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"The hard part is discipline, patience, and judgment. Investors need discipline to avoid the many unattractive pitches that are thrown, patience to wait for the right pitch, and judgment to know when it is time to swing."

–Seth Klarman

- Enjoy more of our favorite value-investing quotes




In This Edition:
- Global Debt About to Crash the World Economy?
- Will China Be the Source of the Next Downturn?
- Anemic US Economic Growth
- 23 Nations Around The World Where Stock Market Crashes Are Already Happening
- Coming Next

(Read Part 1, Read Part 3)





WHAT ARE THE RISKS, THE OPPORTUNITIES, and how can you make money?

PART 2 of 3

(Read Part 1)


In Part 1 of this series we covered the largest ever spike in the volatility index during the week of August 16, the most volatile day in history (August 24), the barrage of financial-fright stories in the media, and the fact that not all the news is grim. In Part 2 of this series, we will address some of the very real challenges that are faced by world markets and will also look at the positive factors that might affect stock prices. In other words, we will try to make this a balanced presentation. However, as you will see, it is currently harder to find positive than it is to find negative factors across the world's markets.


Since 2008, central banks have printed $10 trillion in money around the world and $4 trillion in the US alone, to keep the world's economies afloat. However, that money printing, along with the continuous, massive Chinese economic stimulus, has created the largest economic bubble in world history. Profligate private-sector loans were moved on to the public-sector balance sheet, and vast money-printing gave the global economy room to heal.

However, the central banks have now gone too far. In 2008, Federal Reserve Chairman Alan Greenspan stated that one of the primary goals of their new quantitative easing (QE) program was to reinflate the stock market and housing prices to recreate the 'wealth effect.' His philosophy was that if people felt wealthy (based on their 401(k) statements and home values), they would spend more, and the economy would follow. Thus, the US Central Bank has been focused on keeping the stock market elevated. This policy continued under Fed Chairman Ben Bernanke and current Fed Chair Janet Yellen. Each time the Central Bank backed off of QE, the stock market floundered, and subsequently a new QE program was launched. 

While the Federal Reserve has signaled for the last year that they are raising rates as soon as later this month (September 16-17), we expect that may not be the case. In fact, with the recent market downturn and volatility, its possible a new round of QE may be announced at some point. The obvious problem with the quantitative easing strategy is that it has elevated the stock market and other asset prices into overvalued, (some say bubble) territory, without accomplishing the goal of stimulating the economy.  It amounts to the definition of insanity: repeating the same thing over and over and expecting a different result.

Countries around the world have followed the lead of the United States and to stay competitive, they have also adopted quantitative easing programs to stimulate their economies. QE also has a side-effect of debasing a country's currency, which helps stimulate exports. These aggressive fiscal and monetary policies have suspended the free market's 'cleansing' process through zero interest rate policies (ZIRP), borrow-and spend-stimulation, and Central bank money creation.

In fact, our Deep Value Portfolio's stock-selection process recognized and took advantage of these policies by choosing companies that appeared headed for bankruptcy but instead were able to borrow their way back to life. For the Deep Value (DV) portfolio, we chose companies that had seen price declines for more than one year but were being recapitalized by borrowing money at extremely low rates. This infusion gave them a second chance to reinvent themselves. The result was a 145% average annual return, but those days are likely to be over. When we begin selecting stocks for the DV portfolio again, we will need to have to a revised selection process that identifies companies that thrive in late-stage economic cycles.

QE has amounted to what is effectively an economic 'put,' and has created malinvestment across the capital markets for the last six years. In fact, it could be argued that this manipulation of the markets has been going on for the last 35 years. Since the early 1980s, Treasury bonds and mortgage rates have steadily declined, which has made ever-cheaper money easy to obtain and used in a variety of unhealthy ways.

Bond and mortgage rates have been declining for the last 35 years. Chart courtesy of St. Louis Federal Reserve (FRED).

Primary users of cheap debt are the world governments themselves. In some cases, borrowing has been used productively to improve infrastructure and promote diversification in economies. However in the majority of cases, the debt was used unproductively for pork-barrel projects to win votes.

However, the lackluster global recovery has been the primary factor in generating high debt levels. Policymakers sought to restore pre-crisis living standards in a world that has changed in a secular way. For one thing, the baby boom generation has grown older and is retiring in large numbers now. It is impossible for the world economy to maintain the growth that it achieved when baby boomers were in their most productive years. Borrow and spend, debt-based stimulus programs cannot duplicate the economic achievements we witnessed over the prior 40 years, which was based on a oversized number of Americans working at the height of their productive and tax paying years.

“All this debt is probably being accumulated because other sources of growth are increasingly in decline,” says Russell Jones, an economist at Llewellyn Consulting. “There’s a lot of pressure on governments and central banks to keep things going at the old rate.”

The rate of the public debt to GDP has reached dangerous proportions in many countries, especially the US, Japan and many European countries. The world map below shows which countries are in the deepest debt. Note that the US and Japan are leading the pack with the darkest color code (>100%) on the map. Much of Europe (especially Italy) is in the same boat.

Ratio of government debt to GDP by country. (Click to enlarge)

In 2013, the United States public debt-to-GDP ratio was 104.5%, according to the International Monetary Fund (IMF). The level of public debt in Japan 2013 was 243.2% of GDP, in China 22.4% and India 66.7%. Meanwhile, the government debt-to-GDP ratio in 2013 was at 76.9% of GDP in Germany, 87.2% in the United Kingdom, 92.2% in France and 127.9% in Italy, according to Eurostat.

The vast majority of that debt in the US came following the 2008 financial crisis. As shown by the chart below, debt grew from about 75% of GDP to 104.5% in just five years. Much of this increase was a result of the attempt to stimulate the US economy back to precrisis levels, with mixed results. When the Federal Reserve and other agencies were pumping liquidity into the economy at the time of the financial crisis, it did support the survival of banks and the financial system. However, since then the results on economic growth have been anemic.

Public debt to GDP ratio in the United States.  Chart: US Bureau of Public Debt


Today global economic growth is deteriorating, and policymakers have boxed themselves into a classic liquidity trap. The stimulative efforts are now producing little or no economic benefit, but the withdrawal of these measures will surely set off another global financial disaster that could make the 2008/2009 crisis seem like a speed bump.

The problem is that with interest rates still at emergency levels of zero, even six years after the crisis, central banks have nothing new they can do to stimulate the economy now. For most countries, especially the US, their backs are against the wall.

For the last year, the US Federal Reserve has been jawboning about an interest rate increase coming this month (September). However, with the current market selloff and the global growth slowdown in August, that scenario may be off the table. In fact, it wouldn't be surprising to see another round of quantitative easing announced at some point if the market continues to deteriorate.

While not effective in stimulating the overall US economy, quantitative easing has had a very stimulative effect on the stock market. The chart below shows the S&P 500 returns since the economic crisis both with QE (blue line) and without QE (red line).


S&P 500 with and without QE
S&P 500 returns with QE and without QE. Chart courtesy, Bloomberg.
(Click to enlarge.)


The problem with another round of QE is that investors would likely see it as a reversal of the announced plans to tighten based on an improving economy and instead, a desperate emergency measure. With the continuing iterations of the US quantitative easing efforts being less and less effective, what can we hope this will accomplish? It is becoming more clear that QE is ineffective at stimulating the economy.

After all, the QE program in the US and other countries was modeled on the Japanese QE stimulation after their market crash in the 1990s. The program obviously had little effect on the Japanese economy, as it is still suffering economically and pumping even more stimulative money with diminishing returns. QE tends to flow into the stock market and other assets but doesn't make its way to Main Street.

Combined public and private debt has jumped by 36 percentage points since 2007 to 265% of GDP in the the developed economies. The Swiss-based Bank of International Settlements said total debt ratios are now significantly higher than they were at the peak of the last credit cycle in 2007, just before the onset of global financial crisis.


Will the massive amount of debt in the US and across the world be the next source of economic disaster?  The fact is that the debt that triggered the credit crisis of 2007 to 2009 never really went away. It was just moved from the private sector to an even larger debt in the public sector with programs like TARP, TALF, the Emergency Economic Stabilization Act of 2008, and the seemingly endless quantitative easing programs.

Harvard economists Kenneth Rogoff and Carmen Reinhart have made careers of doing research on sovereign debt crises. They found that these crises were common throughout history. In fact, their research discovered that the current level of central government debt in established economies was approaching a two-century high-water mark. Any further decline in global growth could trigger a worldwide sovereign debt crisis.



China was the great primary savior of the world economy following the 2008 collapse. The Chinese government launched an unprecedented stimulus program creating an infrastructure investment boom, the likes of which we have never seen before. This spending program created a voracious appetite for commodities to fuel construction of entire ghost towns that the Chinese expect to be occupied in course of the next 20-50 years. This effort pulled resource-rich emerging market countries along for the ride and spurred their economies to great heights.

However, Chinese economic growth is steadily diminishing. While the Chinese government states that growth has dipped below 7% for the first time in 25 years, the actual data is probably much less than that claim. Based on independent analysis of independent economic assessments on such things as electricity usage, manufacturing activity, shipping, and import/export activity, Communist China's claims of such extraordinary economic performance are dubious at best.  The following chart shows the 'official' Chinese economic growth, not the more realistic one:

According to the Chinese government, economic growth has slowed to just 7%. The truth is it is probably much lower than that.


As a result the decline of its economy, the Chinese stock market has lost about 40% since its high in June 2015.

The Chinese stock market has lost about 40% in the last few months. Is is leading the US market as it did in 2007?


To boost the slowing economy, the People's Bank of China (PBoC) has taken several measures, including slashing the rate for borrowing from 6% to 4.85%. Choosing to devalue the yuan/renminbi last month was a last resort and may be signaling that the era of incredible Chinese growth is entering its final stages.

As examples of the decline, Chinese housing prices have fallen sharply after decades of steady increases. In addition, exports from China were expected to decline -0.3% in July, but instead they slumped -9%, which was a huge miss.

Chinese export growth has slumped dramatically, spurring a devaluation of the yuan. Source: Bloomberg


On Tuesday (Sept 1), China's official manufacturing purchasing managers index for August fell to its lowest level in three years, to 49.7 from 50.0 in July. While it remains the minor, a number below 50.0 implies contraction. This data corroborated earlier indications of a slowdown in manufacturing activity.

As a result of this news, US and world markets dropped precipitously; the S&P 500 was initially down about 15% since the downturn began in July through the August 24.  However, that was followed by a brief oversold rally last Thursday (Aug 27) and Friday (Aug 28),  and now volatility appears to be the name of the game. Fortunately, IntelligentValue subscribers have been in cash through the beginning of this chaos. Once the violent volatility clears up, we will have some recommendations to profit from the market action.



Economic growth in the United States remains the strongest in the world. However, that's not saying much; it is steady but not robust. Moderate economic growth in the US is expected to continue in the second half of 2015, but may not match the 2.2% growth of the first half. The largest drag on US growth going forward is international trade. The strength of the US dollar is discouraging exports and encouraging imports. The slowdown in China will be a further drag on US exports.

Also, corporate profits appear to have peaked and are in decline, predating the China problems. The chart below shows the Russell 3000 (in blue) along with the Russell 3000 operating income (in red). You can see that operating income began to slide downward towards the end of 2014. We find that operating income is a cleaner and more accurate indicator of future stock prices than earnings-per-share because EPS can be manipulated so easily. Therefore, the market decline is not all based on news coming out of China. US corporations have also been facing declining operating income for several months now. (Note: This chart was updated in January 2016. Earnings have been declining since the start of 2015.)



These facts combined with a potential increase in interest rates by the Federal Reserve in mid-September leaves the markets much more vulnerable to an exogenous event. However, as mentioned previously, the interest rate increase may be off the table now. The real question becomes, what can Central Banks across the world do to stimulate their economy if there is a new recession when interest rates are already at zero? Many (including the Federal Reserve) believe the quantitative easing has run its course of effectiveness, and any additional QE will only serve to inflate the sovereign balance sheets of countries that participate. The Central Banks across the world are effectively out of ammo to fight another significant downturn.

23 Nations Around The World Where Stock Market DOWNTURNS OR Crashes Are Already Happening

We don't need to wait to see if a global financial crisis is going to develop. While it may only be beginning to hit the Western world, there are 23 nations whose stock markets have already been in a severe decline for months. Most of these nations are considered 'emerging markets,' and are in Asia, South America, and Africa.

These countries loaded up on cheap loans denominated in US dollars, but as the dollar surged, they found it more difficult the service that debt in their own currency. Combine that with crashing prices in the commodities that these countries are exporting and you have a crisis already occurring.

Here is a list of 23 countries with stock markets already down significantly, some would say 'crashing' (click the name to see the country's chart):

1. Malaysia
2. Brazil
3. Egypt
4. China
5. Indonesia
6. South Korea
7. Turkey
8. Chile
9. Colombia
10. Peru
11. Bulgaria
12. Greece
13. Poland
14. Serbia
15. Slovenia
16. Ukraine
17. Ghana
18. Kenya
19. Morocco
20. Nigeria
21. Singapore
22. Taiwan
23. Thailand

Based on the information we've discussed earlier, this is likely just the beginning. It is possible that the Western world will be feeling the same kind of financial pain as these emerging-market economies soon.


In Part 3 of this series, we will discuss the 1) risk of deflation on the world and US economy, 2) how central banks are losing control, 3) the threat of currency devaluation, and on a positive note, 4) the fact that there are no signs of an imminent recession in the US at this time.

(Read Part 1, Read Part 3)

We hope that we have thoroughly discussed the issues in this Value Alert, and you can implement these ideas to your benefit.  Our objective is to give you the best value-oriented investment information possible, with ease of use, timely identification of the issues that affect our portfolio positions, and a full understanding of our approach.  If you have any questions or comments, please contact us with a support ticket.

Best Wishes for Another Week of Intelligent Value Investing,



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Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Shareholders, employees, and writers associated with IntelligentValue, Inc. may hold positions in the securities that are discussed. If you are not sure if value investing or a particular investment is right for you, we urge you to consult with a Certified Financial Advisor. Neither, nor any of its employees or affiliates are responsible for losses you may incur.