Happy New Year! For me I am glad to see 2015 go. I had a heart injury, a house fire and have been early on several stock picks. Such is life. I survived, nobody got hurt in the fire, I’m back in my house and early doesn’t usually mean wrong if you are patient.

This is very important reading in my opinion, so please get a beverage and hunker down for a half hour. At least one topic I’m going to cover could spawn a book, but I will keep it as short as possible.

 

Average Stock 2015

A Stealth Bear Market

In an article I published on MarketWatch on September 23rd, I declared that “The Bear Market Has Begun.

That article garnered a six figure readership (10-20k is normal) and hundreds of comments. I got the typical responses from indexers who never sell (which is a fine concept if your time frame really is 20 years) to traders who wanted to goose the market higher (it did rally in October) to emotional investors looking for answers they won’t accept (a rational answer doesn’t satisfy an irrational emotion) to conspiracy theories about the financial system, government, industry, aliens, whatever (I’m sure there are some, but not what you think, otherwise it wouldn’t be a conspiracy).

The point of the article was that we were unlikely to have a financial crash or an economic collapse, but that we would get a “normal bear market” with the S&P 500 falling around 30% from its high. I suggested that index could fall to as low as 1200, although I think 1600ish is much more likely.

People have a hard time differentiating between the occurrences I mention above. Many folks think a financial crash, an economic collapse and a bear market are all interchangeable terms relating to the same thing. They are not. Here are my short hand definitions:

Financial Crash — when a market or particular asset — which could be in stocks, bonds, commodities or currencies — experiences dramatic price declines on an order of at least 50%. In general, these crashes are short-term in nature as markets overreact to the downside as much as they often do to the upside. In the intermediate term a reversion to mean is usually what happens. Folks who don’t sell their positions ahead of a crash, should usually do nothing once the crash has occurred. “Losing money” only happens when an asset never rebounds or — as is too often the case with emotional investors — when the investor sells near the bottom and never takes part in the rebound. A crash is scary, so many investors not only sell near the bottom, but also fail to buy when they have cash available to do so with.

  • Bear Market - when a market or particular asset — which could be in stocks, bonds, commodities or currencies — experiences price declines on an order of 20% to approaching 50%. In general, these corrections are short to intermediate length in nature and represent a fairly efficient repricing of assets based upon changing assumptions. Because many people fear a financial crash, they sell their assets near price bottoms hoping to avoid worse price bottoms. The problem is that the vast majority of investors do not re-buy those assets (or replacement assets) at price levels lower than where they sold. So, while they might avoid some short-term price pain, in the intermediate and long-term they lose out on substantial gains. 
  • Economic Collapse — when the economy seizes up far worse than a run-of-the-mill recession (which are simply corrective cycles to periods of slight excess). A collapse includes things like credit freezing up so that people can’t get mortgages or cars and businesses not being able to finance payrolls and capital expenditures. An economic collapse leads to a depression. These are very rare events, but have a lifelong impact on people’s financial psychology. Fear of an economic collapse can lead to a financial crash which could turn into an economic collapse. Central banks around the world are nearly unanimous that to avoid an economic collapse, or at least to respond to one so as to avoid the resulting depression, they will print money to stimulate out of any downward spiral and worry about dealing with resulting eventual inflation later.

An example of a bear market with some assets crashing was the dotcom bust of 2000 to 2002. We saw prices on the stock market fall tremendously. However, the 50% drops were for the most part in the technology space. Most other stocks fell 20% to 40%, merely bear market territory. While we also saw a recession, it was nothing extraordinary, certainly not an economic collapse, and we recovered within a few years. The stock market, excluding technology stocks, rose to significant new highs by 2007. These events happen every decade or two.

An example of an economic collapse with a financial crash was the financial crisis of 2008. The stock market topped in late 2007 and then started to drift down until it cascaded over and turned into a crash in September 2008. The stock market, and many bond markets, in that case were a response to a developing economic collapse that seized up credit around the world and required massive bailouts of banks to avoid a long depression (folks who don’t think a worse depression would have happened without the bailouts are very wrong as it would have taken many years for new lenders to emerge and bring us out of the downtrend). There have been two of these events in a century.

In early 2015 we began to see the makings of a bear market. I wrote extensively about signs of fissures developing in the stock market in the first half of 2015 on MarketWatch. The bear market started decisively on Monday, August 24th when the S&P 500 dropped 5.2% at its worst point from the Friday before’s closing price.

Even before August 24th, we have been seeing a rolling bear market as traders take advantage of the fear in the markets by selling short certain assets that they help create a narrative on using the internet. 

Here let me pause to explain a few things. What I said in the one sentence in that last paragraph is vitally important to understanding the underlying market dynamics right now. I want to break down each part of that sentence:

  • We have in fact seen several parts of the stock market suffer financial crashes. In fact, if we exclude 9NINE — stocks in the S&P 500, the losses are far more substantial and reflect what people are really seeing in highly diversified portfolios. Because the S&P 500 is market cap weighted — meaning the bigger the company the more it counts in the index price — just nine stocks (Facebook, Amazon, Netflix, Google, Salesforce, Starbucks, Priceline, Ebay and Microsoft) have carried that index to about a break-even 2015. Here’s where the average stock really has done by sector and market cap:  Charts courtesy of Bloomberg 

    It is not hard to see that the stock market had a crummy year in 2015. Those who diversified did the poorly. Those who invested in the biggest losers did worse and have not seen a rebound yet. Here I would point to my 2016 Energy Report where I cover the risks and opportunities in energy stocks.
  • The next part of the sentence I am breaking down talks about how traders have been successful at pushing many stock prices down. Certainly many stocks were overvalued and deserving of correction. However, there is a network effect that has driven and continues drive the prices of many stocks much further down than reasonable. This effect comes from a narrative that is painted in the press, primarily the internet and Cable TV, but also radio, that portrays not only a gloomy outlook for the world, but also very specifically targets particular industries and stocks. 

    Here is the short story that really ought to be a book (Michael Lewis are you reading this) that describes how traders use media to drive stock prices down. 

    The first part of the recipe, and really most important, is that the baby boomers are extremely emotional about their money. The primary emotion is fear. Fear of losing again like they did in 2000-02 and 2008-09. That fear is reasonable, however, the actions of the baby boomers are making it more likely to happen in two ways. The first, is that boomers have been selling their stocks for over a year now as they look at charts they don’t understand and believe we must have another crash and collapse. They’re wrong, but more on that later. The impact is less demand for stocks. The second thing that is going to lead to losses isn’t directly stock market related. It is that we are just a few years away from significant inflation due to the combination of central bank money printing and now the massive under investment happening in future commodity production (oil, gas, fertilizer, water, metals…). That inflation will cause dramatically reduced purchasing power. People who aren’t invested in a few types of stocks and commodities soon are going to feel the effects of inflation every bit as much as losing money in stocks, except that once you buy something at an inflated price, your money is gone, at least with stocks, they inflate too.

    The second part of the recipe is that traders, often at the urging of hedge funds, often one degree removed but in close contact with the big investment banks, are very good at planting seeds of doubt in the minds of investors who are too emotional to begin with. They use the internet to create “analysis” that undermines confidence in companies. I have heard of stories where hedge funds pay an “independent” research firm for a report that is in line with their thesis and then release the report on the internet as evidence of their thesis. I have been asked twice to write a negative story on a company and if I get it published on MarketWatch they would pay me (I said “pound sand” or something like that).

    The cheaters use a kernel of truth to create doubts that leads to selling of stocks that drives prices down on stocks they are shorting (betting against). This makes sense, we know the best liars incorporate a little truth in the lie to make it seem plausible. Think about politicians. This sort of manipulation has been around a long time, all the way back to the days of Jesse Livermore (if you don’t know who that is and care to look up the reference, you’ll like the book) and before. The internet has made it much easier to spread rumor and innuendo. Don’t fall for it. No matter what stock prices do short-term, stick with a rational analysis.

    One effect of the cheaters that good investors should keep in mind is that a lot of stocks are very cheap relative to their businesses. A good long-term investor can take advantage by investing in some of the beaten down stocks. The trick is buying closer to the bottom than the middle. This takes emotional stability and deep analysis, but as I see it, there are no fewer than a hundred company’s stocks that could double to triple in price in the next few years.

    Think about this Warren Buffet quote: We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.

    Today almost everybody is fearful and prices are starting to reflect it.

What to Expect in 2016

This is what everybody wants to know. Well here is something you should know. I don’t know. Nobody knows for sure. However, the evidence gives me good idea of what will happen and why, but I just don’t know exactly when.

What I do know is that we probably shouldn’t expect an economic collapse. That doesn’t mean it can’t happen, only that it is very unlikely. People do stupid things all the time and pushing ourselves into a collapse by being afraid of a collapse and acting accordingly mob like could cause a collapse to happen.

I think it an economic collapse is very unlikely though as there just isn’t a big enough mob of folks to create a collapse. The people who believe a collapse are coming have relatively little money to cause that collapse because they’ve been busy buying gold for the last decade that’s lost half of its value in real terms, on top of the fees those paid for the newsletter that told them to buy gold from a high commission brokerage affilitiated with the newsletter — but I digress.

I also know that the central banks have printed so much money and are willing to print more that a collapse is extremely unlikely. I think after some volatility, that the more likely global situation is a very long, very slow growth period that shows moderate inflation with periods of stagflation.

This is where the prices of stocks and other assets come into play. I do think we will see the completion of the already started bear market. Certain sectors of stocks will crash. Some already have, like energy, which is about done crashing.

I am going to cover this in a MarketWatch article, but the reason we are seeing a bear market is pretty simple: world markets are adjusting to what I call “slow growth forever.” As my “Bear Market” report covers (which you can now get free), the combination of debt and demographics simply are preventing a growth to every be what it was before. Governments and many corporations have spent and taken on debt as if we will get higher growth. Alas, they are finding out different and that is holding things back. Here is a chart from my article “Global Growth will Never be the Same:”

Global Growth

Could we see a recession? Maybe, but I have discussed that before too. I think we are likely to get a rolling “skip-straight” recession for several years. That is, slow growth, with the occasional strong quarter and the occasional weak quarter — often the first quarter or second quarter.

Ultimately, this bear market, like all others, will end. Probably sooner than expected since most people are just realizing we are in a bear market that started almost half a year ago. 

A Simple Investment Thesis

In the very short-term, I am heavy in cash and for appropriate accounts, trading in order to make money on declines in stock prices. I am however looking for investments that I can hold for years that will have growth, realization of underlying value and do well in a moderately inflationary slow growth economic environment but not suffer if the economic environment is different (my ex-wife tells me I’ve been wrong before).

I lean towards several types of investments in no particular order and only if they meet very specific criteria:

  • Energy 
  • Alternative Energy 
  • Health Care 
  • Technology
  • Consumer Staples
  • Emerging Markets
  • Industries related to water, agriculture and several other necessities

I invest across all market capitalizations in order to balance portfolios, however, prefer middle size companies which are big enough to survive downturns and small enough to be bought out.

Here’s a chart that I like to show, it’s out of date, but still good. The relationships hold during almost any 20 year period. I like investing on the left side of the chart:

Asset Classes

I’m at my word limit, so will stop here. I have a lot of articles planned for MarketWatch this year, so please follow along there. In the meantime, remember this thing I remind myself of daily:

Direct your thoughts. Control your emotions. Ordain your destiny.” Napoleon Hill

Happy New Year,

Kirk Spano