“Winter Is Coming” (to Winterfell, Certainly, To The Market, More And More Likely)

I predict that Game of Thrones, adapted from the books in the series A Song of Ice and Fire by George R.R. Martin, will most certainly outlive the current bull.

Having been told repeatedly by scores of analysts that “winter is coming” to this particular market and that the White Walkers will surely destroy the market, we can be forgiven if we have tired of their bearish chatter.  So like most residents of the lands south of The Wall, many investors have decided  White Walkers (and bear markets) are only myth and we should go on about our business of seeking wealth and the power wealth brings.  (Game of Thrones haters, you may read on; I promise to stop making references to the TV serialization or the books…)

The point is that bear markets may still occur in our lifetime.  At some point it behooves us to perhaps take some profits off the table, accepting the “possibility” that as much money might be made, going forward, in solid income-producing securities, as might be gained by buying index funds and such. 

Indeed, if the bear is more than a correction and truly awakens from hibernation, such an approach might not only provide reasonable returns in times of turmoil but may actually protect capital so as to provide truly exceptional entry prices at some point a bit down the road.  I place myself squarely in this camp.  

Regular readers have seen a trend since we began to see our trailing stops execute at an accelerating rate in January and February.  It seems ever clearer to me that mid-2016 is not likely to be a good time for “risk-on” investing.  Why not?  There are many reasons, but for this issue let me elaborate on two I have not discussed in as much depth in my previous articles on this subject.  Both are strategic issues that must be addressed if the markets are to be trusted and the economy is ever to get out of the current government-induced doldrums.  I’ll then provide some ideas for how to protect your capital in this environment.

Reason #1: Companies have for years been able to use pro forma rather than GAAP accounting, merrily buying their own shares back to goose the earnings “per share” figure and therefore give their managers massive bonuses.  Some analysts think this is a good idea — after all, it’s only stock, not dollars, and the number of shares is diluted over so many shareholders that the dilution isn’t as evident. But just as water flowing over a rock will not visibly alter it, over many years that rock will become “river rock,” not only rounded but smaller.  

It is the same with individual shareholders’ holdings.  Drip by drip, hired administrators and their favored cronies are making as much or more than those few with real talent.  The dizzying escalation in executive pay, and worse, stock options, has made a mockery of corporate “governance,” with a few at the top of public companies making hundreds or thousands of times as much as the workers in those companies. 

This practice is beginning to catch up to these firms as their boards of directors begin to realize their erstwhile golden boys, now retired with a similar-colored parachute, have left the companies  far behind in research and development and far behind in capital expenditures. They have paid massive capital-draining salaries and bonuses and are now left behind the curve.  

Now the current crop of administrators must now make hard decisions.  Having paid up to and including top dollar for shares selling at new highs, they need to conserve funds for R&D and CapEx or they will lose market share to those who spent their money more wisely.  As this quarter’s results so painfully show, for many large and once-successful companies, their top-line revenues are down, their earnings are down and, for those realizing they can’t keep playing funny-money games, even their earnings per share are down.  

This leaves just one final illusion to perform.  As quarter end approaches, they flurry to the Wall Street analysts who tout their shares and suggest the analysts (who want to look good to get their own bonuses) lower their quarterly earnings “estimates.”  This incestuous relationship ensures that the analyst looks good and both Wall Street and the reporting company can trumpet that while revenues may have been down they once again beat the earnings estimates.  

You ask, they can’t really believe we’re so stupid we don’t notice the sleight-of-hand, can they?  I respond:  I assume your question is rhetorical.  Not only do they believe it, but enough market players (I can’t bring myself to call them “investors”) swallow it hook, line, and sinker, that the game can go on.  But by now, it is going on with decreasing volume.  As more catch on, I fear for the aging bull.

Reason #2: Regulations and red tape are strangling American entrepreneurs. Are we becoming just another tired and bloated European-style social welfare republic?  The facts would support this argument.  The American Dream of prior years is further and further out of reach of the average American.  Red tape is now strangling the entire nation. 

Do you wonder why the elites in the boardrooms and corporate corner offices, the White House, Congress, the Fed, the SES’s (“Senior Executive Service”) administrators, etc. all tout how wonderfully the economy is doing while any cross-country road or rail trip will show just how poorly “the rest of us” beyond the Beltway are doing?  It’s because “their” economy is doing fine.  With what they make and who they associate with all doing exceedingly well, they just don’t understand why the rest of the nation doesn’t get it.