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State of the Market

Global stock markets continue to move in an overall downward direction despite some near term bounces to the upside. These bounces provide a good opportunity to move out of stocks and into more secure short term bond funds or cash. If the markets continue to move the way they have over the past 9 months we can expect a major drop in the indexes on the scale of the “Dot.Com” crash of 2000 or the “Great Recession” of 2007.

The post is updated during the 1st week of every month. Please feel free to use this as your guide.

Click on Chart to enlarge

C-Fund

Good News Bad News!

Most of us cringe when we hear “I’ve got some good news and I’ve got some bad news”, because more often than not, the bad news outweighs the good.

The global economy and financial markets are currently weighing the good news bad news stories on many fronts:

The Good News – Global Oil prices have dropped over 50% since last summer. This is certainly good for the consumer, the transportation industry, and all businesses that use petroleum.

The Bad News – Low oil prices aren’t good for Energy Companies, many of which are shutting down wells and laying-off workers in a mad rush to stay solvent. This could also be bad for the Banks that loaned money to drill the wells. Loan defaults may be right around the corner.

The Good News – Low oil prices are crushing the economies of Russia, Iran, Venezuela, and ISIS. This may slow their aggression.

The Bad News – These same bad actors may do something rash in defiance.

Black Swan Events

The weeks ahead should prove telling as the globe is “a buzz” with potential Black Swan Events that could send this market into a tail spin at any moment. Ebola, Ukraine, ISIL, China, take your pick. One by one, markets across the globe have been falling and now it appears to be our turn.

Black Swan Events are rarely the direct cause of market crashes but they can provide the catalyst for an already weak market to reverse course.

When the market is strong, (i.e. earnings rising at the same velocity as stock prices), a Black Swan Event can actually create a buying opportunity. Once investors realize that the event will not have an adverse effect on earnings, the market will likely rise back to pre-event levels.

But when the markets are weak, (i.e. market prices rising faster than earnings and revenues, and/or earnings showing signs of weakening), a Black Swan Event can ignite a powerful chain reaction causing the market to crash quickly.

Stock Buyback Warning

While a stock buyback warning may appear to be a contradiction in terms, it is far from it in today’s market.

We all know that the primary mission of a publicly traded company is to generate profits, more commonly referred to as earnings on Wall Street. But after the profits are earned the company must do something with the cash.

While it may be prudent for the company to hold some cash for future needs, shareholders don’t like to see the “war chest” get too big. From their perspective this idle cash needs to be invested by the company to increase future earnings or be returned to the shareholders.

If the company can see an opportunity to grow their business by building new stores, expanding their factory, hiring more workers, or investing in research and development they will reinvest the profits to grow future profits. But if the economy simply isn’t presenting any good opportunities they’re not going to take the risk.

If the company can’t come up with a more productive use of the profits they may choose to initiate or increase their dividend payments to shareholders. But first the company must determine if current profits are sustainable to pay the dividend in the future. Shareholders are happy to see an increase in their dividend check but become very unhappy if the company decreases it later.

DOW 17,000

DOW 17,000 Celebrate or Hibernate – While we were winding down this past Thursday and preparing to celebrate our independence, the Dow Jones Industrial Average broke through 17,000 with the S&P 500 not far behind in approaching the 2,000 level. While some are celebrating this event others are sounding the alarm. So who’s right?

Celebrators are heralding the June unemployment report as reason to cheer but this doesn’t really address the $64,000 question? Is the S&P 500 approaching the 2,000 level fairly priced, still cheap, or too expensive?

Just as the per package price of a box of chicken tells us little of its true cost without knowing the price per pound, S&P 500 levels tell us little without knowing how much earnings are being generated by the companies it represents.

To calculate the “price per pound” equivalent of the stock market we simply divide price by earnings to obtain a price to earnings (PE) ratio or multiple.

To adjust for inflationary, seasonal, and business cycle variances in price and earnings, Yale University Professor Dr. Robert Shiller developed the Cyclically Adjusted Price Earnings (CAPE) Ratio for which he received the Nobel Prize in Economics in 2013.

I-Bonds

By far the safest place to save is with I-Bonds from the U.S. Treasury. They are the perfect vehicle to stash cash for emergencies, a new car, a down payment on a home, etc.

So why is this better than a savings account, CD, or money market fund with your local bank or brokerage? First and foremost, Series I-Bonds are currently paying 1.38%. While it doesn’t sound like much it is triple the rate most banks pay on their Variable Rate 1 year CD. But the real beauty lies in their flexibility and safety.

1) I-Bonds are safer than FDIC insured bank deposits because they are fully backed by the U.S. Treasury for principal and interest without limitation. FDIC insured banks accounts are only insured up to $250,000 and Money Market Mutual Funds (MMF) are not insured at all. In fact, you can loose money in an MMF.

2) I-Bonds are inflation protected – interests rates are recalculated twice a year. As interest rates rise, so will your earnings. Interest rates are at their lowest point in 30 years. So, while interest rates could fall further there isn’t much room left to fall.

Wall Street is in a Deep Freeze

Unbridled optimism on Wall Street in 2013 has morphed into caution and indecision in 2014, driven by the worst winter the nation has seen in decades.
Economic data coming in over the past six weeks from housing, employment, manufacturing, shipping, and retail sales have all been disappointing to say the least. But for now, Wall Street is in a Deep Freeze and appears content to blame it all on the weather.

Granted, some of the poor performance figures will prove attributable to the weather but I hope Wall Street is right on this one. Otherwise the spring thaw may bring a flood of investors heading for the exits.
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January brought us a minor decline in the market followed by a partial rebound in February. The market is currently moving sideways with a negative bias.

Stock Market Continues to Defy All Odds

While the stock market continues to defy all odds, it is beginning to reveal cracks in its foundation. Wall Street gamblers have been rolling the dice using borrowed money at record levels to fuel this market.

In the following chart the red line depicts the amount of money investors have borrowed to buy stocks while the blue line depicts the S&P 500.

In November, margin debt reached $424 Billion. This falls within 1% of the inflation adjusted all time high which preceded the market crash of 2007 and is well past the high achieved just prior to the 2000 crash.

Click on Chart to Enlarge

NYSE-margin-debt-SPX-since-1995

So why is high margin debt so dangerous? Investors who borrow money to buy stocks must pay interest on these loans just like any other type of loan. If the market doesn’t continue to climb faster than the cost of the loan, these investors will begin selling the shares they own “on margin”. To make matters worse, margin debt is secured by the stocks owned by the investor. If the market begins to decline, the value of the stocks securing the debt decline as well. When the stocks in the investor’s portfolio no longer support the loan requirements the margin debt is “Called” by the lender. At this point the investor must deposit more cash or sell the stocks. In a falling market this can create an uncontrollable chain reaction. The higher the overall margin debt the bigger the potential chain reaction.

The Stock Market Continues to Defy All Odds

While the stock market continues to defy all odds, it is beginning to reveal cracks in its foundation. Wall Street gamblers have been rolling the dice using borrowed money at record levels to fuel this market.

In the following chart the red line depicts the amount of money investors have borrowed to buy stocks while the blue line depicts the S&P 500.

In November, margin debt reached $424 Billion. This falls within 1% of the inflation adjusted all time high which preceded the market crash of 2007 and is well past the high achieved just prior to the 2000 crash.

Click on Chart to Enlarge

NYSE-margin-debt-SPX-since-1995

So why is high margin debt so dangerous? Investors who borrow money to buy stocks must pay interest on these loans just like any other type of loan. If the market doesn’t continue to climb faster than the cost of the loan, these investors will begin selling the shares they own “on margin”. To make matters worse, margin debt is secured by the stocks owned by the investor. If the market begins to decline, the value of the stocks securing the debt decline as well. When the stocks in the investor’s portfolio no longer support the loan requirements the margin debt is “Called” by the lender. At this point the investor must deposit more cash or sell the stocks. In a falling market this can create an uncontrollable chain reaction. The higher the overall margin debt the bigger the potential chain reaction.

Backbone of our Economy

It is common knowledge that the backbone of our economy is formed by small businesses. It is also widely understood that the stock market is often a leading indicator to changes in our economy.

That being said, it is logical to conclude that investors would keep a sharp eye on the performance of small business stocks as an early indication of potential changes in the stock market.

In a rising stock market, the S-Fund (Wilshire 4500), representing small and medium sized companies, significantly outperforms the C-Fund (S&P 500) which represents large companies. Conversely, the S-Fund suffers higher losses during a falling stock market.

In the chart below you can see that the S-Fund has dropped 1.34% in the last 15 trading days while the C-Fund has risen 1.03%. This could just be a bump in the road but it certainly bears watching.
(Click on Image to enlarge)

Small Business the backbone of the economy