"The Matrix is a system, Neo. That system is our enemy. But when you're inside, you look around, what do you see? Businessmen, teachers, lawyers, carpenters. The very minds of the people we are trying to save. But until we do, these people are still a part of that system, and that makes them our enemy. You have to understand, most of these people are not ready to be unplugged. And many of them are so inured, so hopelessly dependent on the system, that they will fight to protect it."
So, James Altucher is out with another extremely entertaining and wildly outlandish note about the future of markets and the economy. And as usual it has been picked up by more than a few outlets that don't seem to be too interested in whether or not what much of he is saying makes sense or is accurately supported. So, I have again taken it upon myself to point out how for the most part James tends to oversimplify things or site data that has in many cases little relevance for the predictions he is making. Since I have no books to sell (yet), you can assume that my views have a little more to do with figuring out where we are headed instead of my own self promotion. That being said James is still a very talented financial entertainment/technology writer and personality. He is probably up there with Marc Faber, even if he is nowhere close to Dr. Doom when it comes to substance and detail, as far as financial personalities worth watching because they are fun and don't take themselves too seriously
So, let's begin ...
"I could See, but now am Blind"
Home sales: "Housing prices still stink. Nobody should ever buy a home again, in my opinion. The myth of the white picket fence was invented by a trillion dollar mortgage industry powered by an over-accelerated Federal Reserve. Prices are down 2.8% from a year ago. But there’s very good news. Inventories are at the lowest levels since 1963. And at current demand, months of inventory on the market are at six months, the lowest since 2006. In fact, home sales have been up considerably the past few months. Guess what happens in any market when supply goes down and demand goes up: prices go up."
This is about the only point I will agree with James on. Yes, the housing market is mending, which is what a market that went through what it went through is supposed to do over time. I think everyone following housing at this point will be satisfied with prices stabilizing and no longer declining at the national level. Let's not jump the gun just yet.
Corporate profits are at an all time high. This is for three reasons. All the companies fired people two years go. Demand is coming back (see below), and the Internet is actually allowing companies to do things for free that they used to use expensive people for. What happens when corporate profits are at an all time high?
I don't really get the point of using a chart like this. It is like getting excited about buying stocks because nominal GDP is rising. How often is nominal GDP not rising? James is right about a few things though profit margins did get a huge boost from the post crash layoffs, demand did snap back, and the internet is helping cut costs. However, layoffs are a one time boost for EPS growth that can't be tapped again, the demand snapback benefited tremendously from the low base effect that comes after a crash, and internet costs advantages do come at someone else's expense. Ordering on Amazon.com (NASDAQ:AMZN) may be great for me, but Borders (OTC:BGPIQ) and Barnes and Noble (NYSE:BKS) employees as well as state tax coffers would beg to differ. James always seems to get excited about tech related jobs created in web hosting, logistics, and online advertising. Yet, he does not seem to think too much about the jobs that are lost. Job evolution is great, but the real boom was when these industries existed side by side. Now that one has replaced the other you might want to do some netting out. As for the demand snap back, it was inevitable. Take a global economy, shut it down for six months, and then start it up again. And when you start it up give it more efficient fuel in the form of cost cutting, and then nitrogen boosters in the form of stimulus. The only way demand would not have snapped back is if the world had ended. Realistically, this was more of a 2010 phenomena that carried over into 2011 after QE II. The real driver was a weak dollar boosting top line revenue for corporates that now do so much business abroad. That will be a headwind and not a tailwind in 2012. By the way, a more interesting and useful chart to look at going forward is the one of corporate taxes as percentage of corporate pre-tax profit. Considering the current fiscal state of affairs in the United States where do you most likely think this chart will be heading? And better yet, what does that mean for future earnings growth?
Cash in the bank is at an all time high: Non-banks in the S&P 500 have two trillion cash in the bank, the highest levels ever. This cash is sitting around doing nothing. Do you know what happens when cash is sitting around doing nothing?
Probably nothing annoys me more than hearing those ten words when I am talking with someone about the market. When is cash in the bank not at all time high? Go read Galbraith's Great Crash and you will find the same mumbo jumbo coming out of promoters back in 1929. Not like that is a valid comparison, but when don't you here perma bulls talking about cash in the bank being at all time highs. The reality of the situation is that S&P 500 companies are bigger, more global, and paying less in effective taxes than they ever have. So, it makes sense for them to have cash sitting at the highest levels ever. And that is of course assuming that I completely disregard the fiat element of all of this which James seems to not understand as he is always throwing out graphs that can be explained by the long-term growth of the money supply. But I will answer this question of what usually happens when cash is sitting around doing nothing. The answer is nothing, and that's generally the problem these days.
Announced Stock Buybacks are at an all time high: Since 1990 you know who the biggest buyers of stocks are? It’s not mutual funds or retail investors. It’s other companies by a factor of 4:1. Through buybacks and mergers. Announced buybacks for 2012 has hit over $1.1 trillion, the first time this number has breached a trillion. Oh, and guess what, the number of shares outstanding has now gone down for three years in a row, for the first time since 1990. You know what happens in any market when demand goes up (the stock buyback announcements) and supply goes down? See above.
This is the modern day version of the 'there is so much cash on the sidelines' argument for buying stocks. Front run the corporates before there is no stock left to buy. We got a lot of this in 2007 particularly from the likes of Cramer talking about how companies like ATI (NYSE:ATI) were running out of shares for investors to buy. Again this all usually amounts to nothing more than market noise. Buybacks mean very little in the grand scheme of things as companies have to return cash to shareholders in one way or another at some point in time. Tell me what would Microsoft (NASDAQ:MSFT) look like if it had not bought back a single share over the last decade? The float would be bigger, the EPS would be lower, there would be much more cash on the balance sheet, and the multiple would be higher. Since 2001 MSFT has spent some $80+ billion buying 2.7 billion shares, and still the stock is down over 20% over that time period. Had they not bought back a single share the company would be trading closer to 13x earnings instead of the 9x they are trading at today. That would be 13x earnings for a company that had without the buybacks managed to grow their EPS by 12% a year over the last decade. Does the stock still look that cheap? See, excess cash distorts the picture, but the reality is you don't pay a premium for cash. So, MSFT could be sitting on a balance sheet with $130 billion in cash and a market cap closer to $300 billion, but it would still be trading at about 13x earnings which is equal to the rate they grew operating income over the last 12 months. Or it could be sitting on zero cash and $15 billion in debt with a market cap closer to $170 billion and trading at a multiple of 7-8x trailing earnings. Which is probably what you would pay for a stock like MSFT as long as you assumed earnings were not at risk of seriously declining in the future. Now, assume you believe the risk of a steep decline exists over the next few years as margins on Windows and Office monopolies come down and as IOS and Android continue to grow. What would you pay for this stock? And by the way remember that MSFT has been paying nowhere close to the 35% tax rate. If they had paid such a marginal rate this year, the stock would be trading at the market multiple right now. So, let's not get too excited about buybacks causing the market to do anything it is not already doing. Try to buy stocks that are growing their earnings through their core business, and have plenty of appealing places to re invest the cash they are generating. No great returns will ever be generated chasing buybacks.
Consumer spending is up at an all time high. How can this be? Isn’t unemployment still at 8.6%. Yes. But: A) unemployment is 1.2% lower than it was a year ago. And B) many of the unemployed were in lower paying jobs. I’m just the messenger here but it’s the truth. Personal incomes are actually UP 4% over the past year. Not only that but temp jobs are up and the average hourly work week is up. Which means full time employment is going to continue to grow, as it has been all year.
But, you can ask: isn’t this the same problem we had before? People spend, spend, spend, and then owe, owe, owe?
(Consumer spending at an all time high)
This is another bizarre choice by James as Personal Consumption Expenditures, essentially the largest component of GDP, are almost always steadily rising. After looking at all these charts, I wonder why he just didn't graph the price of a can of Coke (NYSE:KO) over the last 50 years. Here is what you are supposed to be looking at when you look at PCE, and while it has improved significantly since the bottom of the recession it is not exactly the type of data that is going to help you best the market. We are slightly below the mean of the last 40 years, and that is after coming off the greatest yr/yr decline over that same time period. What use is the data you are citing about consumer spending if the same all time high statement would apply to almost any single point over the last 70 years?
Household debt obligations are the lowest since 1993. Mortgages, rents, car loans/leases and other debt services added together divided by income after taxes is the lowest since 1993.
Now here James really misleads his readers with a bold headline claiming household debt obligations are the lowest since 1993 even though he then correctly cites the reference to debt service data. Yes, U.S. Household debt service as a percentage of disposable income is the lowest it has been since 1993. Of course that is not saying much as this number has been between 11-14% for the last 40 years. Considering the collapse in rates it should be no surprise that we are closing in on the lower end of that tight range.
But what I think is more relevant when you are talking about household obligations is the aggregate debt to income ratio. That has been coming down, but is nowhere near where it was ten or twenty years ago. So, let's not celebrate household balance sheets just yet.
But what about Europe? I know this blog might have European readers. In fact, we might even have readers from Greece. Hello out there! But do you really think a beach resort in the Mediterranean is going to have an effect on the U.S. economy? Greece’s economy to the eurozone is equivalent to Rhode Island to the U.S. economy. I live 40 minutes from Rhode Island and I don’t think I’ve ever even set foot in that state.
Well, what about Italy and, god forbid, France! Voulez Vouz Coucher!?
History Lesson: 1981: The top 8 U.S. banks were 260% exposed (through leverage it goes higher than 100%) to South America in 1981. All of South America defaulted. Nobody in Europe has defaulted. We had to do massive bailouts combined with down on our knees old-fashioned prayer and still we had a 20 year stock market boom. Meanwhile, the top 5 U.S. banks (mergers) are 8% exposed to Europe and there’s been no defaults.
So why are we so worried? I bring this up on TV and the response is always: you might be right, James, but what about “investor psychology” of these events. No problem! TURN OFF THE TV. These are not the droids you are looking for. Recession news gets a lot more press (and money) than good news. We have this biological instinct to protect the places where we pee regularly. So if there’s going to be news that’s going to upset these sacred peeing grounds then that news drives ratings. I make it a habit to avoid all news.
Now, this is interesting. James definitely picked something worth discussing here, especially when you consider contagion risk and banking systems. But the History lesson is incomplete. In 1981 the top 8 U.S. banks held assets representing 16% of total GDP. Today, the top 8 U.S. banks hold assets representing 71% of GDP. Not exactly a like for like comparison. And the history lesson issues don't stop there. The LDC crisis which started in August of 1982 with a notification from the Mexican minister of Finance would not be resolved until the Brady plan agreement was reached in 1989. Over those seven years debt was rescheduled and regularity forbearance employed to keep the banks afloat. The first losses on LDC debt were not recognized until late 1987. And by the time the Brady agreement was reached the 8 banks had reserves equal to 50% of LDC obligations outstanding. Basically, extend and pretend worked very well because of the simple fact that the big banks were nowhere close to as big a piece of the pie as they are today. And this is before you get into price discovery and derivatives not playing the type of role they currently play. Today, these banks would not be allowed to have the time to slowly and quietly shore up their balance sheets without having to worry about a panic. CDS ensure that something like the LDC crisis would have caused massive losses to be incurred almost instantly. Funding stress on the institutions involved would be severe, and short selling attacks lighting quick. So yes, Europe exposure is nowhere near what the LDC exposure was for the 8 money-center banks in 1981, but that doesn't really matter much when you factor in how different the banking system is today and how much more efficient financial markets are at identifying and exposing weak links.
Bank cash: The Federal Reserve printed up $1.6 trillion in cash for “QE2″. Guess what. Bank reserves increased by $1.6 trillion in cash. They haven’t spent the money! The Federal Reserve DID NOT NEED TO PRINT THAT MONEY. But the banks will spend it. It typically takes 6-18 months for quantitative easing to have an effect on the economy. Nobody tells you that in the news. Guess when the last dollar of QE2 was printed? Six months ago. The only issue with all this is that the accelerator is going to hit too fast. The Federal Reserve should NEVER have done QE2. The accelerator is going to be so fast only the nimble will be able to keep up with it and the middle class will once again be left behind while the banks and the people who “Occupy Money” will win. While the short-term might appear to stimulating it will be stimulating like a roller coaster. The Federal Reserve needs to tell its employees to go on a vacation for a decade or so.
This is probably the most perfect example of a failure to understand what QE is about. When you are facing a massive and swift de-leveraging that cannot be arrested via conventional short-term rate focused monetary policy, policy makers shift their focus to lowering long-term rates. It is in their view the only way to mitigate the pain of de-leveraging and debt deflation, and precisely why bank reserves end up shooting through the roof. The cash will never flood the system in the way James expects because the cash is there to save the system from imploding.
More on Stocks: The S&P 500 trades for just 13 times 2011 earnings versus the historical average of 15 times. Given that earnings will probably continue to improve, the market could move back to the historical average. If you throw in that interest rates are at the lowest levels since 1960 (important since you compare the relative safety of investments by looking at interest rates), the market is at its lowest level since 1960. Going back to historical averages when you take into account interest rates could cause the Dow to more than double (Source: Brian Wesbury at First Trust Portfolios.) If rates go up, as expected, we can still see a 40-50% quick move up from here.
When rates were at their highest and the spread between the earnings yield on stocks and ten year treasuries the most negative was also the best time to buy stocks. I also don't think that it is a 'given' that earnings will continue to improve. That is a pretty big assumption if you ask me, but either way, based on historical data, stocks don't look particularly cheap or expensive at the moment. Of course that historical data is based mostly on markets that have not had to deal with this debt disease problem in over 80 years.
But aren’t things overvalued? AAPL is at less than 10 times next year’s earnings compared to a historical average of around 20. Should AAPL, which grew its earnings 100% this past year, be valued like an electric utility company? I can give more examples (CSCO, MSFT, INTC, all growing, all equally cheap) but AAPL is good enough. (See, “Why Apple Will be the World’s First Trillion Dollar Company“)
In fact most of the electric utilities are trading at a premium to Apple's current multiple. But then again they are paying 4-5% dividend yields, and benefiting from falling costs. Why anyone would think Apple should trade at 20x earnings when it is the most valuable company in an index trading at closer to 13x is beyond me. Once you get very big new challenges emerge, like figuring out what to do with $80 billion in cash earning virtually no return. Apple is without a doubt a great stock, and one I seriously underestimated in 2009 but the road higher from here has very little to do with the historical average. As for MSFT, INTC, and CSCO; I think you can come up with better places to find 'growth'. GOOG still works for me.
Technology. Two years ago I never even heard of an iPad. I had nothing stored in the cloud. I had a dumb phone instead of a smart phone. Fracking was a pipe dream and is going to shortly make the U.S. the largest producer of energy in the world, beating the Middle East. Biotech and genetic diagnostics continue to make astounding improvements. Facebook has 800 million users. The fastest growing company in history (in revenues), Groupon (NASDAQ:GRPN), started in just 2008. And the more ideas we have, the more ideas mate with each other and create new generations of ideas. Those grow and provide jobs, and lead to venture capital, and IPOs, etc.
Remember 2000 when everyone said, “man, I wish I knew a boom was coming in 1996.” Well, here we are again.
This is what makes James so entertaining to watch and read. He gets very excited about innovation, and I can identify with that. Still, it is not like innovation was invented yesterday. 30 years ago I could have written the same thing about the Sony (NYSE:SNE) Walkman, and then 15 years later a Nokia (NYSE:NOK) brick phone. The same thing applies to the Blackberry or the hard drive as it pertains to the cloud. There will always be new gadgets to get excited about, but that does not mean we are entering a new paradigm of cool gadgets. As for fracking, the shale boom is definitely a welcome development but saying it will make the U.S. the largest producer of energy in the world is just outright reckless. Shale well production declines within the first couple of years are massive, and thus lend themselves to something more akin to a speculative bubble than a long-term solution. Now, as the rest of the world embraces fracking maybe we will see significantly lower energy prices down the road before we experience the post shale fracking shock, but I wouldn't declare energy independence just yet. And this is without considering the water cost issues associated with the process. Now onto medical science. I know some people love their biotech stocks and that James in particular loves to write about stocks like Dendreon (NASDAQ:DNDN) and Human Genome Sciences (HGSI), but it is not like Medical progress started last month. Medical science has been making astounding improvements since the beginning of time, so you need to be a little more specific if you think that is going to play a role in a 50% stock market rally. The same applies for the Facebook has 800 million users comment. Fascination with scale is fine, but investors are more interested in how it translates into profits. Facebook has made progress and will continue to make progress, but from a business model perspective it is still nothing more than a seller of ad space and the provider of on line games. As for GRPN, I don't get the infatuation with the revenue growth data. This is maybe the umpteenth time James has commented on it in a post or on tv. If I offered everyone online $1 six weeks from today for every 90c they gave me I would generate revenue pretty quick. I would be the fastest growing company and have biggest email list of users on the planet. I would also be accumulating some pretty sizable losses. Now, luckily for me I have some investors that believe somewhere down the road that I will be able to make another 20-30c off these users. But without those investors and a market filled with people enamored by numbers, all I have is a very efficient way to lose a lot of money very quickly.