Markets Are Profoundly Unhealthy Now

2014 was the best of times and the worst of times in financial markets. Stocks rallied, of course, while bond yields and commodity prices plunged. In 2014, the S&P 500 gained 13% while the yield on 10-year Treasuries dropped from 3.03% to 2.17%, and the price of oil collapsed by 50%.

And the all-important U.S. dollar rallied as other major currencies such as the euro and the yen plunged. Investors looking for a consistent message from markets had to look elsewhere.

In January 2015, a similar theme spooled out in a completely different way...

The S&P 500 lost 3% - its worst performance in a year - while Treasuries had their best month in five years, as interest rates plunged to record lows around the world. In fact, yields on government bonds in many places are negative, a profoundly unhealthy phenomenon.

Crude oil dropped for the 7th month in a row, something it did during the 2008/9 financial crisis, even after a manic rally on Friday, January 30. The U.S. dollar continued to rally for the 7th month in a row and had its best month since May 2012.

Here's what January's action means for the rest of 2015...

Pundits like to talk about the "January indicator" which, according to the Stock Trader's Almanac, holds that, as January goes, so goes the year 89% of the time from 1950 to 2013. Of course, that rule didn't hold in 7 of those years, this is the third year of a Presidential election cycle (when the market usually goes up), and on the other side of the ledger the S&P 500 has never rallied 7 years in a row (2015 would be the 7th consecutive year of gains).

In other words, basing one's investments on these types of statistics is a fool's gambit. What an investor needs to do it look at the facts.
And the facts are grim. Stocks are trading at extremely high valuations against a backdrop of slowing economic growth and rising global financial and geopolitical instability. And bond markets are sending truly alarming signals about the state of the global economy.

A Look Through the "Buffet Goggles"

Let's start with stock valuations. Warren Buffett's favorite valuation measure, the ratio between the total value of all S&P 500 companies and U.S. GDP, is currently at twice its historical average. The Shiller Cyclically Adjusted P/E Ratio, which measure stock values over a rolling 10-year period, is at 1.7x its historical average.

And the forward price/earnings ratio of the S&P 500, which is based on reported earnings that are artificially inflated by many factors (most importantly massive stock buybacks funded with low cost debt), is currently 16x versus an historical average of 14x (and therefore, because earnings are artificially inflated, less overstated than it is). In other words, stocks are very expensive.

An Alarming Number of Bonds Are Sporting Negative Yields

Now let's look at bonds. Ten-year Treasuries are now yielding 1.67% and the iShares 20+ Year Treasury Bond ETF (TLT) returned 9.8% in January. As crazy as it seems, this ETF is still something to buy because the 10-year yield is likely heading below 1.50% and could easily trade in the 1.0% to 1.25% range. The 30-year Treasury yield is trading at a record low of 2.22% and is likely heading under 2.0%.

The scary thing is that U.S. interest rates are still much higher than the rest of the world. Five year German bunds - the European benchmark - are negative and some $3.6 trillion of government bonds around the world are now sporting negative yields.

Investors should make no mistake about it: this is profoundly abnormal, unhealthy, and unsustainable, and a sign that something is seriously wrong with the global economy. And for that reason, it is a big mistake to think that stocks can continue to rise in such an environment.

For that reason, I recommend that investors should buy ProShares Short S&P 500 ETF (NYSEArca:SH) shares. This will rise if the stock market falls, which I expect it to do soon.

The Millstone Holding Down Global Growth

Next, let's look at global financial stability - or instability. The world is currently home to more than $100 trillion of debt. The problem is that the global economy can't generate enough income to pay the interest on this debt or pay it back.

Why is that? Because the money that was borrowed wasn't invested in the types of productive assets that generate income such as new businesses, new technologies, and innovation.

Sure, some of the money was invested in those things, but not nearly enough. Instead, most of the money was invested in non-productive assets such as housing and consumption. As a result, the world was left with too much debt and too little ability to handle it.

All of this debt is making it increasingly difficult for economies to grow. This is why the recovery from the financial crisis has been one of the most disappointing on record. And after several quarters of reasonably impressive growth, the U.S. - the only country in the world that is showing any strength - is stumbling again.

Last week, we learned that gross domestic profit only grew at 2.6% in the fourth quarter of 2014, roughly half the pace over the summer (which was itself overstated by statistical anomalies). For all of 2014, GDP only grew at an average rate of 2.4%, nothing to write home about. While consumer spending was strong in the fourth quarter, businesses pulled back.

First-quarter 2015 growth is also looking sluggish. The truth is that it is very difficult for heavily indebted economies to grow quickly and the U.S. economy is heavily indebted in both the public and private sector. Add the crushing weight of over-regulation, taxes, and Obamacare and you have a structural problem that can only be addressed through policy changes.

Geopolitics Are Playing an Corrosive Role

Finally, let's turn to geopolitics. Russia has increased its aggression in the Ukraine in the face of seeing its economy crumble as a result of the oil price collapse. This poses a direct threat to europe that can only be ignored for so long. The Middle East remains a powder keg.

China continues to advance its interests in the South China Sea and elsewhere. A rare bright spot was President Obama's visit to India last week, but overall global instability is rising and poses a threat to markets.

Against that backdrop, therefore, nobody should be surprised that stocks fared poorly in January. The real surprise is that they did so well in 2014.

Last week was particularly ugly with the Dow Jones Industrial Average (INDEXDJX:.DJI) losing more than 500 points or 2.9% to close at 17,165.95 while the S&P 500 (INDEXSP:.INX) dropped 57 points or 2.8%. The Nasdaq Composite (INDEXNASDAQ:.IXIC) index shed 123 points, or 2.5%, to 4635.24. A number of large companies such as Microsoft Corp. (Nasdaq:MSFT), Procter and Gamble Co. (NYSE: PG), Pfizer Inc. (NYSE: PFE) reported earnings that were hurt by the effects of the strong dollar.

This is a trend that will continue as 33% of S&P 500 earnings come from outside the U.S. Energy companies are also reporting lousy results, which should come as no surprise. Energy giant Chevron Corp. (NYSE:CVX) reported a 30% drop in earnings and announced it was cutting spending and eliminating its stock buyback program (which has been running at $5 billion a year).

Wall Street strategists are now lowering their earnings estimates for the S&P 500 to take into account the effects of lower oil prices and the higher dollar. This should place additional downward pressure on stocks.

According to Bloomberg, investors have lost $393 billion in energy stocks and bonds so far, something that wasn't factored into the optimistic reports about the positive effects of lower oil prices on consumers.

Here's a little bulletin: when the world's most important commodity experiences collapses in price by more than 50% in a period of just six months, it isn't good for anybody - not for consumers (who aren't just consumers - they are also investors, businessmen, and active members of a broader economy), investors or markets. And the reason is that lower oil is a symptom of something much more serious - the weak global economy that I described above.

Prepare for Tough Times Ahead

Through that lens, lower oil should be seen as a major warning sign that both the market and the economy are in for tough times.

And that is what January's stock market action is telling us. Bond and commodities markets have been signaling for months that the global economy is in trouble. Last month, stocks finally caught up. Janet Yellen is going to have to pull another rabbit out of her hat to keep stock prices levitating in the year ahead, and she is quickly running out of rabbits.

About the Author

Prominent money manager. Has built  top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.

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