Tuesday, December 12, 2017

Bitcoin Making a Mockery of the Capital Market System

When I wake up every trading day, I usually check the business news and its impact on the market outlook.  Lately there have been two consistent themes.  One, the DOW futures are trading higher.  I don’t know the exact number of times over the past year this has been the case, but it must be well over 80% of the time. 
 
The second theme is that Bitcoin is trading at another record high.  And on December 11th, with the launch of Bitcoin futures contracts on the CME, the price of Bitcoin surged yet again, and the futures traded up to the point that trading needed to be halted.


The markets for risky and speculative assets are in a trading frenzy unlike none I have seen in my lifetime.  Sure the stock went up rapidly in the 80s after the Reagan tax cuts.  But real economic growth in this time frame was 5-8%, and the gains relative to GDP and the falling level of interest rates made the stock valuation moves justified, at least until a breaking point was reached in 1987. 

The market experienced a similar euphoria in the late 1990s, only to be knocked down after the turn of the century.   Again, high rates of real economic growth coincided with the rise, and the advent of lower growth post year 2000 knocked the expectations for stock returns down, and the market fell.

The big difference with today’s market and these past experiences is the contrived nature of the market movements.  News about the economy means very little in the derivation of what investors should expect as a rate of return going forward.   There seems to be a complete disconnect across all markets.   Sure corporations publish their profit reports, and the level of earnings and the management outlook provide some degree of input into the process of determining how one stock stacks up against another in a relative valuation.  But, the Russell 2000 (IWM) is priced at 24x earnings!  And the DJIA (DIA) is up year over year over 30%.  High yield companies (HYG) are floating long-term bonds at 4%-5%.  And the 10 year Treasury (IEF) is stuck between 2.3% and 2.4% even though the Treasury is in the process of borrowing almost $1 Trillion over a 6 month period. 

These are return and valuation metrics which might be appropriate in a market rebound after a steep correction and hard recession.   But in today’s market, these turbo-charged market returns and valuations are a sign of a more serious problem in the financial markets.  And, the Bitcoin craze is leading the charge in making a mockery of the current state of the so-called free market system.

What basis do I have to say this about Bitcoin?  For starters, Bitcoin is not a real investment asset because it has no natural underlying rate of return.   It is scam founded on the same principles as

Wednesday, November 22, 2017

On a Relative Basis, Stocks are in the Red Zone

The U.S. stock market has rocketed higher since Donald Trump’s election in 2016.  The DJIA (DIA) posted a 28.9% year over year gain through October 31st, and so far in November has shown signs of continuing to move upward.  The rationale behind the market move is simple - stocks are considered a better value than the low interest rate bond alternatives.   

Since the financial crisis in 2008, interest rates have been suppressed for many years now because of Federal Reserve large scale quantitative easing measures, combined with similar bond buying actions by the European Central Bank and Bank of Japan.  The excess liquidity in the market has now inflated stocks to much higher levels.  The question remains, are the present market capitalizations of many companies sustainable?

With the election of Donald Trump, the business news media has become enamored with the idea that economic growth can be pushed much higher in the world as new Tax Reform legislation is passed in the U.S. and interest rates continue to remain historically low.  Therefore, the market commentary goes, stocks are the best investment, and investors need to “fear missing the chance for much higher returns.”

Anytime the market reaches these types of frenzies, it is best to look at relatively similar situations to see if the hype matches reality over a longer time horizon than 3 – 6 months.   As a guide to judge the relative value of stocks and bonds through time, and also to judge whether the market is overpriced, I look at the DOW relative to GDP.  Since 1990 the relative level of the DOW index to the US GDP (nominal) is plotted (gray line) in the graph below:


What you can see from the data is that the DOW:GDP line fluctuates through time, and as the market reaches peak time periods, such as the year 2000 and 2007, the measure approached and exceeded 1.0.  In fact the index was aggressively higher in the late 1990s. 

Saturday, November 4, 2017

The Great Republican Tax Cut Hoax


The devil is always in the details, and the Republican Tax Cut proposal which was unveiled on Thursday November 2nd has changes buried within it that will affect a broad swath of tax-payers.  A large segment of the mass individual tax-payer population gets a bigger tax bill or nothing.  Using averages to sell the plan to the public is misleading.  I suggest checking how the personal exemption elimination while upping the standard deduction while eliminating many popular deductions affects your particular circumstances.  Many families of 4 who own a home with a high mortgages will lose ground if this plan becomes law. 

Meanwhile there is a big reduction proposed for corporate taxes from 35% to 20%.  It appears the plan is constructed to give Apple Inc. (AAPL), and multi-national companies a big pay-off for their prior transfer pricing shenanigans whereby the multinationals set prices of goods, services and intellectual property rights that constantly move between their national business units. In this scheme, which is widely used, a foreign parent (say a Chinese affiliate) charges a U.S. business unit an inflated price for an I-Phone, which allows the U.S. tax bill of Apple to be greatly reduced or potentially even eliminated. 

This transfer pricing practice is widely utilized by multi-nationals throughout the world to avoid paying U.S. taxes.  They can avoid the taxes as long as they do not repatriate these inflated profits to the U.S., which is precisely what Apple has been doing for years, particularly since the I-Phone took off in volume about 5 years ago.  Instead of paying their fair share of U.S. taxes, Apple has amassed $268B in cash and marketable securities, the majority of which is held in foreign custodian accounts in U.S. dollars.  (See Apple 10-K here)  This massive figure represents about $800 in cash for every American citizen.