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5.31.2017 - Free Investment Newsletter Bookmark

The Double Whammy
It’s quite hard to write a “financial” letter 2 times a week for almost 25 years and not go over some of the same things.   Knowing that I try my best to change it up as often as I can, so repetition doesn’t bore you and I to tears.
However, there’s something that I’ve written about before that I think needs not only closer inspection, but a real hard “think” about the ramifications.  So let’s get started with the first part of the double whammy...

By now most of you are at least comfortable with the idea that a lot of the up movement in the market is the result of the Central banks. That’s a good thing, because it shows you can indeed connect the dots. I find it amazing that it is absolutely open knowledge that Mario Draghi prints 80 billion Euro’s a month, and “jams” it into the economy as “QE” and there’s people that still don’t believe a significant portion of that money ends up in stocks. Yes, even here in the US.
Yes folks, I know the fed’s hint that they aren’t in stocks. But I don’t think it takes a Rocket scientist to figure that if the Bank of Japan owns 50% of their stock market, and the Swiss own 100 billion in stocks and the ECB owns 10% of all European Corporate debt...that our Fed’s probably have a stash, via the Plunge Patrol Team that I commented on Sunday.
But there’s another “problem” concerning why the markets seem to be considerably higher than they should be, and I’ve talked about it before. It’s the change into ETF investing that has really “blown up” things. Let’s go slow and see why this is so “distortional” to everything.
First off, just what is an ETF?  Let’s pull a description from the investing dictionary....
An ETF, or exchange traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund.An ETF is a type of fund which owns the underlying assets (shares of stock, bonds, oil futures, gold bars, foreign currency, etc.) and divides ownership of those assets into shares.
By owning an ETF, investors get the diversification of an index fund as well as the ability to sell short, buy on margin and purchase as little as one share. Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund. When buying and selling ETFs, you have to pay the same commission to your broker that you'd pay on any regular order.
Okay, so you know what an ETF is. What’s the problem? Well, see that area I bolded?  “Owns the underlying assets”  See that? Okay, so as the ETF “fund” gets investor money, they “buy” what their ETF covers. So if it’s a stock ETF like the SPY which “covers” the S&P 500... they buy up the stocks in the S&P.  Okay so far? Good. Now here’s the hitch....
Let’s suppose you are the XYZ company and you can do no wrong. You’re an S&P 500 member and you churn out profits like no one else. You make money, you pay a dividend and people love you.  Well the SPY ETF will buy shares in your company as the ETF receives investor money.
Now let’s suppose you’re the ABC company. You’re barely hanging on. You’ve laid off 75% of your staff. You haven’t made money in two years. By some accounts you should be out of business. Guess what? The SPY ETF will buy your shares just as they do with XYZ that makes a ton of money.
So while no true investor would touch ABC with a ten foot pole, the ETF has no issues with P/E, or price to sales, or price to book. When they get money, they divide it up into the 500 stocks and simply buy them. As you can see, this can create HUGE distortions. If ABC is only going up because the ETF is buying every stock in the index, it means ABC is wildly, vastly, enormously overpriced. 

This is leading to numbers that are quite shocking to people. I’m sure you’re familiar with the Russell 2000 right?  Again, let’s go to the description...
The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index. ... The Russell 2000 is by far the most common benchmark for mutual funds that identify themselves as "small-cap", while the S&P 500 index is used primarily for large capitalization stocks.
According to the Wall Street Journal, the Price to earnings ratio of the Russell 2000 is...drum roll.... 81.  Yes folks, 81. Here’s the link...

Or consider this. Here’s a line out of Mauldin’s latest Email...
Paul Lyons at Tectonics went to his Bloomberg terminal and found that 30.7% of the 2000 stocks in that small-cap index had less than zero earnings for the previous 12 months, as of 3/22/17.
So put your arms around what’s going on here and give it a hug. We have central banks buying stocks. They have no risk in this endeavor as the money they use to buy up these stocks, cost them zero. They simply whisk it up out of thin air. Do they care what the P/E is on the ABC company? Hell no. If XYZ is deemed important to investor sentiment, they buy it up. And Drive it higher. Which pushes the overall market higher.
Yet as bad as that is ( and yah it’s bad) then we have the ETF’s buying every stock in the index, whether they should be superstars or taken out and shot.  Between the two issues, working in tandem, this market is simply distorted to proportions that are truly unknown.
You’re in an experiment. No one has ever seen a market such as this because things like CB’s buying stocks is new. So with that in mind, the only people that know when this market mania comes to an end, is the Central bankers themselves. I just don’t happen to have any of them on my speed dial. 

The Market....

The market was closed Monday for the Holiday. I wondered if they’d come in Tuesday in a bit of a grumpy mood and sell off stocks to some extent. Well, they really didn’t. In the lowest volume day of the year, all we did was tread water, run in place and end the day a bit lower.  I think we lost 50 DOW points and 2 on th S&P.
Today the futures started out looking big and bright green, and it did translate into a green open. But, very shortly after the up open, things rolled over and by 10 am, we had the DOW down 80 and the S&P off 9.  Hmm, I thought to myself...maybe I missed the real selling day by one....
As they seem to “always” do, they bought the dip and we spent the bulk of the day hovering with the DOW off maybe 30 - 40 and the S&P down 3 - 6.  Maybe they were waiting for the Fed’s “beige” book to light them up? Nah, that came and went and the market went nowhere. Maybe they were waiting for late afternoon, so they could make their accounts look good for the last trading day of the month?
In any case, they pulled off their magic once more, taking a DOW that was down 80+ points in the morning and closing the show with it down 20. The S&P likewise, down 9, ended down....1.
And so it goes. Red appears to be illegal, as the Central bankers ( and ETF buyers, which could be redundant) simply don’t allow dips. If you’re in the right stocks, you get rewarded. If you’re not, maybe you just tread water.  
So far one of the “right” stocks is MMM. We took it on several sessions ago at 199.01 and it closed out at 204.47 today. Five bucks a share in a handful of days is “good stuff”.  But they aren’t that common to find, and who knows how long its uptrend will remain?
Tomorrow is the first day of a new month. “Usually” the first day sees some upside action as pension money and bi-weekly injection money makes its way into the market. So I wouldn’t be surprised to see us end the day green tomorrow.
There’s not much more to say folks...the market is going to hold up or go up until it doesn’t. Fundamentals don’t count any more. Momentum, Central banks, ETF buying, “adjusted earnings”, buy backs, and a host of other things are pushing us to these insane valuations. 81 P/E on the Russell? Yep.  24 P/E on the S&P? Yep. 27 P/E on the NASDAQ 100? Yep.  The talking heads say we’ll grow into those numbers. Right. You bet. Well, time will tell.
Lean long, don’t marry things and stay awake. I’ll see you all Sunday. 

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