[embedded content]Jordan: Hello everyone, and welcome back to the Atlas Investor Podcast, with Tiho Brkan. Thank you so much for joining us today for episode 7. In this episode, we are going to deviate from our normal structure, because Tiho has a very important update for our listeners and his followers. Tiho is going to provide observations and analysis on the US equity market, and why this is a time to be very cautious. Okay, Tiho, so please give us an overview of what you’d like to cover in this episode.Tiho Brkan: Hello to you, Jordan, and hello to all the listeners, and readers — if you are following the transcript. Basically, it’s an important time to be cautious, in my opinion. The bull market has been very strong and there are overpriced assets left, right, and center, and
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Jordan: Hello everyone, and welcome back to the Atlas Investor Podcast, with Tiho Brkan. Thank you so much for joining us today for episode 7. In this episode, we are going to deviate from our normal structure, because Tiho has a very important update for our listeners and his followers. Tiho is going to provide observations and analysis on the US equity market, and why this is a time to be very cautious. Okay, Tiho, so please give us an overview of what you’d like to cover in this episode.
Tiho Brkan: Hello to you, Jordan, and hello to all the listeners, and readers — if you are following the transcript. Basically, it’s an important time to be cautious, in my opinion. The bull market has been very strong and there are overpriced assets left, right, and center, and sentiment is buzzing with optimism. That doesn’t necessarily mean you should go out and short things. It doesn’t mean that you should go out and become ultra bearish, but there could be a more meaningful correction that will be playing in the cards over the coming weeks and months ahead, potentially as the Fed continues to unwind in the balance sheet and hike interest rates.
The four things I would like to discuss today, Jordan, is we should look at some valuations, which is very important so we know where we are in a cycle. We should look at what’s happening in news and media, and track the current sentiment and mood of the investors. And finally, we should look at the market price and what’s been happening in all of the assets, and sectors, across the board, and what they’re telling us.
Jordan: Okay, Tiho, so let’s start with valuations. Now, coming into this year, Tiho, you noted that valuations were fairly high, yet the momentum of the market was still strong and that included foreign and emerging markets. And because of the cheaper valuations, you have tilted portfolios to foreign and especially emerging markets, which have strongly outperformed this year. I mean, that was the place to be in stocks, not in the S&P 500, but with where we are right now, talk about valuations and why you’re more concerned right now than I guess you were at the beginning of the year.
Tiho Brkan: Sure thing, Jordan. Well, you correctly stated that yes, I have tilted a lot of my client’s portfolios towards foreign stocks, in particular emerging markets, which have been depressed and moving sideways for quite a long time — while the S&P has been outperforming. And the story reversed this year, so we got that correct and we profited handsomely from that; however, the picture is now getting a little bit scarier for all assets. Basically, the all-country world index is up every single month this year from January until November — and basically, that’s never happened since the inception of the index. So the momentum is running really hot and S&P 500 hasn’t had an even 5 percent drawdown in 361 trading days as I’m making this podcast. That’s pretty much getting close to the tie of record momentum stretch without any kind of a reset in sentiment and any kind of a reset in breadth — and to make the index at least short-term oversold. Also, no reset in valuations, which is what we’re going cover right here.
Since the beginning of the year, we’ve seen the set price-to-sales ratio in the S&P 500 move from about 2 towards about 2.2 now. So Jordan, we’re right next to March 2000 levels — which is the old tech bubble for some of us that were around trading and might be able to remember that. Those were crazy times, and looking at the S&P 500 valuations are quite similar. In some measures when we look at the median price-to-sales ratio, they are even higher than they were in 2000 or 2007. So that’s one thing investors should take note of, the fact that we are two standard deviations above the mean, and if you believe in mean reverting markets, you should definitely look out for that.
Moving along, I’d also like to discuss price-to-book ratio with you, which is quite a common indicator of valuation that’s used, and it’s a standard for just about all fund managers.
Jordan: Yes, Tiho, and the price-to-book ratio, according to your chart when we prepped for this podcast — it was 3.1, but now you say it’s already up to 3.3. I mean, as far as recently.
Tiho Brkan: Yeah, that’s correct. I mean, looking back, historically. We’ve never had valuations this high apart from the tech bubble. And the same is true of price-to-sales, and the next indicator we’re also going to cover is the CAPE ratio — the cyclically adjusted price to earnings ratio. So looking at the price-to-book during the 60s and the 70s overvalued markets — especially the peak in 73 — price-to-book was around 2 times. Prior to the 1987 crash, it was 2.4 times. As we got into the tech bubble, the price-to-book really went high, and we almost reached 5 times. In 2007, it got to 3 times. So now you’re paying about 3.3 times premium for assets that you’re buying, these corporate assets. So I have to say that’s quite a lot of premium. Whenever you pay a premium this high, forward returns over the long term — if you plan to buy and hold — they don’t necessarily show you a very good profit. Maybe this time is different, and maybe we will get to 5 times book, and even higher, but you’re betting on a historical anomaly here.
One thing that I also do want to mention about price-to-book is that the market peak in 2000 saw a 4.9 times price-to-book, and after two devastating bear markets — the Tech Crash in 2000 until March 2003, as well as the Global Financial Crisis from October 2007 until March 2009 — we saw the price-to-book revert back to 1.5 from almost 5. That was quite a lot of valuation and mean reversion occurring there. And there was a pretty good moment to buy. However, none of us got the really clear buy signal that we were all looking for, which is similar to 1974 or 1982, or even 1949. These were major generational infliction points when we saw S&P trade below book value. We just didn’t see that. It fooled a lot of investors, some of the most famous in the world, who missed out on this bull market — or at least parts of it — and got in at other times when they noticed that the momentum was strong. But nevertheless, price-to-book is now signaling that this is not the time to be chasing.
Shall we look at also price-to-cape ratios and also which percentile we’re in, Jordan?
Jordan: Yeah, absolutely. Tell us what percentile we’re in right now, and where that compares with some other historical markers.
Tiho Brkan: Well, we’re at 31.3 according to Robert Shiller on the CAPE ratio, and basically that is the 97th percentile, which is similar to 1929 and higher than 2007 peak. But not yet reaching those euphoric moments of the TMT bubble and the Dot-com bubble in the late 90s and early 2000s. Basically, there’s been only a handful of months in 1929 where we traded higher valuation than today and several quarters during the late 90s. So we’re really in a high percentile here for US stocks, Jordan. And as I said before, similar to price-to-book, forward returns 10 to 12 years out using this indicator seem to be anywhere from low single digits to flat returns. So investors who are tilting towards the passive strategy, buy and hold in the US, they might experience some turbulence and also some disappointments over the next decade.
Jordan: Tiho, before we move on to other valuations, I just want to get your comments on something else quickly just regarding the CAPE, and that is that there are some people who are wanting to remove the global financial crisis in the negative earnings there from the CAPE, thinking that’s some kind of outlier. But as you told me, even if you remove that from the CAPE, the CAPE is still fairly overvalued.
Tiho Brkan: That’s correct. If you look at the earnings drop that we had from December 2007 to the next 1 and a half years into the trough of middle 2009, and if you were to completely remove that from the cyclically adjusted price-to-earnings mathematical equation — you would have only a little bit of a reduction in CAPE. And we would go down towards the mid-20s or high 20s, but the overall median level, as well as the percentile level, would only change by a point or so. So we would still be in a very high percentile looking at history going back to 1900s.
But the more interesting point is, why would we bother removing the financial crisis? I mean, we might as well remove the Great Depression, and just wipe it out from all the history books — and also the 1974 Oil Embargo. The good times come with the bad times. Markets tend to ebb and flow. We have secular bull markets and secular bear markets. It’s up for discussion where we are in a current cycle and what stocks will do, and for every market bull, there’s also market bear. That’s fair. But why go and exclude certain events just to create a confirmation bias? I really don’t understand why people do this. If we have a crash similar to 1987 in a year, two or three from now — we might as well not worry about it, because we can just remove it, Jordan.
Jordan: Well, Tiho, moving along, I wanna get your thoughts on the Crestmont PE ratio, because I know this is something that you follow, but this is not very widely known. I mean normally people just use the CAPE but I understand that Crestmont is somewhat similar?
Tiho Brkan: Yeah, a little bit of a different analogy when it comes to how inflation impacts the earnings and how it’s averaged throughout the history. But nonetheless, because there’s a bullish confirmation bias to remove the collapse of the earnings in the GFC, I just thought I’d do the other side of it, and also create an equal argument for both sides — and say that there are a handful of indicators out there like the Crestmont PE, as well as the Buffett’s favorite indicator, which is US equities relative to the GPD, which are actually signaling that we are more expensive than the peak in 1929 — and we’re now kind of matching the peak of the Dot-com Bubble. We’re at nosebleed levels, which is basically 3 standard deviations above the mean in Crestmont PE, and also very, very similar level for Wilshire 5000 relative to the GPD.
And Jordan, don’t forget that both of these indicators confirm what the price-to-sales ratio is saying as well, which is the first one we discussed at the beginning of the segment. So all of them are kind of confirming that we are very, very expensive, and investors should expect some turbulence in coming weeks and months ahead — maybe with a meaningful correction. Also, eventually whenever the economy starts to slow down — and in this point in time it’s not, and whenever the cycle starts to come from the late stage towards a recessionary stage — I think markets could have a serious bear market, because valuations are so high. For the time being, we still look “okay” because the economy around the world is in a synchronized and locked step boom, and is helping underpin these overpriced markets, because earnings continue to grow. But this momentum won’t last forever, and investors need to really prepare for what’s coming around the corner.
Jordan: Next, Tiho, we’re going to talk about some recent news headlines that have caught your eye, and just talk to us about these headlines in maybe what they’re signaling as far as the markets.
Tiho Brkan: Well, this section I would say is something that you do not see in market bottoms. Honestly, these kinds of news headlines tend to occur near market peaks or prior to market peaks — even if the momentum runs for a little bit longer — if you want to play musical chairs and you want to push your luck and be the winner and finally get the last chair while everybody else misses out. Maybe you’re a very good trader and investor, and you’ll probably try to do that, but these signals are letting you know that the music might stop playing soon.
Basically, we have prominent and famous head managers who have been doing really, really well over the last several years and throughout their career, over the last decade or so, and have had very good returns in their career. They are losing reputation and they are underperforming the market. This usually happens to value investors, Jordan, and we see this near market tops, because growth outperforms value, and momentum outperforms value. So everyone’s piling into the Teslas, and the Netflixes, and the FANGS, and the BATS, which we’ll cover later. For those who don’t know, BATS are Baidu, Alibaba, and Tencent from China. And the FANGS I’m sure everybody knows, but basically value managers who maybe try to maybe play the long short side of the things like David Einhorn, where they try to short the basket of “bubblish” stocks, which are overvalued — such as the FANGS and the BATS. These stocks have been hurting him, while the value stocks that he’s been buying have been underperforming the market so people like this tend to lose their reputation near market peaks.
We saw something similar happen to Buffett from 1998 to 2000 when the tech stocks went through the roof, while Buffett’s Berkshire Hathaway declined by some 35, 40 percent, I believe during that time. And I think people were laughing at Buffet and calling him an old geezer who’s lost his way, and who’s not a good investor anymore, but things are always like that. Things are always euphoric, exuberant, and a bit crazy near market peaks.
Moving along, we also have another headline that’s very interesting because we are in a similar overvaluation to tech in 1999 — where we have Broadcom trying to sweeten the deal on the Qualcomm takeover, which was rejected only a handful of weeks ago. Now, if this was to go through, this would be the highest deal in the semi-conductors and technology space in history. So obviously, mergers and takeovers that are record-breaking don’t occur near market lows.
Finally, we move into a segment, which we discussed recently while I was in the Czech Republic. Alternative assets, in particular, we’re looking at here luxury property, and collectibles — such as art and others including diamonds. Recently, we had news that Leonardo Da Vinci’s painting got sold for almost half a billion dollars, a record-breaking auction at Christie’s. And also Vincent Van Gogh’s painting received almost 82 million around the same timeframe. There was another handful of paintings that also got sold including two Andy Warhol’s masterpieces. I think 60 Last Suppers, and the famous painting, which I really like because I live in Asia quite a lot of my time throughout the year, and that’s Mao from 1972. And that one got sold for 32 and a half million. So we have all these trophy collectible assets.
Moving along, I think in Hong Kong recently we had a record-breaking sale for a pink diamond, and if that’s not enough, Hong Kong is also breaking a record for trophy properties. These are not even luxury properties. These are really trophy properties where a certain buyer paid 77 million dollars or 16,800 dollars per square foot for a property of the peak. Now… I lived in Hong Kong, and The Peak is wonderful. It’s the best area to really invest — if you can afford it — in the overpriced and exuberant real estate market of Hong Kong. But to pay for 16,800 dollars per square foot for 4,600 square feet — and to pay 77 million dollars, that’s absolutely ludicrous. Now, for my international listeners, that’s 181,000 US dollars per square meter, which is equivalent to a decent 50 square meters in Saigon, where I’m currently during this interview from — Ho Chi Minh City, Vietnam. So 77 million dollars, Jordan, for 424 square meters. You know, quite remarkable.
Jordan: So, the real signal basically, as far as news, it’s basically excess. I mean, that’s the common theme, right?
Tiho Brkan: Yeah, there’s money sloshing around thanks to quantitive easing, loose monetary policies and also the boom that we’re having. Booms create overconfidence by consumers, by businesses, by CEOs, by managers. It’s the same old cycle that we’ve always seen. And I’m not surprised that we have large art sales, Jordan, because basically, we’ve had large art sales in the late 80s, 1989 to 1990, prior to the crash of Japan, the Scandinavian banking crisis and the Savings and Loan crisis in the United States — that also marked a 20 percent bear market in the S&P 500 in Nasdaq.
We’ve had a lot of sales in the late 90s and 2000s. These sales also marked the peak in the stock market, and then we had record-breaking sales of art in 2006 and early 2007, just prior to Subprime debacle, also the crash in commodities and Global Financial Crisis, which basically slaughtered equity markets all around the world. We had quite a large record-breaking sales in the art in 2011, particularly May 2011, just prior to the global indexes excluding the US, peaking. It was where Japan, Eurozone, Emerging Markets and Frontier Markets declined meaningfully over the handful of years into the Eurozone Debt Crisis and other problems that we had around the world — while the US continued to march on its own.
Finally, late 2014, early 2015, a cluster of sales in the art world, predominantly because of a lot the investors who were borrowing at very low-interest rates, whether it was in Europe and Japan in negatives or rock-bottom in the United States. These investors started to get the signals from the Federal Reserve that interest rates will soon start to rise. And we had a cluster of sales, which basically was around the time also that the Chinese stock market crashed, and Emerging Markets went into a crisis — and also commodities and oil bust occurred. Now, we’ve had a record art sale, so looking at it historically, they don’t always mark perfect peaks. But a cluster of sales or even a record sale itself — like we’ve seen now— and we’ve seen both, actually… tend to occur near market peaks, Jordan.
So when we put it all together, whether it’s the mergers and takeovers, or the bidding up of collectibles and the fine art, or luxury and trophy properties around the world from New York to London and particular Hong Kong — these are all signals that there is trouble ahead.
Jordan: Okay, Tiho. Now let’s talk about sentiment. Can you share with us some of the sentiment indicators that you’re looking at right now that concern you the most?
Tiho Brkan: Well, first of all, a major indicator it seems to me the bears have pretty much capitulated. I could be off by a few months, here and there, but from everything that I’m looking at, there is not a lot of evidence to show that the bears are active, and there are short-selling funds out there that are actually making money, and that people are going out there and setting up short-selling funds or preparing for some black swan event. So generally speaking, that’s the theme, and that’s the feeling that I’m getting. First and foremost, I look at the way that investors are using their cash, and what they’re doing with their cash as opposed to what they say.
When I look at Merrill Lynch’s client and location from their recent report, basically we have cash as a percentage of assets under management at all time lows going back to all the data they have — going back to the early 2000s. So the trough in 2007 was around 11 percent cash in their books, and that was just before GFC, the Global Financial Crisis was just around the corner. That dropped to around a similar level just before the Eurozone debt crisis kicked off, and the equity markets around the world corrected meaningfully. Markets outside of the United States had serious bear markets, whether it was Emerging Markets or Eurozone and Japan.
Following that, we had a serious trough in 2015 prior to the collapse of oil, the sharp rise of the US dollar and the correction in Chinese markets, which I guess roiled and scared the living lights out of everyone around the world. But nonetheless, S&P 500 held up pretty well by only having about a 16 percent drawdown, I believe. Nevertheless, that was also a signal that came from very low cash levels and complacency from investors.
Moving towards today, we have the lowest level of cash that high net worth individuals who are speculating and investing with Merrill Lynch hold on their books, so that’s a cautionary tale, Jordan.
Moving along, retail investors — your mums and dads — they’ve also been holding very low cash levels as well —and as they always say, when cash is high, it’s time to buy. Now that sounds quite funny, the phrase rhymes, but it’s actually quite true. If we look at 2002, in October, as well as March 2003, that was the time when cash allocations spiked above 35 percent, almost reaching 40 percent according to the AAII indicator that I posted here for those that are watching on YouTube. And that was a very good time to buy, post the Dot-com Bubble crash.
Moving along, October, November 2008 as well as March 2009, very similar dates to 2002 and 2003 when it comes to months. And once again, cash was high, and you should start to buy. I believe Warren Buffett was using up all the cash that he had on his books around this time. And here we are, with a very powerful return ever since. Cash levels have been very, very low, and if we slap on a moving average over the last 12 months, they’ve been one of the lowest levels just prior to the Dot-com Bubble.
So cash levels, Jordan, not signaling very good forward returns, I believe that we can expect around the corner.
Jordan: Okay, Tiho. What about consumer confidence and business confidence? What are these things showing right now, and what do they signal to you?
Tiho Brkan: Well, usually, when we look at certain indicators, we are looking at what hedge funds are doing, what are the advisors doing, and what high net worth individuals are doing. And all of this is fine, but we should remember that one of the classic — let’s call them “dumb money” indicators — is usually the public. The public is so disconnected from what we talk about here in the podcast every day, every week, and every month, that they don’t really care. But when they pay attention and notice, usually these are the extremes, and these events tend to be inflection points in the market.
So this was around late 2008, 2009 when the public was really fearful, similar to October 2011 when they were just as fearful as the Global Financial Crisis. These were times to buy the stock market, and as you remember on my old website, The Short Side of Long, I call the bottom of the October 4th, 2011. That was right on the day to buy US stocks, and my clients benefited quite a lot from the call. However, market tops are not events like market bottoms. They don’t happen on a precise date or a precise week, where there is a signal to kind of jump in and buy, whether it’s 6th of March 2009, or 4th of October 2011, or maybe early February 2016.
Whenever consumers get really optimistic, markets start to peak out, and we get closers and closer to the top, and tops tend to be rounding. So this is a cautionary tale. Basically, US consumers are feeling the most optimistic since the 2000s, according to the Consumer Confidence Index. And if we throw in the spread between consumer confidence and presidential approval ratings — we have basically a cluster of warning signals that happened in ’68 going into ’69, just prior to the bear market that occurred in 1970. And also we have a cluster of readings that happened in March 2000, just prior to the dot-com crash. And now we have a cluster of readings again. So very low presidential approval ratings, with very very high consumer confidence, tends to be a negative omen for the stock market, Jordan.
But moving along, global consumer confidence is very high, we can see highest since 2007 in Eurozone, and also quite elevated in Japan too. Nowhere near the signal that we should be looking to buy stocks. Finally, to answer your question, German stock market has been doing very well, reflecting the German business confidence, and the confidence there is pretty much as high as 2007 and 2011, if not higher. So as we go back in time and we look at 20 years of data, whenever German managers, CEOs, and main company decision makers were this optimistic, we almost always had a bear market in the DAX. So either a very, very serious correction, or a full-on bear market. Basically, this indicator tells us that the current optimism is just about discounted in the price. And let’s not forget the markets are usually, not always, but usually a discount mechanism that prices in current conditions and tries to look towards the future.
Jordan: Okay, Tiho, something else I want you to cover. What is the sentiment as far as financial advisors, as far as optimistic and pessimistic? Is that telling you anything right now?
Tiho Brkan: Yeah, well, I think two weeks ago, looking at the Investor Intelligence Survey — which basically tracks gurus, experts, newsletter writers and financial advisors — basically reached the spread that hit a record. We’ve had something like 64 percent bulls and very low percent of bears, and the spread was at 50 for the first time ever. So, just about everybody — every Tom, Dick, and Harry out there is bullish — and what does that mean? Well, looking at forward returns, whenever we had readings in the spread between the optimists and the pessimists this high, or even at a record where we are now — which is very, very rare as it occurs very infrequently — looking three months forward, six months forward, and even twelve months forward, the returns in the US equity markets were rather muted. So what I’m expecting is a lot of volatility, ups and downs, but in the end, within the next twelve months, most likely a case scenario is that you’ll go nowhere and you might even have some losses on your books, so you might get disappointed there.
Jordan: Okay, Tiho, with that being said, just give us some final thoughts on sentiment and what this may mean for the markets and the weeks and months to come.
Tiho Brkan: Well, high net worth individuals are speculating and very complacent, in a similar fashion prior to the GFC, and the Emerging Markets crash in 2015. So I’m worried because of that. I’m also worried because retail investors are very complacent, and the low level of volatility has just made them like that, so they have very low cash levels too. Finally, consumers in the United States, consumers in Eurozone, consumers in Japan and in other countries around the world are very, very optimistic. Some of them are partying like it’s 1999.
If we look at the longterm picture of the US consumer confidence, dating back to the last 50 years, consumers have really been this optimistic. The last two times they were this optimistic was in the mid-60s and the late 90s. Jordan, do you know what happened whenever those two events occurred? We had a secular bear market from the mid-60s to early 80s and from late 90s to, let’s say, 2012, 2013. So, both of those were a lost decade of performance, so that makes me very, very worried.
And finally, business confidence around the world, exports are booming, manufacturing is booming, we have a global synchronized boom as I’ve said, so that’s all well said and done. Having said that, usually by this time it becomes obvious to the public, it’s obviously wrong, as I always used to say. So chances are, a lot of this is already discounted in price, and we should be at least cautious, if not bearish. I’m not shorting anything, I’m not looking to bet against anything as long as the economic cycle is still progressing into late stage, but this is the time to be cautious and maybe look for a pullback, covering all of the indicators that we just covered here, Jordan.
Jordan: Okay, Tiho. And finally, we are going to discuss the price action of the market and some observations on some things that you have? And starting off, let’s talk about how many days it’s been since the last 5 percent drawdown in the S&P 500, because I mean, it seems that these types of charts, we’re seeing them make their rounds on Twitter every day.
Tiho Brkan: Yeah, we’re coming towards a record-breaking run here. The momentum has been running so hot that whoever says to me — you should invest because of the momentum, clearly doesn’t understand what they’re talking about. You should have already invested because of momentum, and momentum has carried us this far, despite high valuations. But now even momentum is so high that it’s at nosebleed levels compared to the last hundred years of history. We’ve rarely had a run like this, which is 361 trading days without even a 5 percent correction, or 5 percent drawdown. So this is incredible.
You had to be trading around 1996, which was more than two decades ago, just to experience one of these, because the market volatility is so low, it feels like this kind of a trend has been going for a lifetime, until the markets wake up one day and will have utility jumps. And I have to say at the time of this recording, Jordan, we are noticing semiconductors coming down hard, we’re noticing tech stocks like the FANGS and the BATS coming down and correcting, and this is where a lot of the investors hold a high exposure. These are the investor darlings of the current cycle. The fact that we haven’t had a one percent intra-day move, I think in the Dow Jones in the last 50 days or so, also signals that this is one of the quietest markets in the history.
Moving along as well, I just want to let you know that the VIX recently had an intra-day low of 8.5 and change. I mean, that’s so low. And realize volatility is at the lowest level since the 1960s, and in some ways, when measured, the average true range of the market itself is at the lowest level ever. So this is the most complacent market without even a 5 percent pullback, Jordan.
Jordan: Okay, now let’s talk about another area that has been pretty hot. I mean, you’ve done fantastically this year, as we’ve talked about before in Emerging Markets. Now, the breadth in the Emerging Markets is coming down a little bit, I mean looking at the chart, the rise of Emerging Markets this year — it’s almost been straight up. No real pullback except for a few little pullbacks. Tell us about what you see in Emerging Markets right now?
Tiho Brkan: Yeah, well we got very lucky, I would say. My mentor always used to say that you can never be smart in finance, so I always say that I was lucky. Basically, when you get something right, you’re lucky, and when you get something wrong, you’re an idiot.
So, as I said, we got very lucky this time around investing in Emerging Markets, and they went up like a rocket — and we’ve done very, very well there. But what we’re seeing now is basically globally, we’re having fewer and fewer components of indices, whether it’s S&P or Eurozone, or Emerging Markets, participate in the uptrend. And basically we’ve had the majority of these heavy swinging, high market cap stocks push the index higher. These are your FANGS and your BATS and so forth, and basically, we’ve had some sectors gone parabolic, like semiconductors, really pushing the market cap of the industries higher while the majority of these lesser-known companies are not really participating in the uptrend. That’s also happening in Emerging Markets.
This is not a timing indicator, Jordan, when it comes to tops. It tends to be a pretty good one when it comes to bottoms. But when it comes to tops, this is just a signal and a warning that we should start to turn more and more cautious, because something is eventually going to happen. We don’t know when, as these divergences can last for a little while, and sometimes even longer than expected — but eventually they do play out, and they play out in bearish ways. That’s something definitely to keep an eye on. As you know, in Podcast Episode 1, we also covered the US breadth, and not a lot has changed since then, so covering here in Episode 7 Emerging Market breadth makes sense, but they’re all quite similar.
Jordan: Now, Tiho, speaking of past episodes, and Episode 6, you covered credit interest rate spreads. We covered that a little while ago. Are there any new observations that you want to make here, for the listeners and maybe if you just touch on your general view for the listeners that haven’t caught the last episode yet?
Tiho Brkan: Sure, well my expectation is that relative to the last, let’s say, five, six, seven decades of history, depending on how much data you have and how much of research you’ve done in financial history — credit spreads are quite narrow relative to the mean or the average. So, as the Fed runs off his balance sheet, and as pretty much everyone in the investment world is bullish and holds low levels of cash, while bidding up trophy properties and trophy collectibles such as artwork — I’m a little bit cautious here. What I’m noticing is that credit spreads are not compressing that much anymore. The Fed is not that stimulative, and the ECB and the Bank of Japan might turn to be less of buyers in 2018 and the QE globally speaking, will not be a tailwind, but instead a headwind for investors going forward.
I’ve noticed that credit spreads are already kind of muddling sideways and they haven’t started to widen yet to indicate that the trend is reversing, but one of the things that I have noticed though, is that the riskiest of Junk Bonds, the triple C credit spreads already are bottomed out, and for the last six months or so throughout 2017 have not been compressing. They have not been narrowing like the ones that I’m showing here in the chart if you’re looking through our YouTube video. So credit spreads are telling me it’s time to be cautious, not yet bearish, but credit spreads really tend to spike and they tend to widen in times of financial turmoil, especially when it’s connected to a drop in earnings and a recessionary economic activity. Nothing major to worry about yet, but I’m watching this basically on a weekly basis, Jordan, it could change from week to week very, very quickly. Keep an eye out for this one.
Jordan: Now, Tiho, you reference the FANGS and the BATS earlier in this episode.
Tiho Brkan: Sounds like we’re talking about an animal zoo.
Jordan: Yeah. Tell us what you see there and why this concerns you right now?
Tiho Brkan: Well, the FANGS and the BATS, you know, FANG stocks are your Facebook, Amazon, Apple, Netflix, and Google, and I’m sure everybody out there knows them, and your BAT stocks are basically your Baidu, Alibaba, and Tencent from China. These are your popular technology stocks. Now Merrill Lynch Fund Manager Survey has come out and stated for the last six months running that tech is the most overcrowded trade. Prior to tech, it was the US dollar, and in late 2016, early 2017 that ended up proving to be a great contrarian indicator — where we saw the US dollar had a very, very bad correction in 2017. Now, I’m wondering if the same will happen to the FANG and the BAT stocks.
I’ve noticed that over the last four or five days, Tencent, after moving some three standard deviations from its 50-day moving range basically got extremely overbought as it was moving into parabolic vertical run-up, and now it’s starting to correct. And over the last couple of days, we’ve seen Facebook, we’ve seen Amazon, we’ve seen Netflix, Google, even Tesla, and a lot of the semiconductors like Nvidia and so forth — start to correct very meaningfully. The market valuation and the market cap of these FANGS and BATS and your other animal zoo poster child investment themes, basically has hit higher market cap than the German DAX, the market cap than the Canadian and Australian economies, and it’s even higher than how much PIMCO manages — which I think is one of the world’s largest mutual funds and pension funds.
So we’re getting up to 1.6 trillion United States dollars in value, so incredible. Investor sentiment is something that we discussed in this episode, and these are your poster boys of investing. Everybody’s just been chasing these higher, if not these, than it’s the Bitcoin. But basically the technology seems to be running hot in the press and everybody seems to be after these stocks. I would be very, very cautious here.
Jordan: Okay, Tiho. You’ve covered so much today. Now, before we sign off, how about just a minute or two summary or so?
Tiho Brkan: Sure, so we’ve covered valuations, price-to-sales ratios nearing 2000 valuation level, price-to-book is not there yet, but you’re looking at paying 3 to almost 3 and a half times premium for some of the assets relative to what you would have been buying in some other generational lows — or even in March 2009 low. CAPE ratios and price to GDP ratios, which is what Buffet uses, are also nearing levels last seen in either 1929 or level of 2000. Valuations continue to signal that eventually, stock markets will have a major setback. Having said that, momentum carries them through, and has continued to carry them throughout the whole of 2017 as we’ve seen every single month positive for the all-country world index, a record-breaking run since the 1988 inception.
In news and media, we’ve covered quite a lot of headlines, all of which sound to me like exuberant, euphoric investors who are outbidding themselves to pay record prices for collectibles or trophy properties, luxury properties, and also for other assets when it comes to mergers and takeovers.
Moving along, bears seem to have capitulated, short-selling is not really all that evident, there is not too many bears to be found in media. Whether we’re looking at global consumers or global business CEOs and managers — they are extremely optimistic. Obviously, because of this kind of a fever pitch sentiment, cash levels are very low, and everybody’s just about invested. Not that much cash on the sidelines, as we’ve been hearing all these years.
Finally, we have credit spreads starting to widen a little bit, and not really continue its narrowing trend, which we’ve seen since January 2016 when oil bottomed and the recovery in the stock markets around the world started. The breadth continues to deteriorate. Basically, the participation of companies is falling and that’s happening locally in the United States and globally around the world.
Finally, investors are obsessed with momentum, in particular, growth stocks such as FANGS and the BATS, but in recent days, these sectors of the market, as well as the semiconductors, have started to get shaken up and it remains to be seen whether this is the start of something more meaningful, or whether this is just a temporary blip in an ever-rising parabolic trend there — as the market cap overlaps the size of the Canadian economy, Jordan.
So all in all, a cautionary signal from me, it’s probably smart to start raising some cash if you haven’t already. You should be anticipating a market correction sometime soon. Because there are no recessionary indicators around the corner, I assume that this would be more of a buying opportunity, but eventually, as the late-cycle plays out — and that’s where we are today — we are going to be setting ourselves up for a major market peak, at which point a serious bear market and a setback could occur.
Jordan: Okay, Tiho, well great work today on all of this, and I’m sure that we will follow up on this and update our listeners in due time. Now, Tiho, let’s talk about the next episode before we sign off here. Where will you be, and what will you be covering in episode 8?
Tiho Brkan: Yeah, I’m finished all of my travels in Europe, but we’ll be posting an episode 8, our German travel as I went through Berlin, went to the great wall, looked to German property prices and the booming economy. As most of you already know, Germany is an export powerhouse, and the central piece of the European Union — basically the central player there. So, a very important episode not to miss. There is quite a lot of movement in the property market in Berlin, and I have to say to you, I definitely enjoyed some German sausages and some beer. But bloody hell, it was freezing.
Jordan: Well, I’m glad that you’re not back in a much warmer climate.
Tiho Brkan: Yes, me too, me too!
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