Why the Market is Doomed

May 29th, 2013

by Dave Skarica

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.


I consider myself a total and utter contrarian. I think I have taken even more of a role as a contrarian and value investor in the past 4 years since the bottom of the financial crisis. I love what others hate.

It is important to see pessimism and embrace it. To as my mentor Sir John Templeton said "Buy at the point of maximum pessimism". This has saved us in the past year. I realize many of my subscribers are gold bulls and many did not follow me into my European trades of Hellenic Telecom (HLTOY) and Portugal Telecom (PT) last year, both of which are up. I also realize most didn't by my tech turn around plays of Sharp, Nokia and RIMM again all which are up. Most did not buy my solar turnaround plays LDK and STP again both of which are up. Or not to mention our Japanese trades which have also done well. These bailed out our falling gold stock trades.

However, I was much more comfortable trading these turnaround stories rather than chasing returns in the S and P 500.

I now think the American markets are in very dangerous territory. I know the call right now is thinking we have broken out and are in a new major bull market. That the market is not cheap trading at 17 times earnings, especially with zero interest rates.

However, what I want to see is real fundamentals follow this rally. We still have the labor participation rate at near 30-year low with stagnant wages and huge consumer debt. Nothing has change nothing is better. This is a bubble fueled on cheap money which is in turn inflating earnings.

Let me show you what I am talking about. Below is a chart of corporate profit margins. Note that they are now at all time highs at over 10 percent. The only times they have been even remotely this close were at the 2000 and 2007 top in stocks. Whenever margins have gotten this high they have never stayed this high.

What is helping is low rates. Just like the government large corporations with AAA and AA ratings can sell bonds at low rates. For example there were many examples of these companies selling 1-2 year short term bonds at 1-2 percent yields in past years. Where in the past they could sell at 5 to 7 percent. So that yield gap of 4-5 percent helps the bottom line. When rates turn up that is gone.

In addition, these low yields are causing people to chase yield. Below are charts of Wal-Mart, Johnson and Johnson and McDonalds and Verizon. Note how crazy they have all gone, straight to the upside. These stocks have yields higher than 10 year bonds, so investors in a desperate attempt are trying to lunge at those yields. What is interesting is it seems we have a bubble in these sorts of stocks rather than high growth stocks. We bought McDonald's at 54 dollars in 2009 and it is now over 100. Even with a 6 percent yield on our buying price, I am considering selling it as I think it is due for a 40 percent market tumble in the next bear market.

Sentiment

It has been a while since I talked about Investor's Intelligence. This is a poll of investment advisers and newsletter writers. Basically When things get interesting in this sentiment pool is when there is more than 2.5 times bulls to bears. Right now we are at 2.7 times. At our peaks in 2011 and 2010 we saw such readings as we did in 2007.

Another ratio I watch is the Rydex Ratio this is run by the rydex group of mutual funds. They also have a ratio of bull to bear funds. This shows how much assets are flowing into bullish instruments compared to bearish. Usually that ratio is about .40 or so meaning about 2.5 times amount of money is going into bull market instruments. When this ratio gets over .70 and especially over 1 to 1 it means investors are getting too bearish.

Right now the ratio is 0.26, meaning more than 3 times as much money is going into bull market funds. This is actually the lowest reading since 2000 when the market was making its monster bubble top.

Then we have the VIX the market volatility index . When the VIX is low it means investors are complacent, We have seen the VIX hovering in the 11 to 15 range for most of the past year. This reminds me of 2006-2007 when it does this right before the market topped then broke.

Bloomberg also reported a recent poll of Bloomberg participants results are in the graphics below. As you again see the participants are bullish on Japan and the U.S. by a more than 2-to-1 margin and they are negative on gold by more than a 2-to-1 margin.

In addition, a few months ago David Stockman, Reagan's former budget adviser, came out with some very negative thoughts on the market. Stockman stated the following.

"We're in a monetary fantasyland," Stockman said.

Stockman, the author of "The Great Deformation: The Corruption of Capitalism in America," says the market will suffer a major downturn when the Fed, which is buying $85 billion worth of securities a month as part of quantitative easing, indicates it will stop printing money.

"The minute the Fed hints that it's going to normalize interest rates in some way, that trade will be unwound," Stockman said. "The fast money will sell the bond and then the slower money will sell the bond and then pretty soon, the mutual fund managers will panic.

"And where is the bid? Right now, the Fed is the bid. The Fed is propping up the price of the bond and the Fed is shoveling free money into Wall Street to speculate."

Stockman said the real growth rate of the economy for the past 13 years has been the lowest since the Civil War and median income of the average family is down 8% since 2000.

"What we have is massive fiscal stimulus; what we have is a Fed that creates serial bubbles," Stockman said. "All of this creates kind of the appearance of prosperity temporarily and then the day of reckoning comes, the bubbles break. Then we have disaster in its wake and then they come back and say let's do more of the same so that we can get out of the mess that we're in." [see Fox video]

What I find interesting is that stockman was attacked in the press for speaking this, which I feel is basically the truth. It reminded me of when naysayers such as Roubini and Schiff were attacking the housing bubble saying it was going to blow up. They were attacked.

Finally, we have just the straight up action in the market. If you look at the last bull market the markets moved choppily up until mid 2006 then went straight up into mid 2007 for about a year. From the bottom of the correction in 2006 to the top in 2007 the S and P went up about 25 percent . This time it has been even more step from the correction in late 2012 to the present the market is up over 33 percent. In addition, it is up nearly 150 percent from the 2009 lows and nearly 60 percent from just the 2011 lows. This is way too hot .

In addition, if you really think the market is breaking out, let me show you otherwise. Enclosed is a chart of the S and P in the 1970s. Note that the S and P broke its 1966 high in 1970, 1974, and 1980 yet the secular bull market did not really start until 1982. The 1980 top was over nearly 50 percent higher than the 1966 high. Therefore, there is no reason the S and P can not rally to 1800, 1900 or even 2000 and still be in a long term secular bear market. Actually, the Dow is trading a lot like the S and P did in the seventies. Again no reason to think we won't go to 16000 or something. However, I think we are closer to the top of this rally than the bottom.

One thing that has helped the market is the internals, the advance/decline line has stayed very positive during the entire market upturn. We need to see some sort of weakness in the internals before we see the market roll over and die.

So what does this mean for gold? Very positive. What I like about gold is it is now trading opposite to the market, which is its traditional role. I think if the market trades down we can trade more like 2000-2002 or the seventies or 2007-mid 2008 and trade up as the market trades down. An interesting ETF too look at is FSG a leveraged ETF that shorts the S and P 500 and goes long gold.

I really think this bull market is doomed. It has been caused by cheap money and delusional thinking. They are just reflating old bubbles like consumer debt and housing. It is going to blow again. However, what is interesting is this time around gold and commodities are not participating in the rally. This could be a sign that they could go counter to the market, once it and probably the dollar blow.


© Dave Skarica
www.addictedtoprofits.net

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