Tuesday, October 25, 2016

How Worried Should You Be about Your Investments Now?

Climbing the ‘Wall of Worry’ is a not so favorite pass-time of most investors.  Currently there is plenty to worry about.  Deutsche Bank could spark an international financial crisis.  Middle East wars in Syria and Yemen could cause disruption in energy supplies.  Central Banks, including the Fed, can change course on monetary easing policies, pushing up interest rates sparking investors to sell over-leveraged assets.  Ultimately such factors could combine to push the U.S. into recession, which post the 2016 Presidential election would not be an unusual occurrence.  Is it a random market event that so many U.S. market downturns coincide with major elections?  And I don’t just refer to the years 2000 and 2008.  Look at 1972, 1980 or even 1946, to name a few.  The passing of the baton to a new party or President almost never happens without some market turmoil.

Financial Relativity Index shows subdued immediate Market Risk 


A technical model that I use to gauge the risk of a major market down-turn currently is not showing signs of an imminent market breakdown.  Although there are several risks highlighted by the model, overall the market currently reflects only subdued risk.

The model as of September 30, 2016 had a reading of 4 on a scale of 20.  The low reading based on the factors assessed historically dating back to 1956 (month end data-points) put the market in low risk until, of course, something happens.  In this model, the usual signal is a year over year collapse in returns to investors.  The big moves downward have typically occurred after a quick spike in the market to a new all-time high, followed within 2-3 months by a down move that puts year-over-year returns in negative territory.  This signature market phenomenon is explained in detail in my book, Theory of Financial Relativity.

Currently returns for investors who bought the DOW market index 12 months ago is 12.4%.  The market, because it has an upward bias through time, rarely signals negative year-over year returns once it has exited a prior correction until it is undergoing another major correction.  The year over year major market return decline pattern is a trusted signal savvy investors anticipate to tell them when it is time to get out of the major US equity markets.

What investors are left to assess at any particular moment are the odds that such a break-down is imminent.  Otherwise, my research shows they should stay fully invested, focusing primarily on proper portfolio balance relative to their risk tolerance.

I use several variables to assess the immediate risk.  One factor that adds to the risk is the market making new all-time highs since the last correction.  Currently since the market bottomed in early 2016, new highs have already been reached.  The fact that the market recovered to a new all-time high so quickly after a correction is, from a historical perspective, and odd event.  The all-time market signal condition puts the market at greater risk based on history for another correction to occur.  However, it says nothing about when it may occur.  My observation is that the last downturn was driven by a profit recession in the oil patch and a brief shift in international capital flows.  However, the market correction did not correspond with a U.S. economic recession.   The next time market risk rises to an elevated condition, as measured by the Financial Relativity Market Risk Index, odds are high that the market will move lower for a much longer period of time.

Another factor I review is how expensive the market is relative to historical valuations.  Since most of my market research involves market valuations relative to economic output, I look at major market indices such as the DOW and S&P relative to current GDP.  Looking back through history, a factor of 1 on the DOW relative to GDP puts the market on the cusp of being in the over-valued warning zone.  Given the low economic growth in the U.S. and the world economies, the current high valuation relative to GDP is much more of a risk if expectations for higher growth do not materialize.  Historically a factor of .8 for the current economy has been the norm.  I attribute the distortion to the Fed effect on stocks from their elongated zero interest rate policy.

Financial market forces working to up-end the stock market


If I can predict perfectly when stock investors are going to realize that their stock returns are about to turn negative year-over-year, then the technical model that I follow is all that is needed to out-perform the market.  But the trick is to predict when the risk level is going to suddenly jump to 10 or higher.  I say suddenly because the change ahead of a steep market decline usually comes with only a brief period of time to assess whether a pull-back is going to be a deep one for an extended period of time. 
Currently my opinion is that the next market break-down will be much  stronger and lasting than the one experienced at the end of 2015 and early 2016.  The question is what market signals can investors use to assess the risk?  For this assessment, I use seven market factors tracked on a monthly basis to create a Financial Force Risk Index.  These factors have been chosen based on research done using data since WWII to track the relative performance of the stock market as these factors change.  The forces and their impact form the foundation of Theory of Financial Relativity, a book that I published in 2013.

At present the Financial Force Index is not as calm as the technical Market Risk Index.  The index is currently on the low end of the warning zone.   Growing risks are being indicated in over heated lending markets that are beginning to slow down, particularly business and consumer loan markets.  The long awaited interest rate policy reversal is also a growing risk.  But the biggest factors that tend to show up prior to trouble in the stock market that are evident currently are a reversal of international flows of capital to finance the U.S. debt at the same time that there is mounting pressure to increase fiscal policy to spur the U.S. economy.    If this scenario plays out post the 2016 U.S. Presidential election, I fully expect the green markers in the Financial Force Index to show more risk than today, putting the current stock market valuation at much higher risk of a major downward correction.

Lending market slowdown is best leading Indicator to watch today


What is the evidence that the loan market is turning from a positive to negative force on the market.  The answer is in the relative direction of lending activity.  Loan defaults is also an indicator, however, the default rate is a trailing indicator, because the flow of loans into many products such as commercial real estate, leverage buy-outs, auto loans, student loans have been perpetually higher in recent years.  The result has been new loans to cover past mistakes rather than defaults.  This mode of operation is the normal course of business for banks, until the money runs out as the banking system begins to restrict new loans in markets that are already historically stretched.  Currently the statistics show the money to make new loans appears to be running out.  

In the table below, you can see a couple of red boxes which show business loan and consumer loan activity relative to US GDP.  The values for both markets are at all-time highs and both are at risk of undergoing contraction at the current time.  The yellow box in the table which shows that the balance of business loans outstanding are growing slower than GDP over the last 12 months is one of the best indicators I have found to watch out for as a risk of an approaching recession. 

What are the odds that a business cycle recession is approaching?  The best evidence I have dates back to 1997 covering the last two down-turns.   Note in both the 2000 and 2008 scenario, business loan activity relative to GDP growth dropped off sharply into negative territory as the recession took hold.  The rate of investment leading up to the downturn was not strong, and was showing leading signs of weakness.  The current business loan market, given the over-extended nature of the market relative to historical standards, means the risk of a business cycle recession is very high at the present time.

Ironically, mortgage loan activity has been the saving grace in the U.S. economy over the last year.  The data show that the de-leveraging in the mortgage market that ensued post the financial crisis in 2008 reversed mid-2015, almost precisely at the same time that oil prices plummeted and the U.S. dollar went up substantially.  My observation was that regulators lightened up on mortgage conditions at this time as the return of the 3% down payment mortgage returned and long-term mortgage rates headed to historical lows.  As luck would have it, the good fortune fell just one year ahead of a U.S. Presidential election.     U.S. mortgage loans are on pace to increase over $600B over the past year, a substantial economic stimulus in an otherwise struggling economy.  The question remains whether the new loans can be serviced if the economy enters a downturn.

Odds increasing that Market is “Out of Gas”


Equity markets expand in value as investment dollars continue to freely flow and returns are sufficient and capital risk low enough to keep investors from selling.  The Financial Relativity Index currently shows investors remain satisfied with their present risk adjusted returns.  However, there is growing evidence that the free flow of capital into a broad range of investments is under-going a disrupting slowdown.  The seemingly perpetual flow of more and more debt into various markets to support financial valuations is slowing down.  Without the debt market for fuel, both domestically and internationally, my forecast is that the stock market will suffer. 

Moving forward, stocks are at high risk of a substantial prolonged downturn as the dysfunctional US government will be looked to for a fiscal policy bail-out the next time trouble is signaled in the market. The Fed can do little now except prolong a debt cycle that is over-extended, at the risk of making the eventual down-turn even worse.  The international markets will also provide little, if not negative support going forward as capital flows from petro-dollar re-cycle and EU and Japan QE are no longer U.S. market tailwinds, as evidenced by the Dollar Re-cycle signal in the Financial Force Index showing a unsettling high 4.0 in the risk calculation.  
I expect a US fiscal policy shift post the 2016 presidential election.  However, it is likely to have a muted and delayed effect on already over-extended equity markets.  The impact of any fiscal policy legislation will likely be false expectations of a life-line, followed by a downturn that will bring the inflated Fed zero interest rate driven market back to reality, quite possibly with a crescendo.

Daniel Moore is the author of the book Theory of Financial Relativity: Unlocking Market Mysteries that will Make You a Better Investor.  All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.

Wednesday, October 5, 2016

Number 1 Issue in the Upcoming Election facing Americans – Taxes plus Trade

I was reading an article published on the CNBC website on October 5, 2016 entitled, This plan brings $2.5 trillion in corporate cash home, and creates jobs.  I was struck by how the economic issue which underlies the argument for this plan may be the single most important issue for several generations.  If left unaddressed by the next elected President, the U.S. will continue to left on a path of perpetual decline.

On the surface, the plan explained in the article nails a good U.S. tax policy response which can potentially unravel the mess we are currently in as a country. But, the cash being hoarded overseas by multi-national companies has a couple of more elements than just the tax rate in the U.S. for corporations. Elements which oddly may not be remedied by a tax code change alone.

The economic issue the U.S. faces is structural, and caused by trade agreements which place the U.S. in the position of exporting jobs for the purpose of importing investment dollars for the U.S. debt. Not a good trade for average American workers who deserve to be able to make a living, but an excellent way for crafty U.S. politicians to try to rule the world.

The historical data clearly show this issue began to manifest itself in uncontrollable fashion post the signing of NAFTA, a hallmark Clinton agreement. Little wonder that the Clinton Foundation is so beloved by so many foreign governments and billionaires such a George Soros and media moguls with International, not American best interest in mind. Many of these "VIPs" can be found to have been given special access to the Clinton State Department as a part of this appeasement foreign policy strategy; not to mention that the Clinton's have scampered off with over a $100M in the process over the past 4 years through the Clinton Foundation, speaking fees, etc..

A change in tax policy may unravel the mess, but could create, at least in the short-term, nothing more than a run on the U.S. debt as the $2.5T in overseas dollar based cash, currently parked primarily in U.S. Treasuries, is sold to take advantage of a tax break windfall. The reason I am skeptical is because the tax policy did not create the problem in the first place, the trade agreements did.  Changing the tax policy only changes the financial flow of capital. Without a solid basis for investment in a U.S. economy which would remain severely disadvantaged by poorly structured trade agreements, the end result would very likely not provide the intended result.

I look for a Clinton Presidency, just like the Obama administration, to stand in the way of any move to unleash these overseas dollars. The basis for the Clinton campaign dollar largess is heavily indebted to those with an interest in the perpetuation of the fleecing of the average American citizen, and pushing the U.S. even more into debt. And, these campaign contributions want pay-back in the form of jobs for foreign, not American workers.  In addition, don’t look for any of these foreign interests to pay a dime of the multi-trillion dollar tax increases proposed in the Clinton economic plan.

My book, Theory of Financial Relativity, published in 2013, provides in-depth research in how and when the U.S. debt expansion became a serious threat to the growth and prosperity of the U.S. economy, and ultimately the wealth manifested in the value of the U.S. stock market.  Please consider reading the book if you want to understand why the tax and trade issue, in my opinion, is the single most important issue facing America in the upcoming election.

Daniel Moore is the author of the book Theory of Financial Relativity: Unlocking Market Mysteries that will Make You a Better Investor.  All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.

Thursday, May 5, 2016

Puerto Rico Needs Restructuring, not a Bail-out

According to an article published by the Cable, Puerto Rico is nearing the Brink of Bankruptcy, the Puerto Rico commonwealth has $72B in debt, some of which it claims it can no longer service, and therefore will default as early as May 2, 2016.  The Island government is asking creditors to forgive up to 45% of the principal on certain loans so that it can recover financially.  The U.S. Congress is now intervening in the crisis with legislation being reviewed which would give added power to the Puerto Rico government to restructure its debts to the detriment of existing creditors.  The public airwaves are currently buzzing with “tell Congress no bail-out for Puerto Rico” ads.

Although a 45% haircut to lenders this large is unlikely, many of the Puerto Rico Financial Development Authority General Obligation bonds are trading for $0.20 on the dollar out of fear about what the outcome will eventually be in the current crisis.  Just why is Puerto Rico in so much financial trouble?  There is a combination of factors which have led up to the current circumstances in which the current government is very likely to run out of cash.  First, the country never really recovered from the 2008 recession.  Unemployment on the island is remains high at 11.6%, and the labor participation rate is less than 40%.  In other words, Puerto Rico’s 1.1M labor force is not big enough or growing fast enough to service the loans.  Adding insult to injury, the island population base is shrinking at a rate of -0.6% per year.

Why has the Puerto Rico economy been shrinking?  One of the major culprits has been the expiration of a federal IRS statue section 936.  The section established tax exemption for U.S. corporations that settled in Puerto Rico, such as large pharmaceutical firms, to allow its subsidiaries operating on the island to send money to the parent company federal income tax free.  The island economy has been in persistent decline since this statute was repealed by the Clinton administration in 1996.  As the manufacturing jobs have vacated the island, new job creating industries have not been forthcoming.

The ability of the island to generate cash for loan servicing is indeed dire, but the island government is not a total victim in this situation.  There are major inefficiency problems in collecting the Puerto Rico Sales and Use Tax, with estimates showing the Treasury is incapable of collecting up to 44% of the tax.  Additionally, public salaries are much higher than the private sector on the island.  Per capita income on the island is $28,850, and public workers generally are paid more than average with legislative advisors for instance making $74,000.

The island economy could also be much more resilient if public policy took better advantage of its natural resources, and depended less on imported goods.  Puerto Rico imports 85% of its food even though 94% of its land is fertile.  The islands geography has many rivers which could be used for hydroelectric power, and yet the island must import all its fuel (coal, natural gas, oil) in order to produce energy.  Renewable energy sources are also heavily under-utilized even though Puerto Ricans enjoy 65% sunshine on average every day, and wind rates average 22 mph.  From an energy standpoint, island residents pay $0.26 per kilowatt hour for electricity compared to $0.11 per kwh in the U.S.

Puerto Rico needs a long-term plan, not a Washington bail-out.  Creditors are very likely more than willing to work with the island government if it truly wants to address the structural issues which are making its financial situation worse by the day.  However, the role of Washington in this situation should be minimal.  The island doesn’t need major loan haircuts which destroy the capital investment process, it needs a long-term economic plan and new direction, neither of which is being put forward currently.  If Washington intervenes as desired by the Puerto Rico government, then who will be next in line – Illinois?

Daniel Moore is the author of the book Theory of Financial Relativity.  All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.