Credit, Credit Everywhere: Why The Wild Roller Coaster Ride Will Continue

Includes: GLD, SPY, TLT
by: Steven Jon Kaplan

Consider the bipolar behavior of the SPDR S&P 500 Index Fund (SPY) in recent years. It rallied to a new all-time high of 119.23 on July 20, 1998, followed by a slump to an important low of 92.22 on October 8, 1998. This was followed by another all-time high of 155.75 on March 24, 2000, and then a slump to a lower low of 77.07 on October 10, 2002. After this, we experienced yet another higher high of 157.52 on October 11, 2007, and then an even lower 12-1/2-year bottom of 67.10 on March 6, 2009, followed by still another higher high of 159.71 on April 11, 2013. After these wild gyrations, few analysts recognize the obvious continuation--an even deeper nadir below the March 2009 bottom during the next few years, followed by an even more elevated zenith above its 2013 top several years later. This would create a sequence of roughly 25 years of higher highs and lower lows for the exchange-traded fund with the largest total market capitalization. Very few realize this pattern of extremes in both directions, which has developed; the few who are aware of it oddly don't think it can continue. Some analysts are bulls and some are bears, but very few can accurately see why both sides will continue to prevail in alternating fashion.

In case this seems like an unusual exception, consider how other assets have behaved. Gold skyrocketed above 850 U.S. dollars per troy ounce on January 21, 1980, and then slumped to a historic low near the turn of the century, which by some measures was an all-time double bottom after adjusting for inflation in August 1999, at 252 U.S. dollars per ounce and again in April 2001, at 254 dollars per ounce. Following the introduction of exchange-traded funds for gold bullion including GLD, we can see that GLD achieved a new all-time high of 185.85 on September 6, 2011, and thereafter slumped to 130.51 on April 15, 2013, which was its lowest point since February 3, 2011, and was accompanied by numerous brokerage downgrades after most or all of gold's decline had already occurred. If this pattern continues, then GLD will achieve a new all-time high within a year or so; afterward, it will probably drop below its 2013 bottom by 2015, or 2016, and will thereafter set a new all-time high before the end of the decade. Gold will thus form a pattern, which is not precisely like the S&P 500's more unusual chain of higher highs and lower lows, but nonetheless represents dramatic swings toward both extremes.

Long-dated U.S. Treasuries and their funds including the iShares Barclays 20+ Year Treasury Fund (TLT), which exclusively holds U.S. Treasuries with an average of 28 years to maturity, have formed numerous higher highs since this asset class had bottomed way back in August 1981, and I strongly believe they have a few additional higher highs ahead during the next couple of years. TLT slumped to 88.14 on February 9, 2011, which was just above a four-year bottom; by July 25, 2012, TLT had soared to an all-time peak of 132.21. During the next year, TLT might slide back toward 100, and then surge skyward again to 140 or 150 as the yield on the 30-year U.S. Treasury eventually plummets below 2%. Later in the decade, U.S. Treasuries could realistically plummet to a multi-decade bottom if Treasury rates "surprise" most investors by moving back into double digits.

We also have real-estate bubbles around the world today, after millennia had passed without anything resembling a bubble. Why would this well-established asset suddenly behave differently in recent decades after merely tracking the inflation rate literally since records were kept?

What is happening here? Why do assets keep fluctuating back and forth between multi-year and multi-decade extremes in both directions? This was much less common in the second half of the 20th century, when the financial markets were mostly characterized by non-volatile behavior and relatively predictable patterns. What has changed?

There are many reasons for this development, including the introduction of exchange-traded funds, which exaggerate up trends by requiring the funds' managers to create new shares after an uptrend and to destroy shares after a downtrend. The increased prevalence of institutional traders including momentum players, compete with computer software, which encourages buying into upside breakouts and selling into downside breakouts, is part of the story. This still wouldn't explain what has happened with real estate, which isn't subject to buy stops and computerized house buying. It also wouldn't account for the sharply increased volatility in emerging-market assets which have fluctuated wildly in both directions in recent decades even more than developed markets, in spite of mostly having a lower participation rate of momentum players and computerized trading.

In my opinion, the key ingredient is the sharply increased use of borrowed money around the world. Through much easier credit than had existed previously, assets, which were previously accumulated strictly on a cash basis are bought with little or no money down. This especially accounts for the increased prevalence of real-estate bubbles around the world, which have become dangerously extended as average annualized rental returns of 7.5% have fallen to roughly half that level in many cities. In the United States, many "homeowners" have zero equity in their property; they are perpetually refinancing mortgages, which will be paid off far into the future, if ever. Many have substituted paying a mortgage for paying rent, and can't see beyond comparing their mortgage payments with rent-equivalent payments without realizing the essential difference in their much higher risk exposure where a 30% decline in home values would put them deeply underwater, would make them likely to default, and would leave them with no realistic way to make up for the loss. In countries where mortgages were nonexistent a few decades ago, people are able to buy houses with little or no money down; especially with negative real yields from safe time deposits, people in many countries are increasingly encouraged to own real estate without understanding the consequences of a substantial price decline. Real-world examples including Japan, Spain, Ireland, and parts of the U.S. haven't discouraged those living elsewhere, who universally perceive their neighborhoods as being magically superior and unique and thereby immune to a serious decline. As a result, real-estate prices will behave similarly to other risk assets, periodically zooming to new all-time highs, while at other times plummeting by 60%-70% as they had done in Phoenix, many parts of Florida, Detroit, Las Vegas, Atlanta, and most of Japan, Spain, and Ireland.

If you're buying a Nasdaq pink-sheet stock with a few thousand dollars, then you know the risks you are taking. If you buy a house for a half million dollars with almost nothing down and a total household income of one hundred thousand dollars per year, then you might not be prepared to be behind by one or two hundred thousand dollars with limited outside assets to cushion the loss. The problem with borrowed money--and make no mistake about it, buying a house on 20% down is not much safer than buying a basket of high-yielding stocks on 20% down--is that it magnifies fluctuations in both directions. On the way up, people will be encouraged to buy much more than they should, while on the way down when credit becomes much more difficult to obtain, people will sell out of panic. Much of the recent plunge in gold and silver was caused by futures being stopped out after having been bought on margin. If houses weren't bought with mortgages, there wouldn't have been such a steep percentage loss in most parts of the world.

In developed countries, credit has been relatively easily available for decades. In emerging nations, there was often a drastic transition from almost an entirely cash-based economy to heavy use of credit within a decade or two (or even less in some places like Vietnam). Whenever money is borrowed, there is an immediate positive impact from the spending, and a long-term negative impact as money, which would have been used for consumption, is needed to repay the loan. Thus, whenever any society transitions from cash to credit, there is an immediate artificial increase in GDP growth, which cannot be sustained over the long run. This increased spending encourages over speculation, which usually finds its way into either inflated equity valuations, or housing bubbles, or both. Countries which have experienced their first-ever overvalued equities combined with their first-ever housing bubbles are the most vulnerable to a sudden reversal for both, which some countries such as Vietnam, Peru, and Mongolia are unfortunately likely to discover during the next few years. Brazil and Russia experienced double-barreled equity and real-estate overvaluations five years ago, with subsequent collapses for both less than a year later--followed by renewed bursts of both growth and contraction thereafter and even more dangerous housing bubbles now than they had five years ago.

The biggest repercussions are likely to continue to be felt in emerging markets, which will have to be accustomed to even more unpredictable boom-and-bust cycles than developed markets. Interestingly, some developed markets including Canada and Australia, have experienced some of the world's most overvalued housing markets, and are therefore going to behave very similar to developed markets. This will include currency fluctuations for the Canadian and Australian dollars which, in spite of their much higher liquidity and importance, will be just as volatile as much less frequently traded currencies in both directions. The Australian dollar may hit a new all-time peak versus the U.S. dollar and other currencies later in 2013, and could then plummet by 40% or more. Four years ago, no Australian city was among the world's top 100 in terms of costs; today, eight out of the top 30 most expensive world cities are Australian, including Sydney, at number three. If the Japanese yen continues to slump, Sydney could take over the number one spot. In Toronto, the artificiality of the real-estate "boom" is belied by the fact that rents have actually declined during the past four years even if you don't adjust for inflation. If both rents and housing prices have doubled in four years, as has been the case in Ulan Bator (Mongolia), then you have some actual economic growth even if some of it may be artificially encouraged by a more widespread use of credit. However, if housing prices have doubled but rents have remained flat or have declined, then there is an even more dangerous situation because it highlights the irrational overvaluation of real estate, which would have to drop by half to restore equilibrium. I doubt that many Canadians or Australians or Brazilians or Russians are prepared to see their housing prices drop by half--and probably by more when measured in U.S. dollar terms.

I don't mean to suggest that countries should go back to being all-cash societies, or that they should outlaw the use of mortgages. For better or worse, credit is a part of modern life; once the genie is let out of the bottle it can't be put back in. However, people around the world must be far more aware of the likelihood of extreme highs and lows for assets, which they may consider to be "safe" such as real estate or high-yielding equities, but which are actually quite dangerous and volatile. Obtaining a negative real yield from a safe time deposit is unappealing, but it may often be the best of a set of unpalatable choices. Investors who are using the lack of yield as a reason to speculate in stocks or real estate or Treasuries or anything else are likely taking risks without realizing how dangerous they really are. Some people will of course benefit from the wild gyrations for assets of all kinds, but far more people will be harmed by them. Very few are selling their houses near bubble peaks, or selling stocks near all-time highs; many will panic out of anything when it is near a bottom whether it's gold, a foreclosed home, or emerging-market stocks whenever lower lows are being set for many weeks in a row and the future looks indefinitely bleak.

The financial markets have always been about the few benefiting at the expense of the many. A century ago, it was mostly upper-middle-class people in a few developed countries repeatedly losing money through equity speculation to better-informed insiders and institutions. Today, middle-class people worldwide are repeatedly buying stocks high and selling them low. More importantly, billions of people are buying homes on margin near bubble peaks, out of fear of missing out, and later being foreclosed near panic bottoms several years later. The real-estate issue is even more pervasive and devastating, because the average family isn't likely to have hundreds of thousands of dollars in stocks and bonds but are very likely to have that much invested in real estate--and using borrowed money.

In early 2009, as emerging-market equities had plummeted by 80% in countries including Brazil and Russia, many people in those places finally learned what capitalism is really all about. Unfortunately, this lesson will become even more widespread during the next few years, with Peruvians soon to understand the risks of a housing bubble, while Mongolians experience their first-ever stock-market crash. It can be exhilarating to finally be part of the global economy, but it can also be impoverishing. If some parts of Africa and other countries where prosperity still hasn't been truly experienced finally enjoy economic growth later this decade, then eventually it will be accompanied by equity and housing bubbles, which will duly collapse sooner or later, enabling Ugandans and Ghanaians and others who live in so-called "frontier markets" to experience similar joys and tribulations. Globalization is mostly about the increased use of credit, which gives and takes with dramatic force. When you're making investment decisions, remember that extremes are likely to become unusually extreme in both directions, back and forth and back again.

What is the best way to capitalize on this situation? The most consistently profitable approach is to recognize that whatever had previously been strongly in favor, but is now just as powerfully out of fashion, will once again become wildly trendy. Therefore, you can either sell short whatever is currently extremely popular, or you can buy whatever is extraordinarily disliked, or both. Currently, high-dividend assets have been so widely recommended by financial advisors and embraced by investors unhappy with negative real yields on safe time deposits that they have made utilities (XLU), consumer staples (XLP), telecommunications shares (IST), REITs (VNQ), and similar high-yielding names dangerously overvalued and therefore good candidates for selling short. Meanwhile, cyclical securities and especially the shares of commodity producers have been trading at multi-year lows, including gold mining equities and coal mining companies, and are therefore ideal for buying. As the wild roller coaster ride continues, keep in mind that what goes up must come down and then go back up again, so you can continue to profit by capitalizing on the most extremely lopsided situations in both directions.

Disclosure: I am long GDXJ, KOL, XME, REMX, SLX, COPX, FCG, GLDX, SIL, GDX. 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: In addition to purchasing funds of commodity producers into pullbacks during the past year, I have been progressively selling funds of general equities since January 28, 2013.