by Preston Pysh
So I’ve wanted to write down my thoughts on the current market conditions for a few months. Here it is.
First and foremost, I have to admit that most of my thoughts have been drastically shaped by billionaires Ray Dalio and Warren Buffett. The reason I’ve focused on these two gentlemen is because I feel like they are the two greatest thinkers in the world for macro-economics and micro-economics. I base that opinion on the sheer net-worth they’ve amassed by exercising their distinctly different approaches. Although I got my start by learning about Warren Buffett and his value investing approach, I’ve tended to focus more on Ray Dalio in the past year. The reason my attention has been drawn to Dalio instead of Buffett is because the circumstance we face in today’s economy is macro-centric. In fact, this might be a very bold statement, but I think Warren Buffett might be making a mistake with his two recent acquisitions during the summer of 2015. You see, the global economy has been in an intense battle since 2008. The battle is against deflationary pressures.
As many know, Ray Dalio is famous for his “Economic Machine” video, where he lays out the premise of a much larger market cycle that captures and collects the smaller business cycles that most people are accustomed to. Here’s a link to the video if you’ve never seen it. The challenge we are faced with today is that we’re at the very end of a much larger market cycle. To only compound the problem, it’s not just a United States problem, it’s a global problem. Since 2008, the world has added over 50 trillion dollars of new debt to the pile. This has only compounded the fundamental problems that already existed. This means something’s got to give.
Although the outcome of this super-cycle is insanely difficult to predict and determine, one thing is certain: Central banks will need to continue devaluing fiat currencies in order to keep the global economy afloat. How long? I have no idea, but it seems like it might be a real long time. The reason they need to devalue currencies is because they can’t drop interests rates any lower in order to induce spending.
Spending is the key element here. As long as people continue to spend, the market cycles will expand. But as credit expansion slows and starts to contract, spending and asset prices go with it. I suggested that this fundamental shift in the credit expansion cycle started to stall and reverse itself at the end of February 2015. Here’s the video in case you’re interested in watching it. Just so you know, the stock market hit it’s all time high of 18,300 on the Dow 3 days after I made the video.
So if we are in fact at the early stages of a global credit contraction, what does this mean for the coming months? Well, I think it’s bad and getting worse by the day. The market has already pulled back more than 10% since the end of February 2015, but I truly believe we have just started to see the beginning of an enormous market contraction.
Does this mean I think we are going to see a stock market crash next month? Maybe, but at the same time, I have no idea. Stock Market crashes typically need a strong catalyst to create a massive pull-back. This would be something like a high number of defaults in the junk bond market (which I think is fast approaching). Because it’s very difficult to know when numerous companies are going to ultimately fail – due to credit defaults – I’m simply suggesting that the market will continue to be volatile and gradually slide down until a fundamental break occurs.
A few of the major factors contributing to my bearish opinion:
1. The dollar
a) Domestically – the strong dollar is punishing US businesses. Consider this, almost 50% of the top line for large cap businesses come from overseas currencies, imagine the difficulty US companies have as they convert those revenues into dollars. I know with my personal business, it’s had a noticeable difference. I can only imagine how it looks for major players handling billion dollar contracts. If the 3rd quarter 2015 comes in strong for corporate earnings, I would be flabbergasted. I just don’t see how that could possibly happen. And don’t forget, the market values business in the short term by the delta between their earnings expectations and their actual reported earnings.
b) Emerging Market – One of the most troubling pieces of the puzzle is the difficulty emerging markets and international countries are having while servicing dollar denominated debt. Think about it. If you are china and you’ve borrowed money in US dollars, think about how fun it will be to pay those coupon payments. This piece of the puzzle is enormous and probably one of the biggest concerns because there’s an unprecedented amount of dollar denominated debt in the world. Those payments aren’t getting any easier to pay as the dollar continues to surge.
2. Flight from Junk Debt
During the past 3 years, investors have been hungry for yield. One of the big illusions was the high yield debt market – or junk bonds. These things were like a bright light on the porch in the middle of a hot summer’s night, and the mosquitos where the investors chasing 6-8% yields. Well, guess what, people are jumping off this high yield debt faster than those brilliant actors in Titanic. So this is the key point. When people leave the high yield bond market, what happens to the yield? That’s right, it goes up. As the price goes down, the yield goes up (assuming it’s actually paid). Now, think about the implications of this dynamic if you are an oil company and you’re highly leveraged. Now think about what kind of interest rate you’re going to get during the next round of funding you need to keep the lights on. Yeah that’s right, the new borrowing is going to be at a higher interest rate. That’s not good. The separation of yield (from safe bond yields) in the junk bond market is going to have very bad consequences for issuers and buyers of junk debt.
So this is a big one. Think of oil as the crazy lunatic that’s giving you the screaming indicator that something is wrong with the engine. For anyone that was an investor during the summer of 2008, I’m sure you’re getting similar vibrations to the insanity that ensued when oil prices surged to $150 and everyone on Wall Street was saying it would go to $200. Just so you know, the market crashed the next month. So a few things have happened since then, manufacturers flooded the market after the 2008 crash because who wouldn’t want to pull oil out of the ground for $50-$70 and sell it for $100+. That’s what they experience prior to the last crash, so who wouldn’t expect $100+ oil to return. Well the problem with the enormous desire to produce is that it knocked the entire global oil supply and demand out of balance. I talked about this concern and my decision to sell all my oil positions in early November 2014. Here’s the episode. As oil continues to stay below $50 a barrel, Calgary and all these other oil producers can’t compete with the Saudi’s $10 marginal cost. This over supply and under demand is a function of market share. These companies are fighting for market share and they aren’t going to stop until there’s blood in the streets. Remember, when companies default, the credit/money disappear. When money disappears, spending is less and asset values go down.
Since May 2015, I’ve been telling people on the podcast that China is the story. I was blown away by the total lack of discussion for more than a month by major financial news sources on the subject, but I think people are finally starting to understand that China is a major player. For example, China has been providing 30% of the global GDP growth. When that stops and violently contracts, guess what…it has huge implications. The entire system is completely interconnected so for analyst to think that China doesn’t matter, they simply don’t understand the larger market forces. To think that credit/money isn’t disappearing in the Chinese markets is delusional. It is disappearing and defaults are occurring. The books were cooked on many companies and the foreign investors are nowhere to be found. I don’t trust the Chinese government and neither does the rest of the world. Good luck controlling the flight of capital, as more Yuan devaluations are likely around the corner.
5. US FED Policy
a) So the FED is hell-bent on raising rates. Stanley Fisher (the #2 guy) has basically said he doesn’t care about the lack of inflation, they are going to raise rates this fall. If that’s actually true, it only amplifies the stronger dollar, the weaker oil, the pressure on the Yuan, and the pressures in the junk yield spread. The current US FED Policy is likely to add more magnitude to the chaos. That sounds like a mess.
b) Additionally, the FED doesn’t have any room with interest rates to ease and help stimulate spending. The only option at this point is QE and devaluing the dollar to simulate spending.
6. The New Tech Bubble…
7. College Loan Debt…
I could easily post more about why I’m a bear and have been since the end of February 2015. I guess this is the question I’ve got for the bull investor. What’s the upside? I mean seriously. Where in the world is the upside going to come from?
Now back to where I started. I’m at odds with my analysis. I can’t make sense of anyone buying equities in this market. I think we are getting ready to have a major run on liquidity. While I say that, and lay out all the reasons why, I look at my micro-economics grand-master, Warren Buffett, and the guy is increasing his position in equities by 36 billion dollars over the last 30 days. What in the world am I missing!? Does he know something that the rest of us don’t, or is he making an enormous blunder?
P.s. I find it ironic that Ray Dalio has basically come out and said the long term debt cycle is now starting to take over and the FED is totally missing the boat. Here’s the article.
P.s.s. As usual, I want to hear why my analysis is wrong. If you’ve got some comments or questions about this post, be sure to leave it here on our forum.