The Pattern of The Market
The Market Ticker - Commentary on The Capital Markets
2017-02-12 06:00 by Karl Denninger
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The Pattern of The Market
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Looks awfully similar to 2008.

Rotation back and forth, with most of the gains coming in a handful of big names with big stories -- but no earnings to back them up.  Claims from the media, including most-notably CNBS, citing 2018 earnings projections that have built in 50% or more increases in earnings -- that have not happened yet -- to "justify" P/E ratios that today stand in the area of 40, 50, 100 or more on current earnings.  These same firms are themselves showing slower growth rates and increases in both spending on "new things" and decreasing margins, along with near-zero growth of customers in the United States.

In 2008 this was happening in banks and...... big tech.

Today it's happening (mostly) in big tech.  But those firms today are even further down the road (if they existed at all) than they were in 2008, and yet..... suddenly, we seem to have magically grown a few new continents for them to expand into (never mind that the revenue available from people in those places, thus far, appears to be near-zero on a per-person basis.)

The market always balances fear and greed; along with this nebulous thing called "liquidity" -- the availability of cheap credit to leverage forward results. What everyone intentionally refuses to consider is that leverage works both ways; it both amplifies profits and losses.  Every turn of the crank irretrievably impacts both in exactly the same amount.  If you buy back shares and reduce the float of your stock by 50% then your earnings are doubled on an EPS basis -- but when the worm turns and you take losses, the losses on an EPS basis are doubled as well.

Nobody believes there will be losses, you see, therefore there is no cost, no penalty, and no risk to turning the crank.

Uh huh.  Sure.

If you think firms like Netflix, Amazon, Facebook and similar are going to grow trees to the sky you're deluded.  Amazon managed to somehow nearly double SG&A expense this last quarter over the same quarter last year.  How did that actually happen and where was that expense from?  By the way, their sales did not double -- not even close. 

You can argue, if you'd like, that there's something special -- "water walking" of some sort -- by these firms.  There's not.  There is plenty of accounting gaming going on, but it's legal to do that within broad limits.  The onus is on you as an investor or trader to actually read said releases and figure out, if you can, what they're doing.  Like, for instance, exactly why Amazon's SG&A doubled -- from what section of their business are they hiding broken-out expenses to prevent you from evaluating, on a fair basis, what the forward profitability of that segment of the business is.....

I have considered banks uninvestable since before the crash.  The reason is simple: I cannot get my arms around their contingent liabilities because the law allows them to hide those liabilities to a degree that putting a number on them with any sort of accuracy is impossible.

You could forgive most of the people in the so-called "analyst" community in this regard up to a point.  You see, the world of ever-lower interest rates has been firmly in place since the 1980s.  That's driven better than half the gains in the markets since 1980 as a purely mathematical matter.  Without that the DOW would stand at 10,000 and the S&P at about 1200 today.

But how do you continue that pattern today when it's not possible to continue the ever-lower interest rate paradigm?  It's entirely possible that we could stall out here and never reverse -- that is, the 10 year Treasury could trade in a range of around 2.2-2.5% for decades.  It has before, and it might again.  But if it does that still doesn't help you expand leverage because you've already borrowed the money at the low rates of the last 10 years!

Note that firms like Netflix, with negative operating cash flow that has persisted through a period spanning yearsonly exist because of their ability to continue to turn that crank!

If that ability to disappears the firm is literally out of business because they have contracted to spend money over the next several years that they do not have, do not generate from operations and cannot raise -- this means their stock suddenly becomes worth zero.

It is not the absolute rate that determines which direction leverage goes it is the change in rate and direction of that change.  If there is no change then there is no change in the bias for leverage.  If rates rise then you wind up with a forced de-leveraging because any money borrowed not to be paid back but simply to be paid coupon upon cannot be held out -- either you pay back those loans or you default, and in a corporate environment that means the firm goes bankrupt and the stock value of said firm is zeroed.

When you look through the economy of today in the United States from 20,000' you find two things that stand out:

  • Forced extraction of money, often apparently in violation of black-letter felony law (e.g. 15 USC Ch 1), supported by either intentional refusal to prosecute or even government involvement in same.  Health care is the standout example, but not the only one. Forced "net neutrality" was one of them from the Obama era, and is the reason Netflix exists at the scale and pricing that it does in the US.  Anything that upsets that apple cart will detonate all the businesses dependent on it.

  • Ridiculous borrowing for uneconomic purposes such as stock buybacks and similar.  Borrowing funds is always dangerous.  It also, however, is sometimes a risk worth taking.  There is no such thing as life without risk.  The question is what's the risk, what's the reward, what's the timeline on that risk and what forward assumptions and their probabilities are you using to measure all three?  That last question, in the last 30 years and especially in the last six or seven has never been asked and expanded upon in public by any firm's public filings I've seen.

Finally, we appear to have a President that cares not for the boundaries of the Constitution when it comes to said extraction, nor will he enforce existing law.  The fact that Trump supports "civil forfeiture" is enough to disqualify him as a President standing alone.  That he has demonstrated no intention to act on medical monopolies is far worse, however, as while civil forfeiture is unlikely to impact you medical monopolies will, with near-certainty, impact either you or someone you love and care about at some point in your life.

You need only get into a car accident that you cannot foresee nor are at fault for to be victimized by this system even if only to a mild or moderate degree.  Your mother or father, or child need only get injured in a pure accident, such as by a snake bite to get rat****ed beyond words and face a quarter-million dollar charge they never consented to.  Unlike many of the injustices this one hoses nearly everyone at some point in their life and yet there is exactly zero outrage in the streets, state-houses or directed at the cops and other law enforcement agencies over any of it.

It was obvious to me in 1997 that the stock market was going to crash and the pets.com wonderkind would be zeros.  What people cite as "different" today is that firms like Facebook and Amazon have "actual earnings."  Well, perhaps, but that just changes whether the bottom number for their price is zero, or some small number over zero.  That you have a functional business that actually does generate something beyond what you spend doesn't make your 2% operating margin delivering goods, and what is rapidly trending toward a commodity-style 10% operating margin delivering services, worth the near-200 times earnings your stock sells for today on the premise that you can manage to hold 50% service margins along with the necessary companion expectation that sales volume will expand by a factor of 10.

Last time around the stupidity centered on the premise that the S-1 filings claimed somewhere north of 10x Global GDP for "expected outcomes" -- a radically stupid proposition that should have met with exactly zero willing buyers in the market.

This time around it centers on equally-stupid premises -- such as the idea that AWS is a $200 billion a year business operating at a 50% margin -- a pair of assumptions that together mean (1) there will be no competitors and (2) there will be no corporate data centers.  Either one of those presumptions standing alone is laughable.  Together they are hucksterism far worse than anything P.T. Barnum ever cooked up.

This sort of "analysis" by Wall Street and their willing mouthpieces in the media ought to be good for felony indictments because they are claims that have a statistical probability of occurrence less-likely than an asteroid hit on the White House in the next 72 hours.

Yet just as was the case in 2000, and in 2008, exactly nobody will face any sort of sanction for any of it -- just as nobody has for nearly 40 years in the medical industry for violating 100+ year old law.

You, on the other hand, will pay the price -- just as you will for the medical monopolies -- because we, the people refuse to demand that it change now and that this crap be put to a stop.

As for exactly when the roof will fall on your head, that's unknowable.  Every time it happens someone calls it right, but hundreds, even thousands of people call it wrong, and usually the person who called it right got it wrong previously for the same event.  The underlying cause of 2008 was clearly visible early in 2007, yet the insanity went on (and the market continued to rise) for more than 18 months.  In 2000 the insanity was clearly visible in 1997, I exited in 1998, and yet from the point that "this is stupid" was obvious until it blew was close to three years -- and well more than a double in the Nasdaq later.

I have utterly no remorse, however, over sitting out the "last burst" of run-up in either case -- because the odds are nearly 100% that you won't get the call on the exact time right to exit, and you risk far more than you can make by trying to do so -- or even worse you wind up second guessing on what you think is a "dip to be bought" and finding out that what you just walked into with your money is an elevator shaft on the 100th floor -- with no car. 

The math is never wrong.

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