Perspectives

Predictions for 2016-17 (Updated)

BarronsUpdate:  It is not looking good for my overall end of 2017 prediction.  So far Barron’s average strategist have been correct and they will remain correct until this market resets.

While I did not think it likely, two things happened that I said had to happen for Barron’s prediction for 2016 to be correct.  Medium PE ratios had to move from nose bleed high levels to higher levels – they did. And the mega-cap stocks needed to do the heavy lifting – they are.

Are my predictions wrong?  No.  Just my timing.  Why was my timing wrong? While I was correct in assuming the US Fed was done with creating money out-of-thin-air to buy financial assets this cycle, I did not foresee the other global central banks (BOJ, ECB and China) creating 4 trillion dollars (out-of-thin-air) to flood the financial markets in 2016.

To say the financial tides are riding high on a sea of liquidity is an understatement – it was a tsunami of insanity. As of 30 April 2017, Vanguard reports that the PE ratio for all the US stocks not in the SP500 is sitting at 78.  Yes, 78 times 12-month trailing earnings. Anything over 20 is richly valued.

This comes at a time when US corporations are hitting peak leverage and US wages may begin to put pressure on corporate profit margins. The saying “the bigger they are, the harder they fall” comes to mind when I think about the financial markets, but never before have the financial markets had the support of unabashed money printers buying up supply.

Both the ECB and BOJ just passed the Fed’s 4 trillion plus balance sheet.  Who really knows what is going on in the giant ponzi scheme called China.

Timing is a challenge with unrepentant central bankers.  So at the end of 2017, I may just re-title my post, “Predictions for 2018 – 2019” and not change much else other than a new expectation that we could instead see a series of deep corrections and ever larger central bank “saves” vices one large drop.  The endgame will still be the same, if not worse…


Predictions for 2016-17

Before getting too excited about how Barron’s couldn’t find a leading strategist that thinks stocks will go down in 2016, realize they couldn’t find one in 2015 either – not one. Barron’s forgot to call TSP & Vanguard Smart Investor this year or maybe they did not want us to ruin their unblemished record of always positive forecasts.

 

First my predictions for 2016-17 with some humor intended (note this is a two year prediction).


Predictions

The indexes

  • The SP500 (TSP C fund) will lose 50% from its peak, again
  • The non-SP500 (TSP S fund) will lose more than the SP500, again
  • The Dow Jones Industrial Composite will lose less because it did not run up as much, again

Economist and Wall Street

Economist will maintain the unblemished record of NOT predicting a recession even after we are in a recession, again. Wall Street will maintain their unblemished record of not warning investors of a pending market crash even as they position themselves for it, again.

The Federal Reserve

The Federal Reserve will not take the blame for the current inflationary financial asset boom that leads to the oncoming bust, again. But they will create more “monetary tools” to continue the transfer of America’s future retirement security to repair the balance sheets of their member banks from the losses on loans and derivatives they should not have made… so they can start the whole cycle over, again.

The Market Analyst

Most market analyst will continue to focus on lagging economic indicators completely ignoring the global financial cycle (credit cycle) that has been the real driver the markets, again. Since the cycle has already turned down, monetary policy dabbling will be totally ineffective in stopping it (unless the Fed starts buying into the stock market to prop it up like the Japanese and Chinese central banks have).

The Financial Media

The financial media will increase their negative coverage but continue to present copious amounts of conflicting information and positive opinions and forecasts to freeze most retail investors into their positions until after significant losses, again.

Herding

Retail investors will continue to reduce “perceived” risk by running with herds (chase recent market trends, follow investment clubs/group/forum advice, or worse the financial media) instead of reducing “real” market risk.  BTW, investment newsletters are not much better in terms of herding.

The bottom in the market

When the remaining retail investors finally capitulate in mass (based on apocalyptic projections from Wall Street via the media) a market bottom will be established, again.  CEOs will use this bottom to set their next round of options-based compensation, again.

The Federal Reserve will unleash new monetary tools to transfer any bad debt from their member bank’s balance sheets onto their own, say it is temporary then hold it infinitely and monetize it, again.  But they will balk at the suggestion of compensating pension funds and life insurance companies for their massive loss of interest income from low interest rates.

They will point out the whole point of establishing negative interest rates is to force savers such as pension funds to take on more risk which will lead to (cough) more jobs through higher business investment (cough, cough… and inflate other financial assets so they repair the banks balance sheet again).

Politicians

Politicians will not let a crisis go to waste and quickly pass locked-and-loaded cuts to programs with little resistance from a shell shocked public.  They will insist on draconian cuts to government workers, private and government pension payouts ensuring the real economy never fully recovers.   Bank welfare along with main street austerity will further damage the real economy.  And the Fed can keep interest rates at zero or negative forever – perpetual financial repression.

A Positive Ending

Okay, I can’t end on such a negative note, so… I predict that by the end of 2017 market valuations will be much improved and offer a much higher future return than today.


The Data

First let’s look at the stock market’s valuations based on research from Ned Davis Research. Unlike standard price to earnings ratios, Ned used medium (middle) data points.  This eliminates the effects of the largest companies have on valuations.

Ned Overvalued

By Ned’s method of calculations the market is more overvalued than it was at the last two market peaks in terms of both earnings and sales. In other words, we are back to nosebleed levels.

So for the SP500 to end 2016 eight percent higher per Barron’s leading analyst, one or a combination of things must happen. For medium PE ratios to maintain these nosebleed values, earnings must grow significantly in 2016.   The two challenges to this are we have already been hitting record level profit margins and the global industrial recession has not fully expressed itself. If earnings do not climb significantly, then PE ratios must climb beyond nose bleed levels.

If the mega-cap stocks within the US indexes advance by 20% in 2016 and the rest of the market remain flat, we could get there. These 50 companies while only 1% of the US publicly listed companies account for 50% of the market value of the total US stock market.  In late 2015, it is the mega cap stocks that held the SP500 up while small and medium sized companies as a group have declined.  So theoretically it is possible, but that does not help small cap funds like the TSP S fund.

Another challenge is the largest buyers equities of late are under stress. Global sovereign funds have shifted from buying to selling in 2015 to balance their government’s budgets due to declining oil and commodity revenue.  Corporations – the largest buyers through buybacks – are going to find higher costs to borrow due to rising interest rates and unwillingness of lenders to extend more debt to over-leveraged companies.

 


 

Final Commentary

The central banks not only failed to control the run-away credit boom that ended in the Great Recession, they encouraged it. And since all credit booms end in bust, both banks and households were left insolvent as asset prices fell below underlying loan values.

Very little of the Fed’s monetary largeness since 2008 transmitted to the real economy and in my view limited the recovery.  Remember, the business cycle existed long before the Fed existed to save us from it. The Fed’s policies did conveniently did transmit to re-inflating asset bubbles in order to repair balance sheets.

The Fed is presently trying to “normalize” monetary policy without deflating financial asset bubbles.  They cannot achieve both which may explain why they did not follow normal policy and drain any of the excessive reserves.  Instead they managed to figure a way of paying the banks an additional $7 billion in interest on idle reserves.   Which makes one wonder if they really tighten or did they pretend to tighten so they can blame tightening?

Once the financial markets falter enough, the Fed will reverse course which will be easy since they never really pulled the trigger.  Credit cycle busts by their nature are tightening which is why the Fed is already pondering negative interest rates.  Negative interest rates will be about as successful as trying to keep a over-inflated balloon inflated after it pops.  But no worries, the Fed has a lot of experience and tools for mopping up their popped bubbles.   It’s the mop that worries me.