The Storm Is Coming
by: Nicholas P. Cheer
- Early signs of distress are starting to materialize, portending stormy seas may lie ahead.
- As risks rise across the globe, U.S. Treasury securities are the investment of choice for discerning investors looking for a port in the coming deflationary storm.
"The future is unpredictable. No one knows whether the economy will shrink or grow (or how fast), what the rate of inflation will be, and whether interest rates and share prices will rise or fall. Investors intent on avoiding loss consequently must position themselves to survey and even prosper under any circumstances. Bad luck can befall you; mistakes happen. The river may overflow its banks only once or twice in a century, but you still buy flood insurance on your house each year. Similarly we may only have one or two economic depressions or financial panics in a century, but the prudent, farsighted investor manages his or her portfolio with the knowledge that financial catastrophes can and do occur. Investors must be willing to forego some near-term return, if necessary, as an insurance premium against unexpected and unpredictable adversity."
Early Warning Signs of Stress
You know that moment right before a storm? The point where the clouds begin to form in the distance? Sometimes it remains sunny for a bit, and sometimes the clouds close in on your location.
While you don't know when, you do know the storm is coming. That is where we are today in the market.

Additionally, the developed world seems to be drowning in debt, and the IMF says it sees challenges ahead for Emerging Europe as well. In Australia, Europe, Japan, and China, debt continues to be an increasing impediment to growth for these nations, even as central bankers attempt to stimulate growth with unprecedented monetary accommodation. This should be far more concerning to investors than it is.

"Altogether there are five European nations whose debts are larger than their economic output, and 21 that have debts larger than the 60 per cent-of-GDP limit set out in the Maastricht Treaty. Greece’s public debt is, unsurprisingly, the highest in the EU - standing at 177 per cent of its GDP. Italy and Portugal are the next most indebted countries, with debts of 132 per cent and 129 per cent of national economic output respectively."

Growing Debt Continues to Strangle GDP

As bad as the debt situation is, we now find out that it may be understated by $13 trillion. BIS researchers have found that:
“Accounting conventions leave it mostly off-balance sheet, as a derivative, even though it is in effect a secured loan with principal to be repaid in full at maturity...In particular, the short maturity of most FX swaps and forwards can create big maturity mismatches and hence generate large liquidity demands, especially during times of stress.”Canada & China: Red Flags Are Visible; Will This Be The Catalyst?

Canadian households are drowning in debt, nearly 65% of it is mortgage debt. As the debt rises, so does the instability of the country's financial system and the risk of a financial crisis.
With the global economy so interdependent, the notion that we in the U.S. can decouple from what is going on with our neighbor to the north is simply impractical.

A new report from The Office of the Parliamentary Budget Officer tells Canadians they may be facing a debt crisis within the next five years as the debt service ratio continues to climb, while incomes stay stagnant. We need to pay attention to what is going on with our neighbors to the North, as Canada is the second largest trading partner with the U.S., and accounted for $544 billion in trade activity in 2016. A financial crisis in Canada will put severe pressure on the U.S. economy. In our global interdependent world, a domino falling in China or Canada will send ripples throughout the world.

"The projected increase in the total DSR to 15.9 per cent would be 3.1 percentage points above the long-term historical average of 12.8 per cent (from 1990Q1 to 2015Q3). It would also be almost one full percentage point above its highest level over the past 25 years, 14.9 per cent, which was reached in 2007Q4. Analysis conducted at the Bank of Canada (see Djoudad (2012)) indicates that an increase in the DSR “would imply that households are more vulnerable to negative shocks to income or to interest rates, making household balance sheets more precarious and having a negative impact on financial institutions"
U.S. GDP Remains Weak

Investors seem to relish the idea of remaining unaware of the fundamentals as they bathe in the euphoria of a market that continues to go up nearly every single day. The new tag line at parties seems to be "how many FANG stocks do you own"? An answer of "none" and you will be banished to the table in the corner. Instead, people should be asking how many Treasuries do you own? Unfortunately, the answer to this, more often than not, is zero. The vilified asset is up 12.67% this year, besting the S&P 500's return of 11.74% and destroying the S&P 600 small cap index, which has phoned in a rather pathetic 1.08% return year to date.


Market Valuations Continue To Rise Past The Obscene
In fact, they argue, stocks should be much higher, especially if we have low rates for a longer period of time. I politely demur at the notion that investors should be overweighting a market that is at its second highest level, behind the tech bubble. Many contend that valuations don't matter and prognosticators are wrong.
I remain very cautious today, not to simply be contrarian, but because I look around the world and see risks like I have never seen in my lifetime or in my studies of market history. This is because central banks around the world have been engaged in stimulus programs we have never seen before.

Warnings on Valuation Continue to Be Ignored Even as Earnings Fall
"investors should remember that the 2000-2002 market collapse wiped out the entire total return of the S&P 500, in excess of risk-free Treasury bill returns, all the way back to May 1996. Likewise, the 2007-2009 market collapse wiped out the entire total return of the S&P 500, in excess of risk-free Treasury bill returns, all the way to June 1995. By the time that a market cycle is completed, a value-conscious, full-cycle investment discipline tends to be enormously forgiving of early exit, particularly when one exits at historically rich valuations. At present, the debt burdens of non-financial companies have never been higher relative to their gross value-added. Meanwhile, the market value of non-financial stocks is also near the 2000 extreme relative to their gross value-added. The sum of equity and debt is known as “enterprise value.” The chart below presents enterprise value as a fraction of corporate gross value-added...which illustrates the extreme value of financial claims on corporations, relative to the revenues needed to serve them. Present levels are within a breath of the 2000 extreme." Dr. John Hussman

Investors continue to dance in a burning room, and so far, they have been unscathed. One day the music will stop, and investors will be overwhelmed by the stampede for the exits. One of the great lessons of investing is not to let fear or greed overtake you. Staying balanced and focusing on opportunities and risks, keeps one from making poor investment decisions.

"...results in the first half of the year “have not been strong enough to warrant positive S&P 500 [earnings per share] revisions,” Goldman Sachs wrote in a note to clients. Of the S&P 500’s 11 primary sectors, it noted, forecasts for 2018’s profits have come down for six of them...Forecasts have come down even more for the remainder of the current year. For 2017, analysts see earnings of $130.46 a share for the S&P 500. That’s down 3.5% from the $135.25 that was forecast at the end of April. "
“An enthusiastic philosopher, of whose name we are not informed, had constructed a very satisfactory theory on some subject or other, and was not a little proud of it. "But the facts, my dear fellow," said his friend, "the facts do not agree with your theory."—"Don't they?" replied the philosopher, shrugging his shoulders, "then, tant pis pour les faits;"—so much the worse for the facts!” ― Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds
I believe investors are taking greater and greater risk playing this game of musical chairs, and I am not the only one. Lloyd Blankfein, CEO of Goldman Sachs, stated "Things have been going up too long." Jeffrey Gundlach, Ray Dalio, Seth Klarman, Howard Marks, and many others have given warnings that markets are overextended.
“When share prices are low, as they were in the fall of 2008 into early 2009, actual risk is usually quite muted while perception of risk is very high. By contrast, when securities prices are high, as they are today, the perception of risk is muted, but the risks to investors are quite elevated.” -Seth Klarman

The book "Extraordinary Popular Delusions and the Madness of Crowds" is an absolute classic because while the date on the calendar changes, and the world seems to change around us, the behavior of humans does not. As Charles Mackay states in the text:
“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.”
Wealthy investors continue to carry more cash than they have before and yet the average investor continues to pile into stocks. The greatest investors in the world are telling you to be cautious, the greatest finance executives in the world are keeping more cash in corporate America than ever before, and the wealthiest Americans are stock piling cash. So I ask you: maybe it is time for the average investor to question why they continue to pile into stock market index funds that are insanely overvalued?
These investors, finance executives, and wealthy Americans believe that they will be able to buy assets cheaper at some time in the future, or they believe that stormy seas may lie ahead and want to be prepared. This is deflationary.
"Commodities prices, broadly, despite the persistent hope for both an acceleration in domestic, and global, economic growth, are down about 13 percent, year-over-year. Crude oil sits at its lowest level of 2017, amid a glut of both oil and gasoline, even in the middle of the summer driving season....used car prices are falling, another sign of weak pricing and some slowing in domestic demand. Overall, the latest batch of economic numbers have been punk, not nearly strong enough to warrant further tightening by the Federal Reserve, despite promises to do so. There is a risk of financial deflation rearing its ugly head again, if price deflation in commodities continues and forces resource companies to retrench again. So, then, how will inflation reach the Fed's stated 2 percent target anytime soon? Very simple … it won't."
We are currently in a world of disinflation, with deflationary forces gaining steam, debt burdens beginning to overheat, restrained GDP growth a reality, and central banks that are in unchartered territory, experimenting with negative rates, and in the process showing their desperation to create some level of inflation, and stave off what they really fear... deflation.
The bond market continues to tell investors in words that cannot be misunderstood; don't take risks.
"People who had been absent from Holland, and whose chance it was to return when this folly was at its maximum, were sometimes led into awkward dilemmas by their ignorance... By 1636, special markets for trading in tulip bulbs were established on the floor of the Stock Exchanges in Amsterdam and other towns. Many people grew suddenly rich, and others, not wishing to be left out, began speculating madly themselves.
At last, however, the more prudent began to see that this folly could not last for ever... It was seen that somebody must lose fearfully in the end. As this conviction spread, prices fell, and never rose again. Confidence was destroyed, and a universal panic seized upon the dealers. A had agreed to purchase ten Sempers Augustines from B, at four thousand florins each, at six weeks after the signing of the contract. B was ready with the flowers at the appointed time; but the price had fallen to three or four hundred florins, and A refused either to pay the difference or receive the tulips.
Defaulters were announced day after day in all the towns of Holland. Hundreds who, a few months previously, had begun to doubt that there was such a thing as poverty in the land, suddenly found themselves the possessors of a few bulbs, which nobody would buy, even though they offered them at one quarter of the sums they had paid for them. Many who, for a brief season, had emerged from the humbler walks of life, were cast back into their original obscurity. Substantial merchants were reduced almost to beggary, and many a representative of a noble line saw the fortunes of his house ruined beyond redemption."