Why Conventional Investors Are Getting Slaughtered

Recently, legendary investor and philanthropist Stanley Druckenmiller made news when he said that investors should sell their stocks and buy gold. Lost in that message – with which I wholeheartedly agree – was another important point that Druckenmiller made in looking back at his career.

He noted that when he started Duquesne Capital Management in 1981, the risk-free rate of return was 15%. That was the era when the U.S. was facing run-away inflation, iconic Federal Reserve Chairman Paul Volcker had raised interest rates to the high teens, and Treasury bonds paid very high yields.

Investors could simply buy Treasuries and earn high nominal returns (though on an inflation-adjusted basis they were far less impressive).

But times have changed, of course, and for investors and taxpayers, they're getting worse and more dangerous by the day…

Diminishing Returns Are Inevitable

Today, the risk-free return is zero (and in many places like Europe and Japan, below zero). Druckenmiller made his comments at the Sohn Investment Conference where hedge fund and other high profile managers hawk their best ideas to raise money for charity.

While he argued that the bull market has run out of steam, a point I've been making for a couple of years based on my belief that we entered a bear market in 2014 as the Fed ended its last bout of quantitative easing (QE) in October 2014, he pointed to a very important point: Investors are operating in an environment where the riskless rate of return is so low that it is increasingly difficult to generate positive returns on their capital.

The evidence of this lies in tatters all around us, as one famous hedge fund after another announces poor returns or, in many cases, large losses. For the most part, the so-called smart money got stupid right around the time that the Fed pulled the plug on its epic monetary experiment and terminated QE and started to talk about raising interest rates.

The only thing "smart" about all this money was that it had figured out how to ride the wave of easy Fed policy. Once that policy turned tight, relatively speaking, most managers had no idea how to make money any more.

This poses a serious and ultimately catastrophic problem for institutional investors, particularly pension funds and others who face inexorably rising liabilities.

While most of these entities are terminally underfunded, they managed to claw back a decent amount of their shortfalls in the 2009-14 period courtesy of the Fed-fueled rally in stocks and other risk assets.

While that rally was occurring, however, their liabilities (payments to beneficiaries for healthcare and pensions) continued to rise at high single digit rates. When the rally ended in mid-2014, their liabilities didn't stop rising, however; they just kept or rising at the same high rates, pushing them back into severely underfunded status.

With the prospects of low to negative returns on stocks and bonds over the next decade, many institutions are now chasing investments in private equity and other alternative assets classes (virtually all of which are illiquid) in the desperate hope that they can produce sufficiently high returns to prevent inevitable funding crises.

So the problem is that none of this will overcome the serious issue that Druckenmiller highlighted: With the riskless rate of return at zero, the ability to generate high returns is severely impaired for every type of conventional investment strategy in the world.

The hole is getting deeper…

A Planet of Debt

In the years ahead, therefore, debt crises such as the one unfolding in Puerto Rico will become the norm for governments rather than the exception.

Puerto Rico's insolvency will be followed by the same phenomenon in Illinois, Chicago, New Jersey, Philadelphia, California and other places. There isn't enough money in the world to pay for all the promises that politicians have made (and keep on making).

The wonder is that voters not only keep believing these promises but keep extracting them from people who can't possibly keep them. We are doomed unless we wake up to these realities and start making radical changes in how we govern ourselves and manage our money.

Most people – and most money managers – are woefully unprepared for what is coming.

Hopefully that is why you follow me – I do not go through life with rose-colored glasses and I know what will happen and how to deal with it. But the only way I can help people is by telling the truth, ugly as it is.

And speaking of ugly…

Markets Are Giving Up Their Gains

Last week, markets started backing off from their irrational exuberance of recent weeks.

The Dow Jones Industrial Average lost 205 points or 1.2% last week while the S&P 500 dropped 10.5 points or 0.5% to 2046.61. The Nasdaq Composite Index fell 0.4% to finish at 4717.69. The big news was that Apple, Inc. (Nasdaq: AAPL) has lost its crown as the world's most valuable company to Alphabet, Inc. (Nasdaq: GOOG) after seeing its stock briefly drop below $90 per share on news that orders for iPhone components were sharply lower.

What may be more remarkable is that Google now has a market cap of nearly $500 billion while Amazon.com, Inc. (Nasdaq: AMZN) and Facebook, Inc. (Nasdaq: FB) are worth about $340 billion each. While Google has a price/earnings ratio of about 30, and Apple a ratio under 10 (when you subtract its huge cash hoard), Apple and Facebook shares are both trading at absurdly high multiples: Apple at many hundreds of times trailing earnings and Facebook at 92 times trailing earnings.

The S&P 500 is being held aloft by these "FANG stocks" and a few other high-multiple, large-cap consumer stocks, such as Nike Inc. (NYSE: NKE), Under Armour Inc. (NYSE: UA), and Starbucks Corp. (Nasdaq: SBUX), while the market is littered with broken stocks that are down in many cases 50% or more from their all-time highs. Without this limited number of large cap high P/E stocks, I believe the market would be trading closer to 1700-1800, which is where I put fair value.

Avoid These Sectors Now

Last week was a sad one for retail stocks. Macy's Inc. (NYSE: M), Kohl's Corp. (NYSE: KSS), Gap Inc. (NYSE: GPS), Fossil Group Inc. (Nasdaq: FOSL), and Nordstrom Inc. (NYSE: JWN) all reported poor results that sent their stocks down sharply.

But Amazon's model of "profitless capitalism," whereby it destroys its own margins and those of its competitors, is decimating the retail landscape. Amazon's strong first quarter earnings were helped enormously by its cloud storage business while its retail margins remained miserly; the problem is that its cloud business will see diminishing margins while retail will remain a bloodbath.

After recent bankruptcies of The Sports Authority Inc. and Abercrombie & Fitch Co. (NYSE: ANF), we can look forward to more retail failures as companies like J. Crew Group Inc., Claires Inc., and countless others owned by private equity firms throw in the towel in the coming years (bondholders have already thrown in the towel on these companies). We are watching creative destruction in motion, and it ain't pretty.

The banking and insurance sectors are also taking it on the chin as zero and negative rates are squeezing margins while excessive regulation saps market liquidity and burdens these businesses with unnecessary costs. Stocks in these two sectors are also down sharply.

The Fed's experiment with low rates isn't working as planned. Instead of causing people to spend money, low rates are causing people to save money; instead of leading banks to lend money, low rates are leading them to keep their hands in their pockets.

When this experiment ends, it is going to end with a whimper.

As you've just seen, the S&P 500 is loaded with trash stocks, propped up by a few performers. But when you spot these "toxic" stocks, you can use Michael's system to play them and profit – he's been doing exactly that for more than 25 years now. Click here for his no-cost Toxic Stock Playbook and you'll get a complimentary subscription to his Sure Money Investor Service, too.

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