized growth rate of just 0.6%. That is a far cry from what the man on the street expects for 2017, but a number that was confirmed in the last week in April when the US GDP actually grew at a 0.7% rate, missing the +1.1% estimate handily.

 

What Now?

 

The market is expensive and risky – but what else is new in 2017? Still, the more comfortable investors become with trusting in ETFs to take all the risks out of stock selection, the more dangerous the markets become. We “know” that if markets were to weaken to any significant degree that the Fed would not be far behind in cutting what rates are left to cut and pumping money into the system. Unfortunately, that is not what the economy needs now, but it is all that t is going to get.

It would be our suspicion and expectation based on the history of the S&P 500 that a setback to its Growth Price (2 times adjusted book value) which would suggest roughly a 23% downside risk from current levels.

For an economy that’s built on the market that’s built on an economy that’s built on the market, the unwinding of this mare’s nest should be something to behold. In the meantime, whether or not “value” is the metric of the day or not – and right now, it is not – we will stick with value stocks in the expectation, no matter how forlorn at present, that good value will prove to be a better investment bed to lie on than hopes and dreams. We feel that a decent amount of cash is a sound strategy, and that given the final outcome, gold stocks will prove their worth.

Posted in Uncategorized | 1 Comment

The “Rules of Prediction

The “Rules” of Prediction

As Benjamin Graham, the father of modern common stock analysis, once wrote, “In the short run, the market is a voting machine, and it’s quite clear that the votes are not always cast in favor of value. Still, in the long run, it is a weighing machine.”

For those looking for some excellent reading, we recommend that you obtain a copy of Michaels Lewis’ (of MoneyBall etc. fame) new book, The Undoing Project. It is, in its essence, the background history of behavioural economics. The two fathers of the modern psychology of predictions, Amos Tversky and Daniel Kahneman, took away the “rules” that used to underlie the assumption of the ‘rational man’, so beloved by people like B.F. Skinner, and gave us a whole new way of thinking about how decisions are actually made. The book is written in Lewis’ usual breezy style with lots of personal stuff to remind us that they are/were human, too, but leading to some fascinating insights into the way that we actually think.

At SAC, we do, of course, attempt to predict the future of stock prices and even overall market movements, even though we are very aware that prediction is often more an art form than a strict science. As cited above, however, we do know that in the long run, the market is, as Benjamin Graham pointed out many years ago, a weighing machine. It is the short term that is often the devil in the details when the market becomes a popularity contest, a voting machine. In chapter 7 of Lewis’ book, we found this excellent summary of the prediction process – which would seem to go some way to explain why markets are the way that they are today.

Consider their outline of the “science” of prediction:

  •         People predict by making up stories
  •         People actually predict very little, but stories ‘explain’ everything
  •         People live under uncertainty whether they like it or not
  •         People believe that they can tell the future if they work at it hard enough
  •         People will accept any explanation as long as it appears to fit the facts
  •         The handwriting may be on the wall. It was just that the ink that is used tends to be invisible
  •         People often work hard to obtain information that they already have, and avoid new knowledge
  • People mistake the delay of consequences with the absence of consequences.

This argument is quite popular with investors who haven’t spent much time getting their hands dirty with historical data, satisfied to repeat verbal arguments they’ve heard elsewhere as a substitute for analysis.

  •         Man is a deterministic being thrown into a probabilistic universe
  •         In this match-up, surprises are (or should be) expected
  •         Since the explanations that are invoked following events “fit the facts”, everything that has already happened must therefore have been inevitable. And if that is so, why is it that we can’t see what is inevitable in the future which lies immediately ahead of us?

A Self-Perpetuating Do-Loop

What seems to have happened recently is a sort of self-perpetuating do-loop between market strength and economic expectations. As John Hussman recently observed, “In recent months, the consensus of survey-based economic measures has turned higher, including a variety of surveys of purchasing managers, as well as indices compiled by regional Federal Reserve banks. At the same time, economic measures based on actual activity such real GDP, real sales, consumption, and employment haven’t been nearly as robust, and in some cases have turned lower. This disparity between “hard” activity-based and “soft” survey-based measures has been particularly wide relative to historical norms.

Soft survey-based measures tend to be most informative when they uniformly surge coming out of recessions. In contrast, during late-stage economic expansions, positive disparities in soft measures tend to be false signals that are resolved in favor of harder measures. Sharp downturns in “soft data” can contribute to recession warnings, but they should be confirmed by measures such as slowing growth in employment, real personal income, and consumption. That has been particularly true in recent years, when historically reliable survey-based signals were regularly distorted by swings in expectations about quantitative easing.

The current positive divergence is particularly likely to be misleading. The charts of survey-based measures demonstrate this. What’s striking about survey-based economic measures is that their 5-year rolling correlation with actual subsequent economic outcomes has plunged to zero in recent years (and periodically less than zero), meaning that these measures have been nearly useless or even contrary indicators of subsequent economic outcomes.

What Hussman is saying is that the (soft) survey data that things are getting better and better are reinforcing the bullishness reaction of the stock market. And the bullish stock market reinforces the soft survey data because it is ‘obvious’ that a strong market is indicative of a strong economy. So this is the ‘story’ that supports the observed outcome, a rising market in the face of increasingly poor actual fundamentals.

Now to finish the story, the higher that the market goes and the weaker the fundamentals that support it, the less investors are able to rely on solid fundamental data to build portfolios upon, and the more that they must rely on momentum. That means that “value managers” tend to underperform the market, and, indeed, almost any form of active management tends to underperform as stock selection implies using sound judgement based on hard data, but it is not that kind of judgement that is driving the market today.

Take that a step further, and we have the powerful move to ETF investing (exchange traded funds which mimic some underlying index of stocks, either the overall market or specific groups however defined). ETF investors simply buy the index and everything in it without regard to value, because they have “discovered” that value investing doesn’t work [anymore]. As the self-perpetuating market/survey-based data do-loop continues to weave its magic, we get another self-perpetuation do-loop, namely that investment selection based on “value” is a mugs game: all you have to do is to buy the index, warts and all, no matter what is inside it as it doesn’t really matter.

As investors pour money into Index ETFs, which by definition have to buy everything in an Index, capitalization-weighted of course, the highly priced and highly cap-weighted get more highly priced and cap-weighted regardless of their intrinsic value. It is a virtuous circle if you happen to manage ETFs and a vicious circle if you do not. As a money manager, you cannot avoid buying the ridiculously priced stocks because to fail to do so is to underperform the

ETFs to which you are being compared.

This Time is Different?

Now that the financial and the popular press has seized on this obvious fact, the resultant upwelling flood of money into ETFs essentially does nothing except to distort the values in the market even further. Professional judgement is not needed any longer. The market therefore concludes that the ETF is here to stay, and investors now have an easy, one-decision judgement to make.

One decision investing! How simple can life get? However, before we embrace the concept whole-heartedly, it might be well to inquire, ‘have we ever been there before?’ and what was the outcome? For those of us who have been around this block before, we remember Charlie Ellis’ great landmark book, Institutional Investing, which appeared in 1971. In his book, Ellis noted that if you bought the then-called Nifty Fifty growth stocks, they had (note the tense) outperformed the market for decades, and that therefore all a money manager had to do to outperform the market was to buy those stocks as the core of any and all portfolios. After that, money poured into those stocks. But can anyone guess what happened next? By the bottom of the bear market of 1973-4, the average Nifty Fifty stock was down by some 80%. Many never came back to their previous highs and those that did often took decades to do so.

Of course, we don’t have to go back that far. Just recall 1999-2000 when the internet was going to revolutionize the world and the dot-com stocks went wild. When we criticized the valuation levels of some of these stocks on BNN (then ROB-Tv), we were accused of “not understanding the 21st Century”. But it turned out that it was not the 21st Century that needed to be understood: it was market valuations and balance sheets that one needed to grasp, and after a 2-year bear market which saw the utter collapse of those stocks, suddenly value was back in vogue. Warren Buffett was not dead (as one earnest advisor assured us in the Spring of 2000) after all!

As Tversky and Kahneman discovered in their research, fear of remorse over lost opportunity gains often drives decisions. If the market goes up 10%, and you are in too much cash or too cautious, how annoyed, concerned, and bothered would you be, even though you know that the values that you would have had to be invested in were stupidly extreme – if you only make 3-4-5% instead? Being “left out” is tough to swallow. And it helps to have a willingness to suspend belief in support of the ‘the story’. We observed, for instance, that CP Rail recently had a flat quarter, and the stock is close to an all-time valuation high with no fair market value potential left? Of course, the stock jumped 4% because management assured us that ‘things will get better’. There’s a lot of story-telling without supporting evidence going around these days. It’s all bullish (no ‘T’ in the spelling!).

Plus Ça Change, Plus C’est La Même Chose?:

What Now for the Market?

Valuation extremes require investors to argue “this time is different” – and dismiss the entire history of the financial markets – because valuation extremes have always ended badly. As the saying goes, when everyone thinks alike, no one thinks. Dry powder has considerable value here, not because of the poor return it currently generates, but because of the opportunity it may afford to establish constructive and even aggressive market exposure over the completion of this cycle, at much higher prospective returns than are currently available.

In our North American Value Portfolio, ex the gold stocks which we hold for insurance purposes, the median price/book ratio for the majority of stocks is fairly close to 1.1 times, and the average forward Price/Earnings Ratio about 12 times. This is a far cry from the average price/book of the S&P 500 of more than 2½ times and an average PE of 21.3x. For the SPTSX, the numbers are 1.5 times for the price/book and 18.6x for the average PE Ratio. And we hold some cash because we suspect that sometime in the not so distant future, cash may well be king again.

We continue to hold about 10% of the fund in gold shares. We do suspect that if, as, and when markets are weak (bearish), the Fed will mount another charge to the rescue – as it has since the sudden market collapse in 1987 – and flood the land with money again. The Donald would not have it any other way!  

Will the gold stocks hold up if markets go south? Not entirely, but they will come back earlier and faster than the rest of the market because the Fed is highly likely to have a catfit if markets head south, and they will “do something” (stupid but helpful to gold investors) to head off anything too serious in the way of a decline. Are there any better hedges than golds? Not likely, except cash. The reality of markets is that in weak markets (i.e. bear markets) investors sell their garbage first (the stocks that are plunging) and then the good stocks a bit later (the ones that haven’t plunged so far) because “they didn’t go down, so I took some profits to offset my losses”. Even banks take it on the chin, albeit often not so badly, even if sometimes it feels as if they are as bad as anything else. Investors lose all perspective in bear markets and this one may be quite interesting because all those innocent folks who are investing in ETFs will find out that ETFs don’t mean a thing from a safety point of view in a bear market. Most people don’t have a clue as to what’s inside them, but as they are designed to act like the market so they will get pasted like the market and provide you with no cushion of safety at all.

Hussman concludes that, put simply, investors are in an echo chamber now, where their optimism about economic outcomes drives optimism about the stock market, and optimism about the stock market drives optimism about economic outcomes. Given the deterioration in correlations between “soft” survey-based economic measures and subsequent economic and financial outcomes, investors should be placing a premium on measures that are reliably informative. On that front, hard economic data, labor force constraints, factors influencing productivity (particularly gross domestic investment and the position of the current account balance in the economic cycle), reliable valuation measures, and market internals should be high on that list. The hard economic data tell a much different story than soft survey-based measures, and there is a risk that investors may be setting themselves up for considerable disappointment. The GDPNow projection from the Atlanta Fed for first-quarter 2017 GDP growth has dropped to a projected annualized growth rate of just 0.6%. That is a far cry from what the man on the street expects for 2017, but a number that was confirmed in the last week in April when the US GDP actually grew at a 0.7% rate, missing the +1.1% estimate handily.

 

What Now?

 

The market is expensive and risky – but what else is new in 2017? Still, the more comfortable investors become with trusting in ETFs to take all the risks out of stock selection, the more dangerous the markets become. We “know” that if markets were to weaken to any significant degree that the Fed would not be far behind in cutting what rates are left to cut and pumping money into the system. Unfortunately, that is not what the economy needs now, but it is all that t is going to get.

It would be our suspicion and expectation based on the history of the S&P 500 that a setback to its Growth Price (2 times adjusted book value) which would suggest roughly a 23% downside risk from current levels.

For an economy that’s built on the market that’s built on an economy that’s built on the market, the unwinding of this mare’s nest should be something to behold. In the meantime, whether or not “value” is the metric of the day or not – and right now, it is not – we will stick with value stocks in the expectation, no matter how forlorn at present, that good value will prove to be a better investment bed to lie on than hopes and dreams. We feel that a decent amount of cash is a sound strategy, and that given the final outcome, gold stocks will prove their worth.

Posted in Uncategorized | Leave a comment

The “Rules” of Prediction

As Benjamin Graham, the father of modern common stock analysis, once wrote, “In the short run, the market is a voting machine, and it’s quite clear that the votes are not always cast in favour of value. Still, in the long run, it is a weighing machine.”

For those looking for some excellent reading, we recommend that you obtain a copy of Michaels Lewis’ (of MoneyBall etc. fame) new book, The Undoing Project. It is, in its essence, the background history of behavioural economics. The two fathers of the modern psychology of predictions, Amos Tversky and Daniel Kahneman, took away the “rules” that used to underlie the assumption of the ‘rational man’, so beloved by people like B.F. Skinner, and gave us a whole new way of thinking about how decisions are actually made. The book is written in Lewis’ usual breezy style with lots of personal stuff to remind us that they are/were human, too, but leading to some fascinating insights into the way that we actually think.

At SAC, we do, of course, attempt to predict the future of stock prices and even overall market movements, even though we are very aware that prediction is often more an art form than a strict science. As cited above, however, we do know that in the long run, the market is, as Benjamin Graham pointed out many years ago, a weighing machine. It is the short term that is often the devil in the details when the market becomes a popularity contest, a voting machine. In chapter 7 of Lewis’ book, we found this excellent summary of the prediction process – which would seem to go some way to explain why markets are the way that they are today.

Consider their outline of the “science” of prediction:

  •         People predict by making up stories
  •         People actually predict very little, but stories ‘explain’ everything
  •         People live under uncertainty whether they like it or not
  •         People believe that they can tell the future if they work at it hard enough
  •         People will accept any explanation as long as it appears to fit the facts
  •         The handwriting may be on the wall. It was just that the ink that is used tends to be invisible
  •         People often work hard to obtain information that they already have, and avoid new knowledge
  • People mistake the delay of consequences with the absence of consequences.

This argument is quite popular with investors who haven’t spent much time getting their hands dirty with historical data, satisfied to repeat verbal arguments they’ve heard elsewhere as a substitute for analysis.

  •         Man is a deterministic being thrown into a probabilistic universe
  •         In this match-up, surprises are (or should be) expected
  •         Since the explanations that are invoked following events “fit the facts”, everything that has already happened must therefore have been inevitable. And if that is so, why is it that we can’t see what is inevitable in the future which lies immediately ahead of us?

A Self-Perpetuating Do-Loop

What seems to have happened recently is a sort of self-perpetuating do-loop between market strength and economic expectations. As John Hussman recently observed, “In recent months, the consensus of survey-based economic measures has turned higher, including a variety of surveys of purchasing managers, as well as indices compiled by regional Federal Reserve banks. At the same time, economic measures based on actual activity such real GDP, real sales, consumption, and employment haven’t been nearly as robust, and in some cases have turned lower. This disparity between “hard” activity-based and “soft” survey-based measures has been particularly wide relative to historical norms.

Soft survey-based measures tend to be most informative when they uniformly surge coming out of recessions. In contrast, during late-stage economic expansions, positive disparities in soft measures tend to be false signals that are resolved in favor of harder measures. Sharp downturns in “soft data” can contribute to recession warnings, but they should be confirmed by measures such as slowing growth in employment, real personal income, and consumption. That has been particularly true in recent years, when historically reliable survey-based signals were regularly distorted by swings in expectations about quantitative easing.

The current positive divergence is particularly likely to be misleading. The charts of survey-based measures demonstrate this. What’s striking about survey-based economic measures is that their 5-year rolling correlation with actual subsequent economic outcomes has plunged to zero in recent years (and periodically less than zero), meaning that these measures have been nearly useless or even contrary indicators of subsequent economic outcomes.

What Hussman is saying is that the (soft) survey data that things are getting better and better are reinforcing the bullishness reaction of the stock market. And the bullish stock market reinforces the soft survey data because it is ‘obvious’ that a strong market is indicative of a strong economy. So this is the ‘story’ that supports the observed outcome, a rising market in the face of increasingly poor actual fundamentals.

Now to finish the story, the higher that the market goes and the weaker the fundamentals that support it, the less investors are able to rely on solid fundamental data to build portfolios upon, and the more that they must rely on momentum. That means that “value managers” tend to underperform the market, and, indeed, almost any form of active management tends to underperform as stock selection implies using sound judgement based on hard data, but it is not that kind of judgement that is driving the market today.

Take that a step further, and we have the powerful move to ETF investing (exchange traded funds which mimic some underlying index of stocks, either the overall market or specific groups however defined). ETF investors simply buy the index and everything in it without regard to value, because they have “discovered” that value investing doesn’t work [anymore]. As the self-perpetuating market/survey-based data do-loop continues to weave its magic, we get another self-perpetuation do-loop, namely that investment selection based on “value” is a mugs game: all you have to do is to buy the index, warts and all, no matter what is inside it as it doesn’t really matter.

As investors pour money into Index ETFs, which by definition have to buy everything in an Index, capitalization-weighted of course, the highly priced and highly cap-weighted get more highly priced and cap-weighted regardless of their intrinsic value. It is a virtuous circle if you happen to manage ETFs and a vicious circle if you do not. As a money manager, you cannot avoid buying the ridiculously priced stocks because to fail to do so is to underperform the

ETFs to which you are being compared.

This Time is Different?

Now that the financial and the popular press has seized on this obvious fact, the resultant upwelling flood of money into ETFs essentially does nothing except to distort the values in the market even further. Professional judgement is not needed any longer. The market therefore concludes that the ETF is here to stay, and investors now have an easy, one-decision judgement to make.

One decision investing! How simple can life get? However, before we embrace the concept whole-heartedly, it might be well to inquire, ‘have we ever been there before?’ and what was the outcome? For those of us who have been around this block before, we remember Charlie Ellis’ great landmark book, Institutional Investing, which appeared in 1971. In his book, Ellis noted that if you bought the then-called Nifty Fifty growth stocks, they had (note the tense) outperformed the market for decades, and that therefore all a money manager had to do to outperform the market was to buy those stocks as the core of any and all portfolios. After that, money poured into those stocks. But can anyone guess what happened next? By the bottom of the bear market of 1973-4, the average Nifty Fifty stock was down by some 80%. Many never came back to their previous highs and those that did often took decades to do so.

Of course, we don’t have to go back that far. Just recall 1999-2000 when the internet was going to revolutionize the world and the dot-com stocks went wild. When we criticized the valuation levels of some of these stocks on BNN (then ROB-Tv), we were accused of “not understanding the 21st Century”. But it turned out that it was not the 21st Century that needed to be understood: it was market valuations and balance sheets that one needed to grasp, and after a 2-year bear market which saw the utter collapse of those stocks, suddenly value was back in vogue. Warren Buffett was not dead (as one earnest advisor assured us in the Spring of 2000) after all!

As Tversky and Kahneman discovered in their research, fear of remorse over lost opportunity gains often drives decisions. If the market goes up 10%, and you are in too much cash or too cautious, how annoyed, concerned, and bothered would you be, even though you know that the values that you would have had to be invested in were stupidly extreme – if you only make 3-4-5% instead? Being “left out” is tough to swallow. And it helps to have a willingness to suspend belief in support of the ‘the story’. We observed, for instance, that CP Rail recently had a flat quarter, and the stock is close to an all-time valuation high with no fair market value potential left? Of course, the stock jumped 4% because management assured us that ‘things will get better’. There’s a lot of story-telling without supporting evidence going around these days. It’s all bullish (no ‘T’ in the spelling!).

Plus Ça Change, Plus C’est La Même Chose?:

What Now for the Market?

Valuation extremes require investors to argue “this time is different” – and dismiss the entire history of the financial markets – because valuation extremes have always ended badly. As the saying goes, when everyone thinks alike, no one thinks. Dry powder has considerable value here, not because of the poor return it currently generates, but because of the opportunity it may afford to establish constructive and even aggressive market exposure over the completion of this cycle, at much higher prospective returns than are currently available.

In our North American Value Portfolio, ex the gold stocks which we hold for insurance purposes, the median price/book ratio for the majority of stocks is fairly close to 1.1 times, and the average forward Price/Earnings Ratio about 12 times. This is a far cry from the average price/book of the S&P 500 of more than 2½ times and an average PE of 21.3x. For the SPTSX, the numbers are 1.5 times for the price/book and 18.6x for the average PE Ratio. And we hold some cash because we suspect that sometime in the not so distant future, cash may well be king again.

We continue to hold about 10% of the fund in gold shares. We do suspect that if, as, and when markets are weak (bearish), the Fed will mount another charge to the rescue – as it has since the sudden market collapse in 1987 – and flood the land with money again. The Donald would not have it any other way!  

Will the gold stocks hold up if markets go south? Not entirely, but they will come back earlier and faster than the rest of the market because the Fed is highly likely to have a catfit if markets head south, and they will “do something” (stupid but helpful to gold investors) to head off anything too serious in the way of a decline. Are there any better hedges than golds? Not likely, except cash. The reality of markets is that in weak markets (i.e. bear markets) investors sell their garbage first (the stocks that are plunging) and then the good stocks a bit later (the ones that haven’t plunged so far) because “they didn’t go down, so I took some profits to offset my losses”. Even banks take it on the chin, albeit often not so badly, even if sometimes it feels as if they are as bad as anything else. Investors lose all perspective in bear markets and this one may be quite interesting because all those innocent folks who are investing in ETFs will find out that ETFs don’t mean a thing from a safety point of view in a bear market. Most people don’t have a clue as to what’s inside them, but as they are designed to act like the market so they will get pasted like the market and provide you with no cushion of safety at all.

Hussman concludes that, put simply, investors are in an echo chamber now, where their optimism about economic outcomes drives optimism about the stock market, and optimism about the stock market drives optimism about economic outcomes. Given the deterioration in correlations between “soft” survey-based economic measures and subsequent economic and financial outcomes, investors should be placing a premium on measures that are reliably informative. On that front, hard economic data, labor force constraints, factors influencing productivity (particularly gross domestic investment and the position of the current account balance in the economic cycle), reliable valuation measures, and market internals should be high on that list. The hard economic data tell a much different story than soft survey-based measures, and there is a risk that investors may be setting themselves up for considerable disappointment. The GDPNow projection from the Atlanta Fed for first-quarter 2017 GDP growth has dropped to a projected annualized growth rate of just 0.6%. That is a far cry from what the man on the street expects for 2017, but a number that was confirmed in the last week in April when the US GDP actually grew at a 0.7% rate, missing the +1.1% estimate handily.

 

What Now?

 

The market is expensive and risky – but what else is new in 2017? Still, the more comfortable investors become with trusting in ETFs to take all the risks out of stock selection, the more dangerous the markets become. We “know” that if markets were to weaken to any significant degree that the Fed would not be far behind in cutting what rates are left to cut and pumping money into the system. Unfortunately, that is not what the economy needs now, but it is all that t is going to get.

It would be our suspicion and expectation based on the history of the S&P 500 that a setback to its Growth Price (2 times adjusted book value) which would suggest roughly a 23% downside risk from current levels.

For an economy that’s built on the market that’s built on an economy that’s built on the market, the unwinding of this mare’s nest should be something to behold. In the meantime, whether or not “value” is the metric of the day or not – and right now, it is not – we will stick with value stocks in the expectation, no matter how forlorn at present, that good value will prove to be a better investment bed to lie on than hopes and dreams. We feel that a decent amount of cash is a sound strategy, and that given the final outcome, gold stocks will prove their worth.

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Access to Strategic Analysis Corporation Website

In a way, I must apologize to those who have come to my blog site to read my piece on the Two Dozen Potentially Killer Stocks. There is some SAC nomenclature in there which will not be immediately familiar to the casual reader. However, since most of those who have come to this site have done so because of my exposure on BNN, then you have also heard me use some of the terms that you will have encountered in the TDPKS piece and may wish to learn more about what it is that we at SAC actually do when we analyze a company.

We have a company landing site for those who are interested in our approach to security analysis but do not necessarily wish to approach us directly for more and detailed information. Our site is www.strategicanalysis.ca and has everything that you would want to know about SAC and the background to our services, along with a few short tutorials that will walk you through our techniques in fairly short order.

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Two Dozen Potentially ‘Killer’ Stocks

Severe Valuation Alert (September 2016)

2 Dozen “Quality” Stocks That Could Wreak Havoc in Your Portfolio

One good thing about ­that comes from trying to find value in an expensive market on a regular and ongoing basis is that eventually it dawns on you that among other things, there are an awful lot of stocks which offer very poor value to investors in the sense of any potential increase/decrease to their Fair Market Value (the dotted FMV line on our charts), and yet which the stock market persists in pricing at extremely high valuations (in the SVA price/book sense). When we find a stock that trades at 8 times book value or higher, and whose fair market value is only half of the current price, we have to expect that sooner or later some – or all – of that excess pricing will be taken away. Certainly, based on our experience with our FMV measure, it has had a powerful tendency to attract prices so that when we find that the downside risk of any given stock is 50-70% or more, we can say with confidence that the resulting hole that will be left in ones’ portfolio will be substantial.

When we ran the data for the S&P 500, we discovered, for instance, that 241 stocks in the S&P Index are currently trading with zero to negative Fair Market Value. Now, this is not the bottom of the stock market in a nasty recession that we are referring to, where earnings may have disappeared for the time being and which are likely to bounce back when the economy turns stronger, but eight years into a bull market expansion during which time investor confidence in a number of stocks has vastly outrun the ability of the underlying companies to generate supporting value. Worse, the overall earnings for the S&P 500 have been weakening for 5 quarters running. Of course, the analysts are claiming that 2017 will be a strong rebound year. It will have to be – and in some cases, several more – in order to justify paying some of the prices/valuations that we are seeing. But there is scant evidence that anything like that is remotely possible, save in the imaginations of those forecasting what may well turn out to be impossible earnings.

We have been here before. Only the names of the stocks have been changed to protect the innocently naïve. In 2000, it was high technology with their “for sure” big earnings gains needed to justify their outrageous market price/book valuations. Today, it is Tesla and Netflix among others where big sales and earnings growth are coming – for sure – to justify their massive valuations. Maybe yes, and maybe no – but when the stock market begins to pay for results too many years in advance of their appearance, then it is time for a little prudence to prevail.

When we ran the data for the TSX, of the 230 stocks that we have data for, 130 have zero to negative FMV Potential, with 96 showing actual downside FMV risk potential. We have to underline the reality that nothing is for certain, and just because there is negative FMV potential, it does not mean that a given stock will crater, or even go down. However, in our experience with this measure, when markets do fall, the stocks with very poor FMV potential often do very badly by outperforming other stocks on the downside. The issue is that the same psychology that drove the stocks up way in excess of any semblance of reasonable value, gets turned around against those same winners. We have only to consider the recent experience of Valeant Pharmaceuticals (VRX). When things were going well, management were geniuses, and industry consolidation was the miracle answer to creating value. In the crash, the leverage generated and the questionable goodwill that resulted from high-priced acquisitions saw investors panic when they realized that perhaps there was no, or very little, value at all. Back in 2000, Nortel Networks management created what investors thought was a powerhouse of a company – until investors suddenly realized that they were paying 100 times earnings for a company that was only growing at 15-20% per annum at best (and with a balance sheet equity had virtually all been replaced by goodwill). For the companies that we highlight below, we suggest that you take their bullish “story” and twist it back around and see what you think then. Think about Netflix (NFLX) one of our choices below. Netflix is going to entertain the entire world and is expanding everywhere. Now consider that every telco they are up against is trying to generate content for their own service. Positive earnings are hard to come by and competition is brutal. What is this stock really worth? Time will tell, but at 15 times book value, and an FMV potential of -85%, we for one do not intend to find out by personal experience.

In alphabetical order by company name but not by stock symbol, here are the stocks of two dozen major North American companies whose businesses look unassailable and therefore whose stock prices equally ‘safe and secure’ but who history tells us all too clearly, are vulnerable to massive price declines even if not a lot happens to their future earnings.

 

3M Company (MMM- $179.60)

3M has climbed back to its usual extreme valuation high, its SVA Bubble Price (7.4 times adjusted book). Earnings growth has slowed to a crawl over the past 2 years, and although share buybacks have reduced that Bubble Price by about 22%, they appear to have done nothing for the average earnings per share numbers. The Fair market Value (“FMV”) measure is currently 21.3% lower than the market price. Historically, the market has moved the stock above its FMV measure, but also historically, the FMV has always pulled the price back down to and below that critical measure. Without visible growth and an extended valuation, we can see no investment potential for the stock at this time.

Current MV Ratio (Price/book)      7.9x                 Current FMV (+/-)    -22%

 

Amazon.com Inc. (AMZN – $760)

Amazon may be the most problematic of our 24 over-valued stocks because it is not only fast-growing, but also its Fair Market Value based on current earnings forecasts have been rising at a very high rate over the past 2 years – which is due to the massive investment in e-commerce and which is beginning to pay off in terms of earnings and balance sheet growth. Having noted that, the stock is trading at 36.4 times its book value, the PE Ratio stands at 87, and the Fair Market Value of the stock stands at -79%. In the past, the stock has exhibited huge volatility in weak markets and therefore we would have to conclude that the supporting values – however rapidly they are ‘catching up’ with the current price – still represent massive investment risks to investors.

Current MV Ratio (Price/book)      36.4x               Current FMV (+/-)    -79%

 

Altria Group Inc. (MO) – $66.35

This venerable tobacco and now wine company has enjoyed a terrific gain of over 400% from the lows of 2008-9 to the current day. In the process, the share price has moved well above our Fair Market Value (“FMV”) calculation ($42.25) to a level which is 40% above that measure at the present time. The reason that we are concerned here is that in a bear market, that FMV will not only exert strong downwards pull on the price, but also, if the company’s own valuation history has any influence, the market price of the shares will fall well below that measure before it finds a low. It is probably safe to project a good discount to the FMV of about the same degree as the current price exceeds it today. While the company’s earnings have enjoyed a steady increase over that period, the market valuation (in price to book terms) has grown much more rapidly – and therefore can fall just as easily.

Current MV Ratio (Price/book)      24.3x               Current FMV (+/-)    -36%

 

The Coca-Cola Company (KO) – $43.75

In recent years, the earnings growth of KO has slowed not only to a crawl but have actually fallen on a per share basis since 2013. The company has been buying back stock to boot, so the decline is even more startling. The Fair Market Value of KO is well below the current market price such that it is impossible for us to identify any reason for holding this stock, save for a modestly decent 3.2% dividend yield. In the 2008 bear market, KO fell from a premium to its FMV to a good discount and we have less reason to suppose that this time around should be any different because the fundamentals – including a negative balance sheet trend – all seem to be aligned against the investor. The stock reached the same maximum valuation, the Bubble Price or about 8 times book value, that it did at the peak in early 2008, and is now trending lower, as far as we are able to ascertain.

Current MV Ratio (Price/book)      6.4x                 Current FMV (+/-)    -23%

 

Colgate-Palmolive Co (CL) – $74.50

Sometimes, you have to stare in stunned admiration at what the market will pay of a given company, and CL is one such example. Although the balance sheet has been declining for years now, and if stock buybacks were supposed to enhance the earnings outlook in this case, they have not, as the earnings per share have been flat or in decline over the same period, the price/book of CL has reached a 120 times (and a paltry 2% yield). The current FMV potential for the stock is now 58% lower than the market price and so we can only imagine what might happen if market conditions became hostile to growth stocks in general and massively over-priced ones in particular. We cannot say that there is any evidence that the shares are about to do anything except head higher but we do not want to be there if the music ever stops.

Current MV Ratio (Price/book)      129.3x             Current FMV (+/-)    -58%

 

Constellation Software (CSU) – $545 (TSX)

Constellation Software Inc. is probably one of the largest companies ($11+ billion market cap) that you have never heard of. It is a Canada-based company, engaged in acquiring, managing and building vertical market software (VMS) businesses. The Company operates through two segments: public sector and private sector. It is also engaged in the provision of professional services and support. The shares have enjoyed an almost straight up run since 2006 from roughly $22 to $580 with only a modest blip in that trend in 2008-9. For a lot of that time, however, the stock price was lower than its Fair Market Value, which we cannot no longer say today, as the share price now exceeds the FMV by some 45%. Since the FMV does exert a powerful pull on price, any significant market weakness is highly likely to draw CSU towards (and usually below) that value, particularly because the price to book now stands at 18.8, a heady valuation by almost any measure.

Current MV Ratio (Price/book)      19.2x               Current FMV (+/-)    -46%

 

Costco (COST) – $168

Costco has attained a valuation of 5.5 times book last experienced in early 2000, and is trading well above its FMV measure of $110. What is peculiar about this is that the growth in book value has slowed to a crawl (although the earnings per share have managed to maintain a decent rate of annual gain). The shares are now 35% above their FMV measure. The decline from the last valuation peak was severe and we would not expect anything different this time around. The usual low following every bear market has been the Growth Price (‘G’ Price) of the stock which currently stands at $61. Pardon us if we stand aside from this one.

Current MV Ratio (Price/book)      5.5x                 Current FMV (+/-)    -34%

 

Dollarama Inc. (DOL – $99.50)

DOL is untested by the fickle finger of market fate (a bear market) but is already indulging in some stupid capital market moves that will guarantee that downside price pressures – when they come – will be severe, namely the buying back of stock which is diminishing the book value support as well as diminishing the capital available for expansion in the future, and hence its intrinsic growth outlook in the longer term. The company is currently trading at 24.3 times book value, and its current Fair Market Value is 47% below the current price. It may be the only dollar store game in the Canadian market which appears to have given it a cachet that its results and current value to not support. In weak markets, expensive stocks tend to move back to, and then a discount to, their FMV values. The stock could fall to $30, and still trade as what we refer to as a bubble stock (any stock with a valuation above 8 times book). Caution in this Canadian growth favourite.

Current MV Ratio (Price/book)      24.3x               Current FMV (+/-)    -47%

 

Fiserv Inc. (FISV – $102.70)

Fiserv, Inc. (Fiserv) is a major global provider of financial services technology. The shares are currently trading at their highest valuation ever, having recently risen to their Bubble Price (7.4 times book) before setting back very modestly this far. The stock is 21% above its Fair Market Value, having enjoyed a 1000% price gain since 2008. Of all of our choices, changes in payments methodology is enjoying great optimism so this stock may hold up better than most. But is own history tells us that valuation has become extended and the potential markets risks are rising significantly.

Current MV Ratio (Price/book)      7.4x                 Current FMV (+/-)    -21%

 

Home Depot Inc. (HD – $135)

HD is trading at the highest price/book ratio that it is has [ever] enjoyed, at least for the past 25 years. It is also trading at 30% above its Fair Market Value. While the company has “been here before”, it has also had a nasty tendency to fall back to and then below its FMV measure. Worse – from our point of view – the company has been buying back its own stock at very high price/book levels which diminishes its ability to expand in the future while providing very little benefit to ongoing shareholders in the way of increased earnings per share. We admit that we do not know what is going to happen to such companies in the years ahead, but we do suspect that when companies do things that do make economic sense, eventually their shareholders will pay for those mistakes. Just to remain as a Bubble-valued stock (7.4 times book or greater), the shares could currently fall to $57, which offers scant comfort to investors.

Current MV Ratio (Price/book)      17.7x               Current FMV (+/-)    -29%

 

Illumina INC. (ILMN – $169.50)

Illumina, Inc. is engaged in production development of sequencing-and array-based solutions for genetic analysis. The stock has already suffered a fair setback from its peak valuation to its current price/book ratio of 10.8 times, but in the past, the stock has set back to its Fair Market Value measure, which currently stands at -59.5%. The investment risks into what may be late in the market cycle are therefore considerable. Earnings growth has slowed to a crawl over the past year and, should that trend continue, is likely to cause a further decline in the market price of the shares.

Current MV Ratio (Price/book)      10.8x               Current FMV (+/-)    -59%

 

L Brands Inc. (LB – $77.25)

L Brands, Inc. is a specialty retailer of women’s intimate and other apparel, beauty and personal care products and accessories including Victoria’s Secret. The stock has an almost mystical valuation, trading as it does at almost 80 times its book value, although ‘only’ 20 times earnings. If earnings were growing more rapidly, or the business segment more esoteric, we might understand a little better. Furthermore, the book value has not been growing very rapidly either, although that is due to stock buybacks which further inhibits future growth potential. Anything this expensive triggers an ‘Alert’ in our valuation methodology, and this would be a stock that we would cheerfully avoid.

Current MV Ratio (Price/book)      79.7x               Current FMV (+/-)    -46%

 

McDonald’s Corp (MCD – $114.85)

In the 25 years of valuation history that we have for MCD, the shares have exceeded their Fair Market Value measure only once before. What followed was not the sort of experience that any investor on the long side of the market would choose to suffer. So MCD is up there again, and they are cheerfully buying back stock at extreme prices and collapsing the book value support under the stock while their earnings per share growth and hence their Fair Market Value have totally stalled out for the past 5 years. The company could fall to $48 and still remain with what we term a Bubble Valuation of 7.4 times book value or greater – which would be merited (in a sense) by its very high ROE, but that might offer slim solace to the investor.

Current MV Ratio (Price/book)      17.6x               Current FMV (+/-)    -28%

 

Mead Johnson Nutrition Co. (MJN – $83.25)

MJN stock has gone virtually nowhere in the past 5 years, although it has done so with considerable volatility. Even the earnings per share have been quite flat over the same period. At the same time, the price/book per share has been about 100 times, which is to say that there has been no real book value under the share price whatsoever, allowing for a very Fair Market Value (although the share price still exceeds its FMV by some 53%). The company has managed to achieve this feat by dint of having an extremely high ROE on what equity that it does have. To our way of thinking, the shares do not represent investment value in any meaningful way or in any traditional way of analysis. As the shares have only been public since 2009, there are no historical metrics or guidelines to judge the eventual market outcome for the share price in any potential weak market, so any ‘forecast’ of the future price action is purely notional. On the other hand, What parallels that we do have with similar kinds of valuations would not encourage us to be optimistic about the price outcome for MJN over any longer term time horizon.

Current MV Ratio (Price/book)      100x                Current FMV (+/-)    -53%

 

Netflix Inc. (NFLX – $95.20)

Netflix is going to entertain the entire world and is expanding everywhere. But consider that every telco they are up against are also trying to generate content for their own service. Positive earnings have been hard to come by and competition is brutal. What is this stock really worth? Time will tell, but at 15 times book value, a PE Ratio of 143 next year’s earnings, and an FMV potential of -85%, we for one do not intend to find out by personal experience.

Current MV Ratio (Price/book)      14.7x               Current FMV (+/-)    -85%

 

Nike Inc. (NKE – $60.25)

NKE has only traded up this high – at its Bubble Price or 7.4 times book value – only twice before in its past 25 years of valuation history, and both times came to an unfortunate conclusion for investors. It has also only traded above its Fair Market Value during the same two extreme events. The PE Ratio is also very high relative to most other stocks and the yield is tiny. We therefore have to conclude that the risks in this stock now considerably outweigh any potential returns that may be available and therefore the shares should be held by anyone else except our readers.

Current MV Ratio (Price/book)      7.1x                 Current FMV (+/-)    -30%

 

NVIDIA Corporation (NVDA – $62)

NVIDIA Corporation (NVIDIA) is engaged in visual computing, enabling individuals to interact with digital ideas, data and entertainment. With a $33 billion market cap, this is also one pf the largest companies that not many investors have really heard about. It has enjoyed a powerful run in the past year, doubling in price from 3.5 times book to 7.4, and in the process, outstripping its Fair market Value by a solid 50%. Based on its past history of trading, the stock could easily lose 50% of its price in a market setback as a sort of ‘routine matter’ and so we would be extremely careful at current valuation levels – while also being aware that such a tumble could open up a superb buying opportunity, again based its past history.

Current MV Ratio (Price/book)     7.2x                 Current FMV (+/-)    -52%

 

Paychex Inc. (PAYX – $60.70)

The growth rate of PAYX – as measured by its balance sheet equity per share – of this company has markedly slowed in the past 8 years but the share valuation has happily plowed ahead back to an above the Bubble Valuation that it enjoyed when it was growing much more rapidly. The company has outrun its Fair Market Value by some 39% at this juncture, although it does have a nice 3% yield (which absorbs nearly all of the earnings that the business produces). Growth in earnings only modestly exceeds the equity value per share growth. A once-impressive growth story is coming to earth – as one would expect with the size that the company has achieved.

Current MV Ratio (Price/book)      10x                  Current FMV (+/-)    -39%

 

Starbucks Corp ((SBUX – $57.10)

Been there before, done that before, got crushed before. SBUX is back up at its usual extreme valuation and has managed to run well ahead of its Fair Market Value to boot. The growth rate of the equity per share has slowed even allowing for the share buybacks and the yield is nothing to write home about.

Current MV Ratio (Price/book)      13.4x               Current FMV (+/-)    -32%

 

Tesla Motors Inc. (TSLA – $222.60)

This should be an interesting stock to watch in any market weakness, or worse, a meltdown. The company is running on hot air and hope, having managed to miss virtually every business target set for it. Worse, the balance sheet is very weak as we measure it so there is nothing in the tank if the market price fails to hold up. Lots of promise but poor delivery. This is a raging bull market stock but not one for the faint of heart if ever markets weaken.

Current MV Ratio (Price/book)      15.2x               Current FMV (+/-)    -88%

 

Under Armour Inc. (UA – $43.15)

Under Armour, Inc. is engaged in the development, marketing and distribution of branded performance apparel, footwear and accessories for men, women and youth. The company started out 2016 with an impressive 22% jump in price as it beat estimates by $.02 on a 95% surge in show sales – and that was about it for the year to date! What this proves, we are not sure, but we do wonder whether all of those nice price jumps following under-estimates for earnings that come in 2 or 3% above those estimates wind up the same way – buyer’s remorse. The shares are significantly over-valued based on their FMV measure and we would be concerned that the shares will not hold their price in weak markets.

Current MV Ratio (Price/book)      9.9x                 Current FMV (+/-)    -68%

 

Verisign Inc. (VRSN – $74.45)

If you have ever wondered who manages all of those web domain names, and hopefully stops people from copying yours, here’s your answer. VeriSign, Inc. is a global provider of domain name registry services and Internet security, enabling Internet navigation for domain names and providing protection for Websites and enterprises around the world (Registry Services).  Make no mistake, VRSN has not only had a great run in the stock market, but with a 350% ROE may be able to hold its’ valuation as well. The problem is now what? The stock has a massive valuation, is trading with an FMV measure of -46%, no dividend at all despite its huge profitability. It makes one wonder what they do with all the money that they make. The Stability Ratio is not all that strong, so clearly they are not sitting on bags of cash. Hmmm. Perhaps this will continue to do well regardless of the intrinsic value, but we would not touch anything that looked like this under any circumstances.

Current MV Ratio (Price/book)      72x                  Current FMV (+/-)    -46%

 

Vertex Pharmaceuticals Inc. (VRTX – $97.71

Vertex Pharmaceuticals Incorporated (Vertex) is a global biotechnology company. The Company is engaged in the business of discovering, developing, manufacturing and commercializing small molecule drugs. The shares have had a wild ride over the past 15 years, and to judge by what the company is doing and its current metrics, we can probably expect more of the same ahead. Right now, the shares have been on a roll, are very expensive on a price/book basis, a PE basis, and a Fair Market Value basis. On top of all that, if anyone by the name of ‘Clinton’ gets into the White House in November, we suspect that the pharma companies are going to have a much rougher ride in the future than they have had since the last Clinton left that office. Talk about hopes, dreams and waking up screaming. VRTX has had it all with more to come, as far as we can see.

Current MV Ratio (Price/book)      21.2x               Current FMV (+/-)    -62%

 

Yum! Brands Inc. (YUM – $89.75)

Yum! has reached what may or may not prove to be a double top at the $90 level, but from a valuation point of view, deserves to be a maximum. As we observed last year about this time, “No matter how poor your basic stock values, buy back some stock and the market will drive your shares higher – but not forever. Sooner of later, you have to produce sales and earnings. Or, as YUM found out, your stock price drops. Poor value, risky. We would avoid the stock.” Well, as it turned out, the shares did suffer a hefty decline, but then recovered right back to their previous price high, but well above their previous valuation high in price/book terms. In the meantime, earnings forecasts have been steadily slipping, and the over-valuation as measured by our FMV measure

Current MV Ratio (Price/book)      51.2x               Current FMV (+/-)    -47%

 


 

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Black Hole Economics

Thirty-seven years ago, the late founder of Strategic Analysis Corporation, Dr. Verne Atrill, made a remarkable calculation based on a set of mathematical theorems that he had spent his life developing. He discovered that there is a precise point, a mathematical singularity, which we can measure as the Ratio of GDP/ Total Debt, at which an economy stops expanding and begins to contract instead. This point is the equivalent to the event horizon of celestial ‘black holes’ and it acts in a similar manner, the first one drawing energy (light and matter) into its vortex, and the second drawing economic energy – GDP – into its ‘vortex’ due to the dead weight of massive debts. Below that point, if central banks continue to use so-called Quantitative Easing in all its forms, debt will continue to expand (and may do so increasingly rapidly), but more and more GDP will be sucked in, eventually causing a collapse of the economy along with the value of the currency. Today, parts of the Euro Zone, Japan, and Brazil, are already sliding into that vortex, the US is dancing on the rim, and China appears to be doing its level best to move there as well! I can therefore forecast with confidence (and regret) that there is no global recovery lying ahead of us about to ‘kick in’, regardless of what our central bankers and economists expect.Capture

For those who are curious, the complete mathematics are freely available online by simply googling The Limits of Debt. In it, I have shown the full mathematical development and analysis of a theorem of solvency, from first principles, and have included the associated table of values, as well as the graphic relationship which results (as shown in the chart below). In the chart, a GDP/Debt ratio of .289 ($3.50 of debt per $1.00 of GDP) is the financial equivalent of the “event horizon” of a celestial black hole. Like the celestial sort, the table of values shows that the size of economic ‘black holes’ keeps increasing as the mass of debt increases, but in doing so, sucks in more and more GDP to support that debt (that is, reverses the growth of GDP) as the debt vortex increases. Activity, as measured by the total of [GDP plus Total Debt] may increase, but the growth of real GDP itself turns negative while Total Debt keeps expanding at a faster and faster rate. Total economic activity becomes increasingly frenetic as value (GDP) is being destroyed by the very effort used to keep trying to produce it, that is, the issue of more and more debt. The problem is, nothing sticks to the bottom line. It is activity for the sake of activity, which only serves to crush GDP itself and increase the dead weight of debt on the economy.

Money-issuing governments and central banks, faced with this problem in the past century, have typically reacted by trying to issue more and more paper to compensate for the failure of the real economy to catch fire, not realizing that in doing so, it only serves to feed the debt vortex, actually making the problem worse. Since the beginning of the 20th century, from a study by the Cato Institute dated August 15, 2012, 55 governments have executed this ‘strategy’, all with devastatingly similar consequences for the value of their respective economies and currencies. Thus far in the 21st Century, we have seen this approach at work in Greece, Spain, and Brazil (among several others), and Japan is valiantly trying to follow suit. Of course, while currency values and real GDP may decline, stock market values often soar, so that “stimulus” policies seem to work. Looking at it another way, as the debt aneurism expands and the money has to go somewhere, so it heads into the “safety” of the ownership of hard assets. However, if history is a reliable guide, sooner or later it then heads into price (and wage) hyper-inflation. The US is currently dancing on the edge of its own “event horizon”, and is only still standing because it is the global key currency. It is drawing money from both Japan and Europe, as both are in worse financial condition and there is a flight of money to the US. It is not a situation in which GDP growth will prove to be self-sustaining, however, although it is ‘self-delusioning’ for a while.

At and below a GDP/Debt ratio of .289, the incremental value generation of additional debt in terms of GDP falls to and then below zero. We term this a scientific (mathematical) bankruptcy because the effects of bankruptcy hold, namely that debt compounds while value (GDP activity) recedes. Parenthetically, such a point must exist, because otherwise, Zimbabwe (for one) would be one of the richest countries in Africa, and Greece and Spain would be sitting atop all of Europe.

Japan is a test in real time of the solvency mathematics in Limits of Debt, and will be our canary in the coalmine for the economy of the US. Unfortunately, the minor economies of Greece and Spain are well through that level and their respective GDPs have already been crushed to the tune of some -25%, so studying them is only an academic exercise in hindsight. However, other European economies bear close attention, notably Italy and France. 

Implications of Economic Black Holes

Our central bankers may not be all that happy that they have been unable to get the economic growth trajectory back to something like the economic recoveries from recessions in the past, but at least they can say that all that ‘pump priming’ has not led to inflation, and interest rates are low and encouraging. Milton Friedman’s “Monetarism” theory seems to be out the window, for which everyone can say a hearty ‘thank goodness’. Unfortunately, none of that is true.

For one thing, since growth grinds to a halt, then there are no price pressures due to demand-based shortages. Without demand pressure on goods and services, why would anyone expect price inflation? And without demand pressure, wages and prices will either be steady or go into a slow decline – for a while.

For another, without growth, there is no increase in the demand for money. Both households and businesses have been paying down their debt, not increasing it as has happened following recoveries from past cyclical contractions. Growth is not only grinding to a halt; but worse, shows signs of heading into decline as Corporate America is paying out to shareholders through dividends and share buybacks as much as or more than it is taking in. One need go no further than this to grasp why loan growth hasn’t caught fire in this cycle, even with near zero interest rates. As a consequence, in the shorter term, if we then have a marginal negative demand for money, why would we expect anything but a marginal negative return on money?

In the shorter term, the failure of wages and prices to react to massive monetary stimulus as Milton Friedman had suggested has lulled our central bankers into a sense that the real risk lies in a 1930s-style deflation. (Quick: when was the last time that you can remember that anyone talked meaningfully about the US government deficit?) In truth, the exact opposite is the case. Our central bankers argue that deflation, with falling prices, is the risk when in fact, we are facing rampant inflation, the problem being one of measurement.

Dana Skinner, in his book Seven Kinds of Inflation (written in 1937) pointed out that inflation takes many forms. He identified asset price inflation as one form, and we have had that in spades since 2008-9. He failed, however, to identify an 8th kind of inflation, namely the cost of a dollar of GDP. Consider that for most of the 20th century until about 1984-5, in the US it used to take about $1.45-.50 of additional debt to generate $1.00 of additional GDP (the peak of the Atrill Curve). Since then, the marginal “cost” of an additional $1.00 of GDP has escalated to $3.50 (and more in some countries). Yet central banks and main stream economists are completely mute on this critical issue that has reached global epidemic proportions. They certainly do not refer to this as “inflation”! However, the pathology of country insolvency is clear from the 55 examples since 1900. All of them pursued massive monetary easing of some sort, and all of them ended with a collapse of both their economies and associated currencies. The advent of paper currencies has been a double-edged sword, with as much damage wrought as good has been done thanks to the lack of a mathematics of leverage (“solvency”)! 
The Chinese Miracle Explained…and the Myth Exploded

I now draw your attention to the right hand side of the curve. One can plainly see that there is an area in which additional debt adds to the generation of value (GDP), and for some while in an accelerating fashion. From the MPD Curve, it is clear that the emergence of China as a global economic power has not been due to some superior insight into the economic growth process, the so-called “command economy” to which some Chinese leaders like to attribute their success, but simply to the growing use of leverage (debt). Indeed, the serendipitous advantage of debt is that you can get lots of money (capital) for expansion with the wave of the hand and growth will simply follow almost magically! You can even finance entire ghost cities and roads to nowhere and the economy will keep humming along. The surprising disadvantage (for those not used to obeying what I might call the ‘banking discipline’) comes when an economy roars up and over the peak and heads down the slippery slope towards the Black Hole bankruptcy condition. Suddenly, debt has a cost: the economy slows drastically and retrenchment becomes the order of the day.

China has not discovered a ‘new way’ of managing the economy. It has actually simply followed the post-war roadmap left behind by Japan which followed a similar solvency trajectory. Back then, people rushed to “explain” the Japanese ‘miracle’. (Does anyone remember Herman Khan?) Then 20 years ago, Japan crossed the .289 boundary condition and in a trice, it was all over but the shouting. (You can look up the numbers yourself from Japanese records: it’s all there!)

We don’t (and probably can’t) know the precise Debt/GDP ratio of China, but some analysts do measure it as being in excess of 2.5, in which case China is now solidly on the wrong side of the peak of the MPD curve. The very fact that China is now and has been visibly slowing despite all efforts to the contrary does suggest very strongly that this is now very much likely to be the case. This suggests that to really get the country moving, China will need to rein in its lending activities, restructure its debts, and really start to focus on productivity instead.

With at least three of the key economies of the world, the US, Japan and much of Europe in a deeply insolvent, near bankrupt condition (as I defined it above please!), it is no surprise that global GDP is grinding to a halt. And, of course, if, as seems clear, China has joined the rest on the wrong side of the curve, then China will become less and less of the stimulus than they have been for the last 2½ decades. Add a few other major countries including Brazil (and goodness knows who else), as we all have fallen under the spell of modern central bank solutions for slow- or no-growth, and the grim outlook that lies before us is (at least) easy to grasp.

Six consequences that flow from the Atrill MPD Curve

  1. The Lifeboat Economy

When growth ends and an economy stops expanding and starts to contract, we are left with two possible outcomes, share what there is or grab everything that we can. I call this the Lifeboat Economy because growth can no longer skate our overall desire for more onside. In the US, it is quite clear to what I am referring, as the expansion of budgetary entitlement rights has grown from a modest percentage of government revenues to more than 100% (before deficit financing). Cooperation between political parties has fallen below zero because to share what we already have with someone else is to take away from what we now have. The US political scene has bifurcated into two parts, those who are at least trying to expand the sharing process, although they have nothing to share that doesn’t belong to someone else in the absence of real growth, and the One Percent Party which is determined to keep even more of what they have at the expense of the rest of the populace. Internationally, Greece represents a caricature of the lifeboat phenomenon. Having eaten themselves out of house and home and watched their economy collapse, they have come demanding that others support them. I am sorry to have to say to them: Germany is on the right track about fixing, not pandering to, their debt problem.

 

  1. Austerity Cannot Work

It’s difficult to cover every detail in a short summary of Black Hole Economics but at this point, I need to point out that .289 is what we refer to as a second-order insolvency. There are two additional orders, a first-order insolvency being one that is most relevant to the current discussion. This occurs at a solvency ratio of .499… and marks the point of chronic deficit. This was the precise condition of the US in 1992 when Bill Clinton took the reins of office and set out to clean up the US government balance sheet by raising taxes and cutting costs (i.e., austerity!) – which he did with such devastating effectiveness that there was a fear that government bonds would disappear, as some may recall! When he left office in 2000, the US was on top of the world, its currency was at an all-time high, consumer confidence was at an all-time high, the stock market was booming, and the economy was on fire. Small wonder that he is still revered today on both sides of the political spectrum. Austerity “worked” in 1992-2000 because the impact of an increasingly solvent government balance sheet spilled directly and immediately over into the real economy. The resulting decline in leverage pushed the US economy up the MPD Curve! (It might be impertinent for a Canadian to say, but there is another Clinton running for the presidency this year in the US. Who knows if her mate can work his “fiscal magic” once again!?)

The point of all of this is to say that the reason that austerity cannot and does not work for scientifically bankrupt economies is due to the reality that those economies are so deep in the chronic deficit phase that they will find that austerity cuts do not actually improve living standards. They can only cut into the deficit (debt expansion), but with no gain in GDP, at least for a much longer time than the body politic in democratic countries has any patience for.

 

  • Economic Collapse versus Currency Collapse: Greece and Spain versus Japan

In Greece and Spain, the economy massively declined, while in Japan (so far) only the currency has tumbled but the economy in nominal terms has not. Yet both are scientific bankrupts. Why the difference? I think that the answer is fairly self-evident. Greece is lumbered with a currency, the Euro, that is more or less fixed and immutable (to Greek tampering, at any rate). And so the downwards insolvency pressures fall directly on the economy. In Japan, the same pressures are in evidence, but the currency value has taken the heat in the shorter term and it has fallen instead. The Japanese may be a lot poorer in international terms than a few years ago, but relative to each other in Japan, not much has changed. People aren’t happy but they are not rioting in the streets – yet. If I were Japanese, I would not count on this situation to hold up much longer, and already we are seeing evidence that the Japanese economy is now also starting to implode.

Japan is indeed a story about the failure of Quantitative Easing. If you check the records, you will find that it has been almost 20 years since Japan became a second-order insolvent (bankrupt) with a GDP/Debt ratio of .289. Curiously enough, for a long time after, Japan hung right there and did not get any worse (or any better) although Government Debt as a percentage of GDP rose from 100% in 1995 to about 200% today. GDP essentially flat-lined: it is quite remarkable to look at a chart of their GDP for that entire period. At the same time, household and corporate debt fell to keep the ratio constant. This was not a happy time for Japan, and that country has enjoyed/suffered a succession of 11 prime ministers in that period, each promising an escape from their no-growth economy. Ben Bernanke is the one widely considered to be the cause of current militant QE in Japan by chiding Prime Minister Abe that the problem with Japanese stimulus to that date was that it was not enough and that Japan should try harder. Well, Japan has done so. The results? Since then, the currency has collapsed by some 50%, with more to come I would forecast, and now we are seeing Japanese real GDP start to head into decline. (Consumer spending in 9 of the past 12 months has declined, the other three months being flat.) I would guess that every Japanese citizen should join together in saying, “Thank you, Ben”.

 

  1. Money On Strike

One truly striking characteristic of Japan, the US, and Europe is that the velocity of money in all of those places is not only declining but has been in a steady decline for a long time, in some cases going back nearly three decades (MZM in the US). This is one key characteristic of increasingly insolvent economies: money does less and less “work’ as time goes on, in essence ‘trying’ to offset the overall financial inefficiencies brought on by excess debt. The problem and the challenge to monetary authorities is that of trying to overcome what is effectively a decline in money availability caused by falling velocity. This they have done historically by issuing more and more money through programmes equivalent to very aggressive ‘quantitative easing’. Unfortunately, the solvency mathematics of Dr. Atrill demonstrate all too clearly that this makes the problem worse. This last point is mathematically unimpeachable and as well, there is an abundance of hard evidence.

As 55 countries have already shown, there is a tipping point when price and wage inflation suddenly start to accelerate, and currency values implode. I do not have debt/GDP numbers from those 55, so I cannot be pedantic about where it occurs. I could make an informed guess based on the mathematics, which I would anticipate would be at Atrill’s Third-Order Insolvency level or 0.135 (e2), which he referred to as the “break-up condition”, but that would be a speculation only. Not only does price and wage inflation then reverse their moribund courses but velocity must re-accelerate massively as well (as Weimar Germany, for one, shows. By the way, Germany has left an excellent record of that period for anyone to see, and I recommend the proceedings of the Bundesbank to all students of national insolvencies.). As holders of the currency in question try to get rid of it in exchange for things – anything – which can hold its value, the value of those currencies must and do collapse. Seen in this light, we should all hope that the quest by central banks to stimulate an uptick in inflation (as measured by wages and prices) fails, as they are most likely to waken a sleeping tiger. Germany alone, among advanced Western economies, has already been there but cannot seem to convince the unfortunate Greeks that far worse things may lie ahead.

 

  1. The Miller/Modigliani Hypothesis Can be Retired

I do not know anyone who has initially encountered the Miller/Modigliani Hypothesis (frequently mistakenly labeled as a ‘Theorem’ which it is not, save in the weakest definition of the word) and did not think that it was complete nonsense. Anyone with an ounce of common sense “knows” instinctively and intuitively that debt does count in the valuation process that the market carries out, and in the generation of activity that must fall if there is too much debt. However, having proved that debt does not seem to particularly matter in the valuation process – by using the wrong measure of leverage, the debt/equity ratio – Messrs. Miller and Modigliani did inspire at least one ‘client’, government, to cheerfully ignore the impact of too much debt. [Note that a number of companies also tried to ignore the impact of over-indebtedness during the great LBO craze a couple of decades ago, but the resulting bankruptcies brought the corporate world back to the “banking discipline” again.]

Leverage – as measured by the Atrill Solvency Ratio (see Limits) – does count. As the MPD Curve shows, at .289 economic activity starts to go into reverse. Indeed, I should note that one of SAC’s board members did his Ph.D. thesis on forecasting currency and interest rate movements using the Atrill Solvency mathematics, with excellent success. SAC has been using this measure to forecast currency movements ever since. In our common stock valuation work, it is a truism that price follows solvency (leverage). In short, it is time to expunge the M/M ‘Theorem’ from the books of both government and academia.

 

  1. The Pathology of Insolvency

From our analysis, there are some general characteristics of economies which are heading into mathematical (scientific) bankruptcy, similar to the pathology of a disease. These seem to mark the lull before the storm, and may have been present in all those 55 countries where the currency ended up collapsing under the eventual pressure of hyper-inflation:

  1. Velocity of money falls endemically
  2. Private sector borrowing (and corporate investing) dries up
  3. Interest rates initially fall as there is no demand for money
  4. Inflation, as measured by prices, falls towards zero due the lack of demand growth
  5. The government balance sheet gets steadily worse
  6. Internal political harmony turns to intense dissonance
  7. Central banks are, in effect, left holding the bag in the absence of any political will or agreement to find policy solutions to weakening economies
  8. To central banks, like the proverbial hammer to which every problem looks like a nail, every ‘declining economy’ problem can best be solved by printing more money in one form or another

My suspicion is that when a currency really begins to collapse, that internal prices (i.e.: inflation in that country) start to rise, but their central banks do not react, because to curtail the monetary growth would be to “kill the expansion just as it got underway”. These same fears that stopped Greenspan from acting responsibly (as he openly admitted in his book) were probably there as they were in the US. The difference between the US then and even now and in those 55 countries is that hyperinflation was then underway. The linkage would be fascinating to discover – but now we know where (and why) to look.

 

VII.     Reducing Debt Will Lead to Strong Growth

If, at the peak of the Atrill Curve, it takes $1.50 of debt to generate $1.00 of GDP in a normal, healthy, and solvent economy, then there is an astonishing amount of excessive debt outstanding today in Europe, Japan, and the US, all of which is weighing down on their economic potential. Note that a few years ago, the economist Ken Rogoff identified the value .289 ($3.50 of debt per $1.00 of GDP) as quite possibly having significance, but without these mathematics to back his findings up, Rogoff could not defend his results as being anything but statistically discursive and he was, essentially, simply ignored. The assertion of possible importance without a rigorous mathematical proof could not and did not stand up to powerful critics with their Keynesian axes to grind.

The resolution of the current debt problem is (axiomatically) simple. When we are in a state of bankruptcy as the curve above (and the associated math) clearly underlines, then dealing with the challenge is straight-forward. How would a bankruptcy lawyer or accountant deal with bankruptcy? He would direct the bankrupt to sell assets and pay down debt, write off any and all debt which the bankrupt is unable to pay down, and then live within one’s means (no credit cards!). From the MPD curve, that outcome would mean a large increase in GDP as a result of the debt burden being lifted, a solution devoutly to be wished. However, governments do not like nor want to abide by what is essentially the banking discipline and Greece is proving to be, perhaps, merely the first example of a 21st Century government to outright reject this suggestion and solution!

As Bill Clinton proved from 1992 to 2000, if that excessive leverage could be lifted, then two things would occur simultaneously. The GDPs of those three bankruptcies would lift to a considerable degree. Elsewhere (in my book), I have calculated that the GDP of the US should be in the order of 18-22% higher than it is today without that excess debt baggage. Indeed, average US household income would rise by something in the order of $10,000 if the US were solvent. If that excessive debt could then be redirected to other parts of the global economy that could use those capital resources efficiently and effectively, then global GDP should also take a mighty step upwards.

 

So we have at least three major economies, and probably four if we count China as heading that way, in deep trouble thanks to too much debt, and the best that the politicians, central bankers, and all too many economists can say is, “we need more stimulus”. To that, I would have to conclude that if common sense cannot prevail, I would have to end by asking, gold, anyone?

 

Afterthoughts

The Divine Right of Kings has been supplanted by the divine right of governments. It is this problem that allows and has allowed government spending and borrowing to run rampantly amok to the massive detriment of employment, resource utilization, and general well-being. This needs to be supplanted by a constitutional requirement for the government of every country to be solvent as measured, and as close to peak efficiency as possible.

Let me close by observing that I do not think for a moment that the solvency problems that we are faced with today are the result of political malfeasance, ill will, greed, or even stupidity. In general (in my estimation), politicians and financial leaders in general act in what they consider to be the best interests of the greatest number of people. Their intentions are good. Unfortunately, as Michael Bloomberg has observed, you cannot manage what you cannot measure, to which I have to add, you cannot manage if you don’t know what to measure. Dr. Atrill has shown us what to measure and why: it is now up to us to do something about it.

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Gold and Gold Stocks in 2016

It has been just over 7 years since the largest monetary policy experiment in modern history began. Most of us know this experiment by its American incarnations: ZIRP (zero interest rate policy) and QE (quantitative easing), though there have been variants of both across Europe and Japan. The result of this experiment has been an unprecedented period of cheap money, negative savings, and rampant asset inflation, and a quiet crisis in the investment community where many have resigned themselves to the belief There Is No Alternative to stocks.

Since QE began in earnest in the US in late 2008, we have warned against what we saw as a massive weakening in the government’s balance sheet. As a result, Gold has been a core defensive holding in our annual portfolios since 2009, a position that has largely, until now, been an anchor on the portfolios. Through it all, we have remained steadfast in our belief that the artificial asset inflation and inevitable monetary inflation brought on by the Federal Reserve would come back to haunt the US economy, with similar outcomes across Europe and Japan.

Over the past month, we have started to see the chickens come home to roost. The hard realities of a global economy stuck in neutral are finally starting to sink in, exacerbated by the implosion in oil and many commodities that have wrecked havoc on government balance sheets. For the second straight quarter, year-over-year earnings for the S&P 500 are down, and significantly so, with dwindling optimism for a rebound outside of a select handful of industries.

Amidst the general market carnage, Gold is on a 30-day tear. We can hardly be in a position to gloat, as our gold positions are still collectively down since we introduced them in the 2015 portfolio, but we are observing that the tide of sentiment is starting to finally shift.

But this is well trodden ground for our long-time subscribers. We have always believed gold to be an insurance policy, and while this policy has been expensive to carry over the past few years, we remain even more convinced of its importance in 2016 and beyond. Instead of listening to us pound the table yet again, we are recommending readers watch a highly entertaining, extremely well researched, and thoroughly engrossing presentation by Grant Williams, Portfolio & Strategy advisor to Vulpes Investment Management in Singapore.

In the YouTube presentation below, Williams offers some ideas and thoughts which parallel, but do not necessarily intersect, with our own thinking on gold. This is one of the best pieces that we have seen for some time on the subject – and may be more timely than many, if not most, are thinking right now.

William’s Gold Analysis

Certainly, one thing caught our eye which was his discussion on the amounts of gold China is buying, and the comparison of those amount with the amounts of bullion available on the Comex exchange.

For those who are thinking of increasing their positions in Gold, we offer a few alternatives. The first is to add to existing holdings, whether in the 2016 North American Value Portfolio trio of Alamos Gold (AGI), IAMGOLD (IMG), and Goldcorp (G).

The second alternative is to broaden Gold holdings to include a couple more stocks at attractive valuations. New Gold (TSX: NGD) has just reached its LC Price, and could easily reach its Normal Price with continued strength in Gold prices. Although more expensive at its HC Price, Kirkland Lake Gold (TSX: KGI) has a very robust balance sheet, positive earnings, and (gasp) positive Fair Market Value upside! It hit its Bubble Price back in 2011, so it is still a long way from its peak. The low Canadian dollar has also been a huge benefit, as KGI largely has costs in $C, but sells in a US-dollar spot market.

The third alternative is to diversify a bit into Silver producers, which are highly correlated with their gold mining brethren. First Majestic Silver (TSX: FR) has taken off from its Blue Price and broken out over its Normal Price. In early 2011 it was at its Bubble price, so it offers huge upside if it can regain its lofty heights once again. An option in the large-cap space is Silver Wheaton (TSX: SLW), which is breaking out over its HC Price on the way to the Growth Price (~35%). With a modest uptick in earnings, SLW will have a positive FMV, and also carries a small dividend. In the US, Hecla Mining (NYSE: HL) looks quite attractive coming out of the Blue Zone. In late 2010 it topped out above its MG Price, more than 400% from its current price.

With most stocks up sharply from their mid-January lows, there is a risk that short-term momentum could sputter and cause some reversion. Gold remains a long-term insurance policy, and despite the recent surge, most stocks remain well below their historical highs, offering tremendous upside potential. For those comfortable with their current gold holdings, there is certainly no compelling reason to buy more. For those underweight and looking to add, their are still plenty of options to build long-term positions. We do not trust the markets enough to suggest trading gold stocks, as there are too many ways the price of gold can get shocked by exogenous factors.

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