Forget the Best, Just Sell the Worst

Aug 6, 2014

Ouzilly, France

The Dow fell 139 points yesterday. Gold dropped $3.

It's too early to know if this is just a fake-out...or the beginning of a bear market.

Our old friend Mark Hulbert thinks a bear market is developing. Citing the work of Hayes Martin of ExtremeMarkets, he says there are three indicators that never fail to warn of a bear market:

    In fact, no bear market has occurred without these three signs flashing at the same time. Once they do, the average length of time to the beginning of a decline is about one month, according to Martin.

    The first two of these three market indicators - an overabundance of bulls and overvaluation of stocks - have been present for several months. Back in December, for example, the percentage of advisers who described themselves as bullish rose above 60%, a level Investors Intelligence, an investment service, considers "danger territory." Its latest reading, as of Wednesday, was 56%.

    Also beginning late last year, the price/earnings ratio for the Russell 2000 index of smaller-cap stocks, after excluding negative earnings, rose to its highest level since the benchmark was created in 1984 - higher even than at the October 2007 bull-market high or the March 2000 top of the Internet bubble.

    The third of Martin's trio of bearish omens emerged just recently, which is why in late July he advised clients to sell stocks and hold cash. That's when the fraction of stocks participating in the bull market, which already had been slipping, declined markedly.

    One measure of this waning participation is the percentage of stocks trading above an average of their prices over the previous four weeks. Among stocks listed on the New York Stock Exchange, this proportion fell from 82% at the beginning of July to just 50% on the day the S&P 500 hit its all-time high.

    It was one of "the sharpest breakdowns in market breadth that I've ever seen in so short a period of time," Martin says.

Up? Down?

We're not sure...and not worried. Following the old dictum - Buy Low, Sell High - we sold out of this market a (too) long time ago.

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And following our new dictum - Forget the Best, Just Sell the Worst - we are aiming to avoid some of the stock and bond markets' worst days...which we think lie ahead.

Why do we think so? The answer is in our new book. Our friends have promoted our book - Hormeggedon - so vigorously, we're almost ashamed to mention it. But it explains a much overlooked phenomenon. An investor can survive a lot of failure. But too much success kills him every time.

Too much money (or credit) raises prices, lowers yields, forces investors into subprime investments, increases debt and dooms markets to disaster.

Allan Sproul, head of the Federal Reserve Bank of New clarified the process in 1946 (thanks to Grants Interest Rate Observer for bringing this to our attention):

"As gilt-edged securities, both public and private, rise in price under pressure of the abundant money supply, funds flow ever-increasingly into lower-grade securities, and into equities, and into commodity, real estate and other markets."

Then, Henry Hazlitt elaborated: "Interest rates can only be held down to present levels by continually watering the supply of real capital through a continuous injection of new money and bank credit..."

As ultra-low rates continue, milestones are hit. In 1946, the Union Pacific Railroad was able to borrow at 2.51% -- a record low. But the Union Pacific was a solid business. Today's credit-financed lending bubble finds borrowers with neither tracks nor trains.

Rwanda recently borrowed $400 million - an amount equal to 5% of GDP -- at less than 7% interest. Surely, that is a milestone too.

And so is this ...from our ace investigator, EB Tucker:

    I spoke with someone today who got a loan from last week. Have you heard of it? It's a website where prospective borrowers post a listing detailing their background and capital needs. Then "investors" fund the loan and Lending Club takes an origination fee of around 3-5% for setting it up. That fee is deducted from the borrowers funds when money is transferred.

    His rate was 17.5% and truthfully I'm shocked he found someone to lend the money. He said he's making $80k as a W2 salaried employee. He has a mortgage (relative lives in the home) he rents an apartment, he's in lease dispute over a previous apartment and he has plenty of monthly payments including a $500/mo car payment not including insurance. So he's not that good of a credit risk. He said the loan was to consolidate credit card debt which he has over $35k of.

    But someone privately funded the deal and gave him $35k! Lending Club took 3.7% as a fee and he got the rest.

Great business model, no? You get money from people who are desperate for lend it to people who are desperate for cash...and you take your fees off the top. Then, if the loans go bad, it's not your problem.

EB continues:

    I asked him if he plans to pay the investor back? "Maybe...." He elaborated...."if things go well sure but if I lose my job which I might I'm not paying this idiot back..."

    As for Lending Club....check out the board of directors!

Who's behind it? None other than celebrity cheerleader for the bubble, Mary Meeker...and macro-meddler par excellence Larry Summers.

And, would you believe it, an IPO is in the works!

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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