““I can calculate the motion of heavenly bodies, but not the madness of people.””
Tom representing the USA in Algarve, Portugal on 4th of July.
My right-hand-man, Tom, was on vacation in Portugal for the first couple weeks of July. And I had a 15-ton pile of rocks dumped in my driveway on Saturday morning. I’d guess about 5 of those tons are still there. So, I haven’t had much time to prepare a monthly commentary…
That doesn’t mean there isn’t “a ton” to discuss… 😊. But, I will try to be brief while providing links to some other longer-form market insights.
12 cubic yards of granite…
First things first, “the market” continued its relentless rise in June, if by the “the market” you mean just a handful of megacap stocks. If, on the other hand, you mean the average of the five hundred stocks in the S&P 500, or even the two thousand stocks in the Russell 2000… then by either measure the market was actually down in June.
The S&P 500 Equal Weight Index fell 0.65% for the month and the Russell 2000 dropped 1.40% for the month.
At the end of June, the Russell 2000 was actually still down 17% from its 2021 peak!
This is the bifurcated world we live in. As I have written before (Sep 2023), the market cap weighted S&P 500 is, and has been, hopelessly broken. For some time, it has been a very poor way to measure a diversified investment portfolio.
For those who insist on measuring with that broken ruler, I suggest skipping the 490 stocks that are, on average, falling. Instead, just own the top ten stocks in the index. And then hold on for dear life. As the saying goes, “if you can’t beat ‘em, join ‘em.”
For long-term investors with at least some appetite for risk, and a modicum of patience, our Capital Strategy is a fine choice. It takes a great deal of discipline and some time to build a long-term portfolio. Strictly selling losers at predetermined levels is a process that over time, eliminates losers while they are small and lets winners get big. After a while you’ll notice that most of your positions are up, a few are up A LOT, and very few, mostly newer positions, are down a little. But again, it takes time, patience and a disciplined process. These are not qualities many humans are known for.
Depending on how long you’ve been a client, or reading these commentaries, you may think that am I a “perma-bear.” It isn’t true! We have been plenty bullish in years gone by, and we have even outperformed the (currently, but not always broken) S&P 500 while it was up, for good long stretches of time. We have even launched hedge funds and made venture capital investments due to being so bullish. And despite my recent bearishness, the flagship Capital Strategy is and has been fully invested.
It just so happens that fundamental measurements of the market have been incredibly bearish since at least the end of 2021.
Since then, we watched the S&P 500 drop by nearly 30% (Jan 2022 – Oct 2022). Interest rates have risen 20-fold from 0.25% to over 5%. Banks failed at rates higher than those witnessed during the Great Financial Crisis of 2008-09. Inflation has reached 40-year highs, and persisted. Our national debt has climbed to nearly $35 trillion from $28 trillion.
That’s right, we added $7 trillion of debt in 3 years… last I checked we are not even (officially) at war. For perspective, it took 227 years to add the first $7 trillion. I’d say we are spending like drunken sailors, as the adage goes, but saying so would be offensive to drunken sailors.
I have referenced Porter Stansberry many times before. Love him, hate him, or never heard of him, he is a brilliant analyst. He called the bankruptcy of GM, Fannie Mae and Freddie Mac, among others, while many thought he was crazy. Sure, like everyone, he has been plenty wrong on other things too. But he doesn’t often make bold calls, and so when he does it catches my attention.
On Friday, July 12th, Porter wrote his first note in a long while. In fact, the last time he directly addressed readers was March 26th, 2020, when he “pounded the table” on buying stocks near the lows of the COVID meltdown. So, if it doesn’t go without saying, he isn’t a “perma-bear” either. Admittedly, he can be a bit hyperbolic… but don’t let that detract from the message or his track record.
He opened his note with this:
I believe we are at an important peak in equity prices... that a big decline in stocks is inevitable... and that buying tech stocks here will lead to poor returns for at least a decade.
He continues:
We are in the midst of the greatest financial bubble of all time...
Today's bubble was caused by the same thing that creates every bubble – enormous amounts of newly created credit. This bubble was fueled by the "hidden" bailout of our banking system that began in early 2023 when the Federal Reserve created its "Bank Term Funding Program" to paper over the banks' $500 billion-plus in losses on their government bonds.
Among its actions, the central bank issued more than $164 billion in credit, created out of thin air. Thus, rather than seeing a reduction in credit while interest rates were rising, we've witnessed a gigantic expansion in credit, leading to a financial boom.
The mania in tech stocks today far exceeds the 2000 bubble. Going forward, for the next decade or longer, returns on large-cap tech stocks will be well below average. And for investors who pile into tech stocks today, when they are trading at 30 times sales, the results will be catastrophic.
This advice is contrary to what virtually everyone else is saying about the stock market right now, so I'll understand if you're deeply skeptical of my views. But I hope you'll pour a glass of your favorite adult beverage and let me explain why your actions over the next three to six months matter so much to your financial well-being.
Rising interest rates typically lead to a reduction in credit. That makes sense. That is the intention! To think that we added all these trillions of dollars to the national debt at the same time as interest rates have risen 20-fold is absolutely insane. And people wonder why inflation is still 3%+…
More from Porter:
There are great times to be a buyer of stocks and there are terrible times to be a buyer of stocks. Right now has all of the hallmarks of a terrible time to be a buyer of most stocks, especially tech stocks.
How do I know?...
Stocks as a percentage of household assets are at an all-time high – 35%. Previous peaks include the top of the '68 bull market (29%), the top of the 2000 bull market (30%) and the top in stocks just before the pandemic (34%).
Bear markets bottom when everyone has sold. Bull markets die when everyone has bought. Mid-June saw the largest weekly inflow to tech-centric mutual funds in history.
And who is selling? Insiders at Nvidia (NVDA) have been selling at the fastest pace ever, dumping almost $500 million worth of shares in June.
By every well-proven metric, the S&P 500 is incredibly overvalued...
That's mostly because of the largest 10 companies.
Hmm, the largest 10 companies, eh? Interesting…
In the next section, Porter uses the term “standard deviation,” which just means the amount of variation in a set of values from their average. Higher standard deviation means further away from the average or mean. And usually, values revert toward their average over time, but sometimes it happens very suddenly.
Back to Porter:
Take Buffett's favorite broad measure of the stock market's price level, the total U.S. stock market capitalization measured against U.S. gross domestic product ("GDP").
Before 2020, the previous all-time peak was just below 150% in the 2000 bubble. That peak was two standard deviations away from the historical trend line, suggesting an unsustainable extreme.
Today... that measure of the market sits at 200% of GDP... placing it well beyond two standard deviations above the average.
Nobel laureate James Tobin developed another slightly wonkier measure of the stock market's level. It's called 'Tobin's Q'...
It's difficult to calculate, and the figures needed to do the calculation are only released by the Federal Reserve each quarter. But it is intellectually sound. The Q ratio is the total price of all the stocks in the market divided by the replacement cost of all of the companies.
The long-term-average Q ratio is 0.83. That means that for most of the past 120 years, the stock market has priced publicly traded companies at a small discount to their replacement cost. However, during several notable periods, investors were willing to pay large premiums.
The first time was during the 1960s, when the Q ratio soared to 1.7. It then fell for 20 years, bottoming at 0.29 in the early 1980s. The second was during the 2000 bubble... when the ratio soared to 1.5, before bottoming in early 2009 at 0.70.
And today? Tobin's Q ratio sits at an all-time high of 1.8.
Yikes! So, what do you expect from here, Porter?
Here's a simple prediction for you: Over the next 10 years, stock prices will fall so that this ratio once again is below 1. And when that moment occurs... I strongly suspect that you won't want to buy stocks.
Human emotions are what drive stock prices so far above their intrinsic value and what allow them to fall well below their intrinsic value. If you begin to see prices as merely reflections of the crowd's irrational emotions, you'll be much better positioned to profit from these cycles.
Over the course of many months, I have written plenty about the concentration of returns into just a few large stocks. I have even given reasons for why this is happening and why it could conceivably continue a while longer. Something I am keeping an eye on now is the number of people having their 65th birthday every day. Currently, almost 12,000 American’s celebrate their 65th birthday every day. And by 2030 all baby boomers will be aged 65 and from there this daily number will steadily decline.
Now, not everyone retires the day they turn 65, but it is a decent proxy for when people will begin to access the money in their retirement plans – which are increasingly invested in passive index funds that blindly allocate more money to the biggest stocks without any sort of analysis. When that happens, if enough money isn’t flowing into these passive funds from working age people, the net outflows from these passive funds will have the exact opposite effect as they are having today – the biggest stocks will be the biggest sources of capital and could begin to fall the most. As the great Yogi Berra said, “It is difficult to make predictions, especially about the future.”
Porter continues:
Another critical factor makes the current market extremely unstable and subject to a crash...
The market today is more concentrated than ever before in history.
The top 10 stocks in the S&P 500 now equal roughly 35% of the entire index's value. The only other time the market was anything like this concentrated was during the Great Depression.
This suggests that the real economy is much weaker than anyone realizes, mostly because investors have pushed valuations of the biggest stocks to incredible extremes.
Finally, the stock market is suffering from a growing lack of 'leadership' in the stock market...
For example, on June 17, the S&P 500 set a new all-time high, which is a sign of a strong bull market. But on that same day, more stocks were at new 52-week lows than at new 52-week highs.
This is an extremely unusual "divergence." And it's just another example of how a small group of vastly overvalued stocks has pushed an otherwise weak market higher. The reality is, the market has no real foundation. When sentiment changes, there will be a crash.
The last time we saw this kind of divergence in the market was just before it began a 22% decline in January 2022. And there were only two other instances. One was before a sharp 20% decline in late 2018 – the "crypto crash" – and in January 2000 right before the huge 50% decline in stocks when the first tech bubble burst.
(By the way, hat tip to Hussman Strategic Advisors for this unique piece of market research. You can see the chart below.)
Source: Hussman Strategic Advisors
By the way, I enjoy and frequently cite Hussman’s Market Comment in these commentaries. We even have a link to their website in the “Resources>Reading List” area of our website. You can find other good material there as well – so check it out!
You can read the full June 2024 Hussman Market Comment (where the chart above came from), here.
Back to Porter:
Does this mean that stocks will collapse next week?...
As I sat down to write this Digest yesterday (July 11, 2024), the market began to experience a historic reversal of trend. Incredibly, on Thursday, as I finished writing the first draft of this Digest, the Russell 2000 Index of small-cap stocks closed 3.6% higher. But the S&P 500 (dominated by the big, overvalued tech stocks) fell 0.88%!
Thus, even though yesterday saw advancing stocks outnumber declining stocks by 5 to 1 the "stock market," as defined by the S&P 500, declined (by 0.88%). That has never, ever, happened before in the entire history of the stock market. The market is indeed "broken." Driven by the extreme amount of capital that's "indexed" and the enormous size and valuation of the biggest tech names, the stock market isn't functioning normally.
To understand how extreme the risks are in this market today, you have to realize that the other times in market history that the market has behaved similarly in the past were all during the Great Depression, after the enormous crash of '29. On 12/5/29, 8/18/30, 1/11/32, 8/20/34, and 11/8/34, the market's advancing stocks outnumbered the declining stocks by "only" 2-to-1, not by 5-to-1. In other words, the market's dynamics are even more unusual now than they were during the Great Depression.
You already know the big tech names were down big [on Thursday, July 11th], led by Nvidia, which fell by 5.6%. It's not often that the market confirms a thesis so dramatically literally while you're writing the research, but I believe that's the case here. I think the "top" is in for big-cap tech. I hope you won't try to buy this dip.
Extremely high valuations, like the kind we see today in big-cap tech stocks, are like someone putting dynamite into a hole. The pressure builds and builds and builds. And the more extreme the valuations get, the bigger the inevitable explosion will be.
Right now, the only thing holding up this market is sentiment – the fundamentals are completely broken. When the stocks start to fall, sentiment will disappear. Then there will be a big crash.
And don't look to the government to protect investors...
Ironically, efforts to make financial markets safer and more stable – such as central banking – only permit more and more "dynamite" to build up in the system.
A famous economist, Hyman Minsky, first discovered how financial system stability leads to bigger and more violent financial panics – something called a "Minsky Moment." We're on a one-way track toward the biggest Minsky Moment we've ever seen.
The combination of massive (and unsustainable) sovereign debt and unprecedented valuations of U.S. stocks, along with record-high levels of participation in the stock market, is a recipe for some incredible "fireworks."
…you don't have to call the top to the exact day to be right...
And I don't know what "spark" will light the fire. But when stocks are trading at extreme valuations, any bump in the road can lead to immense carnage.
It might be the collapse of a major private-equity firm because of losses in commercial real estate (which is my best guess). Or it could be the invasion of Taiwan (which I think is unlikely). Or it could be the detonation of a nuclear bomb in Ukraine (I sure hope not).
The point is, if you know a great white shark is in the water, do you need to know exactly where he is to know that going swimming at night probably isn't smart?
OK… so, it’s probably not exactly as fun to read all that as it is to read something from CNBC talking about how this bull market is just getting started and will just keep going up led by Nvidia doubling its revenues until those revenues make up half the global GDP… which is obviously ridiculous.
But it is very fun for me to read something from an analyst for whom I have a great deal of respect, writing things like “broken” as it relates to the same things I have been calling “broken.”
Well, what do we do now? Do we sell everything and buy T-bills at 5%? I think not.
Remember, I can be wrong. It happens all the time. Porter can be wrong too. The market can absolutely keep screaming higher from here led by these top 10 stocks. That is what makes a bubble a bubble. Bubbles inflate beyond all expectations and rationale.
The key is to prepare to sell when predetermined exit levels are hit. That’s it. We keep hunting for wonderful businesses trading at fair prices (which are fewer and further between than ever, but they do still exist) and we buy them aggressively.
We measure and assess the normal volatility ranges of those stocks before we buy them. Using that information we unemotionally set our stop loss alert level. Then, we sell when our stop loss alert is triggered. It is as simple as that. That is how we protect your hard-earned capital.
We might even tighten our stops on some of our biggest gainers and take some more profits off the table before markets get too carried away on the downside.
One more link I will leave you with which is a really great (and short) read. It was originally published in March 2000 during the height of the dotcom bubble by Walter Deemer. Check it out here.
And finally, before I go, a couple of comments from early earnings calls:
Consumers continue to exhibit value-seeking behavior. Financial anxiety remains elevated, particularly in the United States, and especially with mid to low-income households, due to the compounding impact of inflation. In addition, inflation in the food service channel is leading to softness in food away from home consumption and impacting restaurant traffic, particularly with quick service restaurants, across many of our regions… Consumers continue to buy just for what they need and make more frequent trips to the store.
-Brenden Foley, President & CEO of McCormick
[I]n the U.S., there is clearly a consumer that is more challenged and it's a consumer that is telling us that in particular parts of our portfolio, they want more value to stay with our brands…
The consumer is much more price-conscious, is looking for more value. So maybe you see the higher-income consumers that they're not going to expensive restaurants. They're adjusting their behavior to more affordable restaurants, or they stay at home, and then they create their own entertainment moments or fun moments at home. So, you see different behaviors happening everywhere. I think the connecting line would be the consumer is more cautious, the consumer is more choiceful, but the consumer is willing to spend in areas where they see value.
- Ramon Laguarta, Chairman & CEO of Pepsi
“While market valuations and credit spreads seem to reflect a rather benign economic outlook, we continue to be vigilant about potential tail risks. These tail risks are the same ones that we have mentioned before. The geopolitical situation remains complex and potentially the most dangerous since World War II — though its outcome and effect on the global economy remain unknown. Next, there has been some progress bringing inflation down, but there are still multiple inflationary forces in front of us: large fiscal deficits, infrastructure needs, restructuring of trade and remilitarization of the world. Therefore, inflation and interest rates may stay higher than the market expects. And finally, we still do not know the full effects of quantitative tightening on this scale.”
- Jamie Dimon, Chairman & CEO of JP Morgan Chase Bank
Until next time, I thank God for each of you, and I thank each of you for reading this commentary.
Clients, I encourage you to click here to access your personalized performance portal to see how your portfolio performed last month.
Shane Fleury, CFA
Chief Investment Officer
Elevate Capital Advisors
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