Weekly Economic Update 06-16-2017

What’s Your Exit Strategy?
With US equity markets flirting with their all-time highs on any given day, my thoughts have been on investor psychology, more specifically, on what their exit strategy will be. I ask this question because it’s not until we invest in something that we start to believe that it’s going to go up in value, preferably forever. Now that investors have poured every cent that they have or can borrow into US equities, there is a renewed belief that this time stock prices will go up forever. There will be no more corrections. No more recessions. Just ever-increasing stock prices. Yet there are some very wealthy, big name investors that have already exited and have a completely different view.

Warren Buffett started increasing his cash position to about 50 billion in 2014 which grew to 100 billion in 2016 out of the 140 billion he manages. Back in 2007, he raised cash, not with as much money, but with a larger percentage of the money he manages. I’m sure back in 2007 people thought he was crazy, but in 2009 he bought big back into the market. There’s a reason people call him the ‘Oracle of Omaha.’

Today people think that he’s getting old and perhaps not quite as good as he used to be. He can get away with holding cash because he’s Warren Buffett. Even in his own words, history is on his side. His exit plan is not to chase rallies, but to cash in on gains and be ready to buy stocks when they are cheap. Time will tell if he is right.

Legendary billionaire investor Jim Rogers doesn’t even believe it’s a good time to buy US equities. His plan is to buy low and sell high, and with US equities at records highs, it just doesn’t make sense to him. As he says, do you want to buy high and hope it goes higher? His exit strategy involves getting out of US equities and into asset classes that nobody is looking at.

Over the years people have thought some of his predictions were silly, only to find out year’s later that he was right. If you listen to his interviews he doesn’t claim to be a market timing expert, he just looks for underappreciated asset classes that nobody is investing in and he buys, then waits.

Then there’s Jeff Gundlach, a big bond guru who is still predicting higher interest rates, recommended this week that traders and speculators (but not retail investors!) start raising cash to buy into stocks when they fall in value. His exit strategy is to start cashing in his positions when prices get high.

It seems now that every week now there’s news that another big-name investor is exiting the equity markets. Yet the public has a completely different view of where markets are headed I ask myself, is there something the public knows that these super smart money managers don’t?

This is where it comes back to investor psychology and how they feel once they are financially invested. I don’t go to Vegas much anymore and when I do I don’t gamble much, but my wife finds slot machines entertaining so I make it a point to play them with her so we can spend some time together. Even I find it easy to be pulled into the notion that I am going to be the big winner because I happened to be the one sitting in front of the machine. But I know casinos aren’t built on winners. Some slot machines even have signs that point out that they pay out less than 100%. Yet that doesn’t stop the feeling that this time because my money is invested, that the outcome will be different. It’s easy to ignore the facts.

The same is true when it comes to the stock market. I can tell people that for over 100 years that any time a two-term President leaves office that the incoming President will experience a recession 100% of the time. I can point out that in the last 16 rate hike cycles that the Fed has embarked on that three have led to a soft landing and thirteen have led to a recession. But somehow people think now that the Fed four hikes into the seventeenth hike that somehow things will be different.

I could talk about the contraction in the money supply or bank credit. I could show how that asset prices have increased over the past eight due to the Fed’s Quantitative Easing programs. I could even show how in every instance in history when a country or nation tries to create prosperity by massively increasing the money supply and lowering interest rates that it has led to an economic depression every single time. No exceptions. History should be our guide here.

I’ve been reading a few books on economic theory and a great deal of what they cover happens to be on the Great Depression. During the 1920’s central banker’s expanded the monetary base to stabilize price levels. Interest rates also fell during this time. It led to a misalignment of capital that created an investment boom. Sound familiar? It should.

There have been several times that I’ve had to stop reading or even put the books down for a night. If I were to omit the dates, I would think I am reading about economic policy today. While people in the 1920’s thought the good times would never end, they eventually did. Central banker’s today are on the same path, but they believe they can avoid the same mistakes their counterparts made in the 1930’s. While I hope they can, it seems as if history is going to repeat itself.

Today investors have the same sentiment but are betting their life savings that the outcome will be different. What concerns me is that investors have gone ‘all in’ and don’t have an exit plan. When this cycle turns, it will be ugly.

Many will say they will know when to get out. I doubt it. If history is a guide, investors will find themselves too late to the exit. It’s no different than when the coyote is chasing the roadrunner, by the time he figures out there was a turn, he’s hanging over a cliff. It’s too late.

That’s why it’s critical to not only understand what is really going on in the economy but to have an exit strategy. This time will be different; most will be too old to recover from the losses. At some point, we all reach an age where going back to work isn’t an option.

My exit strategy is clear – when the risks get high, get out and wait for opportunity to knock. Cash is always king. Cash creates opportunity – a lesson I learned at a young age. By the time I was sixteen I had owned three cars. Two I bought low, fixed up and sold for a profit. My exit strategy was to buy low.

Later I would up the stakes when I had an opportunity to buy a new home just before the housing bubble would pop. Just a month before completion I bought the house and at the insistence of my Realtor, it was listed for an outrageous sum. I knew the housing market was overvalued and my strategy was simple – lower the price until it sells. I did and it sold, about 90 days before housing market peaked. Here again, I had an exit strategy.

Today we are in the midst of the third stock market bubble in less than 18 years. You’d think investors would learn by now, but they haven’t. Central bank policies will lead to the same outcome they always have. There will be a recession. When the recession happens, it will be ugly. By that point, it will be too late. Markets will already be tumbling and investors will once again feel like the coyote hanging over the cliff looking at the ground below. It will be too late.

My exit strategy is simple. I don’t want to lose half my money and have to rebuild for the third time. I’d rather wait for the turn and take advantage of opportunities as the market goes down – which there are asset classes that historically perform well when stocks fall. From there I plan to buy low at what I believe will be the some of the lowest valuations in my lifetime.

It’s possible I will be wrong. This market could go on forever and central bankers may have finally figured out how to eliminate the business cycle. Even if that’s the case then there will be many opportunities to buy back into equities. But history tells me the probabilities are in my favor. I believe Jim Rogers when he says the next recession will be the worst in his lifetime. I believe that Warren Buffett’s decision to hold cash will allow him to keep the title ‘Oracle of Omaha.’

I believe that this time won’t be different and for that reason, I have an exit strategy. I hope you do too.

Video Topic of the Week
This week I discuss how the economic data is turning towards the downside, quant computing and how leveraged loans are making a comeback.

Chart of the Week – Global Credit Impulse
Global credit impulse has dropped as much as it did in 2008, but nobody realizes the effects of credit contraction a highly indebted world.

Client Update

I thought this week I’d cover the various broad sectors and discuss the risk vs reward outlook for each.

US Equities
Pick the metric you like and this market is overvalued and completely detached from its fundamentals. However, there is a great deal of excitement about how the stock market is finally going up forever, which is giving it upward momentum.
Reward: Possibly +3-7% depending on who you ask.

Risk: Bear markets usually experience somewhere between -20-80%.
Risk clearly outweighs the reward.

When market turn they turn fast and this post-election rally could disappear very quickly. There is a potentially bigger opportunity to be short US equities when the market turns.

International Equities
Looking at Europe specifically, they trail our business cycle, meaning many believe there is significant upside potential. It also helps that the European Central Bank is continuing to dump money into the economy and is willing to keep interest rates low. There still seems to be a high correlation between US equities and European equities, meaning when the US falls, they do too. As much as I want to like this, it concerns me that we could drag them down.

Reward: +50% to get back to prior all-time highs.
Risk: Unknown due to correlation with US equities; possibly -40%.

Too many unknowns here.

Emerging Markets
I do have a potential buy signal on emerging markets equities. There is a correlation emerging markets and oil. Unless there’s a clear break between the two, there’s a high amount of risk here if oil prices continue to fall. The upside is their inverse correlation to the US dollar could trigger a sustainable rally.

Reward: +25% or more depending on how close they track a declining dollar.
Risk: Potential correlation to falling oil prices means there could be a significant drop in price.

Gold/Silver Miners
I like the miners over the metals, but the rally I had hoped for hasn’t started. In 2008 gold and gold miners dropped with the market, but I’m not sure that will happen this time. Central bank policies have weakened the global banking system and with massive money printing, I believe investors will seek out precious metals as a means to protect their wealth when the next financial crisis hits.

Reward: +200% (for the miners)
Risk: -10%

I’m just waiting for prices to bottom.

Agricultural Commodities
These performed will during the last recession, nearly doubling in a 12-month period as stocks plummeted. Prices are currently trading below momentum and technical breakout levels, but are holding a price level established back in early 2016. Recently legendary investor Jim Rogers said he’s invested in agricultural commodities and he’s well known for making investments in asset classes that generate large returns.

Reward: +100% if a new bull market breaks out and prices return to their prior all-time high, which is normal in bull market rallies.
Risk: -5% which is back to all-time lows.

This is one asset class where the risk-reward scenario makes sense and is why we have bought in.

US Treasuries
Every time there has been a recession yields make a new all-time low and bond prices make a new all-time high. While many have called for the end of the secular bull market in bonds, with a weak global economy and record levels of debt, it’s more likely that interest rates will fall during the next recession.

Reward: 5-6%+
Risk: The risk was that yields would break out but stopped twice at 2.6% and have fallen since. I believe the downside risk on Treasuries has been established.

Given the high probability there will be another recession and that it will be one of the worst in history, I like US Treasuries. I also expect the Fed to quickly react and cut interest rates which would be very bullish for Treasuries.