Brexit referendum pushed financial markets into turmoil. Even if this is only the beginning of tough times the main reason behind this is definitely not the result of the UK referendum. What we see today is merely a result of financial markets being disconnected from the real condition of the global economy. The red flags signalling overpriced markets (especially in the case of the US) now are raised not only from statistical data but also from experienced investors having a good forecasting record.
From the start, I would like to focus on aforementioned statistical data. They can give us clear picture of the US economy and what happened after previous crisis until now. The financial situation of the US is crucial because it is the American stock exchange that delivers 44% of the global capitalisation of financial markets. American financial sector is responsible for setting trends and today those trends are pointing south. Developing markets are falling right behind the trendsetter. One of the best indicator showing how healthy is the economy is the velocity of circulation of money. The better the economy, the more money people and other participants of the economy spend – this increases money circulation.
At first glance, you can see that after 2008-09 crisis situation worsened. During official ‘post-crisis recovery’ velocity was slightly above 1.7 while during the first quarter of 20016 it fell below 1.5 (for comparison – before the crisis it around 2.0). The above chart is not the only data point. Low money velocity means also less consumption – this is visible in higher inventory-to-sales ratio. Below you can see a record of it:
Today this indicator is above the Lehman level. What is more, it soon can match the levels of the worst phase of the 2008 meltdown. This clearly shows how American society is getting poorer. Below the chart pointing to the homeownership rate:
Compared with 2007 the rate fell from 69 to 63.5%. To find a similar level in history you have to scroll back to the mid-'80s.
Fewer Americans own their homes and this is no surprise if you check the median household income:
You should pay attention to this chart because although we are a few years into ‘boom’ this rate never returned to the pre-crisis levels.
I have to make a pause here and explain one more thing. The above data is overestimated. How is that possible? When the calculations are made the official increase in prices is taken into consideration – today approximately 1%. Should we utilise methodology used to calculate inflation back in the ‘80s we arrive at the result marked blue below.
When compared with official inflation this difference amounts to 7.5%. This enables us to verify the US GDP growth rate – officially at 2%. Using more accurate numbers we can see that the US economy is shrinking by 5.5% each year. It corresponds to the plethora of data points presented above. Why would the government falsify crucial data about growth? Because the myth that America is growing is just that – a myth. Politicians try to present record low unemployment rate when the real situation doesn’t look that good. Below chart shows the labour participation rate.
Here you also see the disparity between the level of 2007 and today. In just 10 years the labour participation rate dropped from 66 to 63%. Many people after failing at finding a new job – resign from further search and they are being excluded from the unemployment rate calculation. Now you know the reason behind such optimistic data having no connection with reality.
The last point is that high inflation coupled with ZIRP hit the average citizen with their small savings very hard. Some of them choose to put their money into equities to defend against falling worth of a dollar. Equities took long to pick themselves up after 2008 crisis but they keep moving horizontally for a year now.
Growth without fundamentals
Recent equity growth seen in the US had little to do with companies’ performance. For example price-to-sales ratio (P/S) being higher than 2008 levels since 2014. This unequivocally shows that the revenue generated by companies is low compared to the price you have to pay for their share.
Last years’ growth was fuelled by shopping spree of central banks around the world. We can find some well-known corporations on the balance sheet of Swiss National Bank. Below is only part of their purchases:
The Swiss bank is not the only one helping out American equities. We cannot forget about circumstances financial markets were functioning. Printing dollars was a big leg up for them. Hovering around ZIRP enables companies to acquire more cheap capital.
Prices also climbed due to buybacks – companies buying their own stocks. I want to mention few points here. When buying own shares an enterprise bears the costs and later wipes out from the register purchased shares. What is more, buybacks are more often than not credited and this negatively affects financial situation of the company. There are also other two significant consequences:
a) After the buyback, the amount of shares on the market is smaller. This translates into a higher price of shares but also increase in revenue calculated per share. From the outside, it looks truly amazing.
b) Part of the buybacks is done utilising available money assorted for this goal. If the money wasn’t used for buyback it could finance R&D or other investments. In case investment spending is curtailed too much sooner or later it will adversely reflect on the competitive position of the company.
Today we see that buybacks are popular again. Since the beginning of 2016 we have seen inverted trend.
Source: Marc Faber, Bloomberg
During first four months of 2016, the scale of buybacks is visibly smaller than during the similar period previous year - 37% lower. The first fall since 2009. We saw the peak of them in 2015.
Above pieces of information, all point to the lack of fundamentals of equity growth. Today warnings of investors with good track record are being vocalised ever louder than before.
Druckenmiller: “Bull market is exhausting itself”
There are few investors in history recording similar results as Stanley Druckenmiller. During his time when he managed Duquesne fund (1986-2010), he produced impressive 30%+ average return each year.
During a conference in New York, he said that the bull market is clearly going to end soon. He admitted that in his portfolio it is gold that enjoys the biggest share. He also criticised policy of the FED as ineffective.
“I now feel the weight of the evidence has shifted the other way; higher valuations, three more years of unproductive corporate behaviour, limits to further easing and excessive borrowing from the future suggest that the bull market is exhausting itself.”
Former business partner of George Soros forecasted in his Bloomberg interview that "America is facing a storm that could be much worse than the 2008-2010 crisis". Druckenmiller also touched upon the demographic problem in the US. In 2050 the number of pensioners per one American citizen is going to double that of what is was at the beginning of XXI century.
Spitznagel: “The markets are overvalued to the tune of 50%”
Mark Spitzenagel’s tone wasn’t optimistic either. The founder of Universa fund which doubled their clients’ money by short selling the market in 2008.
According to Spitznagel today’s market is not fulfilling its traditional role but is rather a reflection of central bank’s whim. Mark also stated that market overvaluation can be even 50%.
“This is the greatest monetary experiment in history. Why wouldn’t it lead to the biggest collapse? My strategy doesn’t require that I’m right about the likelihood of that scenario. Logic dictates to me that it’s inevitable.”
Soros is selling shares
In early 2016 Soros changed his investment strategy. The amount of money invested in shares dropped by 37%. Known billionaire doubled his position in options playing for S&P 500 plunge.
Even more interesting is the fact that the biggest part of his portfolio was allocated in Barrick Gold equities – one of the biggest gold producer in the World. His shares were worth 264 billion USD. In his portfolio we also can see 1.05 million buy options of ETF SDPR Gold Trust.
Gross: “Capitalism doesn’t work with zero-interest rate policy”
Bill Gross – co-founder of PIMCO – also criticised today’s situation in the financial markets. He warned against buying corporate bonds and risky equities and advised investors to be elastic - even by keeping cash.
“Ultimately, they have to move back up and I think a certain number of Fed governors realize that the normalization process is necessary in order to save business models and to save capitalism basically because capitalism doesn't work at 0 percent and it doesn't work at negative interest rates.”
Few weeks ago, Gross admitted in an interview that “smart investors know there is something wrong” with the system. The situation is very bad for investors trying to secure sensible rate of growth for their clients.
For a considerable period of time amount of noise preaching the market's performance in the US was louder than signals from the economy itself. The difference is now even respected and humble in words investors don’t pull any punches against the FED. It doesn’t mean that situation is going to change but aforementioned quotes constitute another big warning against any risky investments – especially in the US equity market which is disconnected from reality.
After blaming China for the bad performance of financial markets we can assume that next one in the blame game is going to be the UK. Brexit is the perfect justification for another round of QE. This means further dollar devaluation and higher inflation, lowering the debt-to-GDP ratio at the expense of every single taxpayer.
Independent Trader Team