Apple math

Apple just issued a brutal warning for the quarter just ended Dec 31:

– revenues of $84 billion, -4.9% (vs. previous guidance of $91 billion, a 3.1% gain)

– gross margin of 38% (vs. 38.4%)

– operating margin of 27.6% (vs. 29.8%)

We’ve felt Apple bulls have been guilty of recency bias and extrapolation for some time, especially with regard to its fat profit margins.  Annual operating margin has slowly drifted lower over the past three years, from 30.3% to 26.0%.  Where does that settle out for a company heavily dependent on one product in a market that is saturated and losing market share to a slew of feisty competitors?  Our best guess is 15%.  Worse, what happens to sales, especially as we head into a global recession?  We think down 20% from the peak is a strong possibility.  That would take Apple’s revenues back to where they were just 3 1/2 years ago.

With these assumptions, Apple’s earnings per share drop to $5.50 ($5.00 if you assume they squander their remaining cash on pricey buybacks all the way down, a safe assumption considering CEO Tim Cook’s assurances).  According to Yahoo Finance, the 42 analysts who follow the company expect Apple to earn $13.29 this year and $14.64 next.

Assuming the analytical herd has it wrong, what would you be willing to pay for such a company?  10x earnings?  Perhaps 12x assuming a turnaround?  8x in a worse case?  At $5.00/share in earnings, that gives you a stock price of anywhere from $40 to $60, i.e. 58%-72% lower than the current $143.42.

The importance of Apple to the foundation of the everything bubble cannot be overstated.  257 U.S. ETFs own AAPL, the most of any stock.  At just 10.8 x illusory “forward earnings,” Apple’s inflated margins help support the narrative that “stocks are cheap at less than 15 x earnings.”  Lastly, how much has AAPL’s outperformance over the past 10 years helped foment a bubble in passive investing where $2.0 trillion flowed out of active funds and $2.5 trillion into passive funds?  Indexing leader Blackrock (BLK) is down less than 2% on a day when AAPL is -9%.  For now, investors are failing to connect the dots…


Predictions for 2019

1. The everything bubble unwind is in full swing.  Stocks have their worst year since 2008.

2. The first leg of the bear market culminates with a panic, sometime in the first quarter.

3. The global economy ends the year in recession.  China is a constant source of economic jitters with the Eurozone not far behind.

4. The U.S. budget deficit ends the year over $1 trillion.  State budgets are stretched.  Underfunding of public pensions goes from $5 trillion to over $7 trillion.  Trump’s popularity hits all-time lows.

5. The U.S. dollar weakens against the euro and yen.

6. Global bond markets are a mixed bag.  Eurozone yields rise as the ECB ends its quantitative easing.  Italy’s debt problems become unmanageable.  Yields on Italy’s 10-year (2.77%) rise to over 5%.  Despite its safe haven status, yields on German 10-year (0.25%) break above 1.5%.  U.S. Treasuries are caught in a tug-of-war between safe haven buying and budget concerns.  Yields on the 10-year (2.69%) remain below 3%.

7. Reach-for yield ends in tears. High yields bonds and leveraged loans are severely underwater.

8. Gold and other precious metals rally as financial bubbles deflate, economies weaken, and the omnipotence of central bankers comes into question.  Silver outperforms gold.  Gold stocks finally catch a break; low fuel costs provide an added boost.

9. Active managers outperform passive managers in U.S. equities, as FAANG stocks underperform.

Our favorite longs for 2019:

– pharmaceuticals (Bristol-Myers Squibb, Regeneron Pharmaceuticals)

– discount retailers (Target, Wal-Mart)

– retail roadkill (Bed Bath & Beyond, Dick’s Sporting Goods)

– gun manufacturers (Sturm Ruger)

– poultry producers (Sanderson Farms)

– natural gas E&P (Range Resources)

– fertilizer (CF Industries, PhosAgro)

Our favorite shorts:

– Tesla

– global banks (Deutsche Bank, Westpak Banking, Canadian Imperial Bank)

– domestic banks (Bank of America, JPMorgan Chase)

– Chinese financials (CHIX)

– auto finance (CarMax, AutoNation, Ally Financial)

– municipal bond insurers (Assured Guarantee, MBIA)

– passive investing (BlackRock, MSCI)

– office REITs (Boston Properties, Vornado)

– retail REITs (Simon Property Group, Realty Income)

– technology (XLK)

– industrials (XLI)

– infrastructure (Caterpillar, U.S. Steel, United Rentals).

Investors have coal in their stockings

A new twist on an old Christmas poem…


Visions of Sugar Plums

‘Twas the night before Christmas, when all through The Street

Not a broker was stirring, not even a tweet;

The stockings were hung by the chimney with care,

In hopes that St. Nicholas soon would be there;

Investors were nestled all snug in their beds,

While visions of sugar highs danced in their heads;


From a ten-year bull market, whose gifts did accrue,

A correction had come, from out of the blue;

Their 401(k)s had taken a hit,

Yet Cramer refrained from pitching a fit;

Trade wars and shutdowns and too much QT,

The weight of it all was no cup of tea;

From Bernanke and Yellen, they were all spoiled,

Now thanks to Jay Powell, their diapers were soiled;

The Fed was their friend, to stocks it did boost,

Had 8 years of ZIRP come home to roost?


I tossed and I turned, and went into a sweat,

Ghosts of bubbles past, I could not forget;

“Stocks for the long run” and “just buy the dip,”

Should I double down now, or abandon ship?

We just need the big guy, all trim in his beard,

Six trillion in stock wealth has just disappeared!


When out on the lawn there arose such a clatter,

I sprang from the bed to see what was the matter.

When, what to my wondering eyes should appear,

But a miniature sleigh, and eight tiny reindeer,

With a little old driver, so lively and quick,

I knew in a moment it must be St. Nick.

More rapid than algos his tickers they came,

And he whistled, and shouted, and called them by name;

“Now, Facebook! now, Netflix! now, Salesforce and Apple!

On, Tencent! on, Tesla! on, BABA and Google!

To the up of the trend! to the top of the chart!

Now dash away! dash away! Make me look smart!”


As I drew in my head, and was turning around,

Down the chimney St. Nicholas came with a bound.

He was dressed all in fur, from his head to his foot,

And his clothes were all tarnished with ashes and soot;

A bundle of toys he had flung on his back,

And he looked like a peddler just opening his pack.


He spoke not a word, but went straight to his work,

And filled all the stockings; then turned with a smirk;

He wolfed down my cookies and crumpled my note,

He grabbed some spare change and tossed in his coat.

He cleaned out the fridge and clawed at a wreath,

In the light of the moon, I could see his sharp teeth;

As he gave me a wink, to my great surprise,

It wasn’t St. Nick, but a bear in disguise.


6 reasons why an equity bear market has begun

Market leadership

Out of 35 country stock markets, just four are up this year, led by the Norway and the U.S.  Thirteen are down by double digits.  China and India, which account for 18% of the world’s GDP, are -15.4% and -20.7% respectively.  Even within the U.S., fewer and fewer stocks are participating.  According to Delta Investment Management, just 50.8% of 3,600 stocks are in uptrends, even though the S&P 500 is up 13.1% over the past 12 months and just 1.5% below its all-time high.


Investor sentiment

Sentiment has rebounded from the whiff of pessimism created by the February-March selloff to levels of extreme bullishness.  Sampling our 10 favorite sentiment indicators, the median reading is in the 90th percentile of bullishness.


Bullishness Percentiles

Indicator 10-YearBearish








Date ofRecent


S&P 500 2901.61 10/4/18
VIX 59.93 9.14 12.12 85th 9/28/18
3-Month VIX 48.90 13.00 15.75 87th 9/28/18
Investors IntelligenceBulls – Bears -26.4% +54.0% +42.3% 92nd 9/21/18
Consensus, Inc.Bulls 18% 78% 69% 68th 9/21/18
AAII Cash Allocation 44.8% 13.0% 16.0% 84th 9/30/18
NAAIM Equity Exposure Index (Median) 0% +100.0% +82.5% 59th 10/3/18
MMF / Mutual Fund + ETF Assets 41.0% 12.2% 12.4% 99th 8/31/18
Mutual FundCash Levels 4.1% 2.9% 3.0% 94th 8/31/18
Rydex Bear Fund Assets / Total Assets 59.2% 3.4% 4.8% 96th 10/3/18
Rydex MMF / Bull +Sector Fund Assets 98.6% 6.8% 7.1% 93rd 10/3/18

Sources: Investors Intelligence, Consensus, Inc., American Association of Individual Investors, National Association of Active Investment Managers, Investment Company Institute, Guggenheim Investments, Bearing Asset Management


Interest rates

Interest costs on the $21 trillion federal debt have doubled since the 2016 election as we move closer to trillion dollar budget deficits.  The 30-year Treasury bond yields 3.38%, a 4-year high.  The 10-year yields 3.23%, its highest level since 2011.  Cash (using 2-year T-bills as a proxy) is the most competitive with stocks since late 2007.



The world’s central banks have been cutting back on quantitative easing.  The Federal Reserve has contracted its balance sheet 5.0% the past 12 months.  Combined, the Fed, Bank of Japan and ECB will no longer be adding liquidity by the end of the year.



Stocks are priced for perfection and investors are positioned as if the record 10-year bull market will go on indefinitely.  Retail investors cash levels, from TD Ameritrade to Schwab, are at all-time lows.



Since 2009 total worldwide debt increased by over 40%.  Within the U.S., since the end of 2008 student loan debt is up 127%, auto loan debt 57%, corporate debt 76%, and public debt 98%.  Margin debt has more than tripled.  There is currently $8 trillion in dollar-denominated debt outside the U.S. and currencies in 20 countries have declined by double digits against the U.S. dollar.  In other words, their interest costs are rising.  We’re already seeing cracks appear in countries like Argentina, Turkey and South Africa.  To this fragile situation, President Trump is risking a trade war.  Never a good idea, but the timing couldn’t be worse…


7th Reason

It’s October…

Bearing rules for selling short

1. Never fight human progress. I want to ride secular waves, not fight them. Tech and health care are mostly off limits from the short side. There are always exceptions, like Valeant Pharmaceuticals and Tesla, but if the stocks are simply overvalued, we’ll be a spectator. If anything, I’d rather be long clear winners, even if I have to pay up a little. This is a natural hedge against our short position.
2. Short companies highly vulnerable to the cyclical event. These are typically dependent on cheap credit in one way or another. They also tend to drink the Kool Aid during the boom and take on too much leverage.
3. Short consumer fads… when the stocks are priced as if growth will continue indefinitely. Canada Goose might be an example today, but it’s only on my radar for now.
4. Only short a stock if you see a path to a potential 75-100% decline. Otherwise, the risk/reward isn’t worth it. (There is a lower bar for bonds, but the same risk/reward formula applies.) That means the business will be impaired, which usually involves intensifying competition and indefensible moats. The ETF business is a good example.
5. Compartmentalize risk. Evaluate every position on risk/reward. Don’t assume your hedges will work (they often break at the most inopportune times). Don’t allow one losing position to swamp the rest of the boat.
6. Big trees will underperform. $1 trillion market caps of AMZN and AAPL are a good example. This doesn’t necessarily mean they qualify as impaired businesses or stocks that can go down 75-100%, but knowing they are highly likely to underperform over the next decade (after all, trees don’t grow to the sky) is valuable information. E.g., this could be the pin that pops the passive investing bubble.

Predictions for 2018

When reviewing our predictions for 2017, the biggest surprise was that we actually got a few right:

  1. Inflation begins to become a concern.
  2. U.S dollar peaks.
  3. Official U.S. deficit for fiscal year ended 6/30/17 exceeds $600 billion.

Yet the stock market ignored all of this bad news and rallied, with the S&P 500’s total return over 21%.  Large cap tech stocks did even better, reflected in the Nasdaq 100’s 38% rise.

Our picks for best performers on average outperformed the S&P 500 while the worst performers underperformed:


  • Wal-Mart (WMT): +46.56%
  • Dollar Tree (DLTR): +39.04%
  • Illumina (ILMN): +70.64%
  • Bristol Myers (BMY): +7.71%
  • Fertilizer stocks (POT, PHOR.ME)


  • Global banks (DB, CM, WBK): +16.06%
  • Investment banks (GS, JPM): +17.84%
  • Auto finance (AN, KMX): +6.41%
  • Municipal bond insurers (AGO, MBI): -21.88%
  • Office REITs (BXP, SLG, VNO): -6.41%
  • Retail REITs (GGP, O, PEI, SPG): -6.76%
  • Technology (XLK): +34.25%
  • Industrials (XLI): +23.99%
  • Chinese financials (CHIX): +53.60%

Our predictions for 2018:

1) The bubbles in blockchain, cryptocurrencies, and cannabis all burst.  Bitcoin ends the year under $5,000 (and possibly under $1,000).

2) Global bond markets continue the bear market that began July 2016.  The yield on the U.S. 10-year note, 2.40% to start the year, ends over 3.00%.  Government and corporate bonds sporting negative yields ($10 trillion currently) drop below $5 trillion.

3) Global stock prices peak in the first quarter.  The S&P 500, which hasn’t had a 5% draw down in a record 400 trading days, ends the year down at least 15%.

– best performers: genomic sequencing (Regeneron Pharmaceuticals), discount retailers (Target, Wal-Mart), retail roadkill (Bed Bath & Beyond), offshore drillers (Transocean, Ensco), natural gas E&P (Range Resources)

– worst performers: Tesla, global banks (Deutsche Bank, Westpak Banking, Canadian Imperial Bank), Chinese financials (CHIX), auto finance (CarMax, AutoNation), municipal bond insurers (Assured Guarantee, MBIA), passive investing (BLK, MSCI), office REITs (Boston Properties, Vornado), retail REITs (Simon Property Group, Realty Income), technology (XLK), industrials (XLI), infrastructure (Caterpillar, United Rentals).

4) The U.S. budget deficit goes from roughly $700 bil to over $850 by the end of 2018, despite an influx of repatriation taxes.  Higher debt service costs begin to become a concern.

5) Nascent global price inflation proves to be unshakable.  Gold and other precious metals benefit, helped also by less competition from digital currencies.  Gold mining stocks gain from the added tailwind of reduced costs relative to gold – especially fuel and equipment – and lower regulatory costs courtesy of the Trump administration.

6) Commodities will be a mixed bag with food commodities generally higher and economically-sensitive commodities lower:

– strong: coffee, wheat, natural gas

– weak: lumber, copper, crude oil

War complacency

With investor complacency already high (65% of the sub-10 VIX readings since 1993 took place in the past 3 months), it should be no surprise that the escalation of tensions with North Korea would be met with a yawn.

At 2:21 PM E.T. yesterday (with the S&P 500 down 0.87% on its way to a 1.45% loss), MarketWatch columnist Mark Hulbert published an article advising investors to remain calm:

If war breaks out with North Korea, we’ll have bigger things to worry about than our portfolios.  But that’s OK, because doing nothing is almost always the best investment strategy during a geopolitical crisis.

That is the clear conclusion to emerge from an analysis conducted by Ned Davis Research of the most momentous geopolitical crises of the last century. The firm found that far more often than not, the stock market, as measured by the Dow Jones Industrial Average strongly rebounds from its post-crisis panic low — so much so that within six months it is actually higher than where it stood before that crisis erupted.

The research report covered 51 events from 1900 to 2014, including the bombing of Pearl Harbor and JFK assassination.  Of note: the average stock market drop during each crisis was 17.5%, so the positive returns came after a fair amount of pain.  With stock valuations broadly at record high valuations, it is not difficult to envision a much larger correction if war breaks out with North Korea.

One problem with these sorts of back tests is that economic and market events can’t be replicated in a lab.  History doesn’t repeat, though it often rhymes.  To unravel this complicated puzzle, let’s look at three variables: valuations, sentiment and economics.  From a valuation standpoint, there is no way to compare past crisis lows to today’s twin asset bubbles in both stocks and bonds (at the lowest yields in 5,000 years of recorded history).

As for sentiment, a bit of history:

  • After WWI there was a sharp but brief depression in 1921.
  • After WWII, economists predicted another depression.  Instead we got a two-decades-long boom.
  • Initially, in the early-1960s there was complacency about the Vietnam conflict.  That eventually ushered in the intractable inflation of the ‘70s, which helped trigger (along with Watergate) the worst bear market in stocks since 1929-32, in real terms, from 1972-74.
  • The Gulf War brought back memories of the quagmire in Vietnam and was widely anticipated.  Stocks sold off in late 1990 as a result.  Operation Desert Storm began mid-January of 1991 and was over in a month.  There was no quagmire.
  • In 2003, the Iraq War was widely predicted to be brief, but it turned into quagmire.  Fortunately for stocks, they were 3 years into a burst tech bubble and prepared for bad news.  An aggressive Fed fomented the housing/credit bubble of the mid-2000s.

The lesson of #4 and #5 was that war – brief or quagmire – leads to bull markets.  Investors constantly fight the last war.  The complacency regarding North Korea is a direct reflection of recent past war experience plus an 8-year bull market where buy-the-dip behavior has been constantly reinforced by central bank asset purchases.

Lastly, let’s take a look at economics.  With the onset of war, we can expect the following to occur:

  1. The war economy is engorged while the real economy (or consumer economy) is drained.  GDP growth is highly misleading during wartime.  The consumer is worse off as resources are siphoned off to be destroyed (see chapter 3 of Henry Hazlitt’s Economics in One Lesson, “The Blessings of Destruction“).
  2. The immense costs of war are paid for through government borrowing and inflation.
  3. Government, aka the public sector parasite, is ratcheted up during war, but doesn’t relinquish all of those gains after the war (see Crisis and Leviathan by Robert Higgs).

Imagine these maladies foisted on an economy struggling to grow (the most anemic recovery post-WWII) and wheezing under record debt levels including $20 trillion of government debt (having doubled the past 8 years), $1.2 trillion in auto loan debt, $539 billion in margin debt, etc.  That debt has remained manageable thanks to miniscule interest rates, but a wartime economy would threaten this state of nirvana.

Moral of the story: act before the crisis.  With stocks and bonds priced for perfection, ignore impending danger at your peril.

Is new ETF to track ETF industry another sign of an ETF bubble?

Burton Malkiel, early influence (along with Eugene Fama) on Vanguard founder and indexing pioneer John Bogle, has been hired to join the investment committee of the Tosoro ETF Industry Index.  This index guides the ETF Industry Exposure & Financial Services ETF (TETF) recently unveiled on June 26th.

Adding irony to the launch, there appear to be flaws with index construction, not uncommon for ETFs.  The companies in Tier A, which make up 50% of the index and have “direct financial impact” from the ETF industry, are equal-weighted.  That means BlackRock (BLK), with a $71 bil market cap, has the same weight (6.25%) as Wisdom Tree Investments (WETF) with a $1.43 bil market cap.

One dirty little secret of the ETF industry is that there is no such thing as a “passive” index.  Otherwise, why the need to hire an investment committee to decide components and weightings?  The timing of a new ETF is another matter, and almost always a backward look on performance and forward look on what will entice investors.  These are not impartial decisions made by machines, but value judgements made by humans.  Value, as any Austrian economist knows, is always subjective.

Canaries in the coal mine

  1. Several debt-fueled roll-ups have unraveled
  2. U.S. middle class consumer under stress
    1. Trump populism a symptom
  3. Creative destruction adding to woes of retailers
  4. State government finances under pressure
    1. Connecticut, Illinois, Kansas
  5. 35-year bond bull market ended a year ago


Is Mario Draghi pulling away the punch bowl?

“Draghi hints ECB may start winding down QE,” read the MarketWatch headline this morning:

European Central Bank President Mario Draghi hinted on Tuesday that the ECB might start winding down its large monetary stimulus as the eurozone economy picks up speed, even as he warned against an abrupt end to years of easy money.

The comments, at the ECB’s annual economic-policy conference in Portugal, come as investors watch closely for a sign that the world’s second most powerful central bank is preparing to withdraw controversial policies such as its EUR60 billion ($67.52 billion) a month bond-buying program.

Mr. Draghi said the ECB’s stimulus policies are working and will be gradually withdrawn as the economy accelerates. However, he warned that “any adjustments to our stance have to be made gradually, and only when the improving dynamics that justify them appear sufficiently secure.”

With the Fed now talking about contracting its balance sheet and the BOJ and ECB doing the heavy lifting, this seems like a big deal, yet equity markets have barely noticed.  The Euro Stoxx index was -0.13% while S&P 500 futures are currently -0.07%.  3-month VIX futures (Oct contract) stand at just 14.25. The eurozone sovereign debt markets are a different matter:

Germany 10-year = -0.56% (0.32% yield-to-maturity)

France 10-year = -0.59% (0.69% ytm)

Italy 10-year = -0.80% (1.98% ytm)

“Today Draghi moved his first step towards indicating that ECB monetary policy will become less [stimulative] in 2018,” said Marco Valli, an economist with UniCredit in Milan.

Mr. Valli said the ECB might reduce its monthly bond purchases to EUR40 billion in the first half of next year, followed by a further reduction to EUR20 billion per month in the second half of the year. That would be a slower pace of stimulus reduction than many analysts had been expecting.

Keep in mind, the ECB and Bank of Japan have been doing the heavy lifting as year-over-year growth in total assets shows:

Fed = 0%

ECB = +36.7%

BOJ = +20.0%

The bond markets are starting to pay attention (though still wildly delusional). Perhaps the equity markets should as well.

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