Tuesday, August 08, 2017

Stock Market Mania Will End in Tears

In the first quarter, real GDP increased 1.2 percent, according to the Bureau of Economic Analysis. Yet, that weak performance didn’t stop all the major US stock indexes from closing at or near record highs.

Though the economy strengthened in the second quarter, expanding at a 2.6 percent clip, it was still tepid by historical standards. However, the Dow Jones has just experienced a streak of nine record closes. Over the course of 2017, the Dow has posted 35 record finishes.

Records have become commonplace for the Dow in recent years. In fact, the Dow has reached a new high, on average, once every seven days since fully recovering from the Great Recession in March 2013. In all, the Dow has achieved a new record 154 times in that span.

The S&P 500 also rose to a new record this week. The index has advanced nearly 11 percent so far in 2017. The NASDAQ and Russell 2000 indexes also closed at record highs this summer.

So far this year, the US economy has expanded just 1.9 percent, yet the stock markets are going nuts. It’s all come on the heels of a weak 1.6 percent expansion for all of 2016.

With that in mind, ask yourself this: Why are all of the stock markets at, or near, all-time highs?

This is the definition of “irrational exuberance,” as former Fed Chairman Alan Greenspan once described it.

The stock market is supposed to be forward looking. Yet, that sort of wisdom has become a thing of the past. Federal Reserve officials now expect GDP to remain around 2 percent through 2019. The markets are somehow unconcerned with this projection.

While most members of the 30-stock Dow make a big chunk of their money overseas, they are a pittance compared to the thousands of U.S. companies who do not.

The truth is, the stock market is not an accurate measure of the health and strength of the economy. The markets are simply a bet on the future performances of a select group of companies listed on a few stock exchanges.

Most American companies aren't even publicly traded. In fact, less than 1 percent of the 27 million businesses in the U.S. are publicly traded on the major exchanges.

Additionally, the number of public companies in the U.S. decreased by nearly 50 percent from 1996 to 2014, according to the National Bureau of Economic Research.

So, in reality, Wall St. is not a true reflection of how the average American worker, or the average family, is faring. In fact, nearly half of us don't own any stocks at all.

According to Gallup, 52 percent of U.S. adults owned stock in 2016. Since Gallup started measuring this in 1998, that's only the second time ownership has been this low. These figures include ownership of an individual stock, a stock mutual fund or a self-directed 401(k) or IRA.

Furthermore, the gains from this surging stock market have been flowing mainly to richer Americans. Roughly 80 percent of stocks are held by the richest 10 percent of households.

Clearly, the ballooning stock market is not a reflection of the financial well-being of the vast majority of Americans. Half of them aren't even investors. The markets are simply Wall Street’s betting games.

The reason for the markets' meteoric rise has been the Federal Reserve’s vast financial engineering.

During the 2008 financial crisis, the Fed cut its key interest rate to zero. After determining that this radical move wasn’t sufficient, it took the dramatic step of initiating quantitative easing, or QE.

Following three successive rounds of these Treasury and mortgage bond purchases with magically conjured money, the Federal Reserve’s balance sheet ballooned to $4.5 trillion. That amounted to a fourfold increase from late 2008 to late 2014. Much of that freshly-created money flooded into the stock markets. The money had to go somewhere.

Most people can’t live with, or on, the measly interest rates from savings accounts or certificates of deposit, which seem downright antiquated at this point.

Treasuries offer little help. Check out these yields (as of today):

1-year: 1.22 percent
2-year: 1.36 percent
5-year: 1.83 percent
10-year: 2.28 percent
30-year: 2.86 percent

Remember that the S&P has advanced nearly 11 percent so far just this year. It’s little wonder that investors are willing to roll the dice and hope that the good times just keep on rolling.

Of course, bets don’t always pan out. The markets always correct and they sometimes crash. Right now, there are plenty of reasons to worry, or at least be deeply concerned.

Michael Lebowitz of 720Global assembled “22 Troublesome Facts” behind his reluctance to follow the bullish stock market herd. Here’s a small sampling:

• The S&P 500 cyclically adjusted price-to-earnings (CAPE) valuation has only been higher on one occasion, in the late 1990s, during the Tech Bubble. It is currently on par with levels preceding the Great Depression.

• Total domestic corporate profits (w/o IVA/CCAdj) have grown at an annualized rate of just .097% over the last five years. Prior to this period and since 2000, five-year annualized profit growth was 7.95% (note: period included two recessions).

• Over the last 10 years, S&P 500 corporations have returned more money to shareholders via share buybacks and dividends than they have earned.

• At $8.6 trillion, corporate debt levels are 30% higher today than at their prior peak in September 2008.

• At 45.3%, the ratio of corporate debt to GDP is at historical highs, having recently surpassed levels preceding the last two recessions.

John Mauldin summed it all up this way:

"So, US corporations are simultaneously more indebted, less profitable, and more highly valued than they have been in a long time. Furthermore, they are intentionally making themselves more leveraged by distributing cash as dividends and buying back shares instead of saving or investing that cash. Yet investors cannot buy their shares fast enough. Maybe this will end well… but it’s hard to imagine how."

As I have long said, this will end in tears. History tells us so. What goes up must come down. Nothing grows in perpetuity.

Millions of investors will be wiped out when this market has its eventual collision with reality. Many think they can time the market, but no one has a crystal ball. When markets tumble, investors by the millions sell in a panic. The trouble is, for every seller, there must be a buyer. When everyone is trying to exit the market at the same time, there won’t be enough buyers. It will turn into a bloodbath.

The U.S. has entered its ninth full year of expansion — making it the third longest since the 1850s — and that creates reason for concern.

Throughout U.S. history, the gap between one recession’s end and the next one’s beginning has averaged just under five years. In other words, this expansion has gotten really long in the tooth, which is a very uncomfortable reality.

Whether it’s the next, inevitable recession that sparks a stock market meltdown (remember recessions often begin before they are officially recognized) or if it's a market collapse that ignites the next recession doesn’t really matter.

The outcome will be the same, and it will be brutal.

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