The ‘magic number’ trade so far…

Friday, 4 August 2017
Melbourne, Australia
By Kris Sayce

The ‘magic number’ trade so far…

Today we have a special edition of Port Phillip Insider. It’s part of the transcript from our recent live event, ‘The Day the Bull Market Ends’.

Market data returns Monday…

The Day the Bull Market Ends

Mike Graham (Host): Vern, you actually think this crash, you actually take a step back and look at it historically. You reckon it’s about eight decades in the making. You’ve got a great analogy about how investors are complacent, you have an analogy about that of a frog in a pot of water that’s slowly being heated on the stove. Can you just expand on that?

Vern Gowdie: Well yeah, it’s about the incremental exposure to a particular experience. And the boiling frog theory is that if you put a frog into hot water straightaway, it’ll jump out. But if you put it into lukewarm water and just gradually, ever so slightly, increase the temperature, ultimately the frog boils. And the moral of the story is that things happen gradually, incrementally.

You know, the last big downturn, I mean major downturn in the economy, was in the 1930s. Then we had World War Two, and then very prosperous decades of the 50s and 60s. And we’ve just gradually since then, we’ve just added more and more and more debt. It’s been going on, I suppose, the debt accumulation process, since 1980. So incrementally we’ve been just getting ourselves exposed to this society or this economy that just keeps running on debt.

I’ve got those examples I’ve shown in recent newsletters about how there’s been a combination of this tripod effect.

Mike: So it’s not just debt — it’s debt, productivity and population.

Vern: Yeah, economic growth. There’s only two components to economic growth, and that’s population and productivity. You know, you have an increase in both of those and you have economic growth coming. And in the charts you’ll see there…

chart image

Source: CMG Wealth
Click to enlarge

…about the productivity we’ve had in society, or in the economy long term. We had a spike up from the Industrial Revolution. Productivity came through strongly, you know, machines could do more work than just one person. So that created greater productivity. That carried the economy though.

At the same time, we were also having population growth as well. You know, our global population in the 1920s or 30s, it was around about two billion people. Now it’s eight billion. So we’ve had a quadrupling of global population. So those combined effects were really winds underneath the wings of the economy. And the economy soared higher.

Then you throw in the debt, and it’s just like turbocharging this economic growth…

chart image

Source: CMG Wealth
Click to enlarge

And so we’ve become accustomed to — and anyone from the 1940s or 50s onwards has really only been accustomed to — this economy that continues to grow, and there’s inflation. That’s because you’ve had these very particular dynamics. And I believe we’re at a point where they’re going to change. Our fertility rates are falling…

chart image

Source: CMG Wealth
Click to enlarge

…so the prospect of population quadrupling in the next century, I think, is remote. In fact, there’s some good work out there that says if you take Africa out of the equation, population in the developed world and the developing world is actually at peak levels.

So we’re not going to get the population push.

Productivity, we had a kicker in the 2000s from technology. Technology came in and we got a short-term boost from the technology helping businesses become more productive. But now, they’re sort of going the other way. We now see the threats to employment from automation and that technology. It’s actually deflation. There’s an article in today’s paper about Japan worried about the Amazon effect.

And then you’ve got now the debt, that helped fuel economic growth, it’s now the lead in the saddlebags.

Mike: Debt’s the killer, basically.

Vern: Debt’s the killer. It’s now taking four or five dollars’ worth of debt now to get one dollar of GDP growth. And so, the things that got us to this point, those dynamics aren’t there anymore. We’re not going to have the population growth, the productivity growth is going to be harder to come by, and we’ve now got this debt, which is all the consumption from the future brought forward. So we’re really getting to a point that probably happens once in a generation. That’s why I say this is going to be, in my opinion, a once-in-a-lifetime thing. Nothing’s been seen like this since the Depression, what’s coming. Because these dynamics, people believe, are going to continue.

Kris Sayce: I think Vern’s right there, and I think that’s the big thing. That’s what makes this one so much scarier than the last, because then it was just — mainly, not entirely — bad debt in the US housing market. Now it’s debt everywhere.

Governments have used low interest rates not as an opportunity to lower their interest costs and reduce debt, but as an opportunity to borrow more.

Businesses have used low interest rates not to lower their interest costs, but for instance to expand operations or to invest in new ventures, many of which may not prove to be viable as interest rates rise.

Vern: I want to cut in there Kris. Some of this, what I write about in this week’s Gowdie Letter, is that a lot of that money that corporates have borrowed — US corporate debt has now reached a historic level — a lot of that has gone into buying back shares.

Kris: That’s right.

Vern: Corporate buybacks have boosted, they’ve put all this debt on their balance sheets to continue to buy these overpriced shares. And there is only one reason they’re doing it. That’s to trigger executive bonuses.

Kris: Yes, correct.

Vern: They’re trying to hit these targets. So it’s all about this short-termism. And really, they’re making out like bandits. They’re jacking the price up, loading these companies full of debt, and triggering these bonuses. But when this goes down, shareholders are going to be left with this debt.

Mike: Everything you guys are saying is freaking me out right now. But let’s be honest, there have been people — and you’re one of them, Vern — who have been saying this for a few years now. And everything you were saying then is just as valid as what you’re saying now. But markets have kept going up. So what’s to say this won’t go on for years and years to come?

Vern: Well, it’s working on the bigger fool theory. So, this just keeps going on. People have bought into this and there’s a momentum behind it, as well. And also, don’t forget, there’s that belief that there is no alternative. You know, the TINA effect. But there is. But people don’t want to accept getting 1% in the bank on their money. So, how long can this go? Until the last fool buys in. And that momentum could go for some time. I don’t know. I’ve seen this before; I’ve been doing this for 30-odd years and I’ve seen this, where you stand back and you go, ‘Geez, this doesn’t make sense to me,’ but what I think makes sense and what other people do are two different things. But markets ultimately do, overpriced markets, ultimately correct.

Mike: You sent me an article the other day, I’ve got it here. The headline…

chart image

Click to enlarge

…where the Bank of International Settlements is basically warning that that might be happening sooner rather than later.

Vern: Yeah, it was an article in the UK Telegraph, and basically they said that when the next global financial crisis hits, it’s going to be with a ‘vengeance’. Obviously I concur with that, because the belief behind that is that nothing’s changed. Or, they say nothing’s changed since 2008. In fact it has — the situation’s got worse.

We had a debt crisis in 2008. The response to that has been trying to cure a debt crisis with more debt. Now, that makes about as much sense as trying to cure obesity with a McDonald’s diet. There is no logic to it. But people have bought into it, and the momentum’s carried forward.

So what the Bank of International Settlements have said — which is the central banker’s central banker — they’ve said when the next one hits, it’s going to come with a vengeance because they’ve really done nothing to correct the problem. They’ve just made it worse. They’ve just taken us to a point that I think is far more dangerous. We’re 60 or 70 trillion dollars farther into debt. We have a share market in the US that is way beyond where it was in 2007–2008. And it’s just created this whole false belief.

Mike: Yeah, so, some people say nothing’s changed since 2008 and the Lehman crisis, but that’s actually not correct, is it?

Kris: Well, no. I mean, for a start there’s a lot more debt in the system, right Vern?

Vern: That’s correct — far more debt. I think it was about $150 trillion back then…pick a figure. It’s now something like $220 trillion. And that’s only the official number. So if you get on Google and check ‘debt clocks’, every debt clock is just going like an electricity metre. They’re probably even spinning faster. None of them are going backwards. They’re all going further into debt.

Mike: Kris, just on timing, you mentioned you have… What’s this special ‘magic number’ that you’ve been talking about?

Kris: I’ll go into this in more detail during the Q&A, but I just want to quickly touch on it. So, it’s related to the Dow Jones Transportation Index. An index that not many investors look at. But it’s a key index because, especially in the modern economy, in order for goods to get from A to B and B to Z, you need to transport them. Whether that’s road, rail or airlines. So keeping a watch on the Transportation Index is a key thing.

So one of the things I’ve looked at is a very simple technical analysis tool, and that’s to use a moving average. A 20-day moving average. And every time I’ve checked this over the past five years — where this has happened, 36 times over the past five years — when the value of the index has fallen below the 20-day moving average, then that has led to further falls in the Transportation Index.

Right now, as of last night’s close, there’s only a 0.12% difference between the index and the moving average. So if that closes below that level tonight, then you can almost guarantee that there are going to be further falls in the transportation index. [Transcript ends]


Post Script: The Dow Jones Transportation Average did fall. You can see this on the chart below:

chart image

Source: Bloomberg
Click to enlarge

The red arrow indicates the day of our live event, and the triggering of the ‘magic number’ on the index.

Since then, the index has fallen 3.25%.

Identifying and trading these ‘magic numbers’ is a key part of the Crash Market Investor service. You can find out more details here.