The Debt Cancer
Despite tremendous progress in the treatment of cancer over the past twenty years, patients with metastatic solid malignant tumors are rarely cured with chemotherapy. Breast, lung, colon, and prostate cancers - the most common solid tumors - can be cured if detected early. Treatment usually involves surgery (or radiation) to treat the localized tumor and adjuvant chemotherapy to treat cells that may have spread, but haven't definitely established themselves.
Cure rates drop precipitously if patients have a metastasis beyond the local treatment area. These conversations are difficult for both patients and physicians. Whether it is a suspicious liver nodule in the 73-year old man with a recently diagnosed colon cancer, or a mass eroding the sternum in a 57-year old woman eight years after completing lumpectomy, radiation, and adjuvant chemotherapy for breast cancer, the patient always reacts the same way. They assume death is imminent.
It requires a great deal of compassion and time to explain that, even though cure may be unlikely, there is the possibility of "managing" their malignancy to provide good-quality life, sometimes many years of good life.
The Debt Burden
My perspective on our financial markets is that globally we have a debt cancer. Fed by central banks, it metastasizes from one sector of our credit markets to the next. At the time of the 2008-2009 financial crisis, it was generally acknowledged that easy credit conditions had created a bubble that resulted in the market's crash. Over a year ago - February 2015 - a McKinsey article "Debt and (not much) deleveraging" observed that worldwide debt had increased by $57 trillion since 2007. It has increased in the interim.
Standard macroeconomic theory posits that borrowing results in investment, which should promote growth. Until recently, there have been few economists willing to challenge that thesis. Despite the consensus, global growth has been hard to come by, even with the continued easy credit. What has become apparent is that financial assets have increased in price. Real estate prices, US stock markets (global stock markets to a lesser extent), and "Unicorns" in Silicon valley have all been beneficiaries. Despite this, true investment that would be a source of future growth has been scant. Instead, companies borrow at cheap rates and buy back their own shares. Chinese executives sell corporate bonds and buy Vancouver real estate.
A few large tech companies have huge hoards of cash, but 99% of US corporations are even more leveraged than they were a decade ago. "Combined, these companies hold just $900 billion in cash and $6 trillion in debt. That puts their cash-to-debt ratio at 15%, the lowest it's been in the past ten years."
The U.S. consumer has generally deleveraged. Consumer debt/GDP levels have fallen from 97.5% to around 80% since the financial crisis. Credit card debt has recently risen and is approaching $1 trillion (the pre-crisis high) as banks try to make up for their lack of income by pushing cards on near prime and sub-prime borrowers. "Auto-loan balances surpassed $1 trillion in the first quarter, a record for the industry, according to a report Thursday from credit bureau Experian."
Federal student loan debt - $1.2 trillion - is the largest and most rapidly increasing category. Despite subsidized loan rates, 43% of borrowers are either in default, late, or in postponement due to economic hardship. Mortgage debt is now more than $8.3 trillion.
In order to allow the US consumer to deleverage, and to encourage more debt (stimulate growth?), federal debt has soared and the public portion is 76% of GDP. This is the highest it has been since WWII. If you include the intra-governmental debt (with important items like social security), the total is $19.1 trillion. In fact, this total still does not capture unfunded mandates, including future Medicare spending. State and local government debt add another $3 trillion. This latter number has been going up more slowly than federal debt, and our local politicians seem to be conscious of the risks. Funding for State and local pensions is now at 74%, and assumptions for growth have been reduced to 7.75%. (I find this optimism fascinating.)
In previous articles, I have discussed the debt-to-GDP levels of Japan and China. Previous estimates of total Chinese debt are too low, according to Goldman. Chinese banks are using short-term credit facilities to make payments on longer-term debt. The fear is this will end the same manner as paying a mortgage with a credit card loan. The alternative is the PBOC will intervene in a way that would be impossible in Western nations. In March, it was suggested that corporate debt could be converted to equity. Early results of this policy do not look favorable.
Japan's efforts to end decades of deflation continue to be thwarted. The OECD recently predicted Japanese public debt-to-GDP will reach 234% in 2017. Now the Japanese corporate sector is aggressively selling debt to yield-starved Japanese investors. I find acceptance of this even more remarkable, given the recent accounting scandals at corporate giant Toshiba (OTCPK:TOSBF).
Like a patient with incurable cancer, we all know our financial markets are riddled with debt. I have had the honor of caring for patients who embraced their tenuous situation and lived bravely and brilliantly each remaining day. The majority, however, vacillate between distraction, denial, and quiet desperation wondering if the next visit to the doctor will bring the dreaded news. Our markets seem to be behaving the same way.
This January and February, it appeared that we were finally seeing the debt burden overwhelm the global economy. The prolonged bear market in commodities, exacerbated by the strong US dollar and slowing demand in China, started a series of threatened defaults in commodity-related companies. The defaults threatened to negatively impact banks, especially in Europe. Sovereign wealth funds of oil-related countries were selling assets in order to fill the holes in their budgets. Emerging market economies were struggling with US dollar-denominated debt and low prices for their products. US corporate earnings were headed for their fourth quarter of declines (now confirmed). Credit spreads started to widen, threatening the financial system.
The medical term for this cascade is "multi-organ failure." Cancer diverts energy that should have maintained our health to multiplying malignant cells. That wasted appearance that doctors call "cancer cachexia" includes the muscles of the swallowing mechanism. Eventually, this can result in aspiration of saliva into the lungs. The patient's weak immune system can't prevent progression to pneumonia, which decreases the ability to maintain oxygen saturation, resulting in cardiac stress, which compromises the kidneys, causing fluid overload, which further impacts lung function, until death ensues or intervention stabilizes the patient.
The recovery from the February lows to the recent top in the market on April 20, 2016 has delighted bullish investors and frustrated bearish traders. The opinions about the current circumstance have been heated, as they are likely to be when the stakes are so high. Let's try to understand the disease using a timeline of the S&P 500 represented by the SPDR S&P 500 Trust ETF (NYSEARCA:SPY).
Raising rates in December, coupled with rhetoric to expect four more rate raises in 2016 scared the market into a sell-off. The rhetoric was probably the greater culprit, because it seemed that the FOMC was blind to the risks the market was seeing on a global scale. Already suffering commodity-related countries and companies became more distressed, with forced selling of assets. Technical analysis pointing towards the beginning of a bear market encouraged short sellers, who had been thwarted by central bank action for the past many years. Interestingly, the US dollar abruptly started to weaken at the end of January. Below is a chart of the US dollar represented by the PowerShares DB USD Bull ETF (NYSEARCA:UUP).
Since much of the turmoil was related to the strong dollar and its pressure on China's currency and on commodities, I believe the weakening US dollar was a major factor in setting a bottom for the market. I would note that the drop in the dollar preceded the change in Fed rhetoric. Did the dollar fall because of intervention or as a response to a US economy that was weaker than previously assumed? Contributing to the bottoming process, technical analysis was also looking for support in the S&P 1780-1810 range.
Lacking additional sellers, the market double bottomed on February 11. A speech by Fed Governor James Bullard just six days later, stating "It would be unwise to continue normalization strategy" acknowledged a reversal in Fed positioning. Continued central bank rhetoric pulled us back from the brink over the next month. James Bullard reversed himself again after the FOMC meeting (and after the market had largely recovered), saying he still favored rate hikes. Fortunately for the bulls, Dr. Yellen quashed this type of talk in her speech before the Economic Club of New York on March 29. This gave the market the green light to rise to a new lower high of 2111 on the S&P 500 on April 20. Since then, we have been trending sideways until Wednesday's high.
Not annotated on the above chart was China's unprecedented $1 trillion liquidity injection in the first quarter, as well as activity in the offshore currency markets to stabilize the yuan. Since speculators had been proscribed in the Chinese A shares market as a result of the boom and bust the previous year, the Chinese bond market had been experiencing similar leveraged bets starting in late 2015.
Chinese traders this spring have moved on to the commodity markets. Iron ore pricing had been moving up as the dollar weakened, but in early March, the price in China surged 19% in a day. Rebar futures pricing showed a 47% surge since the beginning of the year.
The resurgent money flowing into commodities from China, in addition to the weaker US dollar, caused global energy, materials, and commodities stocks to surge. Simultaneously, as the probability of Fed rates hikes diminished, bond proxies, including utilities and consumer staples, have risen. This new breadth has been interpreted as confirmation of the bullish rally in the market. Recently, China clamped down on speculation in their commodity prices by increasing margin requirements and transaction costs. If the rally in commodities is at least partially caused by the Chinese liquidity injection, could that rally to fade with time? Would that dent the breadth of our stock market rally, since it has been led by the energy and material sectors?
The Cancer Committee
The market activity parallels a particularly reassuring oncologist who goes on vacation. Mr. Market saw the doctor's partner in December, who tried to explain the toxicity of the medicine the patient was taking. At the next appointment in February, the patient's usual oncologist returned and expressed that there was no reason to taper the medicine anytime soon. At the cancer committee meeting, the covering oncologist brought up Mr. Market's case and there was disagreement about management, but for now, the patient's oncologist is in charge.
We had been hearing from members of the cancer committee - the FOMC - over the past weeks. Since Janet Yellen's speech at the Economic Club of New York, essentially overruling Bullard and other hawks, Mr. Market is only going to believe Dr. Janet Yellen. She spoke on Friday, May 27, and was distinctly more dovish than other FOMC members. On June 3, 2016, the jobs report was extremely weak. Only 38,000 jobs were created last month, and the previous two months were both revised down. In a subsequent speech, Dr. Yellen said soothing words, and now the S&P is pushing up against all-time highs. No one cares about the opinions of other members of the cancer committee.
Investing in an Indebted World
I find the debt cancer analogy to be helpful in managing my portfolios. There is a very low probability that the debt cancer will be cured with time and gentle therapy. This limits any need I have to chase rallies such as we have recently experienced. In order to cure the disease, some kind of cataclysmic disruption - the financial equivalent of a bone marrow transplant - will be required. The problem with the incurable cancer construct is that there is a tendency, like my patients, to assume that death, or the financial equivalent, is imminent. It may be that we don't improve or get abruptly worse, we simply drift, as the debt limits true growth and central banks delay a collapse in financial markets.
How can we position our portfolios to minimize our risk if there is a cataclysmic event, and yet generate some kind of return if we drift sideways?
Cash is now my largest position - a result of selling into rallies over the past year. The downside is, I am limiting my dividend and bond yield. The positive aspect of this choice is the volatility of my portfolio, combined with my other positions, is much less than the market's. This means I don't have to be sitting at my computer all day, trying to divine the mood of the market. Instead, I have been remodeling my rental property. Demolishing an old tile bathroom has been much more cathartic and productive for me than trying to short-term trade this market.
Equities and Covered Calls
I continue to own a portfolio of about 40 stocks, bond allocations, and ETFs. I have sold covered calls against over half of my equity positions. Because I believe the upside for the market is limited, the covered calls buffer my losses on the down days. They also often expire worthless, and I get to keep the premium for a nice gain (Starbucks (NASDAQ:SBUX) and Visa (NYSE:V) most recently). I have had many of these stock positions since 2009. Particularly in my taxable portfolio, I don't want to sell and pay taxes. Selling upside calls has also allowed me, despite my pessimism, to buy on dips. Apple (NASDAQ:AAPL), DuPont (NYSE:DD), Schlumberger (NYSE:SLB), Exxon Mobil (NYSE:XOM) (now out) were all purchased at the lows. Then I promptly sold out-of-the-money calls. The stocks have generally rallied nicely, and they have appreciated at twice the rate of the calls, leaving me with a nice profit if I were to buy back those calls and sell the stock. This is, in fact, what I chose to do with XOM. In the case of the other positions, I continue to hold them. I am collecting the dividend, and as long as the stock doesn't sell below the purchase price of the stock minus the price of the option, I will still make money.
Bonds and Treasuries
I have recommended owning the long-term US Treasury bonds - TLT - as a counterweight to your equity exposure. As a result of the poor jobs report and ECB intervention, TLT spiked again. TLT is expensive as of this writing, so I would advise waiting for an entry point if you do not have an allocation. There is always a chance that the economy will be able to resume true growth, and low long-term rates will soar. A profitable trade for me has been selling puts on TLT, as I suggested in "TLT: A Policeman For Your Portfolio." Buy these back when their price has fallen more than 50%, and sell them again when TLT falls below the recent trend line. I believe TLT will rise out of this trading range as the global debt cancer prompts another panic, but selling puts is a way to make money in this artificial environment. Always be able to cover your put sales.
I first recommended a gold position in "Civilized People Should Buy Gold." My reasons for owning gold have not changed. It has been exceptionally profitable for me because I have used vertical option spreads on the SPDR Gold Trust ETF (NYSEARCA:GLD) for all of my paper positions. If you are interested in the construction of these trades, I suggest you review my prior articles. Gold had been trending down as a result of concerns over the Fed raising rates. Since the jobs report, gold has rallied again. Certainly, hedge fund positioning had become too extreme in the short term, which contributed to the sell-off. As long as the dollar remains stable or weakens, gold will continue to appreciate over time. Vertical call spreads will allow you to risk less with a greater percentage profit, especially if we remain in the recent trading range.
In my case, I do not directly short stocks, as I never take unlimited risk. I use options to buy puts. I made a heady gain on the initial drop in January with puts on the indexes. After we rallied, I bought puts again, only to watch the market soar further after Janet Yellen's NY Economic club speech. The end result is that I gave back all of my January gains plus more as the rally exceeded my expectations.
If you are a previous reader, you may recall this remark from "Hope And Denial: 2 Sides Of The Same Coin":
"It costs money to protect your portfolio with puts, compared to simply going to cash, but there is the possibility you could make money trading these moves. It is a hard game to win because you have to get direction and timing correct."
I will repeat, it is a hard game to win. Fortunately, I use puts as a hedge rather than as a primary strategy. Thus, my portfolio is doing fine.
Frankly, I underestimated the willingness of money managers to buy the market at current valuations. As an investor managing my own portfolio, I am willing to miss out on a gain in order to avoid taking a big loss. My bias allowed me to forget that professional money managers do not have the same luxury. This means they have to chase their benchmarks. They are married to TINA - There Is No Alternative. She is one ugly bride.
The global economy is ridden with a cancer of debt. Aided by central banks, debt levels continue to rise. Investors should acknowledge this is an incurable disease, but they should be cautious about assuming the death of financial markets is imminent.
The resilience of the stock market is testament to the willingness of investors to be herded into risky positions by central banks. A better example could not exist than the market action after the jobs report, with the S&P 500 trading down only 0.4% after the meager +38,000 jobs number and downward revisions to the previous two months. Eventually, those willing to be herded will be slaughtered, but the timing is too unpredictable. There will be a time to be short equity, but the signal will come from the credit markets. Watch junk bonds and corporate equities. Note that after the jobs report, high-quality bonds - LQD - were up 0.7%, while junk - JNK - was up 0.25%. This is not bearish behavior. The realization that one of the few remaining positive economic indicators over the past year - job growth - is weakening may eventually dent the markets. For now, just don't feel obliged to chase the debt-riddled bulls.
While I favor a sideways market until we break down, I recognize that if we break up out of the recent range, many will chase. That would fulfill the required fifth wave for Elliot wave cycle adherents. It could be fast and furious. If it does, I would suggest you sell into the rally. If you insist on buying something to participate, take profits early, as I just did in the iShares Russell 2000 ETF (NYSEARCA:IWM). In the interim, consider my three successful strategies portfolio allocation strategies this year, selling upside calls on stocks you want to hold, selling puts on long-term treasuries, and owning some gold.
Disclaimer: I am not a financial advisor. All financial decisions should be made considering your own circumstances after careful analysis. Consult with advisors you trust. I continue to own stocks and use options and other instruments to decrease my risk of loss and increase my probability of profit. Most importantly, enjoy your life, have fun, and be a Calm Investor.
Disclosure: I am/we are long AAPL, TLT, GLD, SBUX, DD, V, SLB.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: As expressed in the article, I may have long and short positions in the same stock or ETF. There is no implied obligation to inform readers of a change in position.