After an almost decade long economic expansion, the emergence of liquidity fueled inflation has started to make its presence felt upon the global economy. There is just far too much money sloshing around the planet and it is being used in some inexplicable ways.
Excess liquidity is, in large part, the reason for the cryptocurrency mania; that mania has swept across various investment media outlets. Newly minted paper multimillionaires think little of placing a few thousand, or few hundred thousand dollars, into various cryptocurrencies. Their rationale is that they have earned such a respectable return over the last several years, in equities and real estate, that to lose a bit on cryptocurrencies is just a small , even justifiable, gamble. After all, on the heels of the 2017 returns, many investors received their year end statements and engaged in fanciful thoughts. I know of one investor, normally pretty dour, who is seriously considering purchasing a decrepit Scottish castle, with an endgame of restoring a regional seat and bringing his clan name back to prominence. Appraised against such a lofty, profit-fueled desire, certainly a modest bet on cryptocurrencies pales in comparison?
Such a gambling mentality, “I’ve made so much that I can afford to lose a little”, only makes sense in isolation. Certainly, if one loses a small fraction of unrealized profits on a portfolio, it does no permanent long term damage. However, what happens if cryptocurrencies plunge to zero, while, simultaneously, the global stock market falls 30%, or more, in the coming year or so? And, what if, just as we saw in 2008, the plunge temporarily takes global equities down by 50% or more for a short, highly tense, period of time? And what is this is the END of an economic expansion cycle, not the mid-point? Is it unrealistic to consider that possibility? In a dual selloff scenario, a formerly wealthy investor loses, on paper, half of their real money, plus ALL of their speculative capital. To cap off the pain, everyone’s home, second home and vacation home will also decline in value; markets are funny in that most are non-correlated during upward moves but fall almost simultaneously and by similar percentages during economic pain. A combined equity, housing and cryptocurrency crash offer the potential to stress out the global economy every bit as badly as the 2008 crash, which took equities down by more than 57% from the high.
There are now hundreds of billions of real dollars in cryptocurrencies, most purchased in the past year. A coordinated drop in global equities and cryptocurrencies could wreck the savings, lives and spending habits for several billion consumers on the planet.
In 2008, what broke the economy and sunk the stock market was housing; a speculative consumer bubble fueled by liquidity. The liquidity came from rising home prices and the extraction of current and expected paper “profits” from real estate. The end of the bubble led to a US based economic downturn and the bubble was bad. In the aftermath of that housing debacle, somebody took the time to count and determined that more homes existed in America than there were families to live in them. THAT American bubble had a domino effect globally.
There is substantially MORE liquidity now in the system than in 2008, largely due to quantitative easing programs that pumped trillions into global economies over a number of years. Withdrawal of easing has only been modelled due to the novelty of the program, so the impacts of quantitative tightening are unclear. However, in a general sense, liquidity tightens up as interest rates rise; the carry cost of leverage starts to exceed returns and ultimately, leverage is reduced. The reduction in leverage can readily offset a wide variety of economic good news; non-voluntary leverage withdrawal often exacerbate conditions and accelerate downtrends.
Anecdotally, recent conversations between myself and others have greatly increased my level of concern about equities. As most are aware, I believe that a healthy dose of skepticism is a useful attribute when it comes to investing. Investors, as indicated several posts back, seem to have fully built in Trump tax cuts as a driver of corporate earnings. What has actually taken place at the corporate level, is something less comforting; in the recent quarter, many companies have raised wages sharply and taken a raft of charge-offs against earnings. In some cases, the charge-offs ate up almost all of the tax benefit accrual for 2017. Such charge-offs suggest that companies were hiding a myriad of corporate bad decisions on balance sheets. As to the wage hikes, this represents a permanent increase in the cost of doing business and will be profit limiting for 2018 and beyond.
As an example, consider the announcement of quarterly earnings by CVS Health Corp. (CVS-NYSE, 70.55). CVS Health plans to use at least half of its tax benefit on reducing debt. The company also intends to use the money to increase salaries and benefits, invest in data analytics and care management solutions, and pilot new service offerings at its stores.
These investments and increased spending caused CVS to lower its adjusted operating profit growth outlook for 2018 from 1%-4% to a decline of 1.5% to a gain of 1.5%. The company expects full-year 2018 net revenue growth between 0.75% and 2.5%. In layman’s terms, rising wages could result in a real operating profit decline for 2018, which fully offset any benefits from the corporate tax cut.
Company after company is announcing record earnings, yet guiding down for 2018 based upon wage increases. The scope and scale of corporate writedowns reported in the current quarter is, frankly, shocking.
Investors have been unconcerned about rising interest rates and excess liquidity for some time. Even after about a week of greatly increased volatility and 1,500 point Dow intraday swings, most still remain, firmly, in the denial camp. Widely used justifications bandied about the investment media is that “analysts still rate this company a buy and have a higher target than it is trading, so things must be all right”. That is about a useful a comment as a realtor, representing the home seller, informing you that you should buy the vendor’s home because its going to go up, so trust him/her.
Even assuming that investment firm analysts are not directly tied to their M&A masters’ bidding, the point remains that analysts, at most investment houses, are far from anticipatory. Some are barely reactive; they take information, spooned out to them like porridge at analysts’ days, via a powerpoint presentation. This information is then placed into a spreadsheet, regurgitated to the public who assume that is a sacrosanct seal of approval. The only difference at most firms is their target price forecast; are they calling for a 15% share price increase, a 20% hike, or something greater? Investors love a higher target, so the higher the target, the rationale goes, the more reputable the analyst must be. Such confirmation bias is marketing gone mad near market tops. Has all remaining objectivity left the planet, on a Space-X heavy module, never to be seen again? When does a press release from a corporation get taken at face value when its only purpose appears to be in support of a bullish bias? What seems missing lately from analysts, and ultimately from investors, is legitimate skepticism. One doesn’t have need to be tarred as a cynic in order to legitimately question press releases and then consider alternatives.
Reliance upon brokerage and bank research, in a vacuum, has never been sound policy in the past and won’t save investors in 2018. While investors continue to talk up potential returns, they almost always underestimate the downward potential of equities. The average equity fell by about 57% in the 2008 bear market at the overall worst; some commodity based investors saw their stocks plunge a total of 90% throughout 2009.
Analysts always get a free pass during bear markets, they simply shrug their shoulders, get approval from head office to withdraw research coverage on stocks that fall badly and start anew.
The dirty research secret at investment houses is the use of the term “discontinued”. Investment firms bury portfolio killing mistakes with a simple discontinuance of coverage; it is a virtually risk free approach to hiding bad calls. A public “sell” call, on the other hand is both gutsy and legally problematic. Compliance approval is required, there is a ton of legal paperwork that needs to be signed off. The M&A department and banking divisions also need to clear a sell call, because that corporation being covered is likely not going to do business with an investment house that calls its stock a dog; there are many repercussions, which firms must consider, when downgrading a stock to a sell. So, in uncertain times, investors overly reliant upon an analysts that issued a buy rating, generally wind up holding the bag after the go-to bullish analyst is “reassigned” to other sectors.
And as to cryptocurrencies; the emergence of this mania seems to come straight out of some cautionary Russian fable of old. “A man, poor in wealth, but rich in his understanding of human greed, decides to create a fake currency. His objective is to exchange it for real money and live out a life of luxury. His starting story is that this currency takes considerable effort to produce and that supplies are limited. Armed with this plausible (on the surface) story, co-conspirators are then engaged for a rollout. Paid with the fake currency; the job of the marketers is to talk up the fake money until a sucker actually pays for some with real money. These co-conspirators tell that initial buyers that their new “money” is more valuable and they should buy more; and please, tell some friends”.
Fake currency schemes, the selling of magic beans for real dollars; that is not novel. There always have been, and always will be, suckers. In the case of cryptocurrencies, the wrinkle is that the perpetrators discounted the demand by speculators that arose from excess liquidity washing over the globe. The demand for magic beans took the creators by surprise.
The great conundrum for con-men is not the creation of the con, it is the ending of a successful con job. In 2007-2008, banks provided con-men with the easy exit; banks purchased most of the major sub-prime lenders. In this current market, investment banks, once again, seem to have fallen prey to the herd mentality. By creating legitimate options and futures markets for cryptocurrencies, trading boards (CBOE) have provided an easy exit for the creators of this “cash”. Those who initially dreamed up cryptocurrencies can quietly exit and take their billions of gains to an untouchable jurisdiction, without winding up in cement shoes, via forward contracts. It will be investment banks, and the public at large, that will be left holding the bag, should this end as badly as other manias.
On a macro view, based upon the early indications from corporations, 2018 looks less promising by the day. The cost of doing business for many corporations has now permanently increased, by amounts almost equivalent to the savings proposed from US tax cuts. Judging by the great number of “one-time’ writeoffs as the corporate level, balance sheets were not nearly as pristine as analysts envisioned. Interest rates are on the rise and valuations are priced for perfection. Companies that intend to acquire in 2018 with their tax savings are just buying somebody else’s inflated business. In the commodities sector, I recently reviewed the Andeavor (ANDV-NYSE, $100.80) acquisition of Western Refining, for a total enterprise value cost of almost $6.7 billion US. My conclusion was that the purchase, based upon valuation, might go down as one of the great bungles of 2017. Western largely consisted of three smallish refineries, one held in an LP, with less than 275,000 bpd of refining output, about 700 miles of pipeline, some storage tanks, a wholesale marketing division that provided a lot of revenue (but limited profit), 134 wholly owned gas stations as well as several hundred leased locations. That valuation, at almost 12x EV/EBITDA, seemed outrageous to me at any price other than a market bottom, in the commodity space. Tentative write-downs have already started at Andeavor, in a preannouncement warning. In my view, supposed synergies will be more than offset with massive goodwill; writedown risk is high.
M&A transactions are disconcerting near market tops; they can be absolutely devastating in an economic downturn. In a sellers market, the best decision one can make is to not participate as a buyer, until rationality is restored. Any company that made significant acquisitions in the latter part of 2017 runs the risk of being exposed as a share value destroying “overpayer”, should the economy stall out.
For the first time in 2018, fear is returning to the marketplace. That is always a good thing; fear serves as a counterweight to reign in speculative impulses. However, willingness of investment banks and various markets to legitimize cryptocurrencies, via allowing options and futures to be traded, increases the risk of a crash in one market, that can spill over to, and maim, other markets. I will be surprised if US equities wind up even, at 2018 year end.
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