Listening to the Canary

By Terry Coxon, Senior Economist

During World War II, the British Royal Air Force (RAF) undertook a plan of misdirection to allow a squadron of bombers to approach an exceptionally valuable target in Europe undetected. The target was so heavily guarded that destroying it would require more than the usual degree of surprise.


Although the RAF was equipped to jam the electronic detection of aircraft along the route to the target (a primitive forebear of radar was then in use), they feared that the jamming itself would alert the defending forces. Their solution was to “train” the defending German personnel to believe something that wasn't true. The RAF had a great advantage in undertaking the training: The intended trainees were operating equipment that was novel and far from reliable; and those operators were trying to interpret signals without the help of direct observation, such as actually seeing what they were charged with detecting.

At sunrise on the first day, the RAF broadcast a jamming signal for just a fraction of minute. On the second day, it broadcast a jamming signal for a bit longer than a minute, also around sunrise. On each successive day, it sent the signal for a somewhat longer and longer time, but always starting just before sunrise.

The training continued for nearly three months, and the German radar personnel interpreted the signals their equipment gave them in just the way the British intended. They concluded that their equipment operates poorly in the atmospheric conditions present at sunrise and that the problem grows as the season progresses. That mistaken inference allowed an RAF squadron to fly unnoticed far enough into Europe to destroy the target.

People will get used to almost anything if it goes on for long enough. And the getting-used-to-it process doesn't take long at all if it's something that people don't understand well and that they can't experience directly. They hear about Quantitative Easing and money printing and government deficits, but they never see those things happening in plain view, unlike a car wreck or burnt toast, and they never feel it happening to themselves.

QE has become just a story, and it's been going on for so long that it has no scare value left. That's why so few investors notice that the present situation of the U.S. economy and world investment markets is beyond unusual. The situation is weird, and dangerously so. But we've all gotten used to it.

Here are the four main points of weirdness:

1. The Federal Reserve is still fleeing the ghost of the dot-com bubble. It was so worried that the collapse of the dot-com bubble (beginning in March 2000) would damage the economy that it stepped hard on the monetary accelerator. The growth rate of the M1 money supply jumped from near 0% to near 10%. This had the hoped for result of making the recession that began the following year brief and mild.

2. A nice result, if that had been all. But there was more. Injecting a big dose of money to inoculate the economy against recession set off a bubble in the housing market. Starting in 2003, the Fed began gradually lowering the growth rate of the money supply to cool the rise in housing prices. That, too, produced the intended result; in 2006, housing prices began drifting lower.
   
   But again, there was a further consequence—the financial collapse that began in 2008. This time, the Federal Reserve stomped on the monetary accelerator with both feet, and the growth of the money supply hit a year-over-year rate of 21%. It's still growing rapidly, at an annual rate of 9%.

3. The nonstop expansion of the money supply since 2008 has kept money market interest close to zero. Rates on longer-term debt aren't zero but are extraordinarily low. The ten-year Treasury bond currently yields just 2.7%; that's up from a low of 1.7%.
   
   The flow of new money has been irrigating all financial markets. In the U.S., stocks and bonds tremble at each hint the Fed is going to turn the faucet down just a little. And it's not just US markets that are affected. When credit in the US is ultra cheap, billions are borrowed here and invested elsewhere, all around the world, which pushes up investment prices almost everywhere.

4. US federal debt management is living on borrowed time. The deficit for 2013 was only $600 billion, down from trillion dollar plus levels of recent years. But this less terrible than before figure was achieved only by the grace of extraordinarily low interest rates, which limit the cost of servicing existing government debt. Should interest rates rise, less than terrible will seem like happy times.

Almost no one imagines that the current situation can continue indefinitely. But is there a way for it to end nicely? For most investors, the expectation (or perhaps just the hope) that things can gracefully return to normal rests on confidence that the people in charge, especially the Federal Reserve governors, are really, really smart and know what they're doing. The best minds are on the job.

If the best minds were in charge of designing a bridge, I would expect the bridge to hold up well even in a storm. If the best minds were in charge of designing an airplane, I would expect it to fly reliably. But if the best minds were in charge of something no one really knows how to do, I would be ready for a failure, albeit a failure with superb academic credentials.

Despite all the mathematics that has been spray-painted on it, economics isn't a modern science. It's a primitive science still weighted with cherished beliefs and unproven dogma. It's in about the same stage of development today that medicine was in the 17th century, when the best minds of science were arguing whether the blood circulates through the body or just sits in the veins. Today economists argue whether newly created cash will circulate through the economy or just sit in the hands of the recipients.

Let's look at the puzzle the best minds now face.

If the Federal Reserve were simply to continue on with the money printing that began in 2008, the economy would continue its slow recovery, with unemployment drifting lower and lower. Then the accumulated increase in the money supply would start pushing up the rate of price inflation, and it would push hard. Only a sharp and prolonged slowdown in monetary growth would rein in price inflation. But that would be reflected in much higher interest rates, which would push the federal deficit back above the trillion dollar mark and also push the economy back into recession.

So the Fed is trying something else. They’ve begun the so called taper, which is a slowing of the growth of the money supply. Their hope is that if they go about it with sufficient precision and delicacy, they can head off catastrophic price inflation without undoing the recovery. What is their chance of success?

My unhappy answer is "very low." The reason is that they aren't dealing with a linear system. It's not like trying to squeeze just the right amount of lemon juice into your iced tea. With that task, even if you don't get a perfect result, being a drop or two off the ideal won't produce a bad result. Tinkering with the money supply, on the other hand, is more like disarming a bomb—and going about it according to the current theory as to whether it's the blue wire or the red wire that needs to be cut means a small failure isn’t possible.

Adjusting the growth of the money supply sets off multiple reactions, some of which can come back to bite. Suppose, for example, that the taper proceeds with such a light touch that the U.S. economy doesn't tank. But that won't be the end of the story. Stock and bond markets in most countries have been living on the Fed's money printing. The touch that's light enough for the U.S. markets might pull the props out from under foreign markets—which would have consequences for foreign economies that would feed back into the U.S. through investment losses by U.S. investors, loan defaults against U.S. lenders, and damage to U.S. export markets. With that feedback, even the light touch could turn out not to have been light enough.

To see what the consequences of economic mismanagement can be, and how stealthily disaster can creep up on you, watch the 30 minute documentary, Meltdown America. Witness the harrowing tales of three ordinary people who lived through a crisis, and how their experiences warn of the turmoil that could soon reach the US. Click here to watch it now.

The article Listening to the Canary was originally published at Casey Research

Sign up for one of our Free Trading Webinars....Just Click Here!

Why Gold Is Falling and a Gold Forecast You May Not Like

The bitter truth about what may happen to gold is not all that exciting and likely don’t want to know, but you need to understand what is unfolding as we speak…..

Long story short, the prices of bonds look as though they are about to rally once again. Mounting fears of a stock market correction has money flowing into bonds which in turn will drive interest yields lower yet gain.

But the BIG PICTURE of what he FED said the other week about how they plan to raise rates in 2015 and cut QE down to $55 billion per month hurts the long term outlook for gold.

This news may not sound that important, it actually is and undermines the price of miners, silver and gold in a big way. Find out why gold is falling and the threat that could trigger a much larger meltdown in the long run with my gold forecast video.



Chris Vermeulen
Subscribe to my > ETF Trading Newsletter


Sign up for one of our Free Trading Webinars....Just Click Here!

Hedge Fund Trader Seth Klarman: QE Stimulus Bubble Will Burst

Major hedge fund trader says the QE stimulus bubble will burst.... at some point

In his letter to investors, Seth Klarman noted that “most” investors are downplaying risk and this “never turns out well,” noting that most people are not prepared for anything bad to happen. “No one can know what the future holds, but any year in which the S&P 500 jumps 32% and the NASDAQ Composite 40% while corporate earnings barely increase should be cause for concern, not further exuberance,” Seth Klarman’s investor letter said. “It might not look like it now, but markets don’t exist simply to enrich people.”

Noting that stock markets have risk and are not guaranteed investments may seem like an obvious notation, but against today’s backdrop of never before witnessed manipulated markets Seth Klarman sagely notes “Someday, financial markets will again decline. Someday, rising stock and bond markets will no longer be government policy. Someday, QE will end and money won’t be free. Someday, corporate failure will be permitted. Someday, the economy will turn down again, and someday, somewhere, somehow, investors will lose money and once again come to favor capital preservation over speculation. Someday, interest rates will be higher, bond prices lower, and the prospective return from owning fixed-income instruments will again be roughly commensurate with the risk.”

When will this happen? “Maybe not today or tomorrow, but someday,” he writes, then starts to consider what a collapse might look like. “When the markets reverse, everything investors thought they knew will be turned upside down and inside out. ‘Buy the dips’ will be replaced with ‘what was I thinking?’ Just when investors become convinced that it can’t get any worse, it will. They will be painfully reminded of why it’s always a good time to be risk-averse, and that the pain of investment loss is considerably more unpleasant than the pleasure from any gain. They will be reminded that it’s easier to buy than to sell, and that in bear markets, all to many investments turn into roach motels: ‘You can get in but you can’t get out.’ Correlations of otherwise uncorrelated investments will temporarily be extremely high. Investors in bear markets are always tested and retested. Anyone who is poorly positioned and ill prepared will find there’s a long way to fall. Few, if any, will escape unscathed.”

Seth Klarman’s focus on Fed

Seth Klarman then once again turned his sharp rhetorical knife to the academics that run the US Federal Reserve who seem to think that controlling free markets is a matter of communications policy.

“The Fed, in its ongoing attempt to tamp down market volatility as much as possible decided in 2013 that its real problem was communication,” Seth Klarman dryly wrote. “If only it could find a way to communicate to the financial markets the clarity and predictability of policy actions, it could be even more effective in its machinations. No longer would markets react abruptly to Fed pronouncements. Investors and markets would be tamed.” The Fed has been harshly criticized by professional traders for its lack of understanding of real world market mechanics.

This lack of understanding is a concern given that the Fed is taking the economy into uncharted territory with unprecedented stimulus. “As experienced traders who watch the markets and the Fed with considerable skepticism (and occasional amusement), we can assure you that the Fed’s itinerary is bound to be exceptional, each stop more exciting than the one before,” Seth Klarman wrote, sounding a common theme among professional market watchers. “Weather can suddenly turn foul, the navigation faulty, and the deckhands hard to understand. In short, the Fed captain and crew are proficient in theory but lack real world experience. This is an adventure into unexplored terrain, to parts unknown; the Fed has no map, because no one has ever been here before. Most such journeys end badly.”

While the mainstream media is loaded with flattering articles of the Fed’s brilliance in quantitative easing and its stimulus program, the real beneficiaries of such a policy are the largest banks. Here Seth Klarman notes they have placed the economy at great risk without achieving much reward. “Before 2009, the Fed had never bought a single mortgage bond in its nearly 100-year history,” Seth Klarman writes of the key component of the Fed’s policy that took risky assets off the bank’s balance sheets. “By 2013, the Fed was by far the largest holder of those bonds, holding over $4 trillion and counting. For that hefty sum, GDP was apparently raised as little as 25 basis points in the aggregate. In other words, the policy has been a near-total failure. Bernanke is left arguing that some action was better than none. QE in effect, had become Wall Street’s new ‘too big to fail’ policy.”

Seth Klarman: What do economists know?

There has been considerable discussion that the academic side of the economics profession has little clue how markets really work. Economic academics, who now make up the majority of the Fed governors, often look at the world from the standpoint of a game of chess, where one can explore different options and there is now a “right” or “wrong” approach to market manipulation.

“The 2013 Nobel Memorial Prize in economics was shared by three academics: two were proponents of the efficient market hypothesis and the third was a behavioral economist, who believes in market inefficiency,” Seth Klarman wrote. “We suppose that could be considered a hedged position for the awards committee, one that would never occur in the hard sciences such as physics and chemistry, where a prize shared among three with divergent views would be an embarrassing mistake or a bad joke. While a Nobel Prize might well be the culmination of a life’s work, shouldn’t the work accurately describe the real world?”

Another interesting insight on the topic was to come from David Rosenberg, Chief Economist and Strategist at GluskinSheff, who recently wondered “[A]m I the only one to find some humour, if not irony, in the fact that the three U.S. economists who won the Nobel Prize for Economics did so because they ‘laid the foundation for the current understanding of asset prices’ at the same time that these asset prices are being determined less today by market-determined forces but rather by the distorting effects of the unprecedented central bank manipulation?”

Seth Klarman: Fed Created Truman Show Style Faux Economy

Baupost Group, among the largest hedge funds in the world, returned $4 billion in assets to clients at the end of 2013 because it didn’t want to grow too quickly and dilute performance. Klarman’s fund, which in 2013 had a high of 50% of his portfolio in cash, up from 36% in 2012, posted 2013 returns in the mid-teens consistent with the fund’s nearly 22 year track record.

Seth Klarman on Baupost’s returns

Saying the fund “drew a line in the sand” when it decided to return roughly $4 billion to clients at year end, Seth Klarman reflected on the decision, saying he wanted to control the fund’s head count, noting “we could not allow the firm to grow without limit. We are wise enough to know a good thing when we see it, and cautious enough to want to cherish, protect and nurture it so that we might maintain its essential qualities for a very long time.” A 50% cash position for a hedge fund might be construed as an indication the fund has grown to the point it was having difficulty allocating all the capital in appropriate trades.

He noted the 2013 performance occurred “despite the drag of large, zero yielding cash balances throughout the year.” Klarman, author of Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor, said the performance resulted from “considerable progress in event driven and private situations, and at least some uplift from the strong equity rally. Distressed debt, public equities, structured products, and real estate led the gains.” Tail risk hedges, the only material area of loss in the portfolio, cost approximately 0.2% as the fund reduced exposure to distressed debt, structured products, and private investments while public equity exposure increased modestly.

Market bifurcation {the basis for being bullish on equities}

In 2013 Seth Klarman noted the market bifurcation, which he describes as “a momentum environment of market haves (which we avoid spending time on) and have-nots (which receive our undivided attention) – coupled with our energetic sourcing efforts and valued long-term relationships,” and he expressed optimism for the fund in 2014 amidst what might be a stock market subject to individual interpretation. “In the face of mixed economic data and at a critical inflection point in Federal Reserve policy, the stock market, heading into 2014, resembles a Rorschach test,” he wrote. “What investors see in the inkblots says considerably more about them than it does about the market.”

Seth Klarman noted that those “born bullish,” those who “never met a stock market they didn’t like” and those with “a consistently short memory,” might look to the positives and ignore the negatives. “Price-earnings ratios, while elevated, are not in the stratosphere,” he wrote, stating the bull case. “Deficits are shrinking at the federal and state levels. The consumer balance sheet is on the mend. U.S. housing is recovering, and in some markets, prices have surpassed the prior peak. The nation is on the road to energy independence. With bonds yielding so little, equities appear to be the only game in town. The Fed will continue to hold interest rates extremely low, leaving investors no choice but to buy stocks it doesn’t matter that the S&P has almost tripled from its spring 2009 lows, or that the Fed has begun to taper purchases and interest rates have spiked. Indeed, the stock rally on December’s taper announcement is, for this contingent, confirmation of the strength of this bull market. The picture is unmistakably favorable. QE has worked. If the economy or markets should backslide, the Fed undoubtedly stands ready to once again ride to the rescue. The Bernanke/Yellen put is intact. For now, there are no bubbles, either in sight or over the horizon.

Seth Klarman’s market analysis

Like many of the best market analysts, Seth Klarman looks at both sides of the issue, the bull and bear case, in depth. “If you’re more focused on downside than upside, if you’re more interested in return of capital than return on capital, if you have any sense of market history, then there’s more than enough to be concerned about,” he wrote. Citing a policy of near-zero short-term interest rates that continues to distort reality and will have long term consequences, he ominously noted “we can draw no legitimate conclusions about the Fed’s ability to end QE without severe consequences,” a thought pervasive among many top fund managers. “Fiscal stimulus, in the form of sizable deficits, has propped up the consumer, thereby inflating corporate revenues and earnings. But what is the right multiple to pay on juiced corporate earnings?”

As he outlined the bear case, he started to divulge his own analysis that “on almost any metric, the U.S. equity market is historically quite expensive. A skeptic would have to be blind not to see bubbles inflating in junk bond issuance, credit quality, and yields, not to mention the nosebleed stock market valuations of fashionable companies like Netflix, Inc. and Tesla Motors Inc.

As it turns out he was just warming up. “There is a growing gap between the financial markets and the real economy,” Seth Klarman wrote, noting that even as the Fed promised that interest rates would stay low, they did get out of control to some degree across the yield curve in 2013. “Medium and long­term bond funds got hammered in 2013. Meanwhile, corporate earnings sputtered to a mid-single digit gain last year even as stocks drove relentlessly higher, without even a 10% correction in the last two and a half years,” a concern among many professional traders.

When it comes to stock market speculation and jumping on the bull market happy talk, Seth Klarman notes it’s never hard to build a “coalition of willing” who are willing to climb on the bandwagon. “A flash mob of day traders, momentum investors, and the usual hot money crowd drove one of the best years in decades for U.S., Japanese, and European equities,” he wrote. “Even with the ranks of the unemployed and underemployed still bloated and the economy barely improved from a year ago, the S&P 500 , Dow Jones Industrial Average 2 Minute, and Russell 2000 regularly posted new record highs.”

Seth Klarman noted that whether you see today’s investment glass as half full or half empty depends on your age and personality type, as well as your “lifetime” of experiences. “Our assessment is that the Fed’s continuing stimulus and suppression of volatility has triggered a resurgence of speculative froth,” while citing numerous examples of overvalued internet stocks that defied value investing logic.

“In an ominous sign, a recent survey of U.S. investment newsletters by Investors Intelligence found the lowest proportion of bears since the ill-fated year of 1987,” he wrote. “A paucity of bears is one of the most reliable reverse indicators of market psychology. In the financial world, things are hunky dory; in the real world, not so much. Is the feel-good upward march of people’s 401(k)s, mutual fund balances, CNBC hype, and hedge fund bonuses eroding the objectivity of their assessments of the real world? We can say with some conviction that it almost always does. Frankly, wouldn’t it be easier if the Fed would just announce the proper level for the S&P, and spare us all the policy announcements and market gyrations?” he said in a somewhat hilarious moment that bears a degree of truth.

Seth Klarman on Europe

Seth Klarman still isn’t much of a bull in Europe, as we noted in a previous ValueWalk. “Europe isn’t fixed either, but you wouldn’t be able to tell that from investor sentiment,” he noted. “One sell-side analyst recently declared that ‘the recovery is here,’ a sharp reversal from his view in July 2012 that Greece had a 90% chance of leaving the Euro by the end of 2013. Greek government bond prices have nearly quintupled in price from the mid-2012 lows. Yet, despite six years of painful structural adjustments, Greece’s government debt-to-GDP ratio currently stands at 157%, up from 105% in 2008,” he said, noting a growing concern among fund managers regarding the government debt crisis getting out of hand.

Seth Klarman noted that Germany’s own government debt-to-GDP ratio stands at 81%, up from 65% in 2008, and said “That doesn’t look fixed to us.” The EU credit rating was recently reduced by S&P, he noted, while European unemployment remains stubbornly above 12%. “Not fixed,” he said. “Various other risks lurk on the periphery: bank deposits remain frozen in Cyprus, Catalonia seems to be forging ahead with an independence referendum in 2014, and social unrest continues to escalate in Ukraine and Turkey. And all this in a region that remains saddled with deep structural imbalances. As Angela Merkel recently noted, Europe has 7% of the world’s population, 25% of its output, and 50% of its social spending.” While he notes the problems in Europe, Seth Klarman did not rule out that opportunity might be found in the region.

Seth Klarman on Bitcoin

Seth Klarman also weighed in on Bitcoin, noting that “Only in a bull market could an online ‘currency’ dubbed bitcoin surge 100-fold in one year, as it did in 2013. Now most sell-side firms are rushing to provide research on this latest fad,” he also noted that while “bitcoin funds” are being formed, the fund is “happy to let pass us by, the thinking behind cryptocurrencies may contain a kernel of rationality. If paper currencies – dollars and yen – can be printed in essentially unlimited volumes, and just as with all currencies are only worth what recipients on any given day will exchange in goods or services, then what makes them any better than the “crypto” kind of money?”

Comparing the economy and the Federal Reserve’s management of it to the movie The Truman Show, where the lead character lived in a false, highly-orchestrated environment, Seth Klarman notes with insight, “Every Truman under Bernanke’s dome knows the environment is phony. But the zeitgeist is so damn pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no one wants it to end, and no one wants to exit the dome until they’re sure everyone else won’t stay on forever.” Then he quotes Jim Grant who recently noted on CNBC, the problem is that “the Fed can change how things look, it cannot change what things are.”

Like Outside the Box?
 
Sign up today and get each new issue delivered free to your inbox.

It's your opportunity to get the news John Mauldin thinks matters most to your finances.

The article Outside the Box: Seth Klarman: Investors Downplaying Risk “Never Turns Out Well” was originally published at Mauldin Economics.

Get our "Gold and Crude Oil Trade Ideas"

And the Band Plays On

By Dennis Miller 

Quantitative Easing (QE) is no longer a surprise, but the fact that it's continued for so long is. Like many Miller’s Money readers, I believe the government cannot continue to pay its bills by having the Federal Reserve buy debt with newly created money forever. This has gone on much longer than I'd have ever dreamed possible.

Unemployment numbers dropped in December and the Federal Reserve tapered their money creation from $85 billion to $75 billion per month. Why did the unemployment rate drop? Primarily because people whose benefits have expired are no longer considered unemployed. The government classifies them as merely discouraged, but the fact remains that they don't have jobs.

So, what is the problem? Let's start with the magnitude of money creation. Tim Price sums it up well in an article on Sovereign Man:

"Last year, the U.S. Federal Reserve enjoyed its 100th anniversary, having been founded in a blaze of secrecy in 1913. By 2007, the Fed's balance sheet had grown to $800 billion. Under its current QE program (which may or may not get tapered according to the Fed's current intentions), the Fed is printing $1 trillion a year.

To put it another way, the Fed is printing roughly 100 years' worth of money every 12 months. (Now that's inflation.)"

As Doug Casey likes to remind us: Just because something is inevitable, does not mean it is imminent. Well, sooner or later imminent and inevitable are going to meet. Interest rates are depressed because the Federal Reserve is holding our debt. Eventually those creditors outside the Federal Reserve will demand much higher interest rates.

Currently, 30 year Treasuries are paying 3.59%. If interest rates rose by 2%—still below what was considered "normal" a decade ago—the interest cost to our government would jump by 30% or more. It's hard to imagine the huge budget cuts or tax increases it would take to pay for that.

In the meantime, investors are caught between the proverbial rock and hard place. We cannot invest in long- or medium-term, "safe," fixed income investments because they are no longer safe. They could easily destroy your buying power through inflation.

At the same time, the stock market is not trading on fundamentals. It is on thin ice. Just how thin is that ice? Take a look at what happened when the Federal Reserve stopped propping up the economy with money printing.

Each time they stopped with their stimulus the market dropped. In the summer of 2013, Bernanke made his famous "taper" remark and the market reacted negatively, immediately. The Fed has had to introduce more money into the system to stop the slide.

Investors who need yield know they have virtually no place else to go but the stock market. Most realize it is a huge bubble; they only hope to get out ahead of everyone else when the time comes. And we can't hold cash; inflation would clobber us. So, we've been forced into the market to protect and grow our nest eggs.
It reminds me of playing musical chairs as a kid. The piano player would slow down the tempo. We would all grab the back of a chair and get ready to sit. No one wanted to be the one left standing.

Today the band is playing the "Limbo Rock." Investors are in limbo, knowing the music will stop eventually. We're all going to have to grab a chair quickly—and the stakes are much higher now.

The chart below on margin debt comes courtesy of my friend and colleague at Casey Research, Bud Conrad.

Investors now have a dangerous amount of money invested on margin—meaning they borrowed money from their brokers to buy even more stock. There are strict margin requirements on how much one can borrow as a percentage of their holdings. If the stock price drops, the investor receives a margin call from his broker. That has to take place quickly under SEC requirements. The broker can also sell the holding at market to bring the client's account back into compliance.

Record margin debt, coupled with the thought of traders using computers to read the trend and automatically place orders in fractions of a second, paints an uneasy picture. The unemotional computers will not only sell their holdings, they may well initiate short sales to drive the market down even further.

As the lyrics from the "Limbo Rock" ask, "How low can you go?" When the market limbos down, it will likely be faster and further than we've imagined.

Why is 2014 different? I've been taking stock of 2013 as I prepare our tax filings. Our portfolio did very well last year, thanks in great measure to the analysts at Casey Research. With our Bulletproof Income strategy in place, I am very comfortable with our plans going forward.

At the same time, I am as jittery as a 9-year-old walking slowly around a circle of chairs, knowing that sooner or later the music will stop. The music has played for years now and we are in the game, whether we like it or not. Pundits have gone from saying "this is the year" to more tempered remarks like "this can't go on forever." They place their bets on inevitable, but hedge them on imminent.

What can we do? One of the mantras behind our Bulletproof Income strategy is: "Avoid catastrophic losses." Doug Casey has warned us that in a drastic correction most everyone gets hurt, so our goal is to minimize that damage and its impact on our retirement plans.

Here are a few things you can do to protect yourself.

• Diversify. Not all sectors rise and fall at the same speed. Optimal diversification requires more than just various stock picks across various sectors. Limit your overall stock market exposure according to your age. You don't have to be all in the market. There are still other ways to earn good, safe returns. International diversification will give you an added margin of safety, too, not only from a market downturn but also from inflation.
• Apply strict position limits. No more than 5% of your overall portfolio should be in any single investment. When I look at the record margin debt, I wonder how so many investors can go hog wild on a single investment. Planning for retirement demands a more measured approach.
• Set trailing stop losses. If you set trailing stop losses on your positions at no more than 20%, the most you could lose on any single trade is 1% of your overall portfolio. The beauty of trailing stops is the maximum loss seldom happens. As the stock rises the trailing stop rises with it, which will lock in some additional profits.
• Monitor regularly. As part of my regular annual review, I go over each one of my stop-loss positions. I use an online trading platform to keep track of them. Depending on the stock, you may want to place a stop-loss sell order or use an alert service that will notify you if the stock drops below your set point. Other investors prefer to use a third party for notification.
  
  So, why do I check my stop losses? My particular trading platform accepts the orders "GTC," meaning "good 'til cancelled." But GTC really means "Good for 60 days and then you have to re-enter the notification." Just read the small print.
  
  Also, sometimes stop losses need adjusting. As a stock gets closer to the projected target price, you may want to reduce the trailing stop loss to 15%, or maybe even 10%, to lock in more profits.

We all want to enjoy our retirement years and have some fun. I sleep well knowing we have several good circuit breakers in place. We may get stopped out of several positions and stuck temporarily holding more cash than we'd like. But that means we've avoided catastrophic loss and have cash to take advantage of the real bargains that are bound to appear.

And so the band plays on as baby boomers and retirees continue to limbo.

From the very first issue of Money Forever our goal—my mission­­—has been to help those who truly want to take control of their retirement finances. I want our subscribers to have more wealth, a better understanding of how to create a Bulletproof portfolio, and confidence their money will last throughout retirement.

With that in mind, I’d like to invite you to give Money Forever a try. The current the subscription rate is affordable – less than that of your daily senior vitamin supplements. The best part is you can take advantage of our 90-day, no-risk offer. You can cancel for any reason or even no reason at all, no questions asked, within the first 90 days and receive a full, immediate refund. As you might expect, our cancellation rates are very low, and we aim to keep it that way. Click here to find out more.

The article And the Band Plays On was originally published at Millers Money

Are the Arsonists Running the Fire Brigade?

By John Mauldin

The true measure of a career is to be able to be content, even proud, that you succeeded through your own endeavors without leaving a trail of casualties in your wake.

– Alan Greenspan

If economists could manage to get themselves thought of as humble, competent people on a level with dentists, that would be splendid.

– John Maynard Keynes

And He spoke a parable to them: "Can the blind lead the blind? Will they not both fall into the ditch?"

– Luke 6:39-40

Six years ago I hosted my first Thanksgiving in a Dallas high rise, and my then 90 year old mother came to celebrate, along with about 25 other family members and friends. We were ensconced in the 21^st floor penthouse, carousing merrily, when the fire alarms went off and fire trucks began to descend on the building. There was indeed a fire, and we had to carry my poor mother down 21 flights of stairs through smoke and chaos as the firemen rushed to put out the fire. So much for the advanced fire sprinkler system, which failed to work correctly.

I wrote one of my better letters that week, called "The Financial Fire Trucks Are Gathering." You can read all about it here, if you like. I led off by forming an analogy to my Thanksgiving Day experience:

I rather think the stock market is acting like we did at dinner. When the alarms go off, we note that we have heard them several times over the past few months, and there has never been a real fire. Sure, we had a credit crisis in August, but the Fed came to the rescue. Yes, the subprime market is nonexistent. And the housing market is in free-fall. But the economy is weathering the various crises quite well. Wasn't GDP at an almost inexplicably high 4.9% last quarter, when we were in the middle of the credit crisis? And Abu Dhabi injects $7.5 billion in capital into Citigroup, setting the market's mind at ease. All is well. So party on like it's 1999.

However, I think when we look out the window from the lofty market heights, we see a few fire trucks starting to gather, and those sirens are telling us that more are on the way. There is smoke coming from the building. Attention must be paid.

I was wrong when I took the (decidedly contrarian) position that we were in for a mild recession. It turned out to be much worse than even I thought it would be, though I had the direction right. Sadly, it usually turns out that I have been overly optimistic.

This year we again brought my now-96-year-old mother to my new, not-quite-finished high-rise apartment to share Thanksgiving with 60 people; only this time we had to contract with a private ambulance, as she is, sadly, bedridden, although mentally still with us. And I couldn't help pondering, do we now have an economy and a market that must be totally taken care of by an ever-watchful central bank, which can no longer move on its own?

I am becoming increasingly exercised that the new direction of the US Federal Reserve, which is shaping up as "extended forward rate guidance" of a zero-interest-rate policy (ZIRP) through 2017, is going to have significant unintended consequences. My London partner, Niels Jensen, reminded me in his November client letter that,

In his masterpiece The General Theory of Employment, Interest and Money, John Maynard Keynes referred to what he called the "euthanasia of the rentier". Keynes argued that interest rates should be lowered to the point where it secures full employment (through an increase in investments). At the same time he recognized that such a policy would probably destroy the livelihoods of those who lived off of their investment income, hence the expression. Published in 1936, little did he know that his book referred to the implications of a policy which, three quarters of a century later, would be on everybody's lips. Welcome to QE.

It is this neo-Keynesian fetish that low interest rates can somehow spur consumer spending and increase employment and should thus be promoted even at the expense of savers and retirees that is at the heart of today's central banking policies. The counterproductive fact that savers and retirees have less to spend and therefore less propensity to consume seems to be lost in the equation. It is financial repression of the most serious variety, done in the name of the greater good; and it is hurting those who played by the rules, working and saving all their lives, only to see the goal posts moved as the game nears its end.

Central banks around the world have engineered multiple bubbles over the last few decades, only to protest innocence and ask for further regulatory authority and more freedom to perform untested operations on our economic body without benefit of anesthesia. Their justifications are theoretical in nature, derived from limited variable models that are supposed to somehow predict the behavior of a massively variable economy. The fact that their models have been stunningly wrong for decades seems to not diminish the vigor with which central bankers attempt to micromanage the economy.

The destruction of future returns of pension funds is evident and will require massive restructuring by both beneficiaries and taxpayers. People who have made retirement plans based on past return assumptions will not be happy. Does anyone truly understand the implications of making the world's reserve currency a carry-trade currency for an extended period of time? I can see how this is good for bankers and the financial industry, and any intelligent investor will try to take advantage of it; but dear gods, the distortions in the economic landscape are mind-boggling. We can only hope there will be a net benefit, but we have no true way of knowing, and the track records of those in the driver's seats are decidedly discouraging.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – Please Click Here.

© 2013 Mauldin Economics. All Rights Reserved.

Here's the complete schedule for our upcoming FREE Trading Webinars

Thoughts from the Frontline: Bubbles, Bubbles Everywhere

By John Mauldin

The difference between genius and stupidity is that genius has its limits.
– Albert Einstein

Genius is a rising stock market.
– John Kenneth Galbraith

Any plan conceived in moderation must fail when circumstances are set in extremes.
– Prince Metternich

You can almost feel it in the fall air (unless you are in the Southern Hemisphere). The froth and foam on markets of all shapes and sizes all over the world. It is an exhilarating feeling, and the pundits who populate the media outlets are bubbling over with it. There is nothing like a rising market to help lift our mood. Unless of course, as Prof. Kindleberger famously cautioned (see below), we are not participating in that rising market. Then we feel like losers. But what if the rising market is … a bubble? Are we smart enough to ride and then step aside before it bursts? Research says we all think that we are, yet we rarely demonstrate the actual ability.

This week we'll think about bubbles. Specifically, we'll have a look at part of the chapter on bubbles from my latest book, Code Red, which we launched last week. At the end of the letter, for your amusement, is a link to a short video of what you might hear if Jack Nicholson were playing the part of Ben Bernanke (or Janet Yellen?) on the witness stand, defending the extreme measures of central banks. A bit of a spoof, in good fun, but there is just enough there to make you wonder what if … and then smile. Economics can be so much fun if we let it.

I decided to use this part of the book when numerous references to bubbles popped into my inbox this week. When these bubbles finally burst, let no one exclaim that they were black swans, unforeseen events. Maybe because we have borne witness to so many crashes and bear markets in the past few decades, we have gotten better at discerning familiar patterns in the froth, reminiscent of past painful episodes.
Let me offer you three such bubble alerts that came my way today. The first is from my friend Doug Kass, who wrote:

I will address the issue of a stock market bubble next week, but here is a tease and fascinating piece of data: Since 1990, the P/E multiple of the S&P 500 has appreciated by about 2% a year; in 2013, the S&P's P/E has increased by 18%!

Then, from Jolly Olde London, comes one Toby Nangle, of Threadneedle Investments (you gotta love that name), who found the following chart, created a few years ago at the Bank of England. At least when Mervyn King was there they knew what they were doing. In looking at the chart, pay attention to the red line, which depicts real asset prices. As in they know they are creating a bubble in asset prices and are very aware of how it ends and proceed full speed ahead anyway. Damn those pesky torpedoes.

Toby remarks:

This is the only chart that I’ve found that outlines how an instigator of QE believes QE’s end will impact asset prices. The Bank of England published it in Q3 2011, and it tells the story of their expectation that while QE was in operation there would be a massive rise in real asset prices, but that this would dissipate and unwind over time, starting at the point at which the asset purchases were complete.

Oh, dear gods. Really? I can see my friends Nouriel Roubini or Marc Faber doing that chart, but the Bank of England? Really?!?

Then, continuing with our puckish thoughts, we look at stock market total margin debt (courtesy of those always puckish blokes at the Motley Fool). They wonder if, possibly, maybe, conceivably, perchance this is a warning sign?



And we won’t even go into the long list of stocks that are selling for large multiples, not of earnings but of SALES. As in dotcom-era valuations.

We make the case in Code Red that central banks are inflating bubbles everywhere, and that even though bubbles are unpredictable almost by definition, there are ways to benefit from them. So, without further ado, let’s look at what co-author Jonathan Tepper and I have to say about bubbles in Chapter 9.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

Why has it become so hard to make money as a trader?

Thoughts from the Frontline: A Code Red World

By John Mauldin

I wasn't the only person coming out with a book this week (much more on that at the end of the letter). Alan Greenspan hit the street with The Map and the Territory. Greenspan left Bernanke and Yellen a map, all right, but in many ways the Fed (along with central banks worldwide) proceeded to throw the map away and march off into totally unexplored territory. Under pressure since the Great Recession hit in 2007, they abandoned traditional monetary policy principles in favor of a new direction: print, buy, and hope that growth will follow. If aggressive asset purchases fail to promote growth, Chairman Bernanke and his disciples (soon to be Janet Yellen and the boys) respond by upping the pace. That was appropriate in 2008 and 2009 and maybe even in 2010, but not today.

Consider the Taylor Rule, for example – a key metric used to project the appropriate federal funds rate based on changes in growth, inflation, other economic activity, and expectations around those variables. At the worst point of the 2007-2009 financial crisis, with the target federal funds rate already set at the 0.00% – 0.25% range, the Taylor Rule suggested that the appropriate target rate was about -6%. To achieve a negative rate was the whole point of QE; and while a central bank cannot achieve a negative interest-rate target through traditional open-market operations, it can print and buy large amounts of assets on the open market – and the Fed proceeded to do so. By contrast, the Taylor Rule is now projecting an appropriate target interest rate around 2%, but the Fed is goes on pursuing a QE-adjusted rate of around -5%.



Also, growth in NYSE margin debt is showing the kind of rapid acceleration that often signals a drawdown in the S&P 500. Are we there yet? Maybe not, as the level of investor complacency is just so (insert your favorite expletive) high.



The potential for bubbles building atop the monetary largesse being poured into our collective glasses is growing. As an example, the "high-yield" bond market is now huge. A study by Russell, a consultancy, estimated its total size at $1.7 trillion. These are supposed to be bonds, the sort of thing that produces safe income for retirees, yet almost half of all the corporate bonds rated by Standard & Poor's are once again classed as speculative, a polite term for junk.

Central Bankers Gone Wild

But there is a resounding call for even more rounds of monetary spirits coming from emerging-market central banks and from local participants, as well. And the new bartender promises to be even more liberal with her libations. This week my friend David Zervos sent out a love letter to Janet Yellen, professing an undying love for the prospect of a Yellen-led Fed and quoting a song from the "Rocky Horror Picture Show," whose refrain was "Dammit, Janet, I love you." In his unrequited passion I find an unsettling analysis, if he is even close to the mark. Let's drop in on his enthusiastic note:

I am truly looking forward to 4 years of "salty" Janet Yellen at the helm of the Fed. And it's not just the prolonged stream of Jello shots that's on tap. The most exciting part about having Janet in the seat is her inherent mistrust of market prices and her belief in irrational behaviour processes. There is nothing more valuable to the investment community than a central banker who discounts the value of market expectations. In many ways the extra-dovish surprise in September was a prelude of so much more of what's to come.

I can imagine a day in 2016 when the unemployment rate is still well above Janet's NAIRU estimate and the headline inflation rate is above 4 percent. Of course the Fed "models" will still show a big output gap and lots of slack, so Janet will be talking down inflation risks. Markets will be getting nervous about Fed credibility, but her two-year-ahead projection of inflation will have a 2 handle, or who knows, maybe even a 1 handle. Hence, even with house prices up another 10 percent and spoos well above 2100, the "model" will call for continued accommodation!! Bond markets may crack, but Janet will stay the course. BEAUTIFUL!

Janet will not be bogged down by pesky worries about bubbles or misplaced expectations about inflation. She has a job to do – FILL THE OUTPUT GAP! And if a few asset price jumps or some temporary increases in inflation expectations arise, so be it. For her, these are natural occurrences in "irrational" markets, and they are simply not relevant for "rational" monetary policy makers equipped with the latest saltwater optimal control models.

The antidote to such a boundless love of stimulus is of course Joan McCullough, with her own salty prose:

And the more I see of the destruction of our growth potential … the more convinced I am that it's gonna' backfire in spades. Do I still think that we remain good-to-go into year end? At the moment, sporadic envelope testing notwithstanding, the answer is yes. But I have to repeat myself: The data has stunk for a long time and continues to worsen. And the anecdotes confirming this are yours for the askin'. The only question remaining is for how long we can continue to bet the ranch on wildly incontinent monetary policy while deliberately opting to ignore the ongoing disintegration of our economic fabric?"

And thus we come to the heart of this week's letter, which is the introduction of my just-released new book, Code Red. It is my own take (along with co-author Jonathan Tepper) on the problems that have grown out of an unrelenting assault on monetary norms by central banks around the world.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

© 2013 Mauldin Economics. All Rights Reserved.






Get our Gold, Crude Oil & Index ETF Trading Analysis Newsletter

 

Earnings Growth to Ramp Up? Call Me a Skeptic

By Sheraz Mian

Stocks have performed impressively this year and have largely been able to hold on to the gains despite monetary and fiscal uncertainties and the less than inspiring economic and earnings pictures. In a price-earnings framework for the market, most of the gains this year have resulted from investors’ willingness to pay a higher multiple for pretty much the same, or even lower, earnings.

Reasonable people can disagree over the extent of the Fed’s role in the market’s upward push, but few would argue that the Bernanke Fed’s easy money policy has been a key, if not the only, driver of this trend. If nothing else, the Fed policy of deliberately low interest rates pushed investors into riskier assets, including stocks.

But with the Fed getting ready to institute changes to its policy, investors will need to go back to fundamentals to keep pushing stocks higher.

We don’t know when the Fed will start ‘Tapering’ its bond purchases, but we do know that they want to get out of the QE business in the "not too distant" future. What this means for investors is that they will need to pay a lot more attention to corporate earnings fundamentals than has been the case thus far.

The overall level of corporate earnings remains quite high. In fact, aggregate earnings for the S&P 500 reached an all-time record in 2013 Q2 and are expected to be not far from that level in the ongoing Q3 earnings season as well. There hasn’t been much earnings growth lately, but investors are banking on material growth resumption from Q4 onwards. This hope is reflected in current consensus expectations for 2013 Q4 and full year 2014.

I remain skeptical of current consensus earnings expectations and would like to share the basis for my skepticism with you. The goal is to convince you that current earnings expectations remain vulnerable to significant downward revisions.

Negative estimate revisions haven't mattered much over the last few quarters as the Fed's generous liquidity supply helped lift all boats. But if the Fed is going to be less of a supporting actor going forward, then it's reasonable to expect investors to start paying more attention to fundamentals. It is in this context that the coming period of negative revisions could potentially result in the market giving back some, if not all, of its recent gains.

This discussion is particularly timely as we are in the midst of the 2013 Q3 earnings season that will help shape consensus estimates for Q4 and beyond. In the following sections, I will give you an update on the Q3 earnings season and critically review consensus expectations for Q4 and beyond.

The Q3 Scorecard

 

As of Monday, October 21st, we have Q3 results from 109 companies in the S&P 500 that combined account for 31.6% of the index’s total market capitalization. Total earnings for these 109 companies are up +7.5% year over and 63.3% of companies beat earnings expectations with a median surprise of +2.1%. Total revenues are up +2.1%, with 45.9% of the companies beating top line expectations and median revenue surprising by +0.02%.

The table below presents the current scorecard for Q3



Note: One sector, Aerospace, has not reported any Q3 results yet. NRPT means ‘no reports’; NM means ‘not meaningful’. 

With results from more than 30% of the S&P 500’s total market capitalization already out, we are seeing the Q3 earnings picture slowly emerge. This is particularly so for the Finance sector, where 51.8% of the sector’s total market cap has already reported. Other sectors with meaningful sample sizes include Transportation (47.3%), Consumer Staples (40.4%), Technology (36.9%) and Medical (25.2%).

Finance has been a steady growth driver for the last many quarters and is diligently playing that role this time around as well despite anemic loan demand, wind-down of the mortgage refi business and weak capital markets activities, particularly on the fixed income side. Outside of Finance, total earnings are up +4.4% for the companies that have reported already.

How do the 2013 Q3 results thus far compare with the last few quarters?

The short answer is that they are no better than what we have seen from this same group of 109 companies in recent quarters. In fact, on a number of counts the results thus far do not compare favorably to either the preceding quarter (2013 Q2), or the 4-qurater average, or both.

Specifically, the earnings and revenue growth rates and revenue beat ratio are tracking lower, while the earnings beat ratio is about in-line



The charts below compare the beat ratios for these 109 companies with what these same companies reported in Q2 and the 4-quarter average (beat ratio is the % of total companies coming ahead of consensus expectations).



The trends we have seen thus far will shift to some extent as the rest of the reporting season unfolds, but not by much. A composite look at the Q3 earnings season, combining the actual results from the 109 companies with estimates for the 391, is for +2.1% earnings growth on +0.8% higher revenues, as the summary table below shows.

 

Earnings growth rate has averaged a little over +3% over the first two quarters of the year and will likely stay at or below that level in Q3 as well. With respect to beat ratios, roughly two-thirds of the companies come ahead of expectations in a typical quarter and the Q3 ratio will likely be in that same vicinity.

The ‘Expectations Management’ Game

 

In the run up to the start of the Q3 earnings season, consensus earnings estimates came down sharply. The primary reason for the estimate cuts – guidance from management teams. Companies guided lower for Q3 while reporting Q2 results, a trend that has remained in place for more than a year now.
The chart below does a good job of showing the evolving Q3 earnings expectations over the last few months.



The Q3 estimate cuts weren’t unusual or peculiar to the quarter, as we have been seeing this trend play out repeatedly for more than a year now. The chart below compares the trends in earnings estimate revisions in the run up to the Q3 and Q2 reporting seasons



These expectations mean that Q3 wouldn't be materially different from what we have become accustomed to seeing quarter after quarter, with roughly two-thirds of the companies beating consensus earnings estimates. This game of under-promise and over-deliver by management teams has been around long enough that it has likely lost most of its value in investors’ eyes.

Beat ratios may not carry as much informational value this time around, but what will be particularly important is company guidance for Q4 and beyond. Guidance is always very important, but it has assumed added significance this time around given the elevated hopes that Q4 represents a material earnings growth ramp up after essentially flat growth over the last many quarters.

Evaluating Expectations for Q4 & Beyond

 

Let's take a look at how consensus earnings expectations for 2013 Q3 compare to what companies earned in the last few quarters and what they are expected to earn in the coming quarters.
The chart below shows the expected Q3 total earnings growth rate for the S&P 500 contrasted with the preceding two and following two quarters. (Please note that the Q3 growth rate is for the composite estimate for the S&P 500, combining the 109 that have reported with the 391 still to come)



The Finance sector has been a big earnings growth driver for some time. Outside of the Finance sector, total earnings growth for the S&P 500 was in the negative in 2013 Q2 and is expected to be no better in Q3. But the high hopes from Q4 and beyond reflect a strong turnaround in growth outside of Finance.
The chart below shows the same data as the one above, but excludes the Finance sector.



What this means is that quarterly earnings growth was +3.4% in the first two quarters of the year, is expected to be 2.1% in Q3, but accelerate to a +9.4% pace in Q4. And not all of the expected Q4 growth is coming from the Finance sector, as the rest of the corporate world is expected to reverse trend and start contributing nicely from Q4 onwards.

The chart below shows the same data, but this time on a trailing 4-quarter basis. The way to read this chart of steadily rising expectations is that total earnings for the S&P 500 are on track to be up +3.8% year over year in the four quarters through Q3, but accelerate to +4.5% in Q4 and +5.6% in 2014 Q1. Consensus expectations are for total earnings growth of +11.8% in calendar year 2014.



The two charts below show earnings for the S&P 500; not EPS, but total earnings. The first chart shows quarterly totals, while the second one presents the same data on a trailing 4-quarter basis. As you can see, the 'level' of total earnings is very high. In fact, quarterly earnings have never been this high - the 2013 Q2 total of $260.3 billion was an all-time quarterly record.




The data in this chart reflects current consensus estimates. This shows that consensus is looking for new all-time record quarterly totals in the coming two quarters. The high expected growth rates in Q4 and beyond are more than just easy comparisons, they represent material gains in total earnings.
The record level of current corporate profits is also borne by the very high level of corporate profits as a share of nominal GDP, which has never been this high ever. The chart below, using data from the BEA, of corporate profits as a share of nominal GDP clearly shows this.




Where Will the Growth Come From?


There is some truth to the claim that the current record level of corporate profits, whether in absolute dollar terms or as a share of the GDP, does not mean that earnings have to necessarily come down. But earnings don’t grow forever either as current consensus expectations of double-digit growth next year and beyond seem to imply.

After all, earnings in the aggregate can grow only through two avenues - revenue growth and/or margin expansion.

Revenue growth is strongly correlated with 'nominal' GDP growth. If the growth outlook for the global economy is positive or improving, then it’s reasonable to expect corporate revenues to do better as well. But the global economic growth outlook is at best stable, definitely not improving as the recent estimate cuts by the IMF shows.

The U.S. economic outlook has certainly stabilized and GDP growth in Q4 is expected to be modestly better than Q3’s growth pace. The expectation is for growth to materially improve in 2014, with consensus GDP growth estimates north of +3% for 2014 and even higher the following year. Europe isn’t expected to become an engine of global growth any time soon, but the region’s recession has ended and its vitals appear to be stabilizing. The magic of Abenomics is expected to revitalize Japan, but it’s nothing more than a hope at this stage. In the emerging world, sentiment on China has improved, but India, Brazil, Turkey and other former high flyers appear to be struggling.

All in all, this isn’t a picture to get overly excited about. But with almost 60% of the S&P 500 revenues coming from the domestic market, the expected GDP ramp up next year should have a positive effect on corporate revenues, which are expected to increase by +4.2% in 2004. But in order to reach the expected +11.8% total earnings growth in 2014, we need a fair amount of expansion in net margins to compliment the +4.2% revenue growth.

Can Margins Continue to Expand?

 

The two charts show net margins (total income/total revenues) for the S&P 500, on a quarterly and trailing 4-quarter basis. For both charts, the data through 2013 Q2 represents actual results, while the same for Q3 and beyond represent net margins implied by current consensus estimates for earnings and revenues.



The chart below shows net margins the same data for a longer time span on a calendar year basis – from 2003 through 2014.



As you can see margins have come a long way from the 2009 bottom and by some measures have already peaked out.

Margins follow a cyclical pattern. As the above chart shows, they expand as the economy comes out of a recession and companies use existing resources in labor and capital to drive business. But eventually capacity constraints kick in, forcing companies to spend more for incremental business. Input costs increase and they have hire more employees to produce more products and services. At that stage, margins start to contract again.

We may not be at the contraction stage yet, but given the current record level of margins and how far removed we are from the last cyclical bottom, we probably don’t have lot of room for expansion. The best-case outcome on the margins front will be for stabilization at current levels; meaning that companies are able to hold the line on expenses and keep margins steady. We will need to buy into fairly optimistic assumptions about productivity improvements for current consensus margin expansion expectations to pan out.

So What Gives?

 

What all of this boils down to is that current consensus earnings estimates are high and they need to come down - and come down quite a bit. I don't subscribe to the view held by some stock market bears that earnings growth will turn negative. But I don't buy into the perennial growth story either.

So what's the big deal if estimates for Q4 come down in the coming days and weeks? After all, estimates have been coming down consistently for more than a year and the stock market has not only ignored the earnings downtrend, but actually scaled new heights.

A big reason for investors' disregard of negative estimate revisions has been that they always looked forward to a growth ramp up down the road. In their drive to push stocks to all-time highs in the recent past, investors have been hoping for substantial growth to eventually resume. The starting point of this expected growth ramp-up kept getting delayed quarter after quarter. The hope currently is that Q4 will be the starting point of such growth.

Guidance has overwhelmingly been negative over the last few quarters. But if current Q4 expectations have to hold, then we will need to see a change on the guidance front; we need to see more companies either guide higher or reaffirm current consensus expectations. Anything short of that will result in a replay of the by-now familiar negative estimate revisions trend that we have been seeing in recent quarters.

Will investors delay the hoped for earnings growth recovery again this time or finally realize that the period of double digit earnings growth is perhaps behind us for good? Hard to tell at this stage, but we will find out soon enough. My sense is that markets can buck trends in aggregate earnings for some time, as they have been doing lately. But expecting the trend to continue indefinitely may not be realistic.

220 Stocks To Sell Now

 

No matter where the market is headed, one fact is obvious: You should not buy and hold stocks unless they offer good prospects for profit. I can help you weed out many of the ones that don't make the grade. That is because my company, Zacks Investment Research, is releasing to the public its list of 220 Stocks to Sell Now.

These Strong Sells are sinister portfolio killers because many have good fundamentals and seem like good buys.   But something important has happened to each of them that greatly lowers their odds of success. Historically, such stocks perform 6 times worse than the market.

I invite you to examine this list for free and make sure no stock you own or are considering is on it. Today you are welcome to see it and other time-sensitive Zacks information at no charge and with no obligation to purchase anything.

See Zacks’ “220 Stocks to Sell Now” list for Free.

Best,
Sheraz Mian
Sheraz Mian is the Director of Research for Zacks and manages its award-winning Focus List portfolio. 
 
Like Outside the Box?

Sign up today and get each new issue delivered free to your inbox.
It's your opportunity to get the news John Mauldin thinks matters most to your finances.
© 2013 Mauldin Economics. All Rights Reserved.

Get our advanced "Opening Gap Study" today!

Busting Economic and Natural Resource Myths

By The Gold Report

The Gold Report: Why is the theory of tapering or turning quantitative easing (QE) off a myth, and who really benefits from QE?


Rick Rule: My view—as an investor, not an economist—is that QE is misnamed. I think it's another way of saying counterfeiting. It exists in large measure because we're running a trillion-dollar deficit and, while we can hoodwink investors into funding two-thirds of it, we need to print away the last third.

TGR: What are the consequences of turning off QE?

Louis James: Federal Reserve Chairman Ben Bernanke said himself that he had certain criteria he wanted to see before tapering—employment in particular. Those have not been met. Employment figures have improved, but only in—I guess the technical term would be "crappy" jobs. Long-term employment, the middle class' bread and butter, is not better.

TGR: Rick, you defy common sense and argue that bull markets are bad and bear markets are good, but it doesn't feel that way.

RR: JT, at the risk of being sexist, women are normally more rational shoppers than men. Think about the stock market as a mall.

In the mall, the store on the left-hand of the entrance has a big flashing sign that says, "Bear Market Merchants All Goods 70% Off, No Reasonable Offer Refused, Come Back Tomorrow—Prices May Be Lower." The store on the right-hand side has a tiny sign that says, "Bespoke Bear Market Merchants, No Deals Ever, High Margin for Merchants, Don't Even Think About Asking for a Deal, Prices May Be Higher Next Week."

If you're going to buy a pair of shoes, which store would you go to? This is a no-brainer. When people buy physical goods, they act rationally. When they buy financial goods, they want to overpay. It's totally irrational, and it's extraordinarily common. If you want to become wealthier, why wouldn't you buy financial assets when they're on sale?

TGR: Staying with the mall analogy, does that suggest that people are afraid stocks will be on even deeper sale tomorrow?

Marin Katusa: You have to look at the timeframe. This is a great market if you're an accredited investor and have an account with someone like Rick Rule or you subscribe to the International Speculator and follow the right management teams. Today, you can invest in deals with five-year full warrants that would not have been available three years ago. Rick and I have been in meetings where the venture teams laughed at me when I requested full warrants. Rick just said, "Bite your lip, smile, and wait." And he was right.
If you're buying stock today in hopes that the market will go up the next day, you'll be in a lot of pain. But if you have a two- to five-year timeframe, you can get guys like Bob Quartermain and Lukas Lundin on sale.

LJ: What would you give to go back in time and buy Apple just after the Apple II came out? Or to buy Microsoft when DOS was new?

Over the course of the last decade—what I think of as the first half of this great bull cycle—billions of dollars have gone into the ground and done good work.

Companies with 10 million ounces of high grade gold in a safe mining jurisdiction are on sale below IPO prices. Some companies with excellent management and assets in hand are selling for less than cash value. You can buy these companies now, instead of looking for the next Apple or Microsoft.

RR: Words like "want" and "hope" in speculation are truly four-letter words, profanities. Having a stock in your portfolio that cost $200,000 and has a current market valuation of $40,000 is unfortunate, but irrelevant. Investors need to take advantage of their education and do their best with the situation at hand. Right now, things are cheap. When things are cheap you're supposed to buy. In bull markets, when things are expensive, you're supposed to sell.

Right now, buying is easy because you have no competitors. In a bull market, selling is easy because everybody is a buyer. If the market is desperately looking for bids and you are scared to death because your stocks can't catch bids, you have to bid. They say the market was desperate for asks, but this market is desperate for bids.

TGR: Some have said this the end of the commodity supercycle. Is that a myth? And is it more or less of a myth in some sectors than others?

RR: The narrative that existed in 2009-2010, when the commodity supercycle was the currency of all financial thinking, is unchanged. The first part of that narrative was founded on the idea that world population growth was taking commodity consumption higher. World population growth is not over.

The second part of the narrative was that as poor people gained more freedom, they got richer and consumed more. Political liberalization in emerging frontier markets has continued, and people are wealthier and are consuming more.

A third part of the narrative was that Western consumers had lived beyond their means and as a consequence were debasing the denominators, the fiat currencies. If you debase the denominator, the nominal value of stuff would go up. We have not stopped debasing the denominator.

The entire narrative associated with the resource-industry bull market is intact. Nothing has changed except the price. A cyclical decline in a secular bull market is a different way of describing a spectacular sale, for people who understand that the narrative hasn't changed.

TGR: Are there some sectors that still feel as if it's a commodity supercycle?

MK: Definitely. Look at oil.

RR: But your readers don't want to look for hot sectors, because they are overpriced. They want to look for cold sectors. They want to find the sector, management team, or the company that's going to be hot.

TGR: If oil is hot right now, what is going to be hot?

MK: From the energy side, I think within three years uranium will be hot.

TGR: Why the three-year timeline?

MK: There are three major catalysts. First is the end of the US-Russia Highly Enriched Uranium Purchase Agreement (HEU). The last shipment will happen at the end of 2013.

Second is the transitional agreement, in which the Russians will provide up to 50% of the uranium on a new pricing metric than the HEU agreement. Only this time, the Russians have new dance partners: Saudi Arabia, China, India, Korea, even France. The reality is the Americans will have to pay more for uranium from the Russians.

Third, nuclear reactors are not all being taken down; they're being built. Japan plans to bring its reactors back online, just not on the timeframe the junior resource sector wants them to. The Japanese cannot afford to pay the most expensive electricity prices in the world and stay competitive. They have no choice but to move forward with nuclear power.

TGR: Is the end of HEU already priced in to uranium?

MK: Yes, both because the market is determining what it's worth today and because Japan shut down 40 nuclear reactors. That's a black-swan game-changer that shifted everything.

Yet, the long-term price is 50% higher than the spot price, and more than 90% of the uranium being consumed and traded is based on the long-term price. That's the equivalent of saying gold today is $1,300/ounce, but if you want to take delivery in three or four years—which is what nuclear utilities do for uranium—you have to pay $1,900/oz. Or copper at $4.50/pound if you want delivery in five years. That's the situation in uranium today.

TGR: Louis, which sector are you looking forward to?

LJ: There's talk on the streets about helium, although I'm not sure I want to move in that direction. I'm happier focusing on something right in front of me and that I understand. Finding a company that has a multimillion-ounce, high-grade deposit and is on sale at half price is similar to going into the supermarket and finding the thickest, most beautifully marbled T-bone steak, fresh cut today, on sale for half off. Why bother with hamburger of unknown quality?

TGR: We keep hearing that we've hit a bottom, which would imply that the market is moving up. However, Rick, you have described it as a bifurcated market in which the bad stocks will continue to sink, which would be a good thing. How do we know which companies will sink and which will revive?

RR: That's a critical question. Before your readers classify stocks, they need to classify themselves. Are they the type of person who will put enough time and attention into securities analysis to compete on their own? Or do they need other people to help them compete?

While securities analysis and stock selection in the junior market is imperfect, it can be done. It requires understanding the stock. If you're not willing to understand the stock, you need an advisor.

TGR: How many hours does that work take? What questions should investors be asking?

RR: Speculators running their own portfolios without advice should limit the number of stocks in the portfolio to the number that they can spend two or three hours a month working on. That means reading every press release, proxy, quarterly, and annual report. Read the president's message and measure it against what he said the company would accomplish over the year.

Speculators unwilling to do that need to hire somebody who will. That may mean subscribing to one of the trading services offered by Casey or hiring an organization like Sprott to be a broker or a manager.
Getting to bifurcation and stock selection, if 15% of the stocks are moving higher, 85% are moving lower. You won't be able to concentrate 100% in either camp, but if you get more right than wrong, you'll make so much money that the outliers will be irrelevant. If you get it wrong, you'll lose so much money that you ought to be in some other business.

TGR: Are there fewer brokers walking the streets of Vancouver these days?

MK: Definitely, also fewer analysts and fewer corporate development positions and many fewer investor relations people.

There are more BMWs, Mercedes, and Ferraris on sale, and now more offices becoming vacant.

TGR: Does that mean only the best are left?

MK: Not necessarily.

RR: But it does reduce the population. To be a responsible analyst, you once had to look in a cursory fashion at 4,000 companies. Today, having only 3,000 companies to look at is an advantage.

The three of us look at data in a summary fashion to try and dispose of a company. You look for something to kill your interest. The good news is that the population of timewasters is down by at least a third. That's unfortunate for their shareholders, but that's their problem, not ours. Our job is to look after our subscribers or clients.

TGR: Let's talk about regions. Is it true that the Yukon is remote?

LJ: It's no more remote now than it was last year. You can't write off the Yukon or anywhere without looking at and understanding the specifics of individual opportunities. Miners with remote projects that have high enough margins are able to barge or truck diesel fuel in and run gen-sets, etc. If Canadians can mine diamonds in the Arctic Circle, they can mine gold in the Yukon.

Remoteness by itself is not the issue. The issue is margin. If you're in the Yukon and you've got something low grade, with low recoveries and complex metallurgy—don't call us, we'll call you. If you have something high grade, open pit, that leaches, tell me more.

TGR: Rick, in your presentation, you talked about platinum and palladium. Is that an area where the supercycle needs to whip things up?

RR: I don't think it even requires a supercycle. With platinum and palladium, I can look empirically at simple supply and demand. On a global basis, the platinum and palladium industry doesn't earn its cost of capital. That means one of two things will happen: The price of platinum and palladium will increase, or there won't be enough platinum and palladium to supply current demand.

In the context of supply, you don't have to worry about investor inventories because there are almost none. The world supply of existing, finished platinum and palladium is less than one year's fabrication demand.
The consequence of the industry not earning its cost of capital is that production has fallen by 19% over six years. New mine supply is falling. South Africa itself accounts for 70% of world platinum production and 39% of world palladium production.

In South Africa, the industry has deferred $5 billion in sustaining capital investments; workers are dying and infrastructure is more and more decrepit.

A skilled worker crouching 7,000 feet underground in 105-degree heat in two inches of water makes $700 per month. An unskilled worker who mucks the material on his hands and knees 400 meters from the mine face to the adit makes $200 a month. A migratory worker sustaining a family in the homeland is probably sustaining another family at the mine face. Wages have to go up, but they can't because the companies don't earn their cost of capital.

According to the majority of South Africans, social take—taxes and royalties—has to go up, but can't because companies don't earn their cost of capital.

Prices have to go up. Platinum and palladium prices can go up because their utility to users is so high. It goes into high-carat jewelry. Platinum goes up a smokestack. Mostly, it goes out a tailpipe.

It costs $200—the cost of a catalytic converter in a new car—to give us the air quality we enjoy today. There's a social consensus in favor of stricter air-quality standards. If the price of platinum and palladium doubled, the catalytic converter would cost $400 in a $27,000 new car; the demand impact would be de minimus.

LJ: We all know the often-quoted phrase that most of the gold ever mined in the world is still sitting in purified form on the surface in one form or the other. Platinum and palladium are different; they are consumed. I agree with Rick.

I would go one step further regarding South Africa. It's not just the economics that don't work; it's the country itself. It's a balloon resting on pins. I see platinum and palladium as speculation on South Africa going up in flames, which is an easy bet to take now. I'm sorry for the South Africans, but it's a bad situation with no easy way out.

TGR: There's been a lot of talk about the dearth of young, qualified people coming up to take a place in management teams. Has the next generation of managers—and investors, for that matter—left the sector? If so, what will happen?

MK: There's a significant age gap in our industry. When I was taking geology courses at university, our professor would ask why we were taking this class. There were no jobs. He recommended we go into computers, and a lot of people did.

Unfortunately, good management teams are very difficult to come by. Only 1 in 3,000 projects ever becomes an economic mine, and I'd say investing in the right people is more important than any other factor.

LJ: This scarcity makes the investor's job a little easier. Just type the CEO's name in Google and look up his history. Has he done this before? Has he succeeded? Was he an accountant or a used car salesman? Google is one of our primary triage tools.

People is the first of Doug Casey's famous Eight Ps. If I hear about a story that fits our general criteria, the first thing I look at is management and directors. If I recognize the name of someone who has lied to me or whom I don't trust, I don't even look at the project.

TGR: New people coming up need to get experience by being in a successful project. Are there enough successful projects that they're learning how to do it?

LJ: I don't necessarily agree with that angle. All experience is good experience. A person can learn a lot from working for a company that does something wrong. It's having lots of experience, both good and bad, that is so important. The problem is that, unless you get very lucky, you need to have experience to really call shots well, and there are not enough people out there with the decades of experience needed.

On the bright side, because there is money in the field now, geology departments are no longer shutting down; enrollment is up. Supply is improving, but it will be another 5 to 10 years before the supply of highly experienced personnel really improves.

RR: Let's personalize it for your readers. There are three analysts in the room: an old one and two young ones. I guarantee you that, as a consequence of the bear market they just experienced, the two younger analysts will make their readers more money with less risk in the next bull market.

Youth isn't enough. You need to have a decade under your belt so that you have lived through the changes. Marin and Louis just lived through the kind of challenges I lived through in the 1980s. They now have the two things needed to survive in this racket: legs and scars.

MK: He's not joking about the scars.

RR: The transfer of the mantle from the Doug Caseys and Rick Rules of the world to the Marin Katusas and Louis Jameses is under way. The batons are being passed.

TGR: Is the bear market making a better generation of investors? Will they be more patient, have more perspective given what they've been through?

MK: If they stick with it. It's all about timeframe and perspective. The bear market will wash out a lot of investors; do not allow yourself to become a victim. But as Rick said, investors have to mitigate risk to stay alive until the next leg in the bull market.

RR: You're wrong there, Marin. You have to thrive. The year 2000, which was the market bottom, was one of the best investment years of my life. And 2001 was even better, as was 2002.

A bear market is when you make your money. You don't get to put it in your pocket until things turn, but you make your money by thriving in bear markets. You don't thrive in bull markets. You cash the checks. It's very different.

LJ: I expect this will be a painful experience for a lot of people. Some will learn a lesson, but it will be the wrong lesson. The lesson will be: Don't invest in commodities; they're too risky. That lesson will stick until the prices go bananas again, when they'll give it another try and get taken to the cleaners again.

To buy low and sell high, investors have to be able to sell high, which means they are expecting people to act irrationally when prices are very high—which means they didn't learn the lesson. It's unfortunate for our world that human nature is so, but it is so, and investors who ignore the opportunities this creates don't do anyone any favors.

TGR: Marin, going back to energy, there's been a lot in the media about the International Energy Agency (IEA) report about energy independence in North America. Will we be the Saudi Arabia of natural gas?

MK: North America is already the Saudi Arabia of natural gas. Unfortunately, so are the Russians.

The report said that if these eight assumptions happen the way we hope, America will become almost energy independent. The media forgot about the eight assumptions, and they got rid of the word "almost."
The US has done a great job of bringing North American innovation to the shale industry, but the industry has many other challenges to work through.

TGR: Is Saudi Arabia still the Saudi Arabia of oil? Its wells are getting long in the tooth, and the country is building nuclear plants for domestic use.

MK: We're all asking that question. The Ghawar oil field has been producing oil since before Elvis hit the scene and today produces about half of Saudi Arabia's oil. There is significant risk in relying on these old elephant deposits that have been producing for more than 50 years.

RR: I agree. What has happened in the US, and to a lesser degree Canada, is unique because our competitive markets still work. For example, 50 or 60 competitors at Eagle Ford tried and failed using various completion techniques, each time getting better and better. Ultimately, Eagle Ford was an extremely messy success.

In most of the world, there's one quasi-state oil company looking at a basin. There's no competition trying different solutions. Exporting American or Canadian technology doesn't work without exporting the messiness of the North American energy-exploration business.

Marin, would exporting technology from Eagle Ford work in Argentina's Vaca Muerta Shale?

MK: It would take billions of dollars to make it work at Vaca Muerta. A junior company with a $10 million market cap and $500,000 to make management's salary and payment on their BMWs will never be able to develop this billion-dollar shale potential. It will require a big company, like a Chevron.

TGR: We heard a lot about the potential for crowdfunding to save the resource sector by funding more companies. True?

MK: I'd like to make sure that all of your readers stay the hell away from crowdfunding for the resource sector. I've heard it works OK in the tech sector and among the let's-make-a-movie crowd, where all that is needed is to raise $150,000 for something that may or may not work.

In the resource sector, real exploration cannot be done for $2-3 million. If people want to invest in the sector, go to someone with a track record, someone who knows what he's doing. Subscribe to Louis' newsletter and educate yourself. Stay the hell away from crowdfunding for the resource sector.

RR: The last thing the sector needs is more companies. The idea that the crowd would invest $3 million in a de novo project when there are companies out there that have spent $80 million on an existing project, yet have a $6 million market cap is the most counterproductive activity that one could imagine. If there are 3,000 public companies doing exploration on a global basis, we don't need another 300. We need 2,000 fewer.

LJ: It's one thing to go directly to the masses with an art project that some snob at the National Endowment for the Arts turned down, but entirely another to do so for a mine project no knowledgeable investor will touch.

TGR: What myth would you want our readers to stop believing in?

LJ: I would like to dethrone the "grade is king" myth. It's not grade; it's margin. You can have an exceptionally high-grade deposit in an exceptionally expensive, difficult, or kleptocratic jurisdiction, and it won't work. You could have a water table that's so fluid that you spend more money pumping water than mining. There are so many things that can go wrong or add to costs. Too many people believe if a project is high grade, it has to make money. No, it doesn't. High margin is paramount, not grade.

MK: I think the myth that the commodity bull market is over is insane. We're nowhere near being over. This is the opportunity of a lifetime. This is when you start doing your homework and investing money.

RR: The idea that bear markets are bad and bull markets are good is bullshit. It's the other way around. Bear markets are good. Bull markets are bad.

LJ: Bullshit is a technical term.

TGR: I enjoyed talking with the three of you. Thanks.

Hungry for more insights like these? Want specific, actionable recommendations to accompany them? These are the kinds of exchanges that have made Casey Summits must-attend events for resource investors… not to mention why they consistently sell out.

If you missed the 3 Days with Casey Summit and its all-star lineup—

which included Ron Paul, Lacy Hunt, James Rickards, Catherine Austin Fitts, and Dr. Elizabeth Vliet, among many others—you can still listen in on every session… every breakout session… every Q&A… by preordering the Casey Summit Audio Collection. 

It includes all this plus images of any visual aids each speaker used. And if you order while they're in production, you'll enjoy substantial savings.  

Get all the details and reserve your copy—in CD or MP3 format—today.