Thursday, December 20, 2018

Money Illusions Begin to Unearth in Bear Markets

"But in the end, alchemy, whether it is metallurgical or financial, fails. A base business cannot be transformed into a golden business by tricks of accounting or capital structure. The man claiming to be a financial alchemist may become rich. But gullible investors rather than business achievements will usually be the source of his wealth."
-Warren Buffett

"Only when the tide goes out do you discover who's been swimming naked."
-Warren Buffett

A "Dow Theory" indicator, the Dow Transports index is finally in a bear market, down 20% from its September high. As other indexes, including DJIA, continue to hemorrhage (down 13% from October high), uncertainty fills the air. Many individual stocks were already in bear markets, as a Barron's article, reported earlier today [1] . The S&P darlings are stumbling: Netflix, down 38%; Facebook, down 36%; Apple, down 30%; Amazon, down 26%. The S&P's worst decliners include Mohawk Industries, down a whopping 59%, and GE down even more so, 63%!

As an Austrian, one can't help wonder: were these gains ever real to begin with?

Let's rewind for a second, and go back to when QE1, 2, and 3 first happened. The Fed bought MBS, Treasuries, and other securities in bulk primarily to "stabilize" the financial sector in November of 2008 [2]. In November of 2010, three months after the first QE ended, it started up again, with time with a focus on the Fed just buying Treasuries to add to its already bloated balance sheet.

Then, in September of 2012, the Fed introduced the third bout of quantitative easing. The difference between QE3 and previous QE programs was that the Fed chose to have a monthly approach for purchases instead of buying it in bulk.

Bernanke stated once that this Fed policy was primarily to inject liquidity into the equity markets. By late 2012, the DJIA had already recovered to pre-crisis levels, but after QE3, it took off. It's not far-fetched to assume that any gains from the start of 2013 and are just as real as the money Bernanke printed to reflate the stock market bubble [3].

Remember, each program has some lag associated with it. You don't know the extent until some time has passed, and introducing three rounds of QE within a short amount of time doesn't leave much up to the imagination of what follows next, and how big the effects will be. Mises once stated that financial assets are the primary beneficiaries of a central bank's interventions in assets. As we've seen since its peak in 2007, the S&P has almost doubled, a trend unlike past cycles.

Look at stock charts of individual companies within the DJIA, and the S&P. Asset inflation is very clearly evident there. Wherever you see a tide rising, or rising sharply after 2013, look elsewhere for opportunities.

Inflation not only has effects in inflating asset prices, but also has effects in the real economy. Price increases ultimately boost corporate earnings. Which sectors can this been seen? Look in consumer discretionary, industrials, and health care. That should tell you to stay away from companies that rely on price increases to bolster their earnings. Those that come to mind are Apple, Samsung, Mohawk, industrials (airlines), and health care. Why stay away? Selling prices will eventually revert to the mean. When it does, those earnings will collapse.

More importantly, we've seen the build-up of leverage at unprecedented levels at the federal and corporate levels, not to mention bubbles in housing, credit cars, student loans, auto loans, you name it. As the equities are the first to pop (FANGs were among the first to be in a bear market), it won't be long until the "everything bubble" will come crashing down.