What I See For Christmas

Hi Everyone,

Sorry for the delay in posting. I had spent three to four hours writing this post two weeks ago, but I accidentally deleted it from Blogger. I'm rewriting it from memory as there is no trace of the post; it's not in Google Cache or accessible through recent links. I now vow to always export my work to my solid state drive.
I had a programming competition last Saturday, so all my free time went to training. I'm also debating about making a Computer Science blog where I'd post my solutions to online programming problems. My code will be better commented and more readable then the other solutions posted online.

Bear Case: 

In my original post, I had described a red and black Christmas this year, and I wasn't foreshadowing my Christmas presents (I haven't been that naughty). I was talking about companies' earnings reports. I had come to that dismal conclusion from observing interest rate trends, unemployment rate numbers, reading reports about the FOMC, and trying to predict the role the Federal Government shut down would have on consumer spending.

Interest Rates: Federal Reserve Chairman Ben Bernanke enacted the agressive Quantitive Easing program a couple years ago to encourage consumer and business spending. Bernanke's plan called for the US Federal Reserve's purchase of $85 billion in US Bonds and Treasuries per month in order to keep interest rates low. Low interest rates encourage consumers to borrow to spend money and invest in businesses, and allows businesses to take loans to hire more workers and invest in other businesses. The interest rates, currently between 0% and 0.25%, have caused consumer and business spending to be at all time highs.
Consumers are spending more causing companies to get more revenue, and beat analyst opinions in their earnings estimates. This has caused stock prices to reach all time highs; beating estimates shows the company is profitable. As soon as the QE program declines/ends, the interest rates go up, spending comes down, and earnings go down with it. In a recent blog post, I also mentioned that Investor Credit/Margin trading (borrowing money to invest in stocks) was at an all time high.

The low interest rates have caused consumers to spend more money, causing businesses to post increases in revenue. The attractiveness of business growth invited consumers to invest money in a company through the stock market. As more people continue to invest, stock market prices increase. People realize the stock market is profitable, and borrow money so they can invest in the expensive stocks, jumping on the profit bandwagon. 

When interest rates increase, it becomes more expensive for consumers to borrow money to invest in stocks. This will cause them to sell of their investments, so that the increased interest rate doesn't kill their profits. Selling stocks will decrease stock prices, and cause other investors to sell their stocks.

The chart above shows that large investor debt/credit foreshadows a stock market crash. Borrowing (red) increases when stock prices (blue) increase. When the market begins to go down, borrowers rush to sell their holdings, as shown by the positive credit (green) that occurs right after a stock market crash.

Dismal Earnings Season: The US Federal Government shut down for 16 days in the beginning of October because a new budget for the October 2013 - October 2014 Fiscal Year had not been passed by Congress. The  2 Million + Federal Government employees went without pay and the Federal Government went for two weeks without spending any money (except for essentials like Food Stamps). In total, this was expected to cause the GDP to decrease by 0.7%. I also expected consumers to save their money in anticipation of the Government going over the National Debt Ceiling. With a government that spends $60 billion daily and only collects $30 billion daily, it is no surprise that we're reaching the new debt ceiling that Congress raised two years ago. If the US hits the debt ceiling, it will default on some of its payments ($30 billion to spend daily), either interest/yields on bonds, or government programs like Social Security and Benefits. Defaulting on the bond yields would cause the US debt rating to be increased, and cause investors to lose trust in its bonds. In the future, this the US would need to increase its bond yields in order to remain attractive to investors. 

I was expecting businesses and consumers to decrease their spending (Consumer Confidence Index decreased to 71 from 85 last month), causing a dismal earnings season as company revenue would decline.

I was also expecting businesses and consumers to begin saving their money for a future debt ceiling and government furlough/budget crisis that will arise early next year when the federal government begins to get close to the new debt ceiling.

Stock Market Overvalued: The increase in stock prices for the past four years can only be attributed to an increase in spending because of artificially low interest rates, not actual economic growth. 

This chart of the Price to Earnings Ratio show stocks have are expensive relative to 10 year average earnings. The ratio, popularized by Robert Shiller, is about 24, which is much higher then the long-term average of 16. Looking at it's history, this index is at it's highest during recessions. The 1929 high is the same time as the stock market crash that caused the Great Depression. The highs in 1966 were caused by the Cold War/Vietnam fear, in which spending crashed because of fear of getting nuked. The 2000 high was preceded by the stock market crash, and was also high in 2008. 

This chart created by the New York Stock Exchange compares the NYSE Margin Debt (money borrowed to pay for stocks) and the S&P 500 Growth shows that the gap is largest right before a recession. Right now, it's at a 150% difference, around the same difference as it was in October of 2007, two months before the stock market crash.

Simple addition shows that 48% of companies have reported actual sales below  estimated cells, which is lower then the average over the past four years (59% beat estimations). 

Earnings growth percentages are at high rates, and can not be sustained for that long. Once the growth begins to slow down, investors begin selling because the company is becoming less profitable.