THOMAS NOGALES FINANCIAL, LLC
September 2007 Update
The S&P500 is at 1473 on 31-August-2007
Year to date, the S&P500 index is up 5.1% and the TNF Balanced Portfolio is up 2.7% (with half the stock market risk.)
Symbol |
Return |
Asset Class and % of Total |
PCRIX |
+3.01 |
Commodity Futures 10% |
VGSIX |
-8.00 |
REIT Index 10% |
VFINX |
+5.13 |
S&P500 15% |
VMFXX |
+3.42 |
Money Market 5% |
VBMFX |
+3.08 |
Bond Index 30% |
VGTSX |
+9.96 |
International Stock 15% |
VISVX |
-1.16 |
Small Cap Value 15% |
As of 8/31/07
Market Alert Model
The TNF core model is used to time large cap stocks. It’s currently IN the stock market. Stay invested with proper diversification.
Year Ahead Timing Model
The YAT model is used to indicate periods of buy opportunities within the Market Alert Model’s timing cycle. The TNF Market Alert Model always trumps the YAT model. The YAT model is positive.
Interest Rate Model
The TNF Interest Rate model is negative on interest rates and long bonds.
On August 15th, I emailed the following alert to subscribers:
Wednesday, August 15th 2007
At 1406, the S&P500 is now negative for the year. The TNF Market Alert cyclical model remains in the stock market. The TNF Interest Rate Model has been out of long-term bonds since January 2004. This means that the money normally allocated to bonds in a portfolio would be in short-term bonds and not in long-term durations.
I realize that the bad news in the credit markets has many investors afraid. Hedge funds are liquidating stocks to raise cash and regular investors are fearful and some are selling. The perennial bears are out in full force and the headlines are terrible.
My Year Ahead Timing Model now states that current valuations are compelling and extremely positive for stocks. Historically, similar valuations and economic conditions have been very auspicious for stocks over the following months.
The S&P500 could go lower, but it will just wind the spring even tighter.
It's a very rare event when Main Street can witness legions of quants and speculators on Wall Street falling flat on their face. It's a hard squeeze and it offers opportunity.
If you have cash set aside to invest and the courage to step forward, this could be a very good time to add to your portfolio allocations.
The stock market opened lower only to surge back and close the day at 1413. Over the next two weeks the market then went higher. This timing call appears impressive because it caught the short-term market bottom.
This Alert is now cancelled.
It should be clearly understood that my timing models are experimental and there is no certainty of future success. My stock market models are based on 30 years of past data. Statistically, that isn’t enough testing time to say they will continue to work under all future market conditions. I mention this because I don’t want people to “bet the farm” on my models. Financial prognosticators have fallen on their face in the past due to flawed methodologies that didn’t hold up at a critical point.
My timing models continue to say that stocks are safe for the near future. But, what if I’m wrong and my models fail. Are you prepared? I continually stress the need for a balanced portfolio so market downturns don’t crush your finances.
This month’s e-letter will discuss my view of longer-term stock market potential.
Government debt will become a dominant theme after the next election, and possibly before, as the rivets start blowing out on the nation’s economic infrastructure. I believe investors need to be cautious over the next several years because the tide is going out on the traditional supports for the financial markets. It remains to be seen whether robust globalization can take up the slack or even continue.
The question in the news right now is whether the subprime loan mess will lead to a recession. That is the wrong question to ask. A timely recession forecast by the people who track such things is mostly irrelevant to us as investors for the following reason. The stock market usually tanks the most prior to recessions.
A recession forecast comes too late to be of any help. Stock indexes lose points quickly well before a recession is recognized. The stock market is the ultimate leading indicator of financial conditions.
Of more importance to investors are two things. First, we need to know the valuation trend of stocks. Second, what is a nation’s ability to generate the growth that sustains rising corporate earnings. There's reason for concern on both issues.
My research shows that the US stocks are now in a long-term valuation downtrend. The valuation uptrend started in 1982 and, for reasons I’ll soon explain, cannot be sustained.
My prime concern is that the United States now lacks the fiscal reserves to resuscitate the economy when the next big recession hits. The US debt situation is now so serious that it is certain to impact consumer spending, investment returns and national defense. The nation has unsustainable spending and taxation policies. The balance of this e-letter will spell out the problems.
I’ve observed knee-jerk conservatives on TV who go on endlessly about how wonderful the economy is and how Bush’s implementation of Reagan-style economics has created a bounty for the nation. They speak of Reagan with a reverence usually due a saint. Well, this economy is like a skinny guy looking at himself in a sideshow muscle-mirror. Ronald Reagan was the guy with the big smile running the carny. Things ain’t as they appear.
Last month I wrote: Leon Levy, the head guy at Oppenheimer wrote a book just before he died. It was called The Mind of Wall Street. His book was published during the market crash (August 2002). He said that the stock market was in grave danger and would sink much lower and back to 1995 levels (around 600). He said, "The only thing that could hold up this economy would be a massive fiscal expenditure program on the level of WWII."
That's exactly what we got. The Bush administration, supported by the Federal Reserve and congress, went on a spending binge after 2001 to pull the economy out of its tailspin after the stock market crash. The national debt was $5.5 trillion in 2001 when Bush took office and will be $10 trillion when he leaves. After the 2001 market crash, he will have doubled the US national debt in 8 years to prop up the financial markets. The money was spent on his Iraq war, tax cut programs and any other pork project congress could dream up. No spending bills were vetoed. Loan standards were dramatically loosened and consumers were induced to borrow money and spend it. This could only happen with the Federal Reserve's approval. Thus, the subprime loan mess is the direct result of US government policy.
Why did this debt surge occur? It happened because the government typically uses fiscal stimulus (spending lots of money by issuing debt) to lift the economy out of recessions. This traditional method has been used for most of the 20th century. The 2001 recession was so dangerous that they took a big risk and encouraged consumers to borrow and spend recklessly. The Feds needed every dollar from every source to lift the economy.
Back to Leon Levy. He was certain the stock market would go much lower after the 2001 crash, but he was wrong. Why was he wrong and how did the US avoid that fate? Levy was certain stocks would fall because he recognized in 2002 that the level of debt needed to lift the economy would require a ruinous amount of leverage. In 2002 he found it impossible to believe that the president and congress would be so reckless that they’d double the national debt. But, that’s precisely what they did.
Deficit spending works well for a while because every dollar spent has a multiplier effect as it ripples through the economy. Company A gets a government contract and spends on widgets from Company B who earns a profit and pays employees who buy consumer goods from Company C. The government gets tax revenue from companies and workers at each step. Things look great UNTIL the interest on the debt grows faster than the incremental tax revenue collected. At a critical point, the rate of debt growth exceeds the rate of economic growth.
Why is the debt problem not addressed? Because spending money gets politicians re-elected. There were many critics of debt in the 1980’s who have been silenced because the economy continued to grow without a revolt by bond buyers. It’s now fashionable to dismiss warnings about the national debt. Debt critics are dismissed as provincials who don’t understand government finance. Some economists say, “Debt doesn’t matter.”
The chart below shows the annual rate of debt growth compared to GDP growth for each president. The US rate of economic growth is slowing, but the rate of debt growth exceeds GDP growth. That’s because the interest on the debt never goes away. The orange bars need to be lower than the green bars for many years.
Under Johnson, Nixon, and Carter each dollar of debt spent returned an increasing rate of GDP growth. Under Reagan and Bush-1, the situation reversed - they spent debt at a far greater rate than GDP grew. Clinton heeded warnings and tried to cut back on debt. This caused the economy to slow and contributed to a dangerous recession in 2001. The government panicked and national debt doubled under Bush II.
Bush and congress spent everything in the cookie jar and borrowed all they could for eight years. The Iraq war may be a failure, but if Bush stops the spending he risks a recession more severe than in 2001. That’s why he recently stated that the US would not exit Iraq while he’s president. He wants the next president to deal with the war and the economic fallout.
Washington’s hands are now tied going forward. The rate of economic growth has been steadily slowing. That means tax revenue is now growing at a slower rate than debt rises. Left unchecked, debt will overwhelm the nation’s finances. As you’ll soon see, the debt growth rate must be cut back. This means that the US government can no longer continually use debt to expand the economy.
It can’t spend its way out of the next large economic downturn.
Each additional expansion of debt risks another and more dangerous future recession.
How bad is the problem? David Walker is the US Comptroller (America’s top auditor) and he’s been traveling the nation and speaking in town hall meetings in order to warn the public. He gets little notice. He can speak freely because he’s non-partisan and is appointed for a 15-year term.
“The US government is on a ‘burning platform’ of unsustainable policies and practices with fiscal deficits, chronic healthcare underfunding, immigration and overseas military commitments threatening a crisis if action is not taken soon.”
David Walker, comptroller general of the US, issued the unusually downbeat assessment of his country’s future in a report that lays out what he called “chilling long-term simulations”. These include “dramatic” tax rises, slashed government services and the large-scale dumping by foreign governments of holdings of US debt.
Drawing parallels with the end of the Roman empire, Mr Walker warned there were “striking similarities” between America’s current situation and the factors that brought down Rome, including “declining moral values and political civility at home, an over-confident and over-extended military in foreign lands and fiscal irresponsibility by the central government”.
You can Google “David Walker Comptroller” and read more.
Here’s an article from 2005. http://www.usatoday.com/news/washington/2005-11-14-fiscal-hurricane-cover_x.htm
Let’s take a short tour of Ronald Reagan’s ‘economic miracle”.
From 1950 to 1980 debt grew slowly. In the 60’s and 70’s the US experienced inflation. After Ronald Reagan took office in 1980, the government used debt to expand the economy out of its stagflation.
For the 25 years from 1958 to 1982, the national debt rose 340%. From 1982 to 2007 it rose 780%. Critics of these comparisons say debt levels are only relevant if compared to a nation’s GDP – the total of all goods and services produced. That’s true so let’s take a look at the chart below.
The Bush administration claims Reagan’s tax cuts led to a great stock market and a growing economy.. Baloney. Tax cuts had little to do with it. It was the enormous expansion of debt that pushed cash into the economy. Reagan got away with it because he stared out with a debt to GDP ratio of 32% and took it to 52%. Bush started with 57% and it’s now 70% of GDP.
How much debt is too much? Debt as a percentage of GDP is now at WWII levels. After WWII the US was rebuilding Europe and had to spend a lot of money. Bush is spending a lot of debt money to prevent an economic collapse. Comptroller Walker knows this debt level can’t be sustained and Leon Levy knew it too.
Look at the debt chart above and then look at the S&P500 chart below. The stock market started zooming in 1982 at exactly the same time the politicians figured out they could spend us into prosperity. Clinton and Leon Panetta, his budget manager, cut way back on debt from 1996 to 2000 as he tried to control spending. The stock market dropped in 2001 just a couple years after Clinton turned down the debt spigot. Bush turned the spigot back on and the stock market recovered.
I am not implying that debt is the sole reason the stock market rose. The market rises due to growing profits. But, corporate profits have been bolstered by monetary and debt inflation. Inflating the money supply didn’t work after the 1970’s so they switched to inflating debt. The stock market’s rise would have been much more muted without the expansion of debt.
And what about those Bush tax cuts. According to the New York Times:
“Americans earned a smaller average income in 2005 than in 2000, the fifth consecutive year that they had to make ends meet with less money than at the peak of the last economic expansion.
“The growth in total incomes was concentrated among those making more than $1 million. … individuals, who constitute less than a quarter of 1 percent of all taxpayers, reaped almost 47 percent of the total income gains in 2005, compared with 2000.
People with incomes of more than a million dollars also received 62 percent of the savings from the reduced tax rates on long-term capital gains and dividends that President Bush signed into law in 2003.”
The aging baby boom generation will soon put great demands on the nation’s resources. These issues can’t be papered over by legislation or made to go away by a presidential veto. The next president will have to deal with an enormous multi-trillion dollar funding shortfall for necessary social programs and neglected infrastructure. In addition, the debt rate of growth has to drop very soon to below the GDP growth rate and must be held there for many years. Debt spending must be cut by $300B per year immediately. This means reducing spending or raising taxes.
The legend of Ronald Reagan was a nice bedtime story, but the spending binge can’t last much longer. Debt can’t continue at this rate and, when it’s cut back, the excesses and weakenesses in the US economy will be exposed. They pulled out all the stops to prop up the markets in 2001. Can they do it again? Unlikely. Taxes are going up after 2009 and it doesn’t matter who’s elected president or who controls congress. Rising taxes, debt constraints and falling (or flat) home prices will impact consumer spending which accounts for 65% of corporate earnings. It’s hard to make a case for expanding corporate earnings when the rate of consumer and government spending is weakening.
It’s bad enough that the Federal rate of spending must slow, but we’re already at high PE levels for stocks.
Let’s look at one more chart. Professor Shiller, in his book Irrational Exuberance, showed that periods of high Price/Earnings ratios generally produced poor stock market returns over the next decade and longer. He computes the PE using the average of the 10-year trailing earnings. This method highlights periods of prolonged and unsustainable stock market levels that eventually revert to the average by going much lower. I obtained his data and I’ve plotted the 10-year trailing PE ratios since 1881.
Average 10-Year Trailing PE ratios
We now have a 10-year average PE ratio of 26. The only times in US history that the market has been this high was in 1929 and prior to the 2001 crash. After very high PE periods like now, money earned more in fixed income than in stocks.
Let’s look at American stock market history. The following figures are not adjusted for inflation so the declines were actually much more severe. Consider these facts and check them out on the chart above.
In 1901 the 10-year trailing PE was 24. Nineteen years later, in 1920, the real-time PE dropped to 9 and the stock market was 9% lower.
In 1930 the 10-year trailing PE was 24. Eleven years later, in 1941, the real-time PE dropped to 7.9 and the stock market was 66% lower.
In 1966 the 10-year trailing PE was 24. Fourteen years later, in 1980, the real-time PE dropped to 6.8 and the stock market was only 10% higher.
The 2007 current 10-year trailing PE is 26.
This current data implies a probability of poor average stock returns for the next decade or until PE ratios drop considerably. Combined with the extremely precarious US public and private debt situation and the likelihood of rising taxes ahead, I believe a rational investor should acknowledge that future average investment returns on US equities may be lower than in the past.
It’s clear to me that the current level of debt can’t is far too high relative to GDP. In addition, the US is about to bump into the baby boomer aging wave. The demands on government resources will increase dramatically. Something has to give. Tax rates are going up and benefits provided by the government will have to be restrained. The percent of the budget allocated to the military will be cut and this has implications for US political influence. I believe US economic and military dominance has peaked.
Does this mean the stock market will collapse? That already happened in 2001. The stock market is likely to mimic the past scenario of a crash followed by a multi-year, cooling off until PE ratios are extremely low.
Even if my analysis of debt and stocks is just a painful blur on your brain, take a look around at what is happening. It is unprecedented. In only the last six years, we’ve seen a stock bubble, a housing bubble and a subprime bubble. By definition, bubbles are caused by too much money chasing too little value. These bubbles are all derived from excessive US debt as stimulus and the government’s manipulation of interest rates to sustain the debt driven economy.
One thing is certain. The government’s ability to use debt to juice up the economy is becoming increasingly dangerous and causing bubbles, financial dislocations and more debt. Every time a financial artery threatens to blow, they put in another arterial stent to keep the debt monster alive. In last month’s August eletter, I predicted they’d bail out subprime borrowers.
“If things get bad, the Feds will step in. Why? Because the Fed created the mess and will be obligated to clean it up too. They can provide guaranteed refinancing to borrowers and essentially insure the first 20% of the loan.” -TNF August 2007
In today’s news:
“Bush, in a statement scheduled for 11:10 a.m. EDT in the White House Rose Garden, will discuss the need for Congress to pass Federal Housing Administration reform legislation aimed at giving the agency the flexibility to help subprime mortgage borrowers, two administration officials told Reuters. One move will be an administrative change to allow the Federal Housing Administration to guarantee loans for borrowers at least 90 days behind in mortgage payments to help them avoid foreclosure, the Wall Street Journal reported from a briefing given to a few newspapers.” – WSJ 8/31/07
The 1980’s S&L crisis cost taxpayers over $500B. The coming subprime legislation is an attempt to prevent the housing bubble from collapsing. It will expand and end up as a bailout for the banks, the hedge funds and the very wealthy. It will cost average Americans trillions more in new debt. This government is in full scale panic mode. In addition, it's unable to restrain spending or to act in the interests of the working people. We're in a very deep hole. At some point, the real economy will emerge and it will properly price houses, stocks, labor, the dollar and other assets.
It will take many painful years to lower the debt level.
This last month, Yale’s Robert Shiller stated in an article that he thought nominal (unadjusted for inflation) home prices could fall perhaps 20-30% over the next decade. The greatest danger areas are where homes are priced well over the cost of construction. He says people will gradually move to lower cost areas and prices will relentlessly ratchet down in high-cost cities. Don’t dismiss Shiller as an Ivy League egghead. He accurately warned of the 2001 market crash and has been warning about housing too. He backs it up with excellent research.
I subscribe to a professional service that tracks economic cycles and advises corporations and governments. The early data I'm seeing shows leading economic indicators in a freefall. It's too early to say a recession is ahead, but the signs don't look good. Another 4-8 weeks of data is needed to make a determination.
In 2002, Leon Levy said that the coming recession would be the deepest since the Great Depression. He was wrong in the short term, but probably will end up correct.. Bush dodged the last bullet by taking the debt and economic imbalances to a new high. The subprime crisis is a big crack in the economy that will peel back to reveal the rotten egg within. Without a doubt, more turmoil is ahead. The trigger event will be a future decline in the rate of government spending. This will impact consumer incomes and corporate profits.
It’s very possible that the real-time PE on the S&P500 could drop to a range of 6 to 9 (from the current 16). The index itself may stay, on average, about where it is or drift up and down in a range. This has happened in the past after a period of extremely high 10-year trailing PE ratios. During those periods, people lost interest in stocks and instead sought the safety of fixed income.
Remember, my Market Alert model doesn’t predict when stocks will go up or down. It predicts when stocks are safe to own and when they are not. It warns of steep declines ahead for the market. As such, the S&P could stall out at 1500 for ten years and my stock model might never give a sell signal. My model correctly called the steep market crashes and surges from 2000 to 2003 but it can’t forecast declining valuations (falling PE ratios) in a sideways market. That’s why it’s important to hold some bonds and income generating assets in your portfolio.
The recent stock correction was very interesting. As expected, all stock asset classes declined, but so did gold. Money surged into US treasury debt. This is a tip-off to investors of what to expect next time. In a nation loaded up with debt, cash becomes the most important asset.
The markets have recovered fairly well from the recent slump and may make new highs in the months ahead. This is an ideal time to properly allocate your assets. Chasing high past returns ruined investors in 2000 and will again unless capital is invested with the proper balance.
Competing forces will pull both ways at US stock prices. On one hand, weakening government spending is certain to reduce the growth rate of corporate profits. An aging population with lower incomes and stingy government benefits will suppress consumer spending. Rising taxes will lower incomes. On the other hand, foreign and Social Security purchases of US stocks may help to support valuations. The investment world will adapt given enough time.
Ultimately, I believe it’s earnings that matter and that’s what we must watch closely. Earnings will give us a clear signal for the stock market. I don’t expect a stock market crash because the market is currently not overpriced. But, when government spending declines, the stock market will price it and follow in lock step. When earnings bottom out and the average PE ratio declines considerably, investors with cash will be able to take advantage of excellent opportunities in stocks. I believe the best time to increase allocations to stocks is when PE ratios are very low. PE ratios could easily decline to under 9. The world financial system will not collapse. Provided they have time, corporations will shift to other world markets.
The politicians will do whatever it takes to avoid dealing with unpopular legislation until after the 2008 election. The proposed subprime bailout legislation is proof of that. This is not the time to bet on market sectors and narrow ETF products.
This report is my personal opinion. Others will not agree with it and will have a more sanguine view of government finances and the ability of the Fed, congress and hopefully a competent future president to set things right. Fair enough.
I can’t provide a timeline to investors. The government’s ability to print money and issue debt is limitless until some catalyst forces a change. The vast majority of investors are best served with a conservative and properly balanced portfolio. Get into an asset mix you can sleep with. It should consist primarily of index funds. Don’t delay.
Personally, I’m taking a page from professor Shiller’s playbook. He said he has reduced his stock allocation and likes money markets paying +5%. I’m doing the same. For readers of my book, this means I’ve shifted my assets to Safety Portfolio #3 and placed the fixed income portion in short-term government debt.
Best Regards,
Thomas Nogales Financial, LLC (www.thomasnogales.com)
Tom Gleason, Manager & Researcher
Author of: How To Invest If You Can't Afford To Lose
To unsubscribe, send a blank email to: alerts-unsubscribe@thomasnogales.com
Disclaimer:.
Investing involves risk and the future performance of the models cannot be guaranteed. TNF is not a registered investment advisor and nothing published by TNF should be considered personalized investment advice. Any investment recommendations made by TNF should be made only after consulting with your investment advisor and only after reviewing the prospectus or relevant financial statements. TNF does not receive any compensation for mentioning stocks, funds, or financial products.