Chickens Coming Home To Roost

The most remarkable fact the emerges from the chart of the Dow Jones Industrial Index below (source bigcharts.com) is that volume has been falling since 2009

In reality, because much of the actual turnover is related to the so-called “dark pools” which give rise to unreported algorithm based trading, what this implies is that a higher and higher proportion of total turnover has been technical (and speculative) in nature – paying little heed to underlying fundamentals.

But the OBV chart above has been flashing a warning: Since early 2014, the market has been rising whilst, on balance, there has been little buying pressure. What this implies is that “investors” (genuine investors) have been growing increasingly cautious.

In the past few weeks, the bond markets have also been flashing warning signals – possibly reflecting nervousness about consequences of a potential Greek default. Below is a chart of the 10 year bond in the US (courtesy stockcharts.com)

Interestingly, since February, the yield has risen from around 1.7% to 2.4%

As a consequence of rising yields (in the US and Europe) significant capital must have been lost (on paper) in the bond markets – which are largely populated by institutional investors who are not prone to panicking easily.

Nevertheless, the “mood” in the investment world is bound to be influenced by the bond markets.

The following chart shows the P/E ratios of the S&P500 (courtesy http://www.multpl.com/ )

Looking at P/E ratios through the prism of history, we can see from the above chart that since the 1980s when the world’s Central Banks began to loosen the purse strings, P/E ratios have risen from around 7:1 to 20.46:1. (The spike in 2008/9 arose from the temporary collapse in earnings following the GFC)

But let’s keep focussed on the main game: If the air is about to escape from the financial bubble, then (assuming corporate profits remain steady), the stock market could fall by around 25% if P/E ratios fall to around 15:1. However, if the developed world enters a period of deflation, driven by debt defaults, then it is possible that corporate profits might shrink on a global level and, if that happens, P/E ratios in the US might fall to around 10:1 or lower. Such a fall might well result in a greater than 60% fall in stock prices from their current levels.

How does one protect one’s “wealth” in an environment of collapsing bond and stock prices and contracting corporate profits?

Frankly, common sense dictates that debt is a serious “no-no” under such circumstances. Mortgaged property is likely to deteriorate in price as interest rates rise, and this will have a serious impact on home equity as well as on the value of commercial and industrial property.

Gold does not pay interest, so why would one “invest” in gold if it yields no income?

Well, if one has wealth that is surplus to one’s needs then it is clear that gold will hold its value and, if there is a loss of confidence in the global financial system as a whole then gold will probably represent a safe haven during the storm. From that perspective, gold will act as an insurance policy.

However, the chart below – which is a ratio of the gold price divided by the US Dollar Index (courtesy stockcharts.com) shows a different set of facts:

This chart is a 5% X 3 box reversal Point & Figure chart that, because of its scale, eliminates all the trading “noise”. It clearly shows that gold as an investment is now less preferred than the US Dollar.

On the other hand, how one interprets this chart is dependent on where one chooses (subjectively) to draw the trend line. If, for example, one chose to draw the 45 degree trend line beginning in 2003, then one might be tempted to argue that what is happening is a “gut reaction” to the global financial crisis. In terms of this argument, investors are assuming the financial markets hold together, and have concluded that the best place to park one’s capital is inside the United States financial system.

It follows that the price of gold is ultimately dependent on whether or not the Central Bank denominated systems hold together. If they do, then gold will probably continue to fall relative to the dollar. However, if they don’t, then the price of gold might “catapult” upwards from a level of anywhere between $1,076 (the next support level which happens to also be on the blue trend line) and $1,171 (its current price) – see chart below (courtesy stockcharts.com)

How this will help Mr & Mrs Joe Sixpack is hard to fathom. From Joe’s perspective the primary thoughts that will be occupying his mind will revolve around food, clothing, shelter, safety and education of his children (maybe).

From Joe’s perspective, the most sensible thing he might do is pay off all his debt – even if it means that he has to sell some “surplus” assets at today’s inflated prices. If he doesn’t have surplus assets then he is likely to be faced with some serious challenges.

In particular, Joe will have to focus on is “income”. Where will he be able to generate income?

The answer seems to lie in two areas:

The money markets are showing rising interest rates. If he has any surplus cash capital he might invest it in the short short-term with a “stable” institution. That will represent one source of rising income; but the issue here will be counterparty risk. Where will his money be safe?

Joe will need to seek out training in new skills if he wants to find a job because there are elements of the economy that are emerging as fast growing “drivers” of the economy. But in the latter regard, one needs to differentiate between goods and services.

If one studies the chart below – of the Baltic Dry Goods Index (source http://www.investmenttools.com/futures/bdi_baltic_dry_index.htm ) – whilst it may bounce back up towards its 200 day Moving Average (green line) it seems that the traditional markets for “goods” will not be driving the global economy for the foreseeable future. (As at today’s date it was just over 600)

Paradoxically, this might actually be interpreted positively. With miniaturisation, and if consumers switched their attention away from quantity and towards quality, the world might experience a reduction in “frenetic” economic activity and a shift in personal values towards a higher quality of human interaction because people will tend to become more time rich.

Two fascinating facts that have come to the attention of this analyst are:

The general deterioration in revenues of fast (junk) food groups like McDonalds, KFC and others

The “explosion” of cooking related TV programs which are encouraging people to get back to eating at home – and probably with better quality food at a lower cost.

So, assuming that the world will continue to revolve around its axis, and even if the nature of the financial environment changes, where can Joe expect to find a job and, if he has any savings that he might wish to invest, where can he find superior returns on investment?

Of interest is that people under pressure typically adapt. Just as Joe will need to adapt, so will entrepreneurs and businesses adapt. Even as the market size as a whole stagnates and/or shrinks, segments within the market tend to grow as entrepreneurs adapt to changing circumstances.

For example:

Agriculture will adapt to changing eating habits. With a shift towards “fresh” and “nutritious” foods, market gardening will move closer to the cities and may even occur on the roofs of high rise buildings and on public land such as parks. By contrast, broad-acre and paddock farming of staples – meats, grains, legumes – will become more efficient as a consequence of better information flow regarding the drivers of yields per hectare.

Health services will adapt to deliver more medical bang for one’s buck – via personalised medicine (more effective diagnostics) facilitated by mega-databases; and via electronics based miniaturisation;  and via shorter hospital stays facilitated by home monitoring over the internet

Robotics will free people from time “wasting” activities, and allow them to focus on value-add activities with an emphasis on organisational work and creative problem solving Energy consumption per capita will very likely fall as a consequence of better management techniques (facilitated by electronic monitoring) and there will be a continuing move away from fossil fuels. The worlds’ transport infrastructures will adapt to waning availability of fossil fuels and, within stagnating car and truck industries there will be a shift in market shares: Electrically driven vehicles powered by batteries topped up by centrally generated electricity – very possibly a mix of solar and Gen IV nuclear.

Mag-lev bullet trains – also powered by centrally generated electricity – will reduce the need for short distance flights within countries and facilitate the opening of previously unoccupied land at a distance from the cities.

Ships will likely become nuclear powered by implication, some energy related investments will boom whilst others show poor returns.

Governments will need to respond to the needs of the homeless. This will be both economically stimulatory and at the same time very likely change the way homes are designed and constructed.

Sport and entertainment will become “refuges” for relaxation and there might well be an increase in the proportion of total personal income spent in these areas

The above is by no means exhaustive but it serves to illustrate the principle that it is highly unlikely that the world will stop revolving on its axis regardless of what happens in the financial markets. What will have to change is “value hierarchies”.  Generally speaking people will need to contemplate their navels to determine what they think is really important in their lives. Perhaps owning ten different pairs of shoes will come to be seen as relatively unimportant; just as it will become unimportant whether the brand labels of one’s clothing is sewn on the inside or the outside of the clothes.

Conclusion

There can be no doubt that the world is approaching some sort of “catharsis” point which, if one is flexible in one’s outlook, may not be a bad thing. Those who are unable to adapt to the need for changes in behaviour will very likely be wiped out. Those who are smart enough to adapt in advance of the catharsis will likely be relatively unscathed. But one thing is certain: The age of “speculating” to earn a living is drawing to a close. There is no such thing as a free lunch and the chickens are coming home to roost for those who believed that there was such a thing. It is not “money” that drives the economy; it is “value-add activity”

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Brian Bloom

Author, Beyond Neanderthal and The Last Finesse

www.beyondneanderthal.com

Tea Gardens, NSW, Australia

www.beyondneanderthal.com