Why Inflated Asset Prices Are So Dangerous Today

Why inflated asset prices are so dangerous today... Real estate, stocks, and bonds all reach new record levels... Why are earnings falling?... Summer cruising on Two Suns...

In today's Friday Digest... you guessed it. Another warning about the unsustainably high level of financial assets.

But maybe this warning will be different. Maybe this warning will be the one that you really understand.

If you just want the summary, it's easy...

Never before in American history, or in the history of the modern financial system, have financial assets in America been this overvalued, period.

If you believe you're likely to do well as an investor in mainstream U.S. investment assets, like large-cap stocks (the S&P 500), real estate, or government bonds... you're making the biggest mistake of your financial life.

The odds of you getting wiped out (suffering a decline of 50% or more of your wealth) within the next 12 months have never been greater.

To understand my thinking and why I'm more fearful of the stock market than ever before, you need to know two things...

In last Friday's Digest, I highlighted the most important financial indicators, all of which point to a recession hitting the U.S. this year. But today, I'm going to focus just on the two broadest and most obvious problems with the U.S. stock market.

Two factors drive stock prices.

Yes, I know, an endless number of variables influence stock prices on a daily basis. There's market dynamics... sentiment... news flow. And of course, investors make all kinds of irrational mistakes – like the "flash crash" of August 2015.

What I'm talking about here, though, is how stock prices are determined over long periods, like weeks, months, and years.

In this regard, investors generally handicap two factors...

1. Earnings power
2. The market "multiple"

Sure, I know this is Finance 101. But a lot of our subscribers don't know much about how finance works. And even if you think you do... it often pays to review the basics and reconsider your current outlook.

Whether you end up agreeing with me hardly matters. What matters is that you're going to be informed and far more clear-thinking about your choices.

So please consider these two ideas carefully. And take the time to review them, even if you think you already understand these concepts fully.

Remember: There's no such thing as teaching, there's only learning.

You don't have to be a professional stock analyst to understand that the value of a business, ultimately, rests on how much income it can produce for its owners over time.

Income typically comes in the form of increasing dividends, which are provided by rising earnings power. That's why there's so much attention paid to quarterly earnings reports. Investors want to know if the companies they own are actually growing their earnings power.

Such growth usually presages a rise in dividend payments. Small changes to earnings growth can have a big impact on dividends (good or bad) over time. That's why earnings matter.

The other factor in stock prices – the market "multiple" – is equally important. Stocks generally don't sell for only one year's worth of earnings. They normally trade at a "multiple."

Investors constantly debate what the market multiple is and what it should be. Should stocks on average trade for five years' of earnings (a multiple of "5x") or 10 years' worth (a multiple of "10x")?

It makes sense that investors disagree about what the market multiple should be. Everyone is likely to have a slightly different opinion. But how can they debate what the market multiple currently is?

Don't public companies follow uniform accounting rules? Doesn't the U.S. Securities and Exchange Commission (SEC) require timely reporting of this accounting? How can there be any debate? Can't everyone just add up the numbers and do the math?

Well, you'd be amazed at just how much debate there is over earnings and how they should be reported.

Most public companies are so poorly managed and the accounting in these companies is so commonly "finagled" that 11 of America's most powerful and influential business leaders, including Warren Buffett and Jamie Dimon – the chairman of investment bank JPMorgan – recently met (in secret) to propose voluntary reforms.

You can read the open letter they published about the poor quality of America's public companies – the ones you own – here.

The biggest obstacle to understanding the true market multiple is the accounting.

Lots of companies want to exclude real expenses (like stock options) from their reporting. As a result, there's a form of the market multiple that has come into vogue today – operating earnings.

Simply put, these numbers aren't real. They inflate the real earnings power of a business. By doing so, they artificially lower the market multiple.

These new "kooky" numbers also make it hard to judge today's market multiple against earlier periods. Historically, S&P 500 stocks on average have traded for about 16 times their earnings – a price-to-earnings (P/E) ratio of 16.

U.S. large-cap stocks have rarely traded for more than 20 times earnings. When they have, it was usually because a short, sharp recession had decimated earnings (for a short time), not because prices soared so far in advance of growing earnings.

After the depression of 1893, stocks traded at 25 times earnings. Investors were looking past the short-term difficulty and focusing on the longer-term earnings power of the companies. That's what explains the excessive market multiple in the early 1920s, in the mid-1930s, and in the early 1960s.

Since 1990, however, something different has occurred. On two occasions, from about 1996 through 2000 and from around 2006 through 2008, the market multiple soared past 20 (and even 30 in 2000) simply because naive investors were wildly buying expensive stocks.

Investors made terrible decisions for two main reasons. First, the "cult of equity" was beaten into the American public, with systems like 401(k)s that were designed to automatically buy stocks (index funds) no matter what the market multiple or earnings outlook.

Remember that investors who plow money into their 401(k)s and select the S&P 500 Index as their investment vehicle will see their capital allocated according to the index... which simply ranks stocks by how expensive they are.

As a result, rather than handicapping these investments, about 40% of the money Americans put into stocks every year simply goes into the most expensive shares. It's completely illogical... but that's what happens.

Second, the low cost of borrowing money and easy access to discount brokers led to wild speculation in the most popular stocks. And so we've seen popular stocks achieve valuations that are simply nonsense – like the number of companies worth more than $10 billion that are trading for more than 10 years' worth of sales and don't have any profits.

The danger is... investor expectations that rapid earnings growth will justify these extremely high market multiples simply can't be met. Sooner or later, these multiples will contract.

And today, we face an additional, huge problem.

Currently the market multiple (25) is the highest it has ever been, outside of 2000 and 2008. But market participants can point to a U.S. Treasury yield of 1.5% and negative interest rates around the world and argue that compared with rates of return in fixed income, an earnings yield in stocks of 4% (1/25 = 4%) is very attractive.

And this same argument holds for virtually any kind of capital investment, whether it's stocks, junk bonds, or real estate. With money and credit so cheap, virtually any investment seems "undervalued" compared with fixed income.

That has created a much, much bigger problem than just another bubble in the stock market. The truth is, there's an even bigger bubble in bonds and commercial real estate.

Investment assets of all types (not just stocks) have been bid higher and higher to the point where our country now values its assets at more than 500% of our national income. Greg Ip of the Wall Street Journal wrote elegantly about this incredible dynamic last week...

The past two recessions were ushered in by a collapse in asset prices. The risk of a repeat is growing... U.S. stocks have hit fresh highs. Real estate is quietly doing the same...

Home prices are just 2% below the peak hit in 2007. Commercial property values have hit records.

The result is that net wealth in the U.S. now tops 500% of national income. Ominously, net wealth has reached that level only twice before: from 1999 to 2000 during the Nasdaq bubble, and 2004 to 2008 during the housing boom.

Here's my big concern: Excessive valuations don't necessarily trigger bear markets. You can't time the markets using only valuation.

But the more overvalued a market becomes, the bigger the resulting damage when a recession or a bear market finally arrives. I see three obvious triggers for a crash, all of which are already in motion. And I'm incredibly fearful – given the precarious state of our government's finances, the over-indebted nature of the general public, and the growing craziness of our political process – about what's going to happen when the "pin hits the shell."

As I said, the trigger is being pulled right now. How do I know?

First and foremost, economic dislocations that we're seeing in the credit markets today (thanks to the Fed's free-money policies) eventually produce real problems in the underlying economy. Those problems are manifesting themselves clearly now.

I detailed some of these problems last week (falling industrial production being the most important). But these problems are also manifesting themselves in a way that will hurt the stock market directly: falling earnings.

So far, 25% of the companies on the S&P 500 Index have reported second-quarter earnings. On average, the year-over-year decline is 3.7%. Assuming this trend holds (and I believe it will get worse as all the numbers come in), this will be the first time the S&P 500 has reported five consecutive quarters of annual earnings declines since the recessions of 2002 and 2009.

The truth is, we're in a recession right now – we just don't realize it yet. There's no way the market's multiple of 25 can withstand continual declines in earnings. Sooner or later, investors will panic when they realize they've dramatically overestimated these stocks' earnings potential.

When will that panic happen? I wish I knew. But sooner rather than later is my bet. Why do I think so? Because the world simply can't take much more of the central banks' zero-to-negative interest-rate policies.

Nothing works in capitalism with negative interest rates. Banks will collapse. Insurance companies will collapse. And if interest rates can't go any lower without causing a catastrophe, then one way or another, they must go higher.

As I see it, the stock market (and virtually every other financial asset) is inflated in price by at least 50%, if not a lot more. And right now, any one of three things could easily pop this global financial bubble...

1. A global banking panic: See Germany's Deutsche Bank... or the Italian banks... or the Japanese banks... or the Chinese banks. They're all insolvent. Sooner or later, depositors are going to realize that they can't trust these banks... or they'll simply refuse to put money into the system because of negative interest rates.

Already, major "foundations" of the system are turning to gold instead of cash, like insurance giant Munich Re, which for the first time in modern finance purchased and took delivery of more than $100 million worth of bullion.

2. A sustained economic decline in the U.S., leading to much weaker corporate earnings: I believe this is already happening. See industrial production. See the value of the Dow Jones Transportation Average. See the price of oil. See the five consecutive quarters of earnings declines.

3. Higher interest rates: Nobody believes that interest rates will move higher. But as long as interest rates are zero to negative, the pressure on commodity prices, corporate profits, and the banking system will intensify.

You can think of the 10-year U.S. Treasury yield as a kind of barometer for the health of the global financial system. As long as that financial instrument does not offer a substantial real yield (i.e. as long as interest rates don't provide any real return over inflation), this crisis isn't over. Capitalism simply doesn't function without interest.

At the risk of being the "boy who cried wolf," I will continue trying to educate and warn you about the real risks I see in the markets today. It's what I would want you to do for me if our roles were reversed. But please understand... I don't have a crystal ball.

I'm not suggesting that everyone sell everything. Please see my model portfolio in my newsletter – Stansberry's Investment Advisory – to see what I suggest you do, tactically, with your portfolio to help protect yourself.

Most important, diversify your portfolio. Have at least 20% exposure to precious metals. Have at least 20% of your portfolio in cash/cash-like instruments. Follow your trailing stops. (If you don't know how to do it yourself, use TradeStops. It's invaluable for individual investors.)

Whatever you do... don't put your head in the sand. The next 18-36 months will surely be the most difficult financial period of our lives.

But for those of us who are prepared... we will find more opportunities like we saw in 2003 and in 2009.

So don't think of the coming financial crash as a bad thing. Think of it as the greatest opportunity you will ever have to build vast amounts of wealth.

And enjoy the view. It'll be quite a show!

New 52-week highs (as of 7/28/16): AutoZone (AZO), Western Asset Emerging Markets Debt Fund (ESD), First Trust Emerging Markets Small Cap AlphaDEX Fund (FEMS), Fidelity Select Medical Equipment and Systems Fund (FSMEX), Madison Square Garden Company (MSG), Newmont Mining (NEM), Paycom Software (PAYC), Sabine Royalty Trust (SBR), and Wells Fargo – Series W (WFC-PW).

A light day in the mailbag... One subscriber is incensed by the mere mention of libertarian presidential candidate Gary Johnson. Do you agree? Let us know at feedback@stansberryresearch.com.

"How in the world could anybody in their right mind vote for Gary Johnson, a man who admits he gets stoned almost every day!

"It affects your mental thinking, can cause accidents and hurt other people, and it degrades your brain and health, as does alcohol... Do you want a stoner or drunk making major decisions that affect our citizens? I certainly don't!" – Paid-up subscriber Ron V.

Porter comment: Well... I guess my standards aren't as high (and mighty) as yours. What's wrong with getting stoned? How many retired folks drink every day? Compared to the other choices...? Sure, a stoner is fine with me.

Regards,

Porter Stansberry

Baltimore, Maryland

July 29, 2016

P.S. Next week I'm taking my two sons, Traveler (8) and Seaton (5), on our first father-son cruise on our boat, Two Suns (www.twosunscharters.com). We're going to Key West and then on to the Dry Tortugas.

When I bought Two Suns four years ago, this is what I dreamed about doing... having these incredible experiences with my boys. Whatever you're doing this summer, I hope it has been great. Let me know: feedback@stansberryresearch.com.

Teaching Myself Economics, Part I
By P. J. O'Rourke

I taught myself economics.

I'm not saying I did a very good job. But I am saying that the principles of economics are understandable even for a guy like me. I was an English major. I never took a single economics or business class in college.

I wasn't even really an English major. My chosen field of study was "whatever classes meet after noon, preferably only on Tuesdays and Thursdays."

The English professors at my college happened to be a hard-drinking bunch. They didn't get up too early. They were usually hors de combat on Monday and overserved by lunchtime on Friday.

What made me an even worse "econ ignoramus" was the fact that it was the 1960s, and I was a hippie. Hippies considered things like work, savings, investment, and profit to be "a bummer." (Although, with all the "wacky tobacky" we were trafficking, we hippies probably knew more about supply and demand than anybody in the business school.)

I got over being a hippie, but I went on to be a humorist, foreign correspondent, and political commentator who cared nothing about economic matters (other than my own paycheck).

It wasn't until I was about 50 that I finally realized one thing linked every subject I wrote about – whether I was making fun of pop culture, covering a war in the Balkans, or reporting on political campaigns.

Money.

Money isn't the root of all evil. Money is the root of everything. An economic motivation lurks somewhere behind every news story. And I didn't know anything about economics.

I started out by reading the schoolbooks that I would have read if I'd been taking sensible courses in college. Foremost among these was Economics by Paul A. Samuelson and William D. Nordhaus, which was the standard Econ 101 textbook in my day.

Ouch! For one thing, a new hardback copy of Economics retails for $305.37. For another thing, it's 800 pages long and written in a style that's as much fun to read as it is to take the book, lift it above your head, and drop it on your bare foot.

Plus, Samuelson and Nordhaus – while not being left-wing nuts – are pretty much standard-issue big-government liberal tax-and-spend neo-Keynesians. In other words, they're the kind of economists who got our economy into the trouble it's in today.

But it's an important book. Hillary Clinton, Donald Trump, and I are all about the same age. This is likely the book from which Hillary and Trump derived their basic understanding of economics.

The fact that Hillary and Trump don't have a basic understanding of economics makes it all the more important to find out what books they were flipping through and what words they were underlining that made them so ignorant.

I read the whole damn thing and several other typical Econ 101 textbooks. Here's what I learned...

Economists claim to study production, distribution, and consumption. But production requires actual skills, and so it can't be taught by Econ professors because they'd have to know how to do something practical.

And consumption is a private matter. Consider the consumption of toilet paper, condoms, frozen pizza eaten straight out of the microwave in the middle of the night, and cigarettes in the carport when your spouse thinks you've stopped smoking.

Therefore, economics tends to concentrate on distribution.

When economists say "distribution," however, they mean the distribution of everything, not just finished products like the pizzas and the microwave ovens to cook them.

There is also the distribution of raw materials – the seeds and fertilizer needed to grow the pizza toppings and the petrochemicals necessary to make the wood-grain plastic laminates decorating the ovens.

Then there's the distribution of labor – the effort required to freeze the pizza and round up all the microwaves.

And the distribution of capital – the money to buy plastic laminates and market pizzas that taste like quality pizzas.

There's distribution of ideas, too. (Whose idea was it to put pineapple chunks on a pizza?) And there's even distribution of space and time, which is what grocery stores, appliance stores, and Internet-shopping sites really sell us.

They gather the things we want in a place we can get to fast. And voilà, a fattening midnight snack.

All these things that get distributed are called "economic goods." To an economist, anything is an economic good if it can be defined by the concept of "scarcity." And the economist's definition of scarcity is so broad that practically everything can be called scarce.

Air is an economic good. If air gets polluted, we have to pay for catalytic converters and unleaded gasoline to make it breathable again. Even if the air is free, we have limited lung capacity. The more so if we've been out in the carport huffing Camels.

Air is an economic good for each of our bodies, and we hope our bodies are using the air economically – getting lots of O₂ into the bloodstream and not just making burps with it.

From an economist's point of view, everything is scarce except desires. Sexual fantasies are not economic goods. But if we try to act on them, they rapidly become economic (or highly uneconomic, as the case may be).

Goods are limited. Wants are unlimited. This observation leads economists to say that the fundamental purpose of economics is finding the best way to make finite goods meet infinite wants (though it never seems to work with sexual fantasies).

While trying to make finite goods meet infinite wants, economists spend a lot of time mulling over something they call "efficiency."

Economists explain efficiency as being the situation in which an economy cannot produce more of one good without producing less of another.

If you have two jobs, you've probably reached labor efficiency. You can't put in more overtime on Job A without putting in less overtime on Job B or the child-welfare authorities will come to your house. You're efficient, although neither of your bosses may think so.

The example of efficiency that Econ textbooks usually give is guns and butter. A society can produce both guns and butter, they say. But if the society wants to produce more guns, it will have to – because of distribution of resources, capital, and labor – produce less butter.

Using this example, you'll notice that at the extreme point of gun-producing efficiency, howitzer guns are being manufactured by cows. And this is just one of the reasons we can't take Econ textbooks too seriously.

Efficiency is a condition that has never been achieved, as you've seen from watching your inefficient Job A and Job B co-workers.

Economists don't really know much about efficiency, and neither does anyone else.

No doubt the citizens of 18th-century England thought they were producing as many lumps of coal and wads of knitting as they possibly could. One more coal miner would mean one less stocking knitter.

Then, James Watt invents the steam engine. Soon, coal carts were hauling themselves, and knitting mills were clicking away automatically. Now, everybody has more socks and more fires to put wet, smelly stocking feet up in front of.

Efficiency is constantly changing, and Econ professors can't keep up with this because they have to grade papers and figure out what "X" and "Y" equal on the graphs they use in their classroom PowerPoint presentations.

One thing that Econ professors do know is that the study of economics is divided into two fields, "microeconomics" and "macroeconomics."

Micro is the study of individual economic behavior. Macro is the study of how economies behave as a whole.

That is, microeconomics concerns things that economists are specifically wrong about. Macroeconomics concerns things economists are generally wrong about.

Or to be more technical, microeconomics is about money you don't have, and macroeconomics is about money the government is out of.

Since these two problems are all tangled up together in real life, I say to hell with the difference between micro and macro.

Economists also make a distinction – for no good reason I can see – between "inputs" and "outputs." Inputs are the jobs, resources, and money we use in order to make the outputs we want, such as money, resources, and jobs.

All outputs – even crap, heartbreak, and enormous illegal profits – turn out to be inputs: manure, movie plots, and legal fees for Panamanian law firms.

Two additional unimportant Econ textbook terms are "supply" and "demand." Scarcity has already explained these. There's lots of demand and not much supply.

Economists measure supply and demand with curves on graphs. When the supply curve goes up, the demand curve goes down. But how true is this? Concerning supply, do I get less hungry because I know I have a freezer full of pizza? My experience with the microwave at 2 a.m. argues otherwise.

As for demand, can we really know how much people want something? The kid "really, really, really" wants a hoverboard. But does he? Or after three times falling on his butt, is he going to leave the thing in the playroom where it catches fire and burns the house down?

Plus, on the supply curve for hoverboard demand, the concept of efficiency shows us that we don't know how many hoverboards can be produced or how cheaply we can produce them. And if we wait until next year, they may be giving out hoverboards free with Happy Meals.

All I learned from reading Econ textbooks is that, of the basic principles of economics, only one is meaningful: "Things are scarce"... which we all knew already.

I didn't feel like I'd gotten very far teaching myself economics from reading Samuelson and Nordhaus. And I hadn't. So I started reading the work of real economists, as opposed to economists writing Econ textbooks. (You can review my thoughts on those works here, here, and here.) And I started to pay attention to the actual economic behavior of actual people.

Fortunately, it turns out that, besides the useless "basic principles of economics," there are "other principles of economics." And these, in fact, are very interesting. I'll cover them in my next column: "Teaching Myself Economics, Part II."

Regards,

P.J. O'Rourke