Reader “David” wonders why he went wrong in the last two years and asked me to do an article on the “Money Trail” to help him understand why.

David writes …

Hello Mish

I am not stupid but based on what has happened with the stock market, I certainly feel stupid. I realize that my inability to profit over the last two years was due to a lack of understanding about the money trail that the FED creates.

Have you ever thought about building a visual representation of the money trail from step 1 of the FED actually buying bonds to where that money goes and then to where that money might go?

I would think if I had a better understanding of the money trail and the money changers, maybe, just maybe, a little guy like me might be able to be more successful in investing.

There is No “Holy Grail”

Hello David. You are not asking for a “Money Trail” but rather the “Holy Grail”. It does not exist, especially over short-term time horizons.

If the Fed could prevent stock market declines, the S&P; 500 would never have hit 666 in the first place.

If the Japan could prevent plunges the Nikkei would not be down 75% 25 years later.

We are all Guessing

The idea that there is a “money trail” that will tell you what to do is fallacious. Discard it.

People are selling all kinds of ideas. The fact of the matter is simple: They don’t know, and I don’t either.

However, I can tell you with reasonable accuracy whether the market is historically overvalued or not. On that, please consider a recent pair of articles.

No One Can Possibly Know

Bear in mind that one of the best market analysts and authors I know says the Fed will “print and print and print” and the U.S. stock market bottom is in.

He may be right. However, I can assure you he will admit that he does not “know” either (and he would be the first to admit it).

No one can possibly “know”. This is uncharted territory. What will China do? Congress? The ECB? The Bank of England? The Bank of Japan? How will sentiment change?

That latter question is the crucial one. Stock prices move much further and much faster on sentiment than on actual earnings. The willingness to bid PE ratios to the moon is a measure of sentiment.

PE ratios go through cycles of expansion and contraction. During expansion cycles it is difficult to do anything wrong. During major contraction cycles it is difficult to do anything right. However, there are counter-cycles. I believe we are in the mother of all counter-cycles one now.

History is certainly on my side, but no one “knows” when the current state of massive overvaluation matters.

What Country Blows Up First?

We are all guessing what major country blows up first. Many think the US and the US dollar with it. I happen to think Japan. Ironically, that means that Yen-Hedged investments in Japan are at bargain basement prices.

However, you can find any opinion you want.

I am bearish on China, others aren’t. For my China outlook, please consider World’s Biggest Property Bubble: China’s Ghost Cities Revisited; 64 Million Vacant Properties

Tomorrow’s Gold

The closest thing to a “Holy Grail” is to buy reasonably priced things totally and completely out of favor (gold and energy in 2000 are perfect examples) and hold on to them until they are fully valued. However, things can stay out of favor for decades then take decades longer to reach full value.

It is not easy to hold on! Heck it’s not easy to recognize the turn in the first place. Moreover, mistakes are costly.

The best book on explaining the concept of buying things out of favor is one of my favorite books of all times and number one on my recommended reading list: Tomorrow’s Gold by Marc Faber.

Unfortunately, the current state of affairs has little that one can call exceptionally undervalued. Stocks, bond yields, energy, and commodities all seem hugely overvalued and prone to a sharp pullback.

Yen-hedged Japanese equities are the closest thing to “value” that I can find. Japan is hugely out of favor and has been for decades. When or if that trade works, I have no idea.

I like gold but it is certainly not the bargain it was at $250 in 2000. Is it fully valued? The answer depends on what central banks do and how sentiment plays out. The former suggests gold can run a lot longer. The latter? I don’t know. Nor does anyone else.

Sometimes the best thing to do is nothing (taking a significant portion of cash to the sidelines). I am reasonably confident that for most things, far better opportunities await those who are patient.

Mike “Mish” Shedlock
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