When countries burn up their FX reserves, it means they are in trouble. They are defending themselves against currency outflows. In the case of China it means they are liquidating their U.S. dollar reserves, this equals to a reverse QE. A reverse QE leads to a decrease in global liquidity.
A credit spread is the difference in yield between two bonds of similar maturity but different credit quality. For example, if the 10-year Treasury note is trading at a yield of 2% and a 10-year corporate bond is trading at a yield of 4%, the corporate bond is said to offer a 200-basis-point spread over the Treasury.
As credit spreads rise, it gets more and more difficult to finance buybacks (credit conditions are worsening). Yields on corporate bonds go up (which coincides with a credit spread rise), which means that debt issued by the company (to buy back its own shares) has a higher interest rate. The result is that there will be less buybacks. There is a lag of 3 months (we borrow and then we spend).
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| Investment Grade Credit Spread Vs Buybacks |
So you could have predicted black monday in August 2015 (red graph) by looking at the rising credit spreads (blue graph).
So what does this mean to your equity positioning?
The following chart is used to give a valuation on the stock market and gives you the tool to position yourself. It is based on the total stock index (DWCF) divided by the GNP.
The latest data says that GNP was 16.236 trillion in the first quarter of 2013.
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| Table 1: GDP and GNP |
If we look at the Total Stock Market Index (DWCF), we have 17015.
Now divide 17015 by 16236 and we get: 1.05.
105% is modestly overvalued according to the Stock Valuation Table.
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| Stock Valuation Table |
So I wouldn’t buy equities at this stage.
There are several indicators today, marking a major top in the stock market. One of those indicators is the overvaluation in the stock market according to the “Warren Buffett Valuation” of the total U.S. stock market index as compared to U.S. GNP. We found out that stock markets are overvalued today, because the total U.S. stock market index is at 100% of U.S. GNP. Normally we see that the total U.S. stock market index is at 80% of GNP. We just recently had news that U.S. GDP was negative and I wrote about it here. When GDP declines, it inherently means that the stock market must decline, taking into account the Warren Buffett Valuation theory.
Investors are much too bullish on stocks at this moment and we can see that in the Dow-Gold ratio, which is hitting a ratio of 9 to 1 as we speak.
I believe though, we shouldn’t be so complacent about stocks. After all, the P/E ratio of the Dow Industrials stands at 15.3 right now, while in the 70’s, the P/E ratio was on average at 10, which is much lower than 15.3. The question is: “Do we expect higher or lower earnings in the future?”. I believe the earnings are going to get worse in the future. One way to measure this is to look at the Citigroup Economic Surprise Index (CESI). This index is defined as weighted historical standard deviations of data “surprises”. In human language it means that if the index turns negative, the chance of an “unexpected” downward revision goes up. You will hear more bad news out of the media. And what do you know, the CESI did turn negative in the previous month. So you can expect more bad news coming. Historically, when the CESI goes down, the stock market goes down a few months later as you can see on chart 1.
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| Chart 1: Citigroup Surprise Index Vs. S&P |
To read more evidence on a top in equities, go here.
As I warned everyone already in March 2012 in this article, it is finally happening. Japanese equities are indeed outperforming Japanese bonds and we can see this event starting in one of the most important equities brokers, Nomura Holdings (Chart 1). In my previous article I said that Nomura Holdings would flourish as it is the primary brokerage service in Japan.
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| Chart 1: Nomura Holdings |
To find out why this is, go here to read the analysis.
Marc Faber told us to buy Japanese equities last year, saying that government bonds in Japan would underperform equities. One of his stock picks was Nomura Holdings (NMR), which has a dividend of 2% and price to book ratio of 0.65. Its last quarter net earnings were $US 200 million, but has had big losses in the previous quarters. Nomura is a speculative play on Japanese equities, but I believe Japan is undervalued by investors.
Correlation Economics (Backup) 