Presidential Candidates, the Fed, and Status Quo

The battle for President of the United States between Hillary Clinton and Donald Trump rages on towards the finish line, nasty as ever. Despite blinding differences, they each seem to rely on an historically-authoritarian style of delivery (based on dualistic thinking) to underscore their obvious superiority over the other: Insider/outsider, right/wrong, good/bad, black/white, smart/stupid, experience/no experience, etc. Yet does Nero fiddle while Rome burns? Methinks yes. Like an unattended, festering wound, deeper causation of a messed-up world undermines the lives of everyday people both left and right.

“Church of the Sacred Fed”

A September 2016 Truthout article by Dean Baker, Hillary Clinton and the Church of the Sacred Fed, only confirms the ongoing reluctance to tackle the larger issue of a broken monetary system. Mr. Baker shares the disparate views of the candidates to launch his description of the Fed’s inner workings via funny religious metaphors such as Robert Rubin’s “doctrine of the sacred Fed” and the “anointed” referring to members of the Federal Reserve Board.

Hillary Clinton is said to have “denounced” Donald Trump for his comments calling on the Federal Reserve Board to raise interest rates. Apparently, however, this was not her real reason for denouncing him. Her real reason was:

“You should not be commenting on Fed actions when you are either running for president or you are president.”

Disappointing but not surprising, the article fails to venture beyond the Fed’s shoreline to reveal the skewed mathematical mechanics that drive a global monetary system, and the erosive damage to economic stability left in its wake. You see, anyone who makes the effort to learn about how central banks work (The Fed for the U.S.) discovers that, today, only the deep state of powerful self-interest (typically those at the top of money pyramid and their governmental cronies) actually benefit… and not by accident; whereas everyday people lose ground little by little over time.

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Yellen’s Great Interest Rate Game

I am not quite the grandmaster at the classic board game chess, but I do enjoy playing and teaching the game to my kids.

One of the hardest concepts to grasp for a 7-year-old is the need to think several moves ahead.

If you’ve ever played, then you may know the idea is to position yourself in such a way that will force the opponent into moves you can anticipate, and make it all work to your advantage.

In a sense, investing is a lot like a game of chess – thinking ahead about where a future stock price will be based on certain circumstances.

That’s what makes stock price movements somewhat predictable, and ultimately profitable – and that’s what we are going to explore today.

Take, for example, the current state of the Federal Reserve. It’s in a constant battle of whether to raise interest rates or keep them historically low.

This is a dilemma I watch constantly and analyze, and next week we get yet another Fed meeting set to conclude on Wednesday, July 27. Afterward, we will get only a press release from the meeting, which is minimal information since Federal Reserve Chair Janet Yellen isn’t scheduled to hold a press conference afterward.

That means investors and analysts will be left scouring the release for the slightest clues on the Fed’s next move.

By thinking several moves ahead, we already know where the endgame will be – lower interest rates for longer than expected.

And that means there are opportunities for us to profit…

Anticipation for Rising Interest Rates

Let’s think about what’s going through Fed members’ minds for a moment. Since the last Fed meeting in June, the landscape has completely reversed.

In June, we were coming off a dismal May jobs report that showed just 38,000 jobs created versus 162,000 expected and a lingering Brexit vote.

Since then, the Brexit vote happened, and the U.K. chose to leave the EU. But markets have rebounded from the initial reaction, which may give the Federal Reserve some ease over the vote. We also had a huge rebound in the jobs report for June, coming in with 287,000 jobs created versus expectations of 175,000 – which is great, as long as you ignore how this blowout jobs number was inflated by seasonal and one-time job gains.

But, will the Fed dig deeper into the jobs data? I doubt it.

So we already know what we will likely get from the Fed: They are happy to see job creation bounce back and stability in the markets after the shocking Brexit vote, but not happy enough to raise rates.

The fact that things appear to have stabilized will keep the possibility for rate hikes later this year on the table. This will cause investors to begin anticipating a rate hike sooner than later – which will not happen.

And that’s where your opportunity will come in.

Checkmating the Fed

In previous articles, I have highlighted several reasons that the Fed’s hands are tied when it comes to raising interest rates by any meaningful amount: Our economy is too weak, the U.S. dollar is too strong and our government debt is too large.

That’s how I know the endgame: Rates will stay lower for longer than anyone is expecting.

After the Fed’s press release, the pressure to raise interest rates sometime this year will ratchet up, putting pressure on interest-rate-sensitive stocks as well.

The utility sector, real estate investment trust (REITs) and high-yielding dividend stocks will experience a sharp pullback.

That will be your buying opportunity.

These sectors have soared since the last time the Fed raised interest rates, even as the broad market became more volatile and expectations for future rate hikes diminished.

If the current market situation gives investors a reason to expect higher rates in the near future, use that to scoop up stocks in those three sectors.

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Watch Out for This 40% Market Plunge

“So you love details and numbers,” my friend Christy asked me in a conversation last week.

“No. I love facts,” I replied. “I need facts to back up the assertions I make. I hate being in a position where I say ‘x’ and someone says that’s not right, and I have no proof to show that I’m right. So I go to great lengths to have those facts and to know my data is provably accurate.”

Thus, I can tell you without equivocation that the facts I have tell me a frightful story about the future direction of U.S. stocks.

We’re now at record levels on both the Dow Jones Industrial Average and the Standard & Poor’s 500 – records built atop unwarranted giddiness and held together by extreme optimism.

The problem, of course, is that giddiness and optimism are not Gorilla Glue. They are, at best, spit and bubble gum. Neither will last. A decline is imminent. The question is: How low can it go?

I have some ideas rooted in those facts I love…

When it comes to broad market valuations, I track what’s known as the Shiller P/E ratio – a measure of stock market valuation based on 10 years of inflation-adjusted earnings. To me, it’s a more accurate reflection of valuation, because instead of capturing a single moment in time (as does a traditional P/E ratio), the Shiller P/E captures the cyclicality that is inherent in earnings.

Today, the Shiller P/E approaches 27 – an oxygen-depleted level it has seen only three times previously: the 2004 to 2007 period when Greenspan’s low-interest-rate policy led to a housing and stock market bubble, the late ’90s as the Internet bubble engendered a devastating euphoria and the giddy run-up to the Great Depression.

Revert that to the mean – about 16 – and the S&P tumbles sharply.

The Correction Will Cut Deep

Before I tell you how sharply, let me share another necessary fact: The bubble in corporate profits.

Corporate profit margins are near 10% these days – a level they’ve NEVER before seen. Typically, they range between 5% and 7%. Margins also happen to be one the most mean-reverting data points in the market economy. Blame that on capitalism.

High margins always attract competition, which, in turn, always brings margins back to norms.

If profits revert to the mean, and the Shiller P/E reverts to the mean, the S&P would be looking at a price below 1,300 – a 40% fall from current levels.

I get there by applying a historic sales growth rate of about 4.3% to the S&P’s sales of $1,100 per share for 2015 (giving me sales-per-share of about $1,147 for 2016); applying a 7% profit margin to those sales (giving me net income of about $80.31); and then applying a historically normal P/E ratio of 16 to those earnings (giving me an S&P value of 1,285).

Now, I’m not saying that’s the precise level we’ll hit. And I’m not saying S&P sales growth and profit margins will hit those levels this year, though they could.

I’m saying that these are the levels we will move toward because history has demonstrated forcefully that the market cannot sustain such rich levels indefinitely. It always – always – reverts to the mean.

Thus, it must correct. And that means much lower prices.

I won’t go into the same numeric breakdown, but I will tell you that the S&P also currently trades at price-to-book value of nearly three and a price-to-sales of almost two. (Those are not cyclically adjusted; they’re just a moment-in-time snapshot.) Both are double or more their historic norms.

Again, revert those to the mean, and the S&P 500 is somewhere between 1,130 and 1,320, roughly speaking.

Protect Against a Market Collapse

I’m not going to tell you the end of the good times are nigh without giving you some hope and a strategy.

First, the strategy. Go through your portfolio and axe the losing positions that you have no particular attachment to.

Then pare back some of your winners. If you’ve doubled your money in a particular stock, sell three-quarters of the position. You will recoup your original investment plus a 50% gain, and you can allow the remainder of the position to keep working for you.

There’s a good chance the remaining 25% you retain will fall in value in the decline that’s coming, but it won’t be as painful because you already locked in that 50% profit. Plus, the position isn’t likely to go to zero – so you will still be profitable – and when prices decline you can go back into the stock at a better value with all the cash you’ve built up.

Second, buy some put options, purely as you would an insurance policy on your house. Consider the cost of the puts the premium and deductible you pay to protect your home – only with this you’re protecting part of your wealth.

I am not, by constitution, a pessimist. I am actually quite upbeat. But I am a realist – and I have my facts. And, realistically, those facts say that now is the time to avoid the optimistic giddiness that has pushed U.S. stocks to unsupportable highs. Now is the time to be a contrarian and prepare for the decline that’s in the offing.

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