BUBBLES AND BOTTOMS: December 2018

November 2018 - Introduction -

Last week must have been the most insane week, in the most insane quarter since 2008. We still have 1.5 more weeks to go before the end of the year, but it already looks like it`s going to be a red Christmas.

The most amazing part about the declines over the past weeks, is that the S&P 500 has “only” lost 10+% so far. If you look at previous bear markets, there`s lots more downside, with a decline of 40% almost being a base scenario. Yet it already feels like the world is collapsing from underneath us.

There`s a few reasons for this. First of all, the US has been the last man standing. The rest of the world is much worse off and has already been in bear market territory for a while. For all the other countries aside from the US, the world is actually collapsing from underneath them, and serious cracks start to appear in their economies.

Second, there are a few industries that are leading the declines, and are in much more pain than the rest. The main example would be the tech industry, where the once beloved FAANG stocks are now suddenly the most hated stocks.

What does surprise me though, is that there has not yet been a specific “trigger” for the declines. Yes, the China and US trade relations are terrible, but last week it seemed that this issue would be fixed very soon. Corporate debt hasn`t blown up yet, there is no BREXIT vote, the FED hasn`t made a decision yet about their interest rate policy, employment rates seem to be stable and consumer confidence is still high. The Brexit bill vote and the FED interest rate decision will definitely shake up the markets even more than they already have in the past 2 months, and I would like to warn all the readers of this newsletter for more downside ahead, with massive spikes in between that make it look and feel as if “the worst is behind us”. But don`t fool yourselves, the average bear market takes 18 months to develop, and so far we`re only in month 2.

Over the past 4 months I have prepared you for what`s coming. I`d highly suggest to read all 4 newsletters to understand the “triggers” to this stock market decline, because if you would only listen to the mainstream media`s narrative, you`re at least 6 months behind. The “everything bubble” is slowly deflating and it is now up to us to either profit from it, or to try to get out of it at the right time.

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

Robbert-John Sjollema

Next page

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.

November 2018 - Bubbles and Bottoms for Consumers -

Consumers are starting to feel the squeeze and as usual, this squeeze starts in the housing market. The number of US mortgage applications is now at an 18 year low, despite the fact that mortgage rates are at a relatively affordable level.

One of the main reasons for this low level of US mortgage applications is the fact that consumers are still deleveraging from the previous debt cycle that ended in 2008. If you would compare this consumer deleveraging to the corporate debt binge that is taking place simultaneously, it is quite easy to see that the next bubble won`t take place in the consumer sphere, but rather among large corporations.

In the following chart you will see the unemployment rate, the natural rate of unemployment minus the employment rate, and the long-term natural rate of unemployment. The natural rate of unemployment is a concept by Milton Friedman and Edmund Phelps, and basically says that even when an economy is running at full steam, there will always be a group of people who are unemployed. This can, for example, be due to a mismatch in education, wages, or a reluctance for an employee to travel further than a certain distance or time. You can see that when the unemployment rate dips below the long-term natural rate of unemployment, a recession takes place soon after. Over the past 40 years the shortest duration for a recession to take place was 21 months after the dip, and the longest was 50 months. Currently we are at 19 months, and this means that we are likely very close to an official recession.

Because a person has to be either working or looking for work to be counted

as part of the labour force, an increase in the number of people too discouraged to continue

their search for work would reduce the unemployment rate, all else being equal -

but not for a positive reason.

- Ben Bernanke -

Previous page Next page

November 2018 - Bubbles and Bottoms for Companies -

Over the past few months I already spoke about the stock buybacks, and how they have reached all-time highs. This was in my opinion the main trigger for stocks to go up over the past few years but has now stalled due to increasing interest rates.

How extreme have these stock buybacks been? In Billions of dollars, the buybacks have surpassed capital expenditure! In the past 20 years, this has only been the second time that this is happening. The last time, unsurprisingly, was in 2007, right before the credit crisis.

40% of the value added to S&P 500 stocks since 2009 has been through dividends and buybacks. Has real value been created? Has there been real innovation? Have companies focused on growth and outpacing their competitors? No, the only thing that has been created is a smile on shareholders` faces.

On the face of it, shareholder value is the dumbest idea in the world.

- Jack Welch -

This year can really be seen as the grand finale of share buybacks, with a record amount announced; more than 750 Billion dollars as of Q3 2018.

The cracks slowly start to grow, and obviously it will hurt the most in the areas where money has been flowing freely. Case in point: startups. Since 2013 there has been an explosion in Venture Capital deals raising 100 Million dollars or more. Having been stable from 2007-2013 with about 0 -5 of such deals announced, over the past 5 years it has grown to 45 deals announced! If you are looking at one of the largest bubbles that are blown since the previous crisis, look no further than startup funding.

I have been a startup consultant over the past 4 years, and to look at the industry up-close is just stunning. The number of VC`s, incubators, accelerators and private investors is mind boggling. I am in close contact with these investors, and I still find it amazing to see that none of them actually care about profitability of a startup. Heck, the startups don`t even necessarily need to have any revenue! It`s all about daily active users, the average number of minutes spent on an app, and many more of these useless metrics that have just been brought to life to cover up the one thing that matters: profitability.

Being a startup consultant, it is my job to try to lower the chance of failure of a startup from let`s say 98%, to 92%. You might wonder why anyone wants to hire a consultant who is so downright pessimistic, but in my opinion that is exactly what startup founders need: some grounding. They need someone to drag them back to earth, tell them about the viability of their product or service, the potential size of their market, and the chances of becoming profitable.

What I feel is that many of the startups are playing a game of “who can hold their financial breath the longest”. A good example is the Southeast Asian fight between Grab and Uber; from the start, these companies have been throwing buckets and buckets of money at their customers, trying to lure them in as regular customers. I remember a point in time where I had 5-dollar discounts with Grab on an 8-dollar ride, every day, for 6 months in a row. Has this increased my loyalty for Grab? Not at all. I still choose the cheapest option, regardless of the service provider. After spending Millions of Dollars on both sides, Uber decided to give up, and sell their Southeast Asian operations to Grab. There have only been losers at that point; Uber lost their markets, Grab (or should I say, Grab`s investors) lost Millions of Dollars in discounts, and the consumer is now dealing with a near monopoly in the market right now.

But let`s look at the mother of all examples: Amazon. Since the late 1990`s they have been squeezing physical retailers, by making online retail cheaper. They have destroyed many of the well know brick and mortar brands and department stores. By playing a game of “Who can hold their financial breath the longest”, they have gotten rid of most of their competitors by being unprofitable in their operations for 20 years. Who has paid for this? Amazon`s investors. Now that physical retailers are leaving in droves, commercial rents are dropping like never before, and guess what…
Amazon now decides to set up their own brick and mortar outlets…
Genius? Yes!
Unfair? How would you feel if a runner on steroids (read: nearly unlimited cheap credit) wins from someone who has worked long and hard to reach their goals?

One of the biggest winners in these examples are the consumers, as they can purchase products and services at the lowest rates. In my opinion, this has suppressed consumer inflation rates massively, and now that we are going back towards interest rates reaching “fair value”, all these discounts and low prices will disappear, and companies will go back to their main goals: becoming profitable.
Most likely, this will result in a spike in inflation, together with a few other factors that I will discuss in the next chapter.

Meanwhile, looking at a different industry, global auto sales have been coming down a lot over the past 2 years, now being back to levels that were last seen in 2009. Is this because of the rise in companies like Uber? Or is it just because we are in the midst of the next global economic downturn? How will this downturn affect auto companies like Tesla, who haven`t even been able to become profitable yet? Will they survive the lethal combination of rising interest rates and declining auto sales?

Previous page Next page

November 2018 - Bubbles and Bottoms for Commodities -

Commodities have been a disappointment for years, but I still see them as the rising stars for the coming decade. Metals and agricultural commodities have, in my opinion, the largest potential to grow, mainly due to their cyclicality.

My all-time favourite is still Silver, and its bigger brother Gold. The following chart popped up on my radar again after making the rounds in 2016, when we were all stunned about the sudden peak in the gold inventory ratio. Back then it reached an all-time high of more than 500 claims per ounce of deliverable Gold. Just to clarify; this means that 500 different people think that the same ounce of gold belongs to them. I`ll clarify again; comex has promised the same ounce of gold, to 500 different people… I think I need to repeat this about 500 times to make myself realize how incredibly crazy this sounds!

However, after the newsflashes faded, the inventory ratio faded as well, going all the way down to a “mere” 30 claims per ounce of deliverable gold in 2017. The chart has now gained popularity again, because it is almost hitting 400 claims per ounce of deliverable gold. The big question now is: will it fade once again, like it did in 2016? Will there be a run on COMEX inventory? Or will the price of gold just rise, with a lower number of claims as a result?

In January 2016, the peak was followed by a 28.7% rally over the following months. Looking at all the geopolitical troubles, I wouldn`t be surprised at all if history repeats.

Previous page Next page

November 2018 - Bubbles and Bottoms for Stock Markets -

The good news? November was less wild than October. The bad news? December started the rollercoaster all over again!

The usual suspects, FAANG, were leading the pack once again, showing declines larger than 20% from their all-time high.

The scary thing is that this might just be the beginning. Comparing the market capitalization of the FAANG stocks to the market capitalization of the tech stocks during the dot com era as a percentage of the total US stock market, you see that FAANG is off their highs, but if they would follow the same path as tech stocks during the dot com bubble, we have a lot more pain ahead.

Looking at the number of occurrences when the Dow Jones index had an intra-month decline of more than 8%, and a closing of the month that was at least 4% lower than the month before, it finds itself in bad company. It took place twice this year and before that, *drum rolls* in 2008 and 2000. This pattern basically takes place every time a market peak is set, and I fear that this time it`s not different.

Whichever way you look at it, things are overvalued and highly irrational. The following chart gives a different perspective, this time in the form of the number of occurrences when the Dow Jones closed at a 52-week high, while less than 50% of the stocks are above their 200-day average. This means that only a select group of companies carry the stock markets to new all-time highs. For a solid stock market to take place, we normally see a broad participation, where the “high tide lifts all boats”. At this stage of the cycle, that`s definitely not the case.

Below is an interesting table about the duration of all drops of 10% or more, from an all-time high. You can see that it can take a while for a bear market to happen, although it definitely happens at a faster pace than bull markets. To go from -10% to -20% can take up to 1.5 years, or 18 months. If you`re a bear, that`s only about a 7% yearly return.

My suggestion is to not fall in love with your position, but instead to “whack a mole”; keep a “fixed” number of shorts on the index. Use a flexible number of shorts to enter the market for a short period of time after a heavy “short squeeze” and exit after a 3-4% profit. This way your “fixed shorts” will benefit from the long-term decline, while the “flexible shorts” will benefit from the highly volatile environment.

Of course, that`s easier said than done and with short squeezes being as large as a 10% increase in a day, not many traders will be able to survive it.

So how bad are the markets right now? Is there any way to earn money anymore, in any type of asset class? The simple answer is no. The number of asset classes that show increases of more than 5% per year, is zero this year. The median asset returns are now -1.69% for the year, with the maximum being a meagre 2.43%.

Looking more closely at stock market returns, you would probably be shocked to find out that total returns of the S&P 500 between 2-9% are actually quite rare, and 60% of the time you will find that 10%+ returns are the norm. When you see this chart, you might have the wrong impression that positive returns happen way more often than negative returns. Do keep in mind though, that it only takes one 50% decline, to erase 200% of profits…

Here are two charts that make you think, “hey, why don`t I just go long pre-market and after hours, in January, March, April, July, October, November and December?” And honestly, I wouldn`t blame you. It seems like going long pre-market/after hours and avoiding the slowest months of the year has been a winning combination for decades, and doesn`t look like it`s going to change anytime soon. (Not taking any broker fees into consideration).
The first chart makes me wonder; is this the best visualization of the “capital flight to the East” that we`ve seen over the past decades, where Asia is getting richer (those markets are open during pre-market/after hours) while the US is gradually losing its power?

I`ll finish this chapter with a funny visualization of what it takes to be a good trader/investor. It`s all about the poker face. Don`t celebrate when you`re up, don`t stress when you`re down. Just stay humble and take the market day by day.

One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.

- William Feather -

Previous page Next page

November 2018 - Bubbles and Bottoms for Governments -

From France and the UK to Venezuela, governments all over the world are being challenged in many different ways. France is struggling with populism, the UK is struggling with the BREXIT, which can also be seen as a populist move. Venezuela is battling hyperinflation, Canada is arresting Chinese citizens, and in return China is arresting Canadian citizens. The US is fighting with everyone it has a trade deficit with, and Russia and Saudi Arabia have suddenly become best friends.

All of these political shifts and crises have one thing in common: they`re all a result of peaking economies and complacency among world leaders and their citizens.

Looking at emerging markets, i`m expecting more fireworks after the past year`s spectacular moves, with, as usual, increasing interest rates being the main culprit. The following chart shows the outstanding debt as a percentage of GDP, 20 years ago, 10 years ago and in Q1 of this quarter. Outstanding debt is now sitting at an average of 211% of total GDP, compared to 124% 20 years ago. Both non-financial corporates and households have increased their debts by more than 30% over the past 10 years.

Looking at the “developed” economies, we see a massive divergence happening between the German 10-year yield and the Fed funds rate. It is now at its lowest in 29 years. The past 3 times when the ratio turned negative, it has coincided with a recession.

To top off all the gloom and doom charts, I leave you with the taxes on corporate income for the US federal government. As you can see, it has fallen off a cliff over the past 2 years. You might want to explain this by talking about Trump`s tax cuts and the fact that Republicans always like to cut taxes, but if you look at the early 2000`s with Bush at the helm, tax on corporate income went through the roof. I think this chart exemplifies that the US economy is sick, and that a recession is around the corner.

The cure? Corporate deleveraging. It has taken banks more than 10 years to deleverage to a level that is “acceptable”, and I see corporate America having to go through the same deleveraging process for the next decade. This will result in rising unemployment, a stagnating economy, and most likely a lot of social unrest.

Previous page Next page

November 2018 - Summary -

The coming recession, or perhaps even depression, will “normalize” the exuberance that our generation has gotten so used to. The millennial generation have become “snowflakes” as it is so perfectly stated by the older generation. Millennials have had it too easy for too long, living off their parents` wealth, owning devices like smartphones that stops them from having real life confrontations and hardship, and instead turns them into keyboard warriors. They “ghost” boyfriends, girlfriends and even new employers, to avoid confrontation, and god forbid, to avoid having to actually fix something or do effort to create a meaningful relationship.

Millennials love to complain about the fact that they have sky high student debt, and even though this is a worrying development, I can`t help but think to myself: who forced you to do a bachelor`s or a master`s study? Who says that you need a degree to be able to have a job? Our entire generation seems to have a degree, and everyone seems to be working in the services industry, no wonder it`s difficult to find a job! Go look at manufacturing or agricultural jobs, they are begging for employees, and pay a handsome salary while they`re at it. But no, our generation doesn`t want to get their hands dirty, let alone leave their screens for longer than an hour!

The bubble that i`ve been talking about over the past 4 months is so much bigger than just a stock market bubble. It`s a political bubble and a cultural bubble. Basically every time you look at the news and think to yourself “this is absurd”, it has to do something with the bubble that we have created. Not just the bubble from the past 10 years, but all the way back to the gold standard in 1971.

We will go back to economic growth as it was meant to be: through productivity growth (technological improvements or better education) and population growth, not by just growing the monetary base into oblivion and continuously “borrowing from the future”.

Deleveraging is the keyword to fix all of this. Slowly deflate the balloon and reduce the “future borrowing” from let`s say 1 year, to 1 month, to today. This process will hurt, and there is not a single country, leader or central bank who would like to be the first to start this. That`s why i`m still assuming that instead of painful deleveraging and tightening the belt, governments around the world will just create an orchestrated hyperinflation scenario and therefore make it easier to pay back debts that were promised to be paid back in the future. The pain will be the same, but it will be faster, more effective, and with broad participation.

Currently we are at a stage where governments will try to tighten the belt. If the US markets will decline by more than 40%, I think they will give up tightening the belt and start lowering interest rates again and print more money in the form of quantitative easing, or programs that will most likely have a different name but the same effect. Stock markets will then rise, people will feel that things are fixed again, and that`s when the “boiling frog syndrome” will take place.

For now, let`s just hope that this will become a regular correction, because nobody will benefit from the above scenario, not even the ones who think they can prepare for it by buying precious metals.

Thank you for reading, and don`t forget to stay positive!

Robbert-John Sjollema

Previous page