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CRASH ALERT!

By Bill Bonner on August 22, 2013

Our operating hunch is that US stocks, Treasurys and gold have all turned over recent months.

After 33 years of falling, Treasury yields are now climbing higher…

After two years of correcting, gold prices are rising again….

And after 4 years… or 12 years… or 31 years of rising prices, depending on how you count it, US stocks are starting to look vulnerable to a real setback.

It’s still summertime. We don’t expect much action in the next few days. But already, kids are going back to school and parents are getting back to work.

And pretty soon, investors could notice that Mr. Market is taking over the controls from the Mr. Bernanke.

Mom and Pop are back in stocks. Meanwhile, sentiment, prices, margin debt – all are at extremely high levels. (There is $377 billion in margin debt on Wall Street, for example. That’s just below its all-time high… and well above its highs before the dot-com crash and the collapse of Lehman Brothers.)

Take away the jive profits of the big banks, and real earnings are weak. The relationship between Fed policy and stock prices is weakening too. From John Hussman at Hussman Funds:

Our estimates of prospective risk are surging…

At present, we have what might best be characterized as a broken speculative peak, in that market internals (particularly interest-sensitive groups), breadth and leadership have broken down uniformly following an extreme overvalued, overbought, overbullish syndrome.

If you recall, the market also recovered to new highs in October 2007, weeks after the initial, decisive break in market internals at that time. Presently, we’re looking at the same set of circumstances. On some event related to tapering or the Fed Chair nomination, we may even see another push higher. It isn’t simply short-term risk, but deep cyclical risk that is of concern.

Deep Cyclical Risk

What’s the “deep cyclical risk” Hussman is talking about?

It’s the risk of a market that has been bubbled up due too much cheap credit. Like any bubble, it floats around until it finds its pin.

This leads us to do something we do very rarely. Today, we’re hoisting our tattered “Crash Alert” flag over our Diary headquarters here in Baltimore. Watch out!

Not that we know anything you don’t know. We gave up trying to predict the future long ago, after we realized we were no good at it. Our Crash Alert flag is not a forecast. It is like a tornado warning. Market conditions are exceptionally ripe for a bad storm.

Yesterday, the Dow fell 105 points. Gold barely moved. Treasury prices continued to fall.

Markets move in cycles of trust.

They begin tentatively, with investors unwilling to pay more than eight or nine times for a dollar’s worth of reported earnings… and too scared to lend money without at least 10% interest coming their way.

Gradually, as things improve and asset prices rise, investors become more confident. Soon, they are buying stocks with P/Es of 12 to 15… and borrowing at only 5% interest.

Then investors become convinced that the good times will last forever. They put aside their doubts. They find reasons to believe that what never happened before is now guaranteed to go on forever.

Ordinary people have come to think that Wall Street is there to help them make money. Progress, prosperity and rising asset prices – now and everlasting. Amen.

Blind Faith

These beliefs are tested. There are setbacks. Shocks. And brief corrections.

But if these are overcome quickly enough, say by Fed policy, a kind of blind faith takes hold. Investors begin to believe the impossible.

Now, for example, investors think the Fed “will not allow” a serious correction.

It should be pointed out, tout de suite, that the Fed can influence the markets. But it does not control them. And the more it influences them, the harder they are to control.

Why?

Investors trust the Fed to protect their money… just as the Fed makes their investments less trustworthy! Because the more influence the Fed exerts over prices, the farther they move away from where they ought to be.

If the Fed offers makes credit too cheap for too long, for example, stock prices adjust…and soon become higher than they should be. At some point, they are so high – and so far removed from solid values – that the proud tower wobbles, and then collapses, regardless of what the Fed is doing.

And based on what’s happening in the bond market, it appears as though the Fed has already lost control.

Ah yes, dear reader, that is one of the curious, always-fascinating feedback loops that keeps life on planet Earth ‘normal.’

Whenever things get too weird, something intervenes to make them less weird. And one of those things is a certain Mr. Market.

It’s all very well for investors to believe the Fed won’t allow them to lose money. That’s what makes it possible for non-delusional investors to make a lot of money. Again, John Hussman (emphasis mine):

Collective belief can create its own reality, and at least for the past few years, collective belief is that Fed actions simply make stocks go up, and so they have. The problem is that this outcome is based almost wholly on perception and confidence bordering on superstition – not on any analytical or mechanistic link that closely relates the quantity of monetary base created by the Fed to the equity prices (despite the correlation-presumed-to-be-causation between the two when one measures precisely from the 2009 market low).

Some of the deepest market losses in history have occurred in environments of aggressive Fed easing. Markets move in cycles, bear markets wipe out more than half of the preceding bull market gains, and this one is likely to be no different.

Mr. Market is watching. He allows bulls to make money. He allows bears to make money. He allows smart people to make money. And dumb people too.

But at some point, Mr. Market gets tired of watching people make money. He likes to see them all lose money too.

This could be one of those times…


Market Insight:

Do Taxes Make Dividend Investing a Waste of Time?

From the desk of Chris Hunter

Yesterday, we shared with you an email exchange between Bill and income investing expert Jim Nelson. It was about whether you can use dividend investing to successfully compound wealth over time. (If you missed yesterday’s issue you can read it here.)

One of the concerns Bill has about dividend investing is that you get hit hard by taxes. But Jim says that the tax issue is overblown:

This is a common misperception.

Last December, there was lots of speculation about what Washington was going to do about the expiring Bush tax cuts.

Obama floated the idea of taxing dividends at a different rate than capital gains. And that got a lot of people worried. But that’s not what ended up happening.

The agreement finally reached was to increase investment taxes only on the top tax bracket… and only from 15% to 20%. But that increase applies to qualified dividends (which covers nearly all domestic and even many foreign stock dividends) and long-term capital gains.

Contrary to popular belief, dividend income is taxed at the exact same rate as capital gains. But there are plenty of smart ways to minimize the taxes you pay on your dividends.

I recommend income investors split their portfolio in two: stocks for a tax-advantaged account (IRAs, 401ks, etc.) in one half and stocks for a “taxable account” in the other half.

Take Dividend Reinvestment Plans (DRIPs), for example. These are plans offered by companies that allow you to reinvest your dividends, commission free, into more shares.

You should always have these DRIPs in your tax-advantaged account. That means you don’t pay taxes on the dividends you receive each year. Instead you’ll pay taxes only when you withdraw from these accounts. And those taxes are identical to capital gains taxes.

There are other ways to get minimize your the taxes you pay on your income too.

When market conditions are right, I recommend Master Limited Partnerships or Real Estate Investment Trusts as ways to compound wealth through income.

Because shareholders in MLPs and REITs are technically “partners” and “trustees,” their distribution income is treated differently than traditional dividends.

For instance, a portion of each distribution MLP or REIT shareholders receive is often considered “a return of capital.” So even though they received a cash payment in the form of a distribution, it is only added on to capital gains later.

In other words, your taxes are deferred. But your income is not.

Because of these inherent tax advantages, you should definitely hold those in the taxable account portfolio.

Okay… so there are ways to avoid taking hits on your dividend income.

But what about Jim’s central claim that dividend investing is a great way to compound wealth over time?

As Bill put it,

This sounds like it would be good for producing income a family might live on…

But to me, it’s capital that counts. And I still don’t see how this kind of strategy helps you build capital. Surely, you’re better off investing in companies that have the most capital gains potential, not the ones that pay out income?

Isn’t that how you really build wealth over time? By investing in stocks that offer you the best capital gains?

This certainly makes sense. But Jim reckons it’s not so black and white.

Again, if you take an extreme view – either an “income only” view or a “capital gains only” view – you’re probably going to lose in the end.

I look for companies that are cheap, offer great capital gain potential AND pay large, growing dividends.

Not only does that give you an ideal situation to reinvest your growing dividends into more shares, it allows you to have more control of your money no matter what stocks are doing.

Let’s say we go through another 2008-09 crisis and the S&P 500 falls 50% in a matter of weeks.

Sitting on stocks that don’t pay dividends (and only offer potential capital gains down the road) leaves you with no cash to take advantage of discounted prices.

Stocks that pay income work best in these markets.

That’s because, if you pick the right dividend-paying stocks, the dividend payments you receive haven’t fallen, but prices are cheaper. So your dividends can buy even more shares than before.

Market volatility is almost always seen as a negative. But as an income investor, I love when markets dip. Because I am able to take advantage of this in ways others can’t. (I have regular cash payments, in the form of dividends, I can put to work.)

Again, if done in a tax-advantaged account, there are no extra tax consequences to this strategy.

This debate isn’t over. Bill has one final objection to Jim’s strategy. Tune in tomorrow to follow their exchange.

And if you want to pitch in on this debate, we’d love to hear from you. Simply reply to this email. Or send your thoughts to [email protected]