Stocks paused from their post-election rally last week as the Dow Jones Industrial Average gained a paltry 18.28 points or 0.1% to end the week at 19170.42. The S&P 500 fell -1% to 2191.96 while the Nasdaq Composite Index fell -2.65% to 52255.65. Further gains or losses may be less dependent on news from Trump Tower and more responsive to Italian voters’ rejection of constitutional reform on Sunday, December 4. The “no” vote in Italy bodes poorly for Italian banks, which are insolvent and in need of government support, and potentially a movement toward exiting the European Union. Despite a wider-than-expected margin of defeat (“no” votes were nearly 60% of the total), markets in Europe and the US by rallying. I have to confess that while I expected the “no” vote I did not expect markets to greet the result by rallying and am scratching my head at the response.
Italian voters are the latest to embrace populism and reject the elites governing their country. Following the Brexit vote and Donald Trump’s victory, Italians rejected much-needed constitutional reforms that could improve governance and chances for economic reform because they were focused on rejecting the heavy hand of the European Union and the straitjacket of the single currency that is suffocating their economy. This is what happened in the UK and points to the likelihood that the European Union is doomed in the long-term. For the moment, however, the immediate threat from this vote is to the insolvent Italian banking system that desperately needs to restructure. In the coming days, markets may come to see the vote with dark rather than rose-colored glasses as I do.
The US Dollar Index faded a bit last week but still closed at 100.66, near its 52-week high. On a broad basis, US stocks are now engaged in a battle between expectations of higher growth and earnings due to Trump’s pro-growth and lower tax agenda and the costs of higher interest rates and a more expensive dollar. The market is expensive with the S&P 500 Market Cap/GDP Ratio at 125%, near a historic high, and the Shiller Cyclically-Adjusted Price Earnings Ratio at 27.02 versus its historical mean of 16.71. While these valuation metrics aren’t deterring investors yet, they indicate that the market is very vulnerable to disappointments – and disappointments can come from many economic and geopolitical fronts. With higher rates and European instability on the horizon, investors should proceed with caution. That may not happen until year-end performance chasing is over, but I would expect the rally to peter out in January.
Truth be told, stocks aren’t a reliable indicator of anything right now.
The real “brains” of the market (and the real profit opportunities) lie elsewhere.
Here’s what you should be watching instead.
In A Misleading Market Climate, One Indicator Tells The Truth
The rise in yields already produced $1.7 trillion in losses, but these are only a small down payment on the catastrophic losses holders of investment grade corporate and sovereign debt are likely to experience over the next few years. If rates were to normalize by 200 basis points (which is a near certainty over the next 3-4 years), that would bring losses to over $7 trillion (though there would be some offset from interest income – at least where bonds are not showing negative yields). The bottom line is that bonds remain a toxic asset class that should be avoided by investors at all costs. In case that sentence wasn’t clear enough, that means that everyone reading this should sell every single long-dated (i.e. longer than 3 years) investment grade, municipal or government bond you own in order to avoid losing money on both a nominal and real (i.e. inflation-adjusted basis). Either stick the money in cash or use some of the money to buy gold (which is selling off for stupid reasons). Professional and sophisticated investors should consider shorting every piece of long-dated high quality debt on which they can get their hands.
One way to do that is to short the Vanguard Total Return International Bond ETF (NASDAQ:BNDX), which carries a very low yield that is heading higher and will lead to big losses. As always, I recommend puts as a safer (and cheaper) way to play the short side.
Of course, you should keep an eye out on our short equity plays too, because we’ve seen bad news for a couple of them very recently…
A Note on Two of Our Favorite Short Plays
Valeant Pharmaceuticals (VRX) received more bad news last week after a proposed deal to sell its Salix business for a multibillion loss fell through. It is becoming increasingly obvious to the market that VRX is insolvent and that its stock has no value, something I warned about a long time ago when the stock was trading at $170 per share (no, I didn’t catch the high tick at $262 but nobody’s perfect!). It ended the week at $15.45 per share. It is going to zero.
Tesla Motors, Inc. (TSLA) is going to be the next VRX, dragging down many hedge funds and other investors as the market comes to realize that the company is a personality cult and Wall Street fee engine rather than a sound investment. The SEC slapped the company on the hand last week for its bogus accounting while more astute investors are making the case that the company’s losses are unsustainable. Its merger with Solar City, which its stupid shareholders approved, hastened the demise of the company, whose stock ended the week at down at $181.47. Believe me, it is going much lower – most likely, all the way to zero. Tesla stock is like the SpaceX rocket that blew up on the launch pad a few months ago – all flash, no cash, a lot of hot air, and dangerous to bystanders. Short away my friends!