BUBBLES AND BOTTOMS: July 2018

July 2018 - Introduction -

The world is not about to end, and i`m not a doomsayer, although I have caught myself saying “this will not end well” more than a few times over the past years. Initially I started telling family and friends about the “irrational exuberance” that private and listed companies, stock indexes and even central banks, were portraying. But when this irrational exuberance started growing into people`s daily lives, I felt like I had to become a bit more vocal and warn my Facebook friends in the form of “Bubble Update” posts, since the outcome of irrational exuberance almost always ends in tears.

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”
- Ben Bernanke -

Irrational exuberance is a state of mind that has intrigued me since I made my first stock trades at the age of 15. It was 1997 and the markets were roaring. I remember visiting Nasdaq.com those final years of the 90`s and checking out the top 50 gainers of the day. The top 20 stocks always had gains of over 100%. Too young to understand how I could trade U.S. stocks, and not enough money to make a real difference, I decided to stick to Dutch stocks and trade local darlings like Getronics and KPN. I was intrigued by the big swings in prices, and only found out after the dot-com bubble burst that these swings were highly unusual and the gains extremely irrational.
This is how my passion for finding bubbles started.

"Stock market bubbles don't grow out of thin air. They have a solid basis in reality, but reality as distorted by a misconception."

- George Soros -

This newsletter is a compilation of bubbles that are brewing on the consumer level, the company level, as well as the government level. Many bubbles are currently growing at the same pace all over the world and are all fuelled by the same thing; years and years of loose monetary policies all over the world. It is almost impossible to pinpoint which bubble will pop first, and what chain reaction it will cause, which is why I am indiscriminately showing you all the charts that, in my opinion, are worthy of the hallmark “bubble”. There`s never a bubble without a bottom being on the opposite side, so i`ve decorated this newsletter with a few “opportunities” as well.

My first prediction in 2018 has already taken place; On the 9^th of February I posted that in my opinion oBike, one of the most popular bike-sharing companies in Singapore, would disappear soon and that my friends should take out their 50-dollar deposits “now that they still can”. Two weeks ago, oBike announced that they would leave the Singapore market, and already 3000 complaints have been filed at the Consumer Association of Singapore, asking for deposit refunds. Was this the trigger that motivated me to finally write this newsletter, after years of thinking about it? Perhaps.

“Speculative bubbles do not end like a short story, novel, or play. There is no final denouement that brings all the strands of a narrative into an impressive final conclusion. In the real world, we never know when the story is over.”
- Robert Shiller -

Twitter is my main source of information, and I must tell you that some of the visual content is not mine. I have created most of the charts via the Federal Reserve Economic Data (FRED) website, which I highly recommend visiting.
This newsletter has purely been created to accumulate the most interesting—and sometimes frightening—charts, tables and articles that i`ve come across over the past few weeks. This newsletter should not be seen as investment advice and all opinions are my own. I am not a financial adviser.

Enjoy the ride, and don`t forget to stay positive after reading this newsletter, this too shall pass!

Robbert-John Sjollema

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The information contained in this publication is not intended to constitute individual investment advice and is not designed to meet your personal financial situation. The opinions expressed in this publication is that of the publisher and is subject to change without notice. The information in this publication may become outdated and there is no obligation to update any such information.

July 2018 - Bubbles and Bottoms for Consumers -

Most of my report is about the United States, mainly because they are still the largest economy in the world and hold the currency that is still being considered as the most valuable in the world. I mention the word “still” twice, since the “shift to the east” has been gradually taking place over the past 20 years and will eventually experience a tipping point.

Consumers in the United States haven`t had it this well for a long time. Unemployment is at the low of the year 2000 and might even go to lows that have last been seen in 1969! Not only in the United States, but all the OECD members (Organization for Economic Cooperation and Development) are seeing an unemployment rate that is at a decades-low level.

What`s the bad news? you might wonder. Well, the unemployment chart also shows you that almost every time the unemployment rate hits a notable low, recession looms around the corner (shaded vertical bars). An unemployment rate under 4% has guaranteed a recession 100% of the time since at least 1950.

“But at least consumer debt will go down and savings rates will go up when unemployment rates are so low, right?”
Yes, this would normally create a buffer for the next downturn and will support the people who have created a financial buffer for themselves. However, the next charts will show you that this time around, debt has only increased, and savings rates have only declined.

“There will be fat years and there will be lean years. But it is going to rain"

- Don Draper -

Consumer sentiment has been on a tear lately and is reaching levels last seen in 2005 and 1999. This sentiment is inversely correlated to the unemployment rate, but also directly related to the spending habits and saving rates of consumers.

Personal savings rates have reached the lows of the previous crisis and are near the lows of the past 60 years. While initially after the housing crisis passed, people increased their savings, it ground to a halt around 2012 and has decreased from more than 10% of income, to around 3% of income.

“Isn`t there any good news for consumers then?”
Net Worth as a percentage of Disposable Personal Income has reached all-time highs! Although, as you can see from the past two occasions, when Net Worth and the Personal Savings Rate start moving in opposite directions, as has happened around the year 2000 and 2006, they will eventually start reversing to the mean.

More good news? 2.5% savings rate seems to be the bottom, based on the levels in 2005 and 2009, and the recent bounce off the 2.5% level. Will we manage to turn around a decades long decline in personal saving rates? The fact that banks have been offering interest rates on savings accounts hovering around 0% for many years has most likely deterred people from saving as well. But wait, if household net worth is at an all time high, but savings rates near an all time low, then where is all that money stored?

"When written in Chinese, the word 'crisis' is composed of two characters. One represents danger and the other represents opportunity."

- John F. Kennedy -

The hunt for higher yields has pushed people to look for riskier investments, mostly in stocks and property. As you can see in the following chart, consumers have been excessively optimistic in the stock market, with “small trader call buying” at peak levels. The adage goes that small traders are considered to invest “dumb money”; they are the last ones to invest in popular stocks, and the first ones to be “under water” with their investments.

Aside from the stock market, the real estate market is another favourite for consumers who are hunting for higher yields. Before the housing bubble, the median sales price for a new house would require 5 times a median household income. Currently we are reaching 6 times the median household income for the median sales price of a new house. If you think that we were in a housing bubble 10 years ago, then you will not enjoy witnessing the current extremes in the market!

Following the increase in housing prices, mortgage debt has come back to record levels, fuelled by ever decreasing mortgage rates. As you can see, mortgage rates have bottomed between 2012 and 2016, and are now seemingly on the way back to “healthier” levels. This increase in rates will inevitably lead to even higher mortgage debt.

Student loans have been on the rise as well. These loans have witnessed a surge, going from USD 120 Billion at the beginning of the housing crisis, to almost USD 1.2 Trillion today! That`s a tenfold increase in 10 years! The total non-revolving credit, or student and auto loans combined, now stands at a record USD 2.858 Trillion.

Revolving credit, which -for consumers- is mostly credit card debt, has also risen to an all-time high at USD 1.04 Trillion.

The following charts clearly shows that the interest rates are (finally) going up, after having been stuck at zero for 7 years thanks to the Federal Reserve. You would think that zero interest rates have made it cheaper for people to pay off their debt and lower their personal interest payments but, as you can see, the interest payments have only gone up over the past few years. You might then start to wonder; if people are already having a tough time paying back their debt at a 2% federal funds rate, what would it look like at a relatively normal rate of 5%? Currently the interest rates on credit card plans are at the highest since February 2010, and the second highest since 2001.

You might wonder why consumers have lowered their savings, while increasing their spending. Aside from the fact that people just start to spend more if they earn more, the reason might also be found in the following chart, where you can clearly see that medical expenses and tuition expenses have outpaced the “general” inflation levels by roughly 250% and 400% respectively over the past 40 years.

Summary:

Consumers are in for a rude awakening, not having saved enough money to withstand the inevitable upcoming downturn in the economy and having invested too much in risky assets. Can the consumer be blamed? Partly; Inflation in items like college tuition and medical care has increased at a much higher rate than general inflation over the past 10 years. Aside from that, lower interest rates have made it increasingly more attractive to borrow money, and less attractive to save it. The savers have put their money to work through different channels other than a savings account, with stocks and property being their preferred options. In the next chapter I will try to show you why the stock market might not be the best investment right now.

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The information contained in this publication is not intended to constitute individual investment advice and is not designed to meet your personal financial situation. The opinions expressed in this publication is that of the publisher and is subject to change without notice. The information in this publication may become outdated and there is no obligation to update any such information.

July 2018 - Bubbles and Bottoms for companies -

Consumers are not the only ones who have made full use of the Federal Reserve`s 7-year zero interest rate policy. As you will see in this chapter, companies have borrowed money like there`s no tomorrow. Over the past ten years, companies have more than doubled their outstanding amount of bonds and loans.

In the United States, corporate debt as a percentage of GDP has reached dangerous levels, surpassing the peak of the housing bubble. You can clearly see that the past three peaks have all taken place around the start of a recession. Currently, the graph is showing a slight downturn, which could indicate that corporate debt might slide back to 40% of GDP. I will not discuss China much in this newsletter, but as you can see in the previous chart, Chinese corporate debt has risen the fastest over the past 10 years, reaching a compound annual growth rate of almost 40%, compared to 7.8% in the U.S. , and 8.6% in Western Europe.

Do you remember CDO`s, Collateralized Debt Obligations? These instruments can be seen as the trigger to the 2008 crisis. Today there`s CLO`s, Collateralized Loan Obligations. The corporate borrowing that takes place at banks, immediately gets repackaged into a CLO security, which can be purchased by other investors. Insurance companies and pension funds are big buyers of these securities, because it offers higher yields than your average bonds. Why would a higher yield be offered? Because the quality of these loans inside the CLO is low, and thus the chance of default is high. As a reward for still taking the risk of purchasing these securities, higher yields are offered. Will the CLO story end in the same fashion as CDO`s did in 2008? Looking at the increases that are taking place in corporate borrowing, and the quality of these securities going down rapidly, I think I can confidently say that CLO`s will make the headlines in newspapers relatively soon.

“What is all this money spent on?”
In a normal economy, a company would borrow money to, for example, invest in Research and Development or to grow their business in a new market. The next few charts will show that most of this borrowed money has been spent on buying back shares (less shares on the stock market means that the company`s profit can be divided over a lower pool of shares, and thus creating the illusion of “higher earnings per share”), and on mergers and acquisitions (M&A). Of course I don`t have to tell you that all these share buybacks are taking place at a time when stock markets are at their peak. Recipe for disaster? You tell me.

Worldwide M&A has increased by 65% compared to a year earlier. It has now reached USD 2.5 Trillion and shows no signs of slowing down. These are record levels, even surpassing the peaks of 2007. As you can also see from the chart below, M&A deals tend to peak right before the start of a recession.

"Never let a good crisis go to waste"

- Winston Churchill -

All this cheap corporate credit has culminated in extremely high stock market valuations, and the use of the acronym TINA (There Is No Alternative): Bonds offer low yields, savings rates are down the gutter, so the only investment that still offers above average results is in stock markets.

Of course, not all businesses are created equal, and a big discrepancy between industries has started to emerge. The tech industry has taken the lead when it comes to extreme valuations, and in particular the FAANG stocks: Facebook, Apple, Amazon, Netflix and Google. These stocks are showing valuations that resemble the dot-com mania. Compared to the S&P 500 index, FAANG stocks have outperformed tremendously over the past 12 months.

As the following table shows, FAANG plus Microsoft are responsible for 98% of the S&P 500`s entire Year-To-Date Returns! The Nasdaq would have even been negative Year-To-Date if it wasn`t for these companies.

How much of a bubble are these tech stocks in? The Dow Jones ECom Index that`s tracking some of the biggest e-Commerce giants like Amazon, Netflix, Google and Facebook, has increased over 600% in a matter of 8 years. This has resulted in a bubble that is almost as large as the U.S. housing bubble, and reaching the levels seen during the tech bubble. As you can clearly see, most of the parabolic moves that have taken place over the past decades, resulted in a decline that was as spectacular as the gains.

This massive increase in stock market valuation has created a total market capitalization of U.S. domestic companies (that are listed on either the NYSE or NASDAQ) which has surpassed the valuation at the peak of the dot-com bubble. As a percentage of U.S. GDP, this equals 177%.

The S&P 500 is now in its longest consecutive positive streak ever if it manages to close the year positively.

“Aren`t there any stocks that are still priced at an attractive level?” But yes, that`s why I have called my newsletter bubbles and bottoms. There`s always an opportunity somewhere! Defensive stocks and financials are showing a clear bottom, as well as individual retailers like JC penny and Sears.

“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”
- Warren Buffett -

You want to see more bottoms? The following chart is about U.S. worker productivity. It has been in decline for almost 1.5 decades and is most likely the cause of mediocre economic growth during most of that period. Despite all the technological advances, productivity doesn`t seem to be able to grow at the pace it used to. Has the internet revolution died down? Are we wasting too much time on social media, and the internet in general? Janet Yellen, the previous Chair of the Federal Reserve, stated that the outlook for productivity growth is a “key uncertainty for the U.S. economy”.

Bubbles are not only taking shape in listed companies. There are many examples where cheap credit has enabled businesses and their ideas to flourish in an environment where risk taking is encouraged, and where non-profitability is quickly being excused by using hype words like “Daily active users”, “Data rich” and “New paradigm”. Here are a few examples of non-listed businesses and activities that I think are in a bubble:

Co-working spaces like WeWork
Bicycle sharing companies like oBike (sharing economy in general)
E-commerce platforms like Lazada and Shopee
Delivery services like Deliveroo, Honestbee and Foodpanda
Taxi companies like Grab and Uber

Why do I think they are in a bubble? High valuations, Low margins, high burn rate and too much competition. The only way these companies seem to be able to create higher revenue than their competition is by offering discounts to the end user. The companies are expecting brand loyalty in return, but do not realize that they have turned their customers into discount-hungry users, who do not care about the platform as long as they can pay as little as possible for the product or service. This competition based on discounts creates a race to the bottom, with the winner being the one who can hold their non-profitable breath the longest.

Bloomberg has identified 69 big companies in the world that have boosted their debt levels by 50% or more in the past 5 years and now have at least USD 5 Billion in debt. Together they carry almost USD 1.2 Trillion in bonds and loans, with most of them having a “junk” status. The majority of these bonds and loans will have to be paid back in the next 7 years.

A few names: Softbank (Japan), China Evergrande Group (China), HNA Group (China), Greenland Holdings Corp (China), CenturyLink (U.S. ), Dell Technologies (U.S.).

Summary:
Companies around the world, especially in China and the U.S., are overvalued and too hungry for cheap credit. Corporate debt in and of itself is a great tool to grow your business, but over the past 10 years it has been made clear that most businesses have used this debt to buy back their own shares or participate in an M&A frenzy, instead of investing in manpower, Research and Development or other means of growing their revenue. This growth in debt has been made possible by, once again, the 7-year long zero interest rate policy by the Federal Reserve. In the next chapter, we`ll find out in detail how the U.S. government, together with Europe, China and Japan have contributed to these bubbles in corporate and consumer debt.

(Click to enlarge)

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July 2018 - Bubbles and Bottoms for governments -

The central banks of the U.S., EU, Japan and China will be discussed in this next chapter, as these four central banks have increased their balance sheet (read: printed money) with the largest amounts. If you want to find the core reason for the massive bubbles in student loans, housing prices, corporate loans, stock markets, medical care, but also more exotic bubbles in cryptocurrencies, the Kardashian`s net worth (funny but true), concert tickets, football transfer fees and fine art just to name a few, look no further than your country`s central bank. Zero interest rate policies and the downright printing of money has inflated assets all around the world, and will be the core reason for the coming economic decline.

Switzerland deserves a special highlight, as they have joined the “printing game” relatively late but are now going into overdrive. Compared to the “big four” their nominal balance sheet is small, but if you look at these holdings as a percentage of the country`s annual GDP, then it starts to become clear:
FED balance sheet: roughly 23%
ECB balance sheet: roughly 41%
BOJ balance sheet: roughly 96%
SNB balance sheet: roughly 130%!

20% of the swiss central bank`s assets are now invested in U.S. companies like Facebook and Amazon (yes, the members of FAANG). The result? A record profit of USD 55 Billion in 2017 for the Swiss National Bank. Everything is awesome! A picture speaks a thousand words, so just to show you the “idiocracy” that`s taking place, here`s the swiss monetary base:

But don`t worry, they`re not alone. The Bank of Japan has gone off the rails as well, and now owns 46% of all outstanding Japanese government debt. It also owns roughly 80% of the 3 big index ETF`s or Exchange Traded Funds in Japan. Picture a supermarket, with the owner being its biggest customer…

Anyone who has learned economics and finance at school, knows that when you print more money, you will create inflation, right? Just look at Weimar, Zimbabwe and now Venezuela. How come there`s no hyperinflation now that we`ve printed so much money over the past 10 years? It`s a question i`ve been struggling with for years, and I probably still don`t have the full answer to this.
I do have a few theories/scenarios that I would like to share with you.

In Switzerland`s case it`s very easy: 94% of their printed money has immediately been invested overseas, and they`ve thus exported their inflation. An interesting statistic? The Swiss National Bank now owns 0.3% of the entire U.S. stock market!
China has their own tricks up their sleeves. They have been on a lending splurge, mostly to 3^rd world countries, under the “belt and road initiative”. Often this lending is partly in USD (they can finally get rid of their USD reserves) and partly in RMB (they can export their inflation). This system is already starting to show cracks, with Sri Lanka not being able to pay back their debt to China, and Kenya`s debt to China growing tenfold in 5 years. Is this China`s grand plan? To create debt slaves and receive cheap commodities or land in return?
The money that has been lent to banks by Central Banks was supposed to get back in “the system” in the form of credit to firms and households. Instead, it has been sitting idle in bank`s reserve accounts. This has not been done completely voluntarily, as the governments around the world have forced banks to increase their financial buffers in order to avoid another crisis. One can also see this as “deleveraging”. Currently, USD 2.2 Trillion in bank deposits are held at the Federal Reserve, almost half of the entire FED balance sheet.
The velocity of money has crashed. “The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time.” This means that all these dollars that have been printed, are not being spent. If the printed dollars are not actively participating in the economy, then obviously they can`t induce hyperinflation (they also can`t boost economic growth). The fact that household net worth is at all-time highs confirms this statement. Below is a chart comparing the money supply to the velocity of money. What happens if the money velocity, that has been crashing since 2008, starts catching up and all that printed money starts seeing the light of day?

The U.S. public debt has now reached 105% of GDP, or USD 21 Trillion! To whom do they owe this debt? 69% of the total outstanding debt is held by U.S. individuals and institutions, while 31% is held by foreign entities. The higher the debt, the more interest has to be paid, and with upcoming rising interest rates, there will be even bigger interest payments ahead. Will the U.S. government be able to ever pay this back? This rhetorical question will be answered on the next page.

During previous recessions, the U.S. could grow its way out, mainly because of its young, growing population. Right now, the opposite is true; the population is aging rapidly, and the population growth hasn`t been above 1% per year since the year 2000. One of the results of this is that Social Security costs are expected to exceed Social Security income this year for the first time since 1982. After this year, the disparity between income and costs will only increase.

What does “growing your way out” look like? For example, you stimulate the economy with a dollar and you get 1.5 dollars in return. This has worked up until the mid-80`s, but then it started becoming more and more difficult for the U.S. economy to grow its way out of debt. Credit to the non-financial sector has grown 47% from 2007 until 2017, gaining USD 15.6 Trillion. In the meantime, the U.S. economy grew by only USD 4.9 Trillion. This means that in order for the U.S. economy to grow by 1 dollar, 3 dollars of debt has to be created.

What does it look like when you combine all the private, corporate and government debt from all over the world? A USD 237 Trillion pile of horse manure. It is of course not fair to look at nominal growth, so knowing that world GDP was almost USD 80 Trillion last year, we can calculate that the world debt is 300% of GDP. The good news? This percentage has been slowly declining over the past 2 years.

Don`t just teach your children to read… teach them to question what they read.
Teach them to question everything.
- George Carlin -

In the meantime, bond yields are doing something that normally precedes a recession. The average short-term bond yields climb above the long-term bond yields, which indicates that the long term economic outlook is bleak, and that the yields offered by long-term fixed income will continue to fall. They call this phenomenon “inverted yield curve” and has taken place 9 out of 9 times upon a recession. The good news? It took an average of 21 months for recession to start, after the inverted yield curve took place, so there`s plenty of time to hide! The first chart shows the U.S. yield curve, which is now almost negative, and the second chart is the global yield curve, which has inverted for the first time since 2007.

I sense that i`ve been showing you more bubbles than bottoms, so I would like to end this newsletter on a positive note and show you an interesting bottom that is taking place in the commodity sector. Below you see the GSCI index (Goldman Sachs Commodity Index) compared to the Dow Jones Industrial Average index. As you can see, GSCI is hitting rock bottom, and is ready to shoot back up (bringing along a nice portion of consumer inflation)

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