A Big Shift in Market Trends

CPA Gone Mad Issue 6: January 9, 2017

A New Year, and the Media Headlines Are Focused on Building Plants in Mexico and Replacing Obamacare. Here at CPA Gone Mad, We’re Focused on a Potential Big Change in Trends!

When the week kicked off, there was a lot of news about President-elect Trump tweeting about GM, Ford moving away from building a new plant in Mexico, and then later Trump tweeting to discourage Toyota from building a plant in Mexico. This was originally going to be my topic for this week’s newsletter. But in a previous issue, I already wrote about moving plants to Mexico. If you haven’t read it, you can find it in the archives online.

There are more important trends occurring that we need to discuss. And two great segments on CNBC drove my focus for this week’s newsletter. I know it may appear I think all mainstream financial outlets provide bad information. But that’s not true. My message is that you need to understand the biases and financial motivations of mainstream financial outlets providing the information, not that there’s no valuable information to be learned from them.

These two particular segments, I think, are great. I encourage you to watch them here and here. They are only three and four minutes, respectively. (Note: The links should work, but I was having trouble getting the video to play at time I was writing. I hope they work for you. If not, I apologize and include relevant quotes below.)

I also encourage you to take a quick read through this issue of The Palm Beach Daily. It’s very short but summarizes what I’ll be discussing.

After watching these segments on CNBC and reading The Palm Beach Daily article, I realized I wanted to make sure everyone understands what the underlying message in these video segments really means. On top of that, I received a great piece of feedback on my book this week.

After reading my book Gen X & Millennials: Protect your Money and Prosper, one of your fellow subscribers wrote in to say he thought the book was written well and easy to read. And he did take action on the eight methods to protect and prosper. That’s the key; he didn’t just read the book, he took action.

But he expressed a concern I often hear, which ties directly into the underlying message of the two segments on CNBC I want to share. Specifically, he said, “I don’t totally buy into the pending doom and gloom of the US dollar and stock market.”

I completely understand this concern. Without going into the details of why and how I believe the US dollar and stock market are nearing a massive burst, which are explained in my book, I’ll try to address some of this concern while explaining the underlying message in the two CNBC segments shared above.

You Can’t Look Backward to the Past or Use Your Beliefs Based on What You’ve Experienced to Drive Your Understanding of or Belief in What Could Happen in the Future.

As you know, the Fed recently raised interest rates. I wrote about this in previous issues of CPA Gone Mad. Rates were at historic lows and practically zero in the US through 2014 and 2015. As described in my book, they were even negative around the world. Even with the rise in interest rates in December 2015 and December 2016, they are still at historic lows.

But the trend could be shifting. And before getting into how this could connect to a stock market crisis, let me explain what the title of this newsletter means.

I’m 35 years old. The demographic of you, my target audience, is 25 to 45 years old. I’ve really been exposed to economics and investing only since college, or around 2000. Even if you’re in the older range of the demographic, you haven’t been exposed to economics and investing much earlier than the mid-1990s.

On top of that, we don’t even need to look back that far. We tend to forget things relatively easily. The stock market has been on a steady rise since 2009. You could have been invested in almost anything and done well in the stock market over those seven years. It’s tough to remember or think of anything but an increase in your portfolio, since the last major correction was over seven years ago.

And as I described in my book, most of us didn’t have enough money invested back in 2008 to feel the pain of the financial crisis. Prior to that, there was a major stock market crash, the tech bubble bursting, in 2001. I was still in college and definitely had no money invested. So it’s even harder to remember or understand the tech bubble occurred.

And before that, there were some crashes in the ’80s and drops in the ’90s, but we were kids. Do we really understand those or remember them occurring?

It’s very easy to sit here today and think, wow, the market has gone up for over seven years straight (the first time you’ve really had any significant amount of money invested) and think that nothing other than that could occur in the future. Especially if you look back at the total return of the market (taking out the drops and corrections) between the ’80s until now. The market is basically an arrow straight up to the right.

But what you must remember is the world is different today. I know this is not related to finance, but do you even remember what it was like to fly in the ’90s? How much later you could get to the airport? And how your family who wasn’t even getting on the plane could come all the way to the gate with you? Compare that with today. Tell me that’s not a sign of how much the world has changed.

Also, as I mention in my book, the US has added $7.9 trillion to the national debt during President Obama’s term, and it added $5.8 trillion during President Bush’s term before that. That’s over $13 trillion in 16 years.

This debt creates a very different environment today. You cannot just look back to what you remember and think that’s what will occur in the future. The world, debt levels, and markets have never been in this situation before. So how can we look to the past to see how they may react?

We had a major correction in 2001, and a crisis in 2008. And as I explain in my book, these corrections or crises were not actually allowed to correct and flush out the bad that existed in the economy and markets. We covered it up with over $13 trillion in debt and zero interest rates. And that doesn’t even count the corporate, auto, and student debt, as I explain in my book.

If the market has corrected or been in crisis territory twice in recent memory and all we’ve done is cover it up with debt, isn’t it possible the same thing could happen again? And will the additional debt the government has added make it much worse when it does? Should we at least accept the possibility an enormous crash could occur and prepare for it?

In my book, I explain how the bond market could collapse at any moment. I’m not going to discuss it in detail here, but corporate debt is at 45% of GDP. And historically, that’s the high it reaches before a correction in the bond market. Several billionaires have even said that they expect bonds to reverse. And the Fed raising interest rates could be one of the triggers to set it off.

Understanding the Relationship Between Bond Prices and Yields

Before I explain the underlying message in the CNBC segments and connect it to this, I want to make sure everyone understands how bonds (known as fixed income in your portfolio) and bond yields interact.

This is mentioned in The Palm Beach Daily article referenced above. As bond prices go up, their yield goes down. The inverse is also true. As yields go up, bond prices fall. Yields are simply the annual interest payments divided by the price of the bond.

The original factors of a bond—for instance, a 20-year bond issue at $1,000 paying 5% annually—do not change. The bond will always pay $50 ($1,000 times 5%). But the price of the bond ($1,000 at issuance) will trade higher or lower depending upon interest rates. The reason this occurs is to get the yield of the bond close to current interest rates. So as interest rates rise, the price of the bond will need to drop in order to achieve this natural market pricing.

None of this matters if you hold your bonds to maturity. If you hold the bond until the end of the term, you’ll earn your $50 annually and get $1,000 back. None of this noise about what interest rates are doing matters.

And most likely you’ll hold the funds in your 401(k), where you are probably invested in bonds, to maturity. So you could ignore all of this. But will you stay fully invested and hold your bond funds until maturity if their price drops drastically? Or will you sell at the bottom, the worst time to sell? And if you were able to buy the same investment at a much cheaper price in the near term, wouldn’t it make sense to sell them now and buy them back later?

Note: My asset allocation guide, Let Your Asset Allocation Build, explains how I apply this to long-term wealth building.

Long-Term Trends Could Be Changing

Now let’s look at those CNBC segments a little more closely. And I’m actually going to start with the second one, which came out on Wednesday.

In the video, they state, “We’re in a long-term, a 33-year channel on interest rates on the 10 year and 30 year. If they break out of that, that’s going to be a huge shift and people have to pay attention to their fixed income portfolios.” During the exchange, they discuss how around 3.00% to 3.03% is the yield that would be considered breaking out of the channel.

They continue to discuss how for 33 years we’ve been in a downward trend. If the yields break above that level, that would be a change from a 30-year trend of lower interest rates and a shift to a trend of rising interest rates.

Think about that. In basically your and my entire lifetime, interest rates have been going down. I remember buying a rental property at a 6% interest rate back in 2008 and refinancing it down to 2.875% in 2013. I’ve heard folks in their 60s talk about getting 12 to 14% interest rates on a house back when they were younger and thinking it was a steal. If you look at the chart in The Palm Beach Daily article I shared earlier, rates in 1983 (when I was 2) were above 14%.

This means in our entire existence, interest rates have been going down; thus, the prices of bonds have been going up. Remember, as we shared earlier, interest rates and bond prices move in opposite directions. So during our entire life, bond prices have been moving up. Therefore, it’s easy to think nothing different could happen with bonds.

But as this exchange on CNBC shared, interest rates could break out of this trend and reverse in the next few months. And as the Fed raises interest rates, it will feed into the possibility of this trend being reversed. We can’t ignore this. Thus I understand how it may seem hard to believe there will be a significant drop in bond prices, because they’ve been going up for 30 years. But trends change. And right now things are different from what they’ve ever been.

A Change in Bond Prices Will Impact the Stock Market

Now you may wonder what this has to do with the stock market. My book explains we’re on the verge of an imminent financial crisis when the stock market could collapse, but above I shared why bond prices may fall. Well, nothing is isolated.

In the first video from CNBC, during the exchange they start discussing whether Congress will allow the deficits proposed by Trump’s economic policies (lower tax rates and infrastructure spending). I’ve already shared in my book why I don’t believe these policies will have the impact the mainstream believes they will. In short, it’s because we already have too much debt and we’re seeing the law of diminishing returns on debt.

But in this exchange, they’re referencing the ability to even get the proposed policies passed, even though there’s a Republican Congress and a Republican president. What they’re saying is when interest rates were dropping and near zero, Congress was more open to deficits. But as interest rates rise, Congress may not be willing to run deficits, and we could have the same stalemate in Congress we’ve had for the past eight years.

They do mention that if the stock market continues to go up, it will create a window for the proposed policies to be passed, even though rates are rising. But the key is how long that window of a rising stock market with rising rates will stay open.

The CNBC exchange continues, “Equities will eventually succumb to the rise in interest rates. We have to remember what got us here. We pulled forward a lot of returns because of zero interest rates and quantitative easing. To think the stock market is going to be immune to rising interest rates I think is unrealistic.”

What he’s saying is that as we’ve added all of this government debt and had zero interest rates, a lot of stock market returns that should have occurred in the future have already occurred. Understand what that means. Returns we would expect in the future may have already occurred!

Lower interest rates allow companies to borrow money and incur very little interest expense. This creates higher earnings, higher dividend payouts, and more stock buybacks. All of these lead to higher earnings per share and higher stock prices.

And when you factor in the government debt that was created, that fueled the sales companies were experiencing—again, leading to higher stock prices.

So as interest rates have been going down for 30 years, it made the ability of companies to grow profits, and thus have their share price rise, easy and almost automatic. And during the past seven years—which, since they are the most recent, are the easiest to remember—the zero interest rates and trillions of dollars in government debt made it even easier.

This makes it difficult to understand and accept that a doom-and-gloom scenario could occur in the stock market. But trends reverse. And a 30-year trend reversing could be catastrophic.

If companies have to pay more to borrow money, earnings will drop, dividends will go down, and share buybacks will stop. This will cause stock prices to fall. On top of that, if companies begin defaulting on bonds because they cannot refinance and afford to pay the higher rates, it will cause further downward pressure on the stock market.

And it will not stop there. It will flow into auto and student loan debt, creating overall economic pressures that will cause stock prices to drop further.

Remember what I wrote in my book:

Bill Bonner, founder of the largest independent financial publisher has a saying “reversion to the mean….Normal exists because things tend to follow certain familiar patterns, shapes, and routines….Occasionally, of course, odd things happen. And sometimes, things change in a fundamental way. But, usually, when people say ‘this time is different’…it’s time to bet on normal.”

Mr. Bonner’s February 2016 issue of his The Bill Bonner Letter further explains mean reversion. “Mean reversion is one of the most powerful forces in the financial markets…mean reversion is a contrarian investment strategy that refers to the tendency of stock prices to always return to a ‘normal’ level after reaching extreme highs or lows.”

I completely understand why it’s tough to understand or accept the possibility of a doom-and-gloom scenario, because we’ve experienced nothing but the opposite in our lifetime. And it appears the proposed economic policies and tax reforms of the new president will have a stimulating effect on the economy. I don’t believe they will, and as described above, some don’t believe they will get passed.

There’s been a powerful trend of decreasing interest rates during our entire lifetime. If that trend begins to reverse and interest rates normalize, what happens may be something we’ve never imagined could occur.

Remember, in 2006 nobody ever thought the housing market would crash, and it did.

I don’t know whether or when this will definitely come to fruition. I’m only trying to help you understand why this is a possibility and that it’s important to prepare for and protect yourself from this possibility—which I believe is highly possible.

To your health, wealth, and personal freedom.

Please send any feedback or ideas for future topics to feedback@coast2coastfinancial.com.
Chad A. Walker, CPA, MBA