Sunday, November 13, 2016

You’re bearish… but there is no euphoric stock market!

Have you heard about the investor who has been short selling for the last 5 years or longer and losing his shirt? He may be right (in the end) but the market can keep on going up longer than he (or you) has money left.
But still we’re now quickly approaching another bull market anniversary – eight years since the lows of 2009? Eh… 2010, 2011, 2012, … We never had such a long-lasting bull market!  Even if you start counting from 2011 - the depth of the European debt crisis - we still have a market that gets quite old and tired.  Wow that is some business cycle and like we have said earlier investor sentiment is not exactly bullish or euphoric, so why be concerned?
Yes, stock market investors are not exactly bullish but you don’t have to go far looking for extreme market bubbles!  Yeah, the bond market! These days, in Germany and Switzerland, the bank pays you for borrowing its money (negative mortgage rates). Can you believe it?  So people pay you to borrow money! That means that money, I am talking Cash here, is a liability if you believe the banks and central banks!  No wonder, people buy real estate with money they get paid to borrow and drive up prices in the large cities of the world such as London, New York and here at home in Vancouver and Toronto!  If that is not a distorted market, then what is?  Central banks have been supporting the bull market in all kinds of assets with this low interest or better this negative interest rate policy.  They are printing money from thin air; buying bonds and forcing retirees to put their money in riskier and riskier investments so that aforementioned retirees may still earn an income.
This is a market extreme; an enormous market bubble! And don’t tell me that nobody is seeing this coming?  A lot of people hope that the central banks will keep on lowering interest rates at every whiff of slowing economic growth and stock market weakness. But it has become like pushing on a rubber string with the tool becoming less effective. And if the central banks are no longer printing money out of thin air who is going to lend money at negative rates to companies that are already over-leveraged.  Still, market volatility indexes like the Vix are near all-time lows, i.e. nobody believes that anything can go wrong. Now there is your euphoria!  If nobody believes in a market crash as indicated by the Vix, likely the opposite is to happen!
As explained in the previous post, you may consider yourself an INVESTOR but even for good assets the returns may be falling during a new credit crisis or recession! For several years now, we have promoted to build up your cash. Now we’re saying start protecting yourself even more actively. We have seen credit defaults in the U.S. on the rise. Defaults of triple BBB rated debt (called investment grade) has increased from typically 1 to now 5%. This is the type of debt banks and insurance companies tend to invest in and you know that in-spite of their improved balance sheets the leverage is still many times their own equity.  Having loans default at 5% may trigger higher defaults as happened in the past. Some analysts consider a 5% loan failure rate as the trigger for the start of the default phase of a credit cycle. If the bond market collapses, interest rates will go up if not sky-rocket and guess what THAT will do to the stock market?  Dividend paying stocks, anyone?

Rising interest rates due to a stronger economy is good but if interest rates rise because of increased credit risk that is another story entirely. So, prepare yourself for tougher times ahead. We’re on the edge of a new boom because of the millennium demographics but we may first have to clean-up the mess of a severe phase of credit defaults in the credit cycle.

Apparently, I am SPECULATING that we are close to a recession and/or market crash which makes me more cautious and I am assuming that my investments will throw off less earnings than previously anticipated. That in turn, especially in an environment of rising interest rates may drive stock prices significantly lower.

What is investing? And Hmmm???

Investing is buying an asset that creates a return – often in the form of a dividend and appreciation.  You know how much the asset earns per year and what portion is paid out as a dividend. If you bought an asset on the hope that its products increase in value over the coming years and the asset becomes profitable or more profitable then you are speculating. Today you buy for a price but you hope that tomorrow something happens that makes the asset more valuable. If nothing happens you don’t earn anything or other speculators may drive the price down until your asset is worthless.
We want to be investors. We know that company A has a good product and a great brand name. If the economy grows at 2% per year, the company will produce even more profit (aha... a bit of speculation). Based on the company’s equity or book value it will have a ‘return on equity’.  Suppose Company A has a book value of $40 dollars per share and it earns an 8% return on equity then its annual earnings are $3.20.  If it pays from that $1.00 dividend and the rest is reinvested in the company, then next year it will have a book value of $42.20.  If the shares of Company A on average trade at a price equal to 1.2x book value, then it’s average share price for the first year would be $48.00 (1.2x$40). The following year it would trade at 1.2 x $42.20 or $50.60. Thus, its average share price appreciated by $2.60 and it paid $1 dividend. Next year it will earn 8% again and if its proportion of the profits paid out as dividends (payout ratio) hasn’t changed next year’s dividend will be increased to 1.08.
This is a very profitable company or asset. After 16 years, the company will have paid its shareholders $30.32 in dividends or nearly 77% of its original book value. It also will have appreciated from an average stock price of $48 to $95.17 – that is close to a double. This is obviously a great company but… how much did you make investing in it? Well… that depends on what you paid for the company shares duuuuh!  Therefore, it pays to be patient and buy a company for the right price!
There are many ways to valuate a company. One way, as done above is book value. You know the markets are more emotional than anything else in this world. Yes, the average value of a Bank may be 1.2 time book value but during the year, its share price may swing from 1.4 to 1.0 x. So you could have bought for $56 or $40. If you bought at $ 40 or at $56 you made the same amount of dividends - $30.32 over 16 years.  If you paid $40 your average annual return would be $30.32/$40 divided by 16 years or 4.7% ; if you bought for $56 then your investment yielded 30.32/56 divided by 16 or 3.4%.  But it gets worse. In terms of capital gains plus dividends, you would have made 69.49 on a $56 purchase and $85.49 on a $40 purchase price. So, $40 invested would have been worth $40 plus $85.40= $125.49 in other words your money tripled and if you bought at $56 you did just a bit more than double.  In terms of compound interest, we’re talking: 5.2% per year versus 7.4% which over 16 years makes the difference between a double and a triple.
Everyone complains on about the low economic growth rate and the low rates of return on stocks.  When you compare today’s 5 to 6% stock market returns with the 10 to 12% of the 1990’s you might feel depressed: “This way I will never become a millionaire”.  Jeremy Siegel’s research indicate that stocks return typically 6% plus inflation.  These days we’re having nearly no inflation while in the 90% we’d have inflation of 5 to 6%.  Returns these days are not so bad maybe after all when talking in real prices or purchasing power.  But wait, there is more! The government want’s its share too – taxes. In the 90’s top income earners paid often nearly 50% taxes and today even in Notley’s Alberta we’re paying about 40%.  Let’s do this again:  in the 1990s we made 12% on stocks, but after taxes only half was left or 6% and inflation was 6% your real return was…. 0%.  Today, we’re paying 40% TAX or we’re keeping 60% of our 6% return which is: a return of 3.6% and after 0% inflation our real return is,,,, gosh… really? 3.6%!!!!

Inflation is right around the corner again. Budget deficits and tax increases are about to make a comeback. The Millenniums are also starting any moment now new families, i.e. loading up on debt along with governments. Isn’t that what we have wanted so badly since 2008?  Hmmm!

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