I’ve spent my investing career accepting improbable events when the world thinks such events are impossible. I’ve also spent a lifetime hiding from popular investment ideas. Often, when contemplating unpopular investing ideas, you don’t have to get the timing right—you just have to be early enough to be prepared for them and avoid becoming trapped looking the wrong way.
I remember back in early 2009, when I told people that QE would solve all financial problems—at least in the short term. People laughed at me—at the time, the banks in America alone had something like $1 trillion in negative equity and it looked as if the financial system would come apart at the seams.
Fast forward five years, in the past few weeks, I’ve had all sorts of people tell me about how QE means that the market goes up forever—as if this were simply a guaranteed fact. Many of these people were the ones fretting about 2009 and selling at the lows. I actually cannot find anyone who worries about the current environment. Sure, employment is terrible, earnings are a mess, housing is rolling over and most businesses are not growing much, but no one seems to care. All that matters is that the Fed prints money. I’ll posit that earnings eventually matter—they have to.
What do market tops look like? They exhibit many of the following traits;
-Investors who are blissfully unwilling to look at negatives.
-Totally lopsided bullish investor sentiment for months at a time.
-Repeated equity offerings (IPOs and secondary offerings) of unprofitable and marginal businesses at valuations that are beyond insane.
-Elevated and increasing margin debt.
-Investors repeating silly mantras. In the late 1920’s investors were convinced that prohibition made workers more productive because they were sober. In the 1990’s investors were convinced that there was a “New Economy” based on technology. Today, investors believe that QE means the markets go up—just because that has been the case for the past 5 years.
Do I think that the markets drop any time soon? I don’t know. However, I think that today is a very dangerous time to be investing and I am on the lookout for the end of this rally. What will those signals look like?
-If this whole rally is based on the Fed cornering the 30-year bond market, I’d start with following that. Why is the bond market starting to leak? After a 20% decline, why can’t it rally—even with Janet Yellen saying (threatening really) that QE as currently envisioned hasn’t gone far enough? I’ve written in the past that as a bond investor, the Fed has your back. I’m starting to wonder if that will be enough.
-Housing was the leading indicator in the 2008 crash—the Fed created an epic housing bubble that popped. QE led to a 3-year echo rally. Property prices started to leak this summer and a small leak is starting to become a flood as hedge funds suddenly realize that owning thousands of single-family properties isn’t a business—it’s a hobby. Without this prop to housing prices, where is the actual market? Watch some of these newly created housing REITS as they come undone.
-The 2008 property bubble was mostly based on residential property. The current bubble extends to commercial property. VNQ (Vanguard REIT ETF) has declined almost 20% from the peak this summer. REITS cannot seem to rally since then. Property prices drop for two reasons; interest rates rise, or rents decline. Interest rates are clearly rising—are rents also declining? Some of the most popular mall retailers are getting destroyed. If consumer spending trails off, so will rents.
-In 2008, people started piling into gold out of fear of QE—leading to a near tripling in gold prices. Gold has now declined by nearly a third from its peak. Ironically, QE worked so well, that investors forgot why they owned gold in the first place. In investors’ minds, the economy is nice, inflation is tamed and the Fed shouldn’t be feared. Watch gold—it will eventually catch a bid.
In summary, I am not predicting an imminent collapse. I am however perturbed that so many people seem to think that QE will lead to continued upside without risks to the downside. Everyone points out Venezuela, Mexico, Argentina and other countries where money printing led to continual and rapid equity price increases. They forget that John Law doubled the money supply in a single month and it did nothing to resurrect the Mississippi Bubble. In the end, the Mississippi was a swamp with little value in 1720—printing more money, only accelerated the bust as investors lost faith in his securities. In an open market, money can escape a crisis. The money isn’t trapped in the S&P.
Once again, I’m not predicting a market decline—but unthinkable thoughts tend to pay off very well if you are early to recognize the change in sentiment. Make your own list of indicators and become cued in if they begin to change.