More than a few clients wonder if the stock market will inevitably head down a significant amount soon. Some even worry about a large crash like 2008. I’ve spent several newsletters talking about why I don’t think a large crash will happen and assuring everyone why I think things will be fine.
I want to explain a five of the statistics or indicators I regularly monitor and, more importantly, what they would have to show before I became concerned. I watch the federal deficit, private debt, financial sector growth, rail traffic and stock market valuation—but not hoping for the movement you may imagine.
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After all, all investment advisors are in the business of selling their clients on investing, so I think it’s only fair to let you, the client, know what danger signs I look for and what might make me conclude that it’s time for us all to worry.
The Federal deficit is probably one of the most important and most misunderstood economic measures.
First, let’s get one thing out of the way: The deficit is neither good nor bad; it’s just a thing. It’s the mechanism by which net new financial assets (net new dollars) are added to the economy.
When an economy is in a recession, depressed, or stagnant, a growing or higher deficit is needed. The economy needs more dollars added to drive higher economic activity. When an economy is overheating and you have broad-based high inflation, a smaller or shrinking deficit is needed. The economy needs dollars to be taken away to slow down economic activity. The deficit does not need to be “balanced over an economic cycle” or any other such nonsense.
Right now, our economy is depressed. Very depressed. Unfortunately, the tag team of idiots (Republicans and Democrats) we have running the country has focused the past few years on reducing the deficit. As a result, the economy has remained stagnant. Continued deficit reduction runs the very real risk of creating a new recession. The chart below shows the size of the Federal deficit.
You can see that since the stimulus was enacted in 2009 the deficit has been shrinking. It’s no surprise we saw the strongest economic growth around 2009 and 2010 with the stimulus and large deficit but mediocre growth as the deficit shrank.
The size of the deficit is also related to the next issue: private debt.
Unlike a government that never has to pay back the “debt” (I use quotation marks because it isn’t true debt) resulting from the currency it issues and introduces into the economy, households must pay back their debt.
If the government is not providing enough dollars into the economy via deficit spending, then households and corporations begin to turn to debt to keep the level of consumption in the economy high enough to support growth. As median wages for households have stagnated and the government has pulled spending from the economy, the private sector has increased its loans from financial institutions to make up the difference. This has taken the form largely of real estate-related debt but also includes other forms, such as credit cards, student loans, and so forth.
The chart below shows how increased levels of household debt corresponded with stagnant wages and how household debt skyrocketed under Clinton’s nonsensical balanced budget push.
As you can see, we still have a long way to go before private sector debt levels return to a level I would view as reasonable and prudent. I’m also keeping my eye out for any sustained upturn in private debt levels that could signal another debt bubble.
Why is private debt so dangerous? Well, that leads in to the next item I monitor.
Financial Sector Growth
Private debt is a temporary solution. When the government creates a dollar and adds it to the economy via deficit spending, that dollar can stay in the economy forever. The government never needs to pay it back. They just continue to roll the debt over so the money stays in the economy. Here is a chart from a previous newsletter showing how our national debt gets paid off COMPLETELY and reissued almost 5 to 6 times per year.
But, you, dear reader, are different. Every person has a finite life and our lending institutions want their money back before we die. This leads to a problem. Taking on debt can sustain growth in the short term, as we saw during the Clinton and early Bush years, but eventually households can bear no more debt and the Ponzi-like scheme collapses.
Let’s say you take out a car loan to buy a new $30,000 car. You stimulate the economy by purchasing the new car now. Then, over the next five years, you pay back the loan and because you are charged interest you end up paying $33,000. (I’m just making up number here.) You now have a $30,000 car (bear with me, I know it’s technically worth less due to depreciation) for which you paid $33,000. The $3,000 difference went into the hands of the bank. You are now $3,000 poorer, but the bank is $3,000 richer because it has your $3,000 as profit. If you had paid cash for that car (and not paid the bank that extra $3,000 in interest), then you may have spent that $3,000 by going to the movies, eating out, buying a new TV, and so forth. So that $3,000 paid in interest is not stimulating the economy but is instead going into the hands of the bank where it ends up stockpiled in the hands of bank executives with a little trickling down to shareholders.
Now, multiply that example over hundreds of millions of people and billions and trillions of loans and we have a serious issue.
The larger the financial sector grows, the more money it siphons from the real economy. Thus, one of the things I keep my eye on is the size of the financial sector and what its current “hot” areas are. Banks and other financial groups have been buying up blocks of homes and rental properties.
Below is a chart from a Harvard study on housing affordability.
As you can, see rental rates (orange line) have been growing while renter incomes (purple) have been shrinking. The more money the financial sector sucks from renters, the less money there is to keep the economy growing. For every extra $100 a family has to pay to BlackRock, Inc. (NYSE:BLK) (a large financial institution), that’s $100 less the family is spending out in the real economy and $100 less economic activity for us all.
The United States is a big country, and the easiest and cheapest way to move large quantities of goods is by rail. This is particularly true for many imported consumer goods that arrive on our shores via ship and need to be distributed nationwide.
It’s helpful to look at intermodal (intermodal means the big metal shipping containers that can be put on a ship, then a train, then a truck) rail traffic. Since consumer spending is the main driver of the economy, intermodal rail traffic gives us the best look into consumer demand. (The closer something is to a finished consumer good the more likely it is to end up in an intermodal container; raw materials like steel, oil, grain, etc., are shipped in different railcar types.)
The graph above, courtesy of Orcam Financial Group, shows intermodal rail traffic since the beginning of 2008. We can see the plunge in traffic during the recession and the huge rebound as the stimulus spending kicked in. As the government has cut back on spending and raised taxes, we can see how traffic has slowed markedly.
The good news is that traffic is still growing, so a recession seems unlikely. But traffic is not nearly robust enough lead me to believe a strong economic recovery is close at hand.
Stock Market Valuation
The final item I monitor is the stock market itself. The economy can be doing great, but if the stock market is overvalued then there is still the risk of a large correction or crash.
It’s important to remember that for a vast majority of my clients, you do not own the stock market. It does not matter to you if the market is overvalued, undervalued, or fairly valued. This is extremely important so let me repeat it: It does not matter if the stock market is overvalued!
Let me give you an example. A new 2014 Honda Accord has an MSRP of about $22,000. Let’s say we visit one of the car dealers in town and find that the dealer has priced all his 2014 Accords at $25,000 and won’t budge on price. So we go to the next dealer. There we find one for $19,000. It’s the last one on the lot, so we decide to buy it. Just for fun we call up all the other dealers in the area and find out they are all pricing their 2014 Accords at $23,000 to $25,000.
What did we learn? Well, we learned 2014 Honda Motor Co Ltd (ADR) (NYSE:HMC) Accords are all overvalued (well, not quite all, but a vast majority). Does this information matter? Not in the least. We got our car for $19,000. Who cares about everyone else?
The stock market is the same. Most of the stocks can be overvalued (I don’t think this is the case though). But as long as I can assemble a portfolio of cheap stocks, then it’s just like the Honda Accord example. Just as the only thing that matters to you is the price you paid for your particular car, the only thing that matters to you as an investor are the investments in your portfolio. Other people’s investments are their problem, not yours.
For the record, I do think we have a bubble or something close to a bubble in certain areas. With the economy stagnant, investors are desperate for growth stories. Social media companies, 3D printing, and other fad companies trade at absurd valuations because they can satiate investors’ appetites for top line revenue growth.
Here are some companies I believe are likely overvalued:
- Netflix: 136 times earnings
- Tesla Motors: Earns no money, valued at 26.25B
- 3D Systems: 114 times earnings
- Facebook: 95 times earnings
- Twitter: Earns no money, valued at 26.53B
- Salesforce.com: Earns no money, valued at 33.88B
I also think the utilities sector, while not a bubble, is unlikely to produce good returns over the next decade. I believe that investors have ditched low yielding bonds and put their money in “safe” utility stocks, which has driven up the prices of utility companies to well above their historical norms. This is the reason we are continuing to prune utility companies from the conservative version of our dividend portfolio and not placing new client funds in that version of the portfolio.
What’s more, my clients also have an advantage. They are paying me to find that $19,000 Honda Accord of stocks. In 2008 and 2009, my job was certainly much easier. Almost every single company was cheap. Today, my job is much harder but not impossible.
For instance, here are some of the companies we own:
- Northrop Grumman: 15 times earnings
- Anheuser Busch InBev: 13 times earnings
- Viacom: 16 times earnings
- Microsoft: 15 times earnings
- GlaxoSmithKline: 15 times earnings
- Philip Morris International: 16 times earnings
All of these companies look to be trading at eminently reasonable levels.
Am I worried that the portfolio of companies we own might crash 50% because the “stock market” is valued too high? No. If a client came to me with a portfolio filled with companies like 3D Systems, Twitter, Facebook, and Tesla Motors and asked if I was worried they might lose 50%, then my answer would be yes! I would be very worried!
As long as you stay away from the insanely overvalued companies (also called high beta or momentum stocks), you have nothing to worry about as far as a big crash due to overvaluation.
Worry Meter on Zero
So where does all of this leave us on our worry meter?
Pros (no worries)
- Federal deficit is “large” enough to support stagnant economy (means no crash)
- Household debt is not growing
- Rail traffic continues to show enough grow to support stagnant economy thesis
Cons (some worries)
- Bubble in “fad” stocks like social media, 3D printing, cloud technology, electric cars, etc.
- Federal deficit is far too small to support any broad economic recovery
- Financial sector is growing again, particularly by extracting income from rental properties
We have a federal deficit that is large enough to ensure a stagnant to slight growth economy. The deficit is far too small to support any kind of sustained broad-based recovery. We see no signs of growing household debt, in aggregate.
So my worry meter is right in the middle at zero. Yours should be too. If you are one of my clients, then you can relax. I am constantly monitoring all these things, so you can get about the business of enjoying your life—worry free.
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