After 42 years, still going strong…

  • A bearish story (in charts)
  • The dangers of passive investing
  • Prepare now

Moore’s Law continues.

You may be familiar with it. It was based on an idea by Gordon Moore, the founder of Intel. In 1965, he proposed that technological advancements meant that it was possible to double the processing power of a microchip approximately every 18 months.

In 1975, he updated his theory to say that the doubling was occurring every two years.

Well, more than 40 years later, Moore’s Law still appears to hold true. As the Financial Times notes:

Thinner smartphones or more space for larger batteries are on the way this year, thanks to a big reduction in the size of the latest mobile processors that power them.

Qualcomm, the leading mobile chipmaker, said on Tuesday that the new version of its flagship processor — the Snapdragon 835 — would take up about 35 per cent less space than last year’s model and consume roughly 25 per cent less power.

The advances in technology are extraordinary. Just when it seems as though technology has hit a barrier, it breaks through it.

Almost since the day that Gordon Moore theorised on the improvement in computing power, folks have tried to claim that ‘Moore’s Law’ no longer applies.

Yet, it still does. And likely will continue to do so, as newer technology begets even newer technology. Nothing can stop progress.

And it all starts here.

Markets

Overnight, the Dow Jones Industrial Average gained 119.16 points, or 0.6%.

The S&P 500 added 19 points, or 0.85%.

In Europe, the Euro Stoxx 50 index closed up 6.35 points, for a 0.19% gain. Meanwhile, the FTSE 100 added 0.49%, and Germany’s DAX index fell 0.12%.

In Asian markets, Japan’s Nikkei 225 is up 428.31 points, or 2.24%. China’s CSI 300 index is up 0.42%.

In Australia, the S&P/ASX 200 index is down 1.58 points, or 0.03%.

On the commodities markets, West Texas Intermediate crude oil is trading for US$52.73 per barrel. Brent crude is US$55.88 per barrel.

Gold is US$1,160.56 (AU$1,602.89) per troy ounce. Silver is US$16.38 (AU$22.62) per troy ounce.

The Aussie dollar is worth 72.4 US cents.

A bearish story (in charts)

Talking about progress, what about the progress of earnings? In particular, we refer to US company earnings, which have gone almost exactly nowhere for two straight years.

But wait…optimism abounds. From the Wall Street Journal:

Wall Street expects U.S. companies to report gains in fourth-quarter earnings in coming weeks, extending a recent recovery and providing fresh fuel to major U.S. stock indexes after a run of records in late 2016.

On Tuesday, the first trading day of 2017, shares of financial companies surged, in part on optimism for their profitability this year, helping the Dow Jones Industrial Average jump 119.16 points to 19881.76, snapping a three-session losing streak. The broader S&P 500 added 0.85%.

Earnings at S&P 500 companies will rise 3.2% from a year earlier in the fourth quarter, according to analysts polled by FactSet. That builds on a 3.1% gain in the third quarter, which marked the first year-over-year rise in corporate earnings since the first quarter of 2015 and could point to a more lasting breakout, analysts said.

Ah, the important word — ‘could’.

Yes, we know. Your editor is an old stick-in-the-mud. But we have to say it: We just don’t buy it.

For one, it’s hard to look past one of our favourite charts — the earnings history of S&P 500 companies over the past 10 years:



chart image

Source: Bloomberg
Click to enlarge


If you’ve seen this chart before, you’ll be familiar with it. If not, here’s the drill…

The white line to the left of the green line shows actual earnings for companies that comprise the US S&P 500 index. The white line to the right of the green line shows forecast earnings for companies that comprise the S&P 500 index.

As is Wall Street’s nature, the future is always rosy, and that means stock prices and earnings only ever go up. That’s why, despite two years of falling earnings, Wall Street analysts believe S&P 500 earnings will rise 22% over the next year.

Wall Street may believe that. The Wall Street Journal may believe that. The markets may believe that. You may even believe that…but we don’t. Not an ounce of it.

We don’t believe it on face value for two reasons. First, as far as we can tell, while investors may believe earnings will grow, there doesn’t actually appear to be any evidence to support that.

What’s more, feel free to call it an obsession, but while the Dow Jones Industrial Average (white line in the chart below) stays high, the Dow Jones Transportation Average (orange line) doesn’t:



chart image

Source: Bloomberg
Click to enlarge


Higher fuel costs no doubt partly explain that. But if fuel costs are a negative for transport stocks, should it also be a negative for industrial stocks?

We believe so. Fuel costs don’t just affect transport companies. There’s heating fuel to consider, too.

Without fear of boring you with another chart, here’s another chart. It shows the price of the Heating Oil futures contract traded on the New York Mercantile Exchange:



chart image

Source: Bloomberg
Click to enlarge


The price of heating oil has risen nearly 94% in less than a year. It’s up over 21% since November.

Is there any chance that could affect business profitability or consumer spending patterns? Our guess is that there’s a big chance it could.

And then there’s that little thing we like to call ‘interest rates’. What many may have missed in the hullaballoo of the past few months is just how high (relatively speaking) US interest rates have climbed.

Check out this chart. It’s of the US government two-year Treasury bond yield:



chart image

Source: Bloomberg
Click to enlarge


In late 2011, the two-year bond yielded 0.153%. Today, the same type of bond yields 1.222%. That’s an eightfold increase in interest rates.

To put that in perspective, how do you think you would be able to cope if your mortgage interest rate went from 5% to 40% in the space of five years?

For the US government, it means that, in 2011, it ‘only’ had to pay US$1.5 million in interest each year for every billion dollars it borrowed for two years.

Today, the interest on each billion dollars of newly-issued two-year debt would set the US government back US$12.2 million per year.

And it’s not just government. During the middle of last year, International Business Machines Corporation [NYSE:IBM] could have issued debt for 0.917%.

Today, it will cost the company an interest rate of 1.644% — that’s a near doubling of financing costs.

Now, do we expect the burden of higher interest rates to have an immediate impact on the market? No.

The last time interest rates went up in the US, the rate-rise cycle lasted two years, from 2004 to 2006. It was another 18 months to two years before markets finally succumbed to the pain of low rates, followed by higher rates.

As we are now, the rate-rise cycle has only just started. The markets expect the US Federal Reserve to raise rates two or three times this year.

If it does, that’s when it will become really painful for the economy. Remember, businesses can typically refinance debt for periods of three or five years. Those that locked in rates in recent years may not have to face higher rates just yet.

But, as time passes, and as rates go higher, those companies will come to a point where they will need to refinance their debts. That’s when it will hit them.

So, analysts, markets, investors and commentators can opine about the positive outlook for US earnings, but we’re not convinced.

Our crash alert is still set to ‘high’, and we see no reason at all to change it.

The dangers of passive investing

Two, three, or five years from now, an article in the Wall Street Journal titled, ‘Wall Street’s “Do-Nothing” Investing Revolution’, may be one of those articles we look back on and laugh at, wondering how anyone could have been so foolish to think such a thing.

To selectively quote, the article informs:

Picking stocks is at heart an arrogant act.

It requires in the stock picker a confidence that most others are dunces, and that riches await those with better information and sharper instincts.

Yet there is a simple, destructive idea taking over Wall Street: that stock pickers can’t pick stocks well — or at least well enough for the fees they charge. And even those who do can’t sustain it year after year. In short, the idea of the “active manager” is rapidly losing its intellectual legitimacy to the primacy of the “passive investor” who merely buys an index of shares. That has certainly been true for the last 10 years, when between 71% and 93% of the U.S. stock mutual funds either closed or failed to beat their closest index funds.

As part of an investment strategy, we don’t have a problem with passive investing, or with index funds. In fact, we think it’s rather a good idea to put a certain percentage of a portfolio in a low-cost index fund.

Not too much, mind you. Overall, despite what the mainstream press may tell you, we believe that picking and backing individual stocks remains the best way to grow long-term stock-market wealth.

The biggest problem we have with index funds and the notion of passive investing is the idea that everyone should be a passive investor.

Without falling into a trap of trying to explain logical possibilities and impossibilities, we’ll merely note that it simply isn’t possible for 100% of investors to be passive investors.

To be a passive investor is to have no view or opinion on the value, worth, direction, or prospects (positive or otherwise) of an investment.

The investor simply buys and then…does nothing. To quote the Wall Street Journal, the passive investor decides to ‘abdicate choice.

Therein lies the problem. The entire premise for the price of a stock is based around active investors. In order for a share to trade at a particular price, one investor must believe it’s worth buying, while another investor simultaneously believes it’s worth selling.

Even if investors can’t immediately agree on a price to trade, they will line up on either side of the market, displaying the price at which they wish to trade. In stock market parlance, you’ll know that as the ‘order book’ or ‘market depth’ screen you see via your online broker.

The point is, the bidding and offering of prices is the act of an active investor, not a passive investor.

In fact, the only reason a passive investor can enter the stock market is because of the presence of an active investor. The passive investment fund (perhaps an ETF) will just buy its quota of stocks at whatever the market price.

The stocks are liquid enough that its buying is unlikely to cause a major move in the price.

But suppose all investors became passive investors. What would the market look like then? If all investors were passive, there wouldn’t be a market. Remember, the passive investor cares not a whit about value or price. He or she just buys and holds because they believe that passive investing is better than active investing.

In which case, who determines the price of a stock — or any other asset?

Yes, we know. We exaggerate. But it brings us to this point.

One of the paradoxes of supposedly ‘safe’ passive investing is that it increases the risk in the market. How so?

Imagine there are 100 active investors. Each has an equal input and influence on the direction of the market.

Now imagine that 20 of those investors become passive investors. They decide to follow the collective actions of the other 80 investors.

Suddenly, rather than 100 influencers in the market, there are now only 80. Time passes, and 20 more of the active investors notice that their returns aren’t any better than the 20 current passive investors.

So they too decide to become passive investors. The influencers in the market have now shrunk further. Instead of 100 investors researching and analysing the market, there are now only 60.

This carries on. As the number of active investors shrinks, the number of passive investors grows. Now, as time has passed, the market comprises 90 passive investors and only 10 active investors.

Now it’s even harder for the active investors to outperform the passive investors because those 90 investors are just passively following and benefiting from the remaining 10 active investors’ actions.

What happens next? Well, it’s perhaps a stretch to think that all investors will become passive. But look at it another way. In our example, there are only 10 investors actively looking at and analysing the market.

Once there were 100…now only 10. That, we would say, is a concentration of risk. In such a circumstance, is it not possible that, with the presence of fewer analysts, the market isn’t being as thoroughly analysed as when there were more analysts?

And isn’t it reasonable to say that a greater amount of capital and wealth is now at the mercy of a bad investment decision by a smaller number of analysts?

The idea is that passive investing is better and less risky than active investing. We’ll challenge that by saying: Of course passive investing has performed well in recent years — it has been a bull market.

The question is how will it perform, and how much will passive investors lose, when the bull market ends?

The idea that any investor should just buy and hold and do nothing at all with their investments is just dumb beyond words.

Prepare now

Speaking of danger, remember to check out our Great Repression conference video package. Before the next collapse comes (and it could be led by ETF sellers), you’ll need all the insight you can get. Details here.

Cheers,
Kris