Wow! Dow down 334 yesterday. Talk about volatility. Things are getting interesting.
Meanwhile, what’s wrong with the Bowery?
We search high and low. We can’t find a bum or an alcoholic. The area no longer looks anything like the old down-and-out Bowery of the 1960s and 1970s. Everywhere you look you see the latest fashions…chic New Yorkers…and $600-a-night hotel rooms.
Last night at dinner, our companion nodded toward a nearby table and said, ‘Look, there’s Michelle Pfeiffer.’
The name sounded familiar, but we couldn’t place her. So we were not as impressed as we should have been. But the Bowery has definitely gone upscale.
Credit distorts everything
‘Credit…’ explained our friend Stephen Jones, the president of an investment management firm here in Manhattan, ‘…the whole US economy has lived on credit for nearly 30 years. It has distorted everything. Even the Bowery.’
Credit has seeped into all sectors of the economy. But there are two places where it has wrought the most ‘growth’: Washington, DC, and New York City. The two biggest borrowers: Washington and Wall Street. The money leaks into all the surrounding counties and boroughs.
Stephen has just published a paper that details an even better way to value the stock market than the Shiller P/E and Tobin’s q. After all, if you’re going to follow the ‘buy low, sell high’ rule, you need to know where high and low actually are.
‘Is this market as overvalued as we think?’ we asked him.
To bring dear readers back into the picture, our Simplified Trading System (STS) calls for getting out of the stock market and buying gold when the trailing P/E of the S&P 500 goes over 20. And buying back into stocks when it drops below 10.
We asked Stephen to take a look at our system to see if he could improve it.
‘The problem is the quality of earnings,’ Stephen explained. ‘If you normalize earnings, the P/E is well over 20…and you should definitely be out of the stock market, if you’re following your rule.
‘Earnings are thought to be good things…and on a micro level, of course, they are. So, we don’t look at them too hard. But we should. Because they have to come from somewhere.
‘If you have an economy where the typical household has less money to spend than it did 15 years ago, you have to wonder where those additional earnings are coming from.
‘This is where it gets interesting…and it’s why my way of valuing the stock market is better than Tobin’s q or the Shiller P/E. I begin with the value of stocks relative to GDP. This gives you a better picture.
‘The earnings of US corporations have never been higher. But GDP growth is running at half the rate of the 1980s and 1990s. Employment is going down. (I don’t mean the employment rate you read about in the newspapers. I mean people with real jobs as a percentage of the population.) And incomes are stagnant.
‘Under these circumstances, how is it possible for corporate earnings to rise?’
‘Negative earnings for the next 10 years’
As Stephen suspected, we already knew the answer:debt.
‘Since 2008, debt has not gone down. It’s gone up,’ Stephen continued
‘This not the ‘Great Deleveraging’ that it was advertised to be. In 2007, there were a total of $69 trillion of debt-backed securities in the world. Now, the total is $90 trillion.
‘This new debt has added a lot of buying power and profits to the economy. But it’s temporary. It’s not normal. And it has to go away when the debt bubble pops.
‘Take out the debt-driven sales, and US corporate profits shrink back to normal. But of course, P/E ratios go up because there’s less ‘E’.’
What does that mean for stock investors?
‘It probably means negative earnings for the next 10 years.’
We think it might mean something else. Earnings depend on debt. So do stock prices. And so does the economy. It took $21 trillion of extra debt to jack up stock prices to today’s level. If the EZ money were to dry up, the economy and the stock market would be hit hard.
For nearly 30 years, the message from the Fed to US stock market investors has been the same: We have your backs.
How likely is it that central banks would forsake speculators now?
The last two bear markets wiped 40% and 50%, respectively, off the value of the US stock market. Each time, the Fed was quick to react with more cash and credit.
How likely is it now that Janet Yellen will stand aside as the market delivers a bitter correction?
More on that tomorrow…
For The Daily Reckoning Australia