The Coming Crash, Part 3: This is Fine

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The Coming Crash is a four-part series examining the 2008 Financial Crisis and current economic conditions. I am not a licensed financial expert. I’m not an economist. I’m just a guy trying to learn each day and share my thoughts with others. Consult your own financial adviser when deciding how to allocate your personal wealth.


“I once said “Greed is good.” Now it seems it’s legal… And the beauty of the deal, no one is responsible. Because everyone is drinking the same Kool Aid.” – Gorden Gekko, Wall Street: Money Never Sleeps

In Part 1, we explored some of the factors that led to the Financial Crisis of 2008. In Part 2, we addressed why many of the attempted fixes following that crisis were short-sighted. Where are we today? Are the current economic and financial conditions ripe for another catastrophe? These are some of the things that lead me to believe that we are close to a market top and potentially an economic downturn.

Rising Interest Rates – Credit Impact

I alluded to this in Part 2; interest rates are rising. The rising interest rate environment is supposed to be a good thing. It signals that the economy is strong and that savers are going to start earning more interest on their deposits. Conversely, rising rates are not good for debtors. And consumers have a mountain of household debt. This is what happens when the Federal Reserve keeps interest rates too low for too long. Credit is too easy and bubbles inflate. To be precise, US Households are currently on the hook for $13.29 Trillion in debt. That’s mortgage loans, student loans, and auto loans. Also, over $1 Trillion of it is on credit cards. That debt is becoming more expensive to service. When consumers are spending more of their income on servicing credit card debt, they’re spending less of it on fun. Less disposable income for fun means an economy that is about to slow down. How bad is it right now? Consumers piled on $92 Billion in credit card debt in 2017. That is the largest single year increase since… 2007. This isn’t a death sentence if real wages are growing at a pace that makes up for the increases in spending. Unfortunately, they’re not.

Courtesy: Visual Capitalist

Stagnant Wages

Without droning on about wages against inflation and the purchasing power of your dollar, we can look at another measure to determine if economic activity is truly healthy. The chart below comes courtesy of EPB Macro Research. What this one tells us is, in the aggregate, income growth has not kept up with consumption growth in 3 years. We are living beyond our means. Is the American consumer tapped out yet? If we’re not there now, we’re close.

Treasury Yield Inversion

This is a point that you might have seen already. The mainstream financial media is actually covering it. The treasury yield curve is flattening. What does that mean? It means longer term 10 year treasury bonds are actually a worse deal than 2 year treasury bonds. Throughout history, when the yield curve flattens to the point that it actually inverts, it’s a leading indicator of a coming recession. Now, just because we’re flattening, it does not mean that the bond yield will invert. But don’t be surprised if it does.

Yield curve aside, one more point about bonds. Rates are rising. As yields continue to become more attractive, you’re going to see money rotate out of equities and into bonds. That means lower stock prices.

Margin Debt

Margin debt is currently at an all time high. When we’re all trying to figure out what happened a couple years down the line, this is what analysts are going to point to as the smoking gun that foreshadowed the stock market collapse. And it’s staring us right in the face. If you don’t trade, you might not know what margin debt is. Here’s a simple explanation: margin is essentially a loan from a broker that allows a trader to buy more stock than that trader has the cash for. Margin levels vary, but let’s use a pedestrian 2:1 leveraged account as an example. If you deposit $25,000 into a 2:1 leveraged margin account, your broker is allowing you to buy $50,000 worth of assets. This generosity, of course, is not free. You will pay an interest rate on the margin loan. Now, let’s say you used that margin to buy $50,000 worth of Geron Corp Stock (Ticker: GERN) on September 26th at the closing price of $6.23. The very next day, the stock crashed about 70% to the low $2.20s – wiping out $35,000 in equity. That morning, you get what is referred to as a margin call, if you’re lucky. Your broker might just sell out of your position without asking. In either scenario, you owe your broker $10,000. You started with $25,000 and lost $35,000. $10,000 of it wasn’t actually your money, and I’m afraid your broker wants it back. This example is not typical. It’s an extreme, no doubt. In a typical situation, the margin call is coming long before your account is underwater. In a typical situation, your options are add more cash to the account, or sell off other assets to pay the broker. There is clearly more risk involved with margin debt. And as we know, margin debt is at an all-time high. That means that a strong market move down is going to trigger a waterfall of selling. 2:1 is the simple math, little guy example. I can assure you there are brokerages offering significantly more leverage. Even 50:1 is not unheard of.

Euphoria

There’s another tell tale sign that you’re at the top, euphoria. How do we measure that? It isn’t easy. The old adage is that when your cab driver is talking about buying stocks, it’s time to get out. We saw this in Bitcoin last year. One Bitcoin was as high as $15,000 dollars and people were starting to take notice and talk about it at the water cooler – it eventually surged to $20,000. Now one Bitcoin costs about $6,500 and that still might be too high. When judging if we’ve reached economic euphoria, we can look to the Consumer Sentiment index. Surprise, surprise, it’s back where it was before the 2008 crash, though not quite to dot com bubble levels.

Big Market Real Estate

I’m not going to say we’re in another housing bubble, but we can look to leading markets to see if housing is overheating. What we’re seeing in places like Southern California and Manhattan would suggest things might be topping. Despite average prices near record highs, home sales in Southern Cali have slid for the 9th time in the last 12 months. In fact, June-August sales dipped 6.8 percent; making it the weakest summer for housing in the region in 4 years. That hasn’t stopped people from listing homes at a feverish pace, however. There are now over 45,000 listings currently available; it’s the largest number in three years. With more sellers than buyers, it’s just a matter of time before the prices move down quickly. It’s even worse in Manhattan where home sales are down 25% – the largest decline since 2009.

Corporate Pump & Dump

But maybe the biggest indicator that we’re near the top of this bull run is coming straight from Wall Street. It’s no secret that corporate buybacks have helped fuel part of this recent market rocket-ship. Corporate buy backs have made an all-time high for two consecutive quarters.

Courtesy: Yardeni Research

The most noteworthy part of the buyback story isn’t the buybacks themselves. It’s what insiders are doing while the buybacks are happening. It’s the opposite! SEC Analysis shows that in 2017 and 2018, insider sells doubled immediately following buyback announcements. Here’s the best part, some of these companies are borrowing to do the buybacks! To recap: borrowing money to buy shares with the corporate balance sheet, while simultaneously selling private holdings. If it looks like a Pump & Dump and sounds like a Pump & Dump, it’s probably a Pump & Dump.

So, what can the little guy do? In Part 4, I’ll share what I’m doing.

Disclaimer: Views and opinions expressed by Mike are not necessarily the views and opinions of CLNS Media. You can follow Mike on twitter @MikeFay34 and read his stock market technical analysis at faybomb.blogspot.com