Today’s economy is far more fragile than you may believe…
By Dan Denning
If you’re an investor, the kind of move that should worry you isn’t a correction like we saw in February. The S&P 500 Index’s 10% pullback was the fastest such correction ever, according to Ryan Detrick of LPL Financial Research. And the Dow Jones Industrial Average’s 10% correction was the fourth-fastest since 1897.
But if you got worried then: You ain’t seen nothing yet.
What should concern you is a cyclical peak, the crumbling of a great mountain of leverage (margin debt), and an even greater mountain of speculation (not to mention a whole continent of mindless buying of overpriced tech stocks via passive index-tracking and exchange-traded funds).
What should worry you is a complete reset of the American financial system.
Our system is burdened by massive and unpayable public debts and governed by inept and corrupt policymakers. They added another $1 trillion to the national debt in the last six months.
And late last month, both houses of Congress were presented with a 2,300-page “omnibus” spending bill for the federal government. They were given less than 24 hours to read it before voting. What’s included?
• There’s a total of $1.3 trillion in spending, more than in any single year in the Obama era.
• $700 billion in spending on defense in 2018 and $716 billion in 2019, which is more than 36% of the global total, according to Forbes, and more than the combined spending of China, Russia, Saudi Arabia, India, France, the U.K., Japan, Germany, South Korea, Italy, Australia, and Brazil.
• a $200 million increase in funding for the IRS for a total of $11.43 billion (in 2018 alone); $300 million in funding is dedicated to implementing simplified forms and procedures from last year’s tax cut…
• and the border wall? It’s funded to the tune of $1.6 billion for a 30-mile stretch.
Does that sound like draining the swamp to you?
Today, our financial system is troubled. It’s a system where phony quantitative easing (QE) money has pumped up stock values by no less than $10 trillion over the past 10 years.
What should worry you is a complete reset of the American financial system.
A system where sound money is a dead concept and cash is headed to the gallows.
The 10% correction in February is a small preview of how quickly something more severe could happen. The speed of the move proves how fragile the market is. There’s more where that came from.
Think of this as a dress rehearsal.
Not to beat a dead bull, but the February correction was easy to see coming. And we’re not out of danger yet. If you look back at stocks in February, you see that all of the valuation metrics were off the charts.
They still are.
The Big One
And there’s plenty of reason to think there is room to fall.
The market-cap-to-GDP ratio peaked on January 26 at 150.8%. Even after the correction, it stands at 143%.
Robert Shiller’s cyclically adjusted price-to-earnings (CAPE) ratio, which looks at the current price of the S&P and compares it to average earnings over the past ten years, is at 31.8. The all-time high is 44.19, reached in December 1999. Stocks are still expensive by historical standards. Very.
And margin debt hit $642.8 billion in December 2017, according to the Financial Industry Regulatory Authority (FINRA).
The NYSE, incidentally, no longer keeps margin debt data on its website. But net margin debt, or margin debt as a percentage of the total market value of NYSE-listed stocks, hit 1.31% in December 2017. That was a new all-time record. The previous record was 1.27% in 2000, according to Goldman Sachs. The data go back to 1980.
By the way, there are several versions of what’s called “the Buffett Indicator.” The one I prefer is dividing the market capitalization of the Wilshire 5000 (around $28 trillion) by the most recent nominal GDP number from the U.S. Bureau of Economic Analysis ($19.3 trillion). See chart below.
No matter which one you use, they all show markets being overvalued.
Source of Trouble
They may be boring, but if you want to know where trouble is coming from, you’re going to have to watch interest rates. The meeting notes from the January 30–31 meeting of the Federal Open Market Committee (FOMC) were received “hawkishly” by investors.
By that I mean there was nothing in them to change the belief that the Federal Reserve could hike interest rates three or four times this year (presumably by a quarter point, or 25 basis points, each time).
And during his first FOMC meeting in March, Fed chair Jerome Powell did announce a quarter-point rate hike.
Goldman Sachs reckons if the 10-year U.S. Treasury rate gets to 4.25% by the end of the year, stocks could fall by 25%. That’s an overly complicated way of saying that debt is a drag on growth. When credit growth slows and rates go up, debt gets more expensive (and outstanding debt gets more expensive to service).
If that sounds gloomy, the below chart from the Fed confirms it. The gray lines on the chart are recessions. You can see that nearly all of them are preceded by a cycle of rate rises by the Fed.
We’ve had six quarter-point rises in the federal funds rate since 2015. How many will it take to cause a recession? See chart below.
Now is the perfect time to start “definacializing” your life.
That means reducing your exposure to an overly complicated financial system that, either because of outside attack or its sheer complexity, is prone to collapse.
Five Ways to Prepare for the Next Crisis
Below, I’ve shared five tips for preparing for an uncertain future. They’re a way to help you prepare for the unknowable future. I practice these habits in my own life, and I find myself all the better for it.
They don’t make me any wealthier. But I think they may give you a bit more peace of mind when you’re dealing with a turbulent system.
Defer consumption no matter what. Save more than you think you need to. It’s a good moral habit, too. When you defer consumption, you accumulate capital. You resist the urge to gratify every desire. As the Stoic philosophers would say, you free yourself from enslavement to your passions.
A little walking-around money. Carry enough cash on you each day to eat a meal or get a cab ride over a long distance if you need to. You never know when the cash machines will break down or you might not be able to get back to your home.
Cash insurance. Have enough accessible savings (in cash) to survive for six months if you lose your job or are ill. If this seems insurmountable now, see rule number one above. Americans have fallen into the dangerous habit of mistaking full grocery store shelves for wealth. We ARE a wealthy culture. But don’t live with “just-in-time” cash management.
Establish a family disaster-recovery plan. Each of your family members should know how to contact one another in the event of an emergency which affects any or all of them. They should know important phone numbers, addresses, and, if necessary, the name of a family friend or lawyer to contact in a legal or medical emergency.
A “bug-out bag.” You may not have heard of a bug-out bag. And if you haven’t, it may sound a little crazy. But I can assure you it’s not as crazy as you think. Events that disrupt the routine of normal life across all of society rarely happen, even at the most extreme times in American history. But they DO happen.
February’s correction was just a dress rehearsal. The main event is yet to come…
The “bug-out bag” is just a reminder that in a real crisis, the value of your portfolio may be the least of your problems. Like the first-aid kit in your bathroom or the spare tire and road flare in your car… it’s the sort of thing you hope you don’t have to use… but shouldn’t be without…
A few things to get you started for the bug-out bag are…
• A bag (obviously)
• A first-aid kit
• Contact names and addresses of friends and family members
• Food and water
• A multi-tool
• A change of clothes
• Hygiene items (toothpaste, hand wipes, etc…)
Don’t wait for the bang. Use this time to implement what we’ve suggested.
As I mentioned earlier, February’s correction was just a dress rehearsal. The main event is yet to come…
Dan Denning is the co-author of The Bill Bonner Letter. Every month, he and Bill Bonner pen their contrarian thinking to provide insights you won’t find anywhere else. Dan was also a founder of Southbank Investment Research, the leading independent financial publisher in the U.K.