Greetings to everyone,
Welcome to October-month of stock market crashes, and also it is month where stock markets bottom out. Never expect the market to move rationally but yet paying attention to the way the market moves, one could find a way to invest money. Even though it is irrational for the market to go up due to the negative influences (more about that later) we face, it is probable that the market could go up from here. It is all about keeping your emotions under control. Carl Icahn was on CNBC last week and he said something very interesting; he said that many little things bother him but losing a billion dollars does not bother him anymore. Yes, he is supposed to have a net worth of about $20 billion but the point is to keep your emotions under control when investing. I have been saying that even though the market fell 1100 pts and recovered in 15 minutes on 8/25/15, nothing got corrected. On 9/18/15, as a CNBC commentator nicely put it, “bottoms do not start at the top”.
According to conventional wisdom, the equity markets should go down in an immense way but that is not the way it has been acting. I will not be surprised if we hit an all-time high over 18,000 on the Dow30 by end of this year. 80% of all trading gets done by algorithms and robots; so computers know that markets usually bottom in October and rally in to the spring of next year. I am talking of trend analysis. Just before a Federal Reserve meeting, the market goes up so now the computers are set up for that. If the market ignores the fundamentals and move up, there will come a time when it would surprise everyone with another tragic crash. I am hedging to the upside too-not only with good stocks with long term prospects but also by going long (call options) on the stock market indexes. The market volatility we have been experiencing is tremendous. Last Friday, 10/2/15, the market opened at 6.30am pacific time with the Dow30 going down by 280 points so I bought some call options on the Dow (strike price=18,000, expiry: 1/15/16) for $0.27 and in just 3.5 hours, the Dow30 was up by 50 and the day ended with Dow30 was up by 200; so from the bottom to the end, Dow30 went up by 480 points in 5.5hours and my call options went up by 52% in 7 hours! For the first time since 1990, money flowing in to money markets beat funds flowing in to bond or equity funds ($17B). Another $3.3B came out of equity funds; especially due to the 8/25/15 ‘flash crash’. Remember I predicted that this would happen. There is a dark cloud looming over us, and as everyone ignored the mortgage crisis till it blew up in front of us, everyone is ignoring this too.
People in finance see these dark clouds hovering and gathering and expect a mild storm but what they do not realize is that we are heading for a category 5 hurricane (i.e. Katrina)!! Maybe like in 1987, we will have a Halloween scare in the market! I am talking about the credit crisis that is heading our way which will have a huge impact on the equity market as well as the economy. Also for the first time since 2009, we had 3 continuous quarters with negative revenue growth for corporate revenue (Q1: -2.9%, Q2:-3.4%,Q3:-3.3%) and analysts expect -1% for Q4 in 2015. If the same happened to our GDP, we would be looking at a recession. Most of this is due to the energy sector where revenue fell by 50% during 2015 Q2 and fell by 65% during 2015 Q3. The other biggest sector in the market is the financial sector and till interest rates go up, you cannot expect higher revenue from the financials sector.
Bond ‘king’, Mohamad El-Erian, Chief Economic Advisor at Allianz stated last week, “ Market valuations are much higher than valuations so we could head in to a major correction. All major emerging markets are in a recession”. Non-recession stock market crashes (i.e. 1987) happened as corporate bond market problems led to equity market crashes; however non-recession crashes recover within a short period of time. For the past few months I have been predicting a huge credit crisis is heading our way and it almost exploded last week when a South African bank issued a statement saying that the UK based Glencore is close to insolvency. On 10/2/15, analysts on CNBC were saying that the way Glencore was trying to show that they were solvent was just like what happened with the financial companies prior to the mortgage crisis. Stay tuned! The problem is not about that individual entity, it is the counterparty risk that can pose a huge problem. If Glencore ($31B) or Petrobras ($120B) goes insolvent, according to Jim Cramer, our whole stock market could go down by 10% to 20%. Shares of Glencore has been going down due to the rise in cost of insuring the company’s debt via credit default swaps. All analysts agree that there is no way Petrobras would be able to pay back their debt. Gifford Fong of Gifford Fong Associates says wider spreads typically reflect credit weakening, liquidity deteriorating, or both. That feeds in to higher stock volatility and lower stock prices. Macro Maven’s Stephanie Pomboy states that the gap between credit and equities would close-painfully.
The exchange traded fund (ETF) for high yield bonds (JNK) is now trading at it’s worst level since October 2011 and if the equity market do the same, we should see a decline of 41%-return to August 2012 level! We have been in the ‘zero Fed interest rate’ era for about 8 years so most believe that companies have locked in to long term cheap borrowings and don’t face major debts anytime soon. Not true! Per Pomboy, out of the total corporate debt level of $7.8 Trillion, $1.5 Trillion would mature in 2016 and 2017. For the past few years, the major banks have been complaining that the new ‘Volker Rules’ made them lend less money as they have to spend money on hiring compliance officers instead of loan officers (not to mention the higher reserve rates).
However as Carl Icahn said on CNBC last week, even though a huge crisis is coming our way, the banks would not be at risk as in 2008 due to the new “Volker Rules”. This is the second time Paul Volker saved America. During the 1970s, President Ford and Carter used to say that we have to learn to live with inflation and stagflation. When Paul Volker raised interest rates to very high level just before the 1980 election, disregarding the independence of the Federal Reserve, Carter lashed out at Volker. Reagan allowed Volker to kill inflation with the prime rate going up to 20% or so and thereafter we were able to enjoy 30+ years of low inflation & moderate growth (the Fed mandate). According to Carl Icahn, the high yield market, the art market and the real estate market is in bubble territory right now. Brazilian 10 year old bond yield is at 16%! Malaysia is not too far behind. Current yield on the 10 year US Treasury is at 1.99%. Many expect the credit market in China to crash too.
On 9/14/15, the Smith Fund stated that China’s money supply (M2) was at $21 Trillion while our US money supply (M2) was at 12 Trillion. By the way,M2 is not the total money supply and M4 is the total money supply. Even with capital controls, over the past few months, $7 Trillion moved out of China (per Smith Fund). On 9/15/15, Kyle Bass stated on CNBC that on all bank loans in China, past due over 90 days rose by 170% during Q1 of 2015! Their total debt is 30 times their GDP (Gross Domestic Product or the total value of all goods and services produced in a country). This is true of most emerging markets. Non-farm job creation in the US went down from 300,000 in December 2014 to 167,000 in September 2015 so this shows the strong dollar and the international pressures are taking a toll on the US economy. Even without an interest rate hike, the market and the economy is doing the job of the Federal Reserve for them.
The US government has been asking China to shift from an export driven economy to a consumer driven economy. Being the #2 economy, China cannot afford to rely on exports for growth. This seems to be happening. On 9/11/15, CNBC announced that China invited the Larry Fink, CEO of Blackrock to get advice on the market. It would have been better if they spoke to Warren Buffet or Carl Icahn. China is our 3rd biggest trading partner-next to Canada and Mexico. China’s impact on our economy is 1.6% and the impact emerging markets have on our economy is 6%. In the US, the Federal Reserve Bank issues a ‘Beige Book’ a couple of times a year to give an assessment of the economy. On 9/21/15, Leland Miller, President of the ‘China Beige Book’ stated that people are wrong about China for the following reasons (1) Manufacturing is not a leading indicator for China (2) Their stock market is different from the economy. (3) They found no deflation in China. Last month Nike announced that they saw a 30% same store growth in sales and China is leading the trend. Apple and Starbucks saw similar trends in revenue growth in China.
Over the past few years, the stock market did not go up due to earnings, it went up due to all the money that was pumped by the central banks so stocks went up through ‘financial engineering’- raising dividends, stock buy backs and merger and acquisition (M&A) activity. Only the very rich got most of the benefit and at the expense of the middle class and the retired who got nothing from bonds. One good example is the Biotech industry. Under our noses, they have been robbing us blind. Over the past 8 years, Pharma/Healthcare industry has been spending $250M average per year to lobby the congress! They say that they have to spend so much money on research so they have to increase prices in a massive way. Lately hedge funds have been buying old drug companies with badly needed drugs and increasing prices sky high. With all the cash the Feds flooded the market, these hedge funds have found a risk free way to make an enormous amount of money by increasing prices in a significant way overnight. If you are not ethical, legally you can make billions if you have access to billions by finding drug companies that have a monopoly on a certain cures and increasing the price by 500% to 1,000% overnight. This is immoral. On 9/21/15, the 32 year old CEO of the Albanian American Hedge Fund, Martin Shkreli, purchased a drug company with a 62 year old drug that is needed to survive by some patients and overnight jacked up the price by 5,000% ($13.50 to $750) and he said that he wants to use the money to do research to improve the 62 year old drug. Initially he refused to lower the price but he thinks that after this political season it will blow over and he will be able to keep the price jacked up like this. Many patients might die due this price increase. Many medical personnel and other drug company officials mentioned that this drug does not need any improvements. CNBC commentators were saying that he should play the role of an evil villain in a movie. This is just the tip of the iceberg, many hedge funds have been doing this and this is why biotech stocks have been in bubble for so long. Federal Reserve Chairwoman Yellen called this Biotech bubble last year and everyone laughed at her. When some politicians made some noise, the biotechs fell by 25%. Still they are overvalued. Utilities are not allowed to increase rates as they see fit as it is a monopoly and when it comes to life saving unique drugs that too should be considered a monopoly and they should have price controls.
Until next time, Fernando