November 2013 Investor Letter

Model Portfolio Update

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Executive Summary

If you strip out the impact of inflation, US stocks are as expensive today as they were just prior to the tech bubble bursting in 2000 and the housing bubble bursting in 2007. You would have to go all the way back to 1982 to see the last time that the stock market was truly undervalued. Investor appetite for high flying tech stocks with no earnings (Twitter) is a great barometer of the current mood. Margin debt, which measures hedge fund borrowing to invest in the stock market just hit a new all time high of $401 billion. The extent of the borrowing is now higher than the two prior peaks in 2000 and 2007.

Bonds have been a great safe haven every time stock markets have corrected. That safe haven status may be coming to an end, though it is a little too early to tell just yet. If bonds fail to rally in a meaningful way on the next big correction in stocks, I will be taking action in the model portfolio, by reducing the allocation and duration of the bonds held. I have already identified a better home for the capital and will be sharing that with you in due course.

Gold continues to search for direction. Gold bottomed in June 2013 at $1,180, rallied to $1,400 over the summer and is now in the process of testing the prior lows. A successful re-test will signal a trend change for gold investors and a strong indication that the 2 year bear market in precious metals is at an end. 

Equity Market Update

Equity market cycle count

"We are in the middle of a kind of bubble market and when they prick the bubble, there will probably be a pretty bad reaction. "
Julian Robertson, hedge fund manager, October 2013.

A few months back, Leon Black, founder of private equity firm The Apollo Group, told investors he was selling everything that wasn't nailed down. This month, retired hedge fund manager Julian Robertson of Tiger Management also passed judgement on the bubble-like characteristics of today's stock market, as did Paul Singer of Elliott Management, another kingpin of the investment industry. Singer noted last week that:

"the recent trading environment has felt like walking into a place and having a sense that something is wrong and dangerous but not knowing exactly what will happen and when. QE Infinity has so distorted the prices of stocks and bonds that nobody can possibly determine what the investing landscape would look like, or what the condition of the economy and financial system would be, in the absence of Fed bond-buying. 

It is also not clear whether stock prices, which are still on a tear and at all-time nominal highs, are at these levels because of optimistic economic prospects, QE, or the beginnings of a loss of confidence in paper money causing a shifting of capital out of fixed income and into purportedly “real” assets. It appears to us that the Fed is basically paralyzed and afraid to reduce, much less eliminate, its bond-buying. In this environment, plain-vanilla ownership of stocks or bonds represents a highly conjectural bet on government-manipulated markets."

Those that continue to hold an overweight position in stocks please take note. 

There is no doubt that equities are expensive today. If you strip out the impact of inflation, US companies as measured by the S&P Composite Index, are as expensive today (Fed bubble) as they were just prior to the tech bubble bursting in 2000 and the housing bubble bursting in 2007. As you can see in the chart below, the stock market has only reached fair value (grey line) once since the mid-1990's and that was briefly in 2009. For the entire remaining period, the stock market has been expensive (red line) relative to corporate earnings. You would have to go all the way back to 1982 to see the last time that the stock market was truly undervalued (green line).

More stocks are trading above 3 times their book value today than at the stock market bubble peak in 2000.

Investor sentiment is also approaching a bullish extreme. Investor newsletter writers for example have rarely been more bullish about the future outlook for stocks than they are today. Every time investor sentiment got this stretched, a correction was not far ahead.

A great example of the extent of the current level of investor optimism is captured in the following chart. Here we show margin debt reported by the NYSE, which has now reached a new all time high of $401 billion. Margin debt is a measure of borrowings by hedge funds and speculators to invest in stocks. The extent of the borrowing is now higher than the two prior peaks in 2000 and 2007.  

Margin debt used by hedge funds and speculators has reached a new all time record of $401.2 billion. 

Retail investors are also getting in on the act. Recent data from the Rydex family of funds shows that Rydex cash fund holdings have fallen to very low levels today, while money is pouring into the stock market. Lipper data recently showed that investors have contributed a net $41 billion to equity funds and ETF's over a three week period in October. Going back to 2002, that exceeds the prior three-week record inflow by more than 17%.  

So, we have a quite a dangerous combination of an overvalued and overbought stock market with overly bullish investor sentiment. The uptrend can of course continue in the short run as momentum feeds on itself and in the short-term, the stock market still looks bullish. Despite being overvalued, overbought and sentiment being overly bullish, we have yet to experience any real selling pressure. 

What could trigger a selloff in the stock market? A medium-term peak in corporate earnings could be the tipping point. Corporate earnings peaked in 1999 in the midst of the tech bubble and peaked again in 2007 as the Fed-inspired housing bubble burst. It could be third time unlucky for equity investors as corporate earnings mean revert once again. This time however, there will be no support from central banks to lower interest rates. Short-term interest rates are already 0% in the US, EU and Japan.

S&P 500 real earnings growth has recovered since the 2008 financial crisis.

 

Equity market volatility has been on the decline since 2009. That trend appears to be changing.

The Vix Index, a measure of stock market volatility, is preparing for a breakout.

Bond Market Update

Bond market interest rates

Is QE losing its effectiveness? Despite the Federal Reserve printing $500 billion since May and using the proceeds to buy US government bonds, US 10 year government bond yields have risen  by 140 basis points from 1.6% to 3.0% in September before backing off a little last month. If money printing at the current extreme is no longer working to keep interest rates at record lows, then the bond bull market / bubble, which has been in effect for over 30 years, may be at a serious inflection point. Despite the record money printing, the bond market may have begun to price in a more inflationary outlook in our future. 

I want to see how bond markets react on the next big down move for stocks, which I continue to believe is directly ahead. Bonds should benefit as capital moves back to safe haven assets. If bonds fail to rally in a meaningful way, I will be taking action in the model portfolio. In any event, early in the new year, I will be looking to reduce the allocation and duration of the bonds in the model portfolio. I have already identified a better home for the capital and will be sharing that with you in due course.

Gold Market Update

Gold market cycle count

Gold bottomed in June 2013 at $1,180, rallied to $1,400 over the summer and is now in the process of testing the prior lows. A successful re-test will signal a trend change for gold investors and a strong indication that the 2 year bear market in precious metals is at an end. 

Although the past two years have been trying for the gold bulls, the fundamental case for owning gold continues to get stronger. I believe the bull market in precious metals is still intact. We are experiencing a vicious bear market within a bigger bull market. The current bear market is resetting sentiment, which will provide the fuel for the next big move higher. When will it happen? Nobody knows for sure, but I think we are getting very close now.

Fundamental Case

Money printing by all the major central banks continues at a pace never before seen in the western world. The US recently raised the debt ceiling once again which will allow them to continue to fund their deficit by printing money. The recent appointment of Janet Yellen as next Fed Chair is also very bullish for gold longer term. The supply of fiat money is limitless; the supply of gold is finite (and falling). Bull markets are hard to hold on to. Gold acts as the ultimate foreign exchange, has no counterparty and physical bullion is difficult to tax by governments. Gold will have its day but investors have to remain patient.

Technical Case

Since the June low of $1,180 gold has rallied to $1,434 and fallen back to $1,275 so far. If gold can move higher from here it will have made a higher low and that is constructive; the first time it has happened in over 2 years. Ultimately gold needs to get back above the declining 200 day moving average to confirm the bull market is back on track. The 200 DMA is currently $1,440 and falling. We need to see continued strength here before burnt investors will start to wade back into the sector.

Sentiment

The pessimistic mood in the precious metals sector is unprecedented. The vast majority of investors have thrown in the towel. Many are calling the bull market over and shorting the sector now. All the big investment banks are confidently predicting much lower gold prices for years to come. There really are very very few bulls left. This level of negative sentiment sets the scene for the next leg higher. 

To learn more about the full range of investment services available at Secure Investments, please contact Brian Delaney by email at brian.delaney@secureinvest.ie.