Time to Make an Orderly Exit from This Market

Tuesday night the US market was a little more upbeat.

Oil continues to retreat to the psychological level of US$30.

The suicide bombing in Turkey was another reminder of the always simmering tensions in the Middle East.

Gold failed to hold ground above the US$1,100 mark. However, with the Aussie dollar falling under US$0.70 cents, Australian gold holders have done OK recently.

All eyes are on China’s casino-like share market. Will investors again take flight, or are their nerves calmed? The reported level of China’s economic growth is fraudulent. Falsified growth data and excessive levels of borrowing created an illusion the West wanted to believe was real. As the extent of the fraud is revealed, China’s market will respond accordingly…more days of large falls await us.

What options do investors have?

Panic. Don’t panic. Invest for the long term. Take profits. Reduce exposure. Buy the dips. Time in the markets beats timing the market. Buy low, sell high.

With so much conflicting advice, what do you do?

Investment Bank RBS has warned its clients to brace for a ‘cataclysmic year’. The banks advice is ‘get outta Dodge’.

According to the report RBS sent to investors: ‘This is about return of capital, not return on capital. In a crowded hall, exit doors are small.’

Others suggest the ‘correction’ is a perfect time to stock up on quality companies trading at a discount.

The following chart shows what the ‘smart money’ is doing.

Traders in S&P 100 (OEX) options — professionals who bet on where the S&P 100 index is headed — tend to pick the correct trend of the market more often than not.

The indicator is triggered when put options (betting on a falling market) outweigh the number of call options (betting on a rising market) by a factor of two to one. This happens when the blue line breaches the dotted red line labelled 2.0.

On Monday 21 December 2015, the indicator hit an extreme reading of 3.3 to 1.

Source: J Lyons Fund Management

Click to enlarge

Between 1999 and 2014 — a period that includes the dotcom bust, 9/11, invasion of Iraq, subprime meltdown, GFC and Greek crisis — the indicator recorded 15 readings greater than two to one.

The professionals were on the money in mid-1999 (prior to dotcom collapse), late 2007 (before the GFC hit) and in 2011 (just prior to the Greek crisis).

In 2015 there were 166 readings. That tells you in bright neon lights how nervous the professionals are about the US share market.

And who can blame them.

The Fed has thrown the greatest asset appreciation party in history. But all good things must come to an end…even the Fed’s legendary generosity to Wall Street.

The recovery has been about as authentic as a $4 note.

The professionals (with real money in the game) know this. But when so much easy money was there for the taking, they had no intention of biting the hand that fed them (pun intended).

However, the game is now getting dangerous.

Companies are running out of accounting tricks to load out earnings. When earnings start to truly reflect revenues, it won’t be pretty.

Multiples being applied to these puffed up earnings are well above historical averages. Everything is priced for perfection or a double down from the Fed to keep the whole charade in play.

Debt levels continue to relentlessly increase. Commodity prices are gripped in a deflationary spiral. Corporate defaults are threatening to explode — the next chart shows the share of companies losing money (LHS) overlaid by the default rate (RHS).

If the 30-year trend remains constant, the gap will close — with corporate defaults skyrocketing.

Source: Credit Suisse

Click to enlarge

The obvious candidates for a spike in defaults are US shale oil companies.

As my fellow Markets and Money editor Jim Rickards has often stated ‘a lot of this debt was issued on the basis of oil being at US$60’. If you would like to hear more of what he has to say check out his publication, Strategic Intelligence, here.

These businesses are losing money hand over fist. Common sense tells you that this is not an arrangement that can last permanently. At some point we’re going see a wave of defaults and credit markets will be swamped with debts worth cents in the dollar.

Income hungry investors — forced to chase this high yield rubbish because of the Fed’s zero interest rate policy — will become capital starved non-investors.

We’ve seen this play out here with unlisted property trusts and mortgage funds that promised high returns and delivered a much lower level of capital.

There’s little doubt China, in an attempt to keep its export sector competitive, will continue to weaken its currency in 2016. That’s bad news for those looking for inflation.

Cheaper Chinese goods flooding the market is deflationary. US manufacturing will suffer, which can’t be good for jobs.

In reading this morning’s Daily Reckoning from the US, David Stockman begins with:

According to the Bureau of Labor Statistics (BLS), the US economy generated a minuscule 11,000 jobs in the month of December.

Pretty pathetic for an economy that’s supposed to be in recovery.

As the currency war escalates, Japan and Europe will respond with a salvo of measures aimed at pushing their currencies lower.

Australia’s response is likely to be further interest rate cuts — with the intent of pushing our dollar lower. The race to the bottom of the currency barrel is destructive and deflationary.

There are powerful forces at play within the economy that will expose the incompetence of the world’s central bankers. When the fraud is revealed it’ll be too late to save your capital…the damage will be done.

The smart money is edging towards those small exit doors before the crowd panics.

The talking heads on TV, fund managers and financial planners will most likely tell you to sit tight and weather a little volatility. All is well with the world. These people make a very good living from you remaining invested.

Take these utterances with a grain of salt.

As always, you should follow the money.

The large number of OEX Options Indicator readings in 2015 tells you the professionals are extremely edgy and are looking to protect their capital. That’s the reality.

My advice is don’t panic, but act decisively. Reduce your share market exposure to a level that will enable you to pass the sleep test…being able to go to bed without having to worry what might happen on overnight markets.

In my opinion we are not in for a single cataclysmic year, we are in for a disastrous few years. Unwinding the excesses of the past will not be done and dusted in the space of 12 months.

We’ve been conditioned for far too long to believe markets respond in a certain manner. Accepting that this is no longer the case will not happen easily. Markets will grind investors into submission, and that takes time.

Every secular bear market in history has had one objective — that’s to crush the over-optimism of the preceding secular bull market. Taking markets from being over-valued to under-valued.

When this market is finished doing what it has to do, pessimism will reign supreme.

As Buffett says, ‘Be fearful when others are greedy and greedy when others are fearful.

The time to move towards the exit is while others still believe the spin from an industry acting out of self-interest and over-confidence.


Vern Gowdie,

Editor, The Gowdie Letter

From the Port Phillip Publishing Library

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Vern is a contributing editor to Money Morning — Australia’s biggest circulation daily financial email. (To have Money Morning delivered straight to your inbox you can subscribe for free here).

Vern has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia's Top 50 financial planners. His previous firm, Gowdie Financial Planning, was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top 5 financial planning firms in Australia.

Vern has been writing his 'Big Picture' column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback. His contrarian views often place him at odds with the financial planning profession. In his leisure time Vern remains active with triathlons and pilates.

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