Excess Capacity & Deflation


This past week the markets rallied on below average volume. While many momentum investors underplay the idea of volume, to me it tells a very important tale.

Because 70%-90% of market activity in any period is typically large investors, when volume is low, that means big investors at a minimum are abstaining from buying. That is a bad sign for retail (small) investors, typcially including mutual fund and self-directed investors.

[It is important to remember that many small investors are directed by “financial planners” who are more product pushers than anything else. In fact, although many of these planners now call themselves advisers while touting themselves as fiduciaries and fee-based (vs fee-only like me), the reality is most are simply repackaged sales people who now take their compensation differently. Be very careful who you follow, take advice from or allow to manage your money, as most are not really trained on how to invest. The Certified Financial Planner program does not teach anything particularly useful on how to invest. That is important for consumers to know.]

With big investors slowing their buying, it is important to know that could lead to. As we all know, the smart money tends to buy when assets are cheap, often after a correction or even a crash. They typically buy from retail investors who are selling out of panic that markets might go do down forever. On the flip side, retail investors tend to invest after they have watched markets rise for a long period of time. When that happens, large investors slowly sell to the retail investors near the top of a market.

What has been going on in markets since late 2013, when I wrote “How Bad Will New Investors Get Hit,” is that in fact, big investors have slowly been cutting their buying, repositioning in to higher quality assets and accumulating cash. I have been pointing out over the past several months, including in my quarterly letters to clients, that we are seeing a topping process in markets and that volatility would be increasing now that the Federal Reserve has quit quantitative easing (QE).

Headline Risks

Adding to volatility are today’s headline risks. Almost everybody is watching what is going on with Russia and Greece. These are important as they are attached to larger issues.

Russia’s role in the world economy can not be understated, even though many people in the press arrogantly or ignorantly dismiss the Russian role. Russia is a large, educated, militarized economy that is rich in natural resources. While oil and gas prices are low today, it is clear that resources continue to become more scarce. In the long-run, Russia will be called upon to provide energy and food to Asia which will be vital to their continued economic growth.

Right now, Russia is wreaking havoc on eastern European security. As I type, the offensive of Russian backed rebels in Ukraine is on the uptick, even though there is a cease-fire that was agreed upon this week that should be in effect momentarily. This is not good.

The negotiations between Greece and the Troika seem to be no closer a resolution today than a week ago, despite rumors of extensions and agreement frameworks to extend Greece’s debts on more favorable terms. 

Here’s what I know about the situation, Greece would probably be better off defaulting on the $320 billion Euros it owes in bailout funds it owes primarily to Europe and the IMF – with Germany on the hook for a large portion – and leaving the Euro.

As of 2015, Greece has roughly balanced its budget. If it were to walk away from the bailout obligations owed to non-Greek entitites, which would wipe out about 2/3 of it’s debt. That would cut the interest on the debt from about 24 billion Euro per year to well under ten. If they left the Euro, they would immediately have a huge advantage from a currency standpoint as they would surely have a much lower currency than the Euro.

With a lower valued currency, tourism would boom in Greece. This is a very important industry for them providing 18% of the nation’s GDP. That would in turn drive job creation. With dramatically lower debts, the country could slowly embark on shoring up the infrastructure that is badly in need of deferred maintenance. Again, this would create jobs.

While many decry the lack of “morality” of such a move, I remind you that corporations file for bankruptcy everyday. Why shouldn’t a nation do it if it will imrove the entire nation’s standard of living. 

There is the catch for Greece of course. They would have very limited borrowing resources for a long-time. They would have to act responsibly. They could not increase pensions or social welfare just because they dumped their debts. They would have to save for a rainy day because it will be a generation before they have financing again that isn’t secured. That is not something that Greeks have been good at EVER.

I am sure I am not the only one that sees the advantages of Greece defaulting on their debts and leaving the Euro. I suspect many in Greece’s new government see it as well. 

Should the peace in eastern Europe not hold – a coin flip at best – and the Greeks decide to default and reset, that would add considerable trauma to the markets. It is a high enough risk that those who are not prepared for it via legitimate hedges, are playing fast and loose with their own money.

Excess Capacity & Deflation

A bigger problem looming for the global economy is that there is excess capacity in many sectors. We are seeing the effects of excess capcity in oil right now with a price collapse. Similar excesses exist throughout the economy. With oil, that will be corrected by gradual cuts in production over a year or two. With the rest of the global economy, evenutally, there will have to be a recession. I don’t think that year is far off. We are already seeing recession in Japan and likely Europe.

Ray Dalio, founder of Bridgewater, the world’s largest hedge fund manager, talks about these issues all the time. If you have not watched this video from Davos 2015 this year, watch it. You will get some very important perspectives about the global economy – pay special attention to Dalio. 

In addition to pointing out excess global capacity in many sectors, Dalio also points out that the United States is pretty well insulated from global pressures. I agree with him. This is why I am very bullish on the dollar and the U.S. economy on relative terms.

My bullishness on the U.S. economy does not mean I expect a boom just yet however. Rather, I expect America to be able to maintain standard of living as global problems are worked though over several more years. While I don’t see an outright U.S. recession soon, I do see what I have deemed a “skip-straight” recession, that is, instead of consecutive quarters of negative GDP, intermittant quarters of negative GDP. In the intermediate term, U.S. energy independence is a major positive, as is the maturing millenial generation.

A Strong Dollar Economy

I am no longer terribly bullish on U.S. financial assets in the short-term, high-yield bonds and equities in particular, after five years of being mostly bullish, most of the time. With a strengthening dollar, no more Fed QE and global economic headwinds years from abating, we will see more regular corrections in the markets.  

Many, especially on corporate sponsored television, decry the stronger economy as bad for competitiveness. This is such a red herring I can’t ignore pounding on that idea.

Only about 15% of corporate earnings in America are from international trade. Much of that trade is not price elastic because it is in the export of high value, difficult to substitute for or resource goods. In addition, as the U.S. continues to ramp up energy exports, from distillates which we started exporting in 2012 to liquified natural gas which we being exporting in the 4th quarter of this year, the numbers will improve. Therefore, the impact of a stronger dollar on GDP is minimal in the short run and could possibly be very positive if we export more natural gas and other hard to substitute goods over time.

About 50% of earnings among the top 50 companies in the S&P 500 are from exports. After those companies, export income falls preciptiously. So, for virtually every other company in America, especially as you move away from multi-nationals, a strong dollar is beneficial. 

There is an interesting corollary as well. Most American multi-nationals, due to tax-avoidance strategies are holding many millions of dollars overseas. As these dollars become stronger and some global assets become cheaper (stocks and corporate bonds), American corporations can go on quite a buying spree, becoming owners or part-owners of tomorrow’s growth assets in certain nations that have favorable long-term growth characteristics. The jist here is, don’t cry for U.S. multi-nationals having a a couple weak years on earnings. Keep an eye on which executives lay people off vs take smaller bonuses, that will be telling. 

Consider now that 85% of American GDP is internal. If the dollar is stronger, that helps almost everybody to pay down debt and eventually spend more, leading to a higher standard of living – the ulimate reason for economic development. A stronger dollar especially helps smaller businesses who are domestic focused. Small businesses are the biggest drivers of employment in America.

It is not hard to follow then that a stronger dollar is good for the economy at multiple levels. 

How Markets React

Ultimately, the U.S. stock market has to have a correction. I suspect it will be in concert with international markets correcting as well.

I am very bearish in Japan intermediate term. They could continue to pump the economy up, however, ultimately, their strucutral problems with demographics and debt are going to be too much for them.

I will be bearish again on Europe soon as they simply refuse to do what is necessary to reform their economy and they have no demographic support. 

China is slowing down, we’ve coverd that before. In addition, we are finally seeing the signs of overspending on building coming home to roost. Also, the new government there is more than happy to allow a shake-out of corruption and over valuation. 

In studying quantitative models of the markets and simply looking at Warren Buffett’s favorite indicator, it is easy to see that the cyclical (Fed driven) bull market is at least due for a break, if not completely done and ready for a cyclical bear market.

It is important to remember that markets can stay irrational for longer than we can stay solvent should we speculate on a collapse. So, while I am hedging a bit now, I am not outright speculating on a collapse. 

If no economic miracles occur and stock prices continue to rise relative to GDP growth, then I will eventually move from hedging a correction or crash, to outright speculating on it. I think we could be over a year away from that time.

In the meantime, I am trimming equities across the board in all but my favorite dozen or so companies and a natural gas ETF, implementing hedges and holding more cash. 

 

Kirk Spano

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