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More Fed Criticism
We Are In Good Company
2/05/16 8:00 AM

Last month’s commentary (which we also made a “special report”) was essentially a response to a financial reporter who asked us why we were so negative on the stock market in 2016 just because the Fed, more than likely, was going to raise rates.  He stated that the stock market almost always rose during the previous rate increases.  We explained the difference between the Fed tightening now, with enormous headwinds to overcome, relative to the times when the Fed raised rates in the past.  We went on to also explain why the same headwinds to the Fed tightening would probably also cause a U.S. recession (and maybe even a global recession). 

The prior comment was written in late December just after the Fed had raised the Fed Funds rate by 25 basis points.  Before this past commentary very few people were warning about a recession, here or globally.  However, now we are reading a lot about criticism of the Fed, and virtually everyone that appears on the financial networks seems to have a strong opinion about the probability of a U.S. or global recession. We have been critical of the Fed since the Greenspan days but seldom heard of anyone else criticizing the Fed or complaining about the ineptitude of the Fed.  Now, however, after the stock market declined sharply in January, we seem to hear about these two areas of concern almost every day. 

One well-reasoned recent criticism was a Wall Street Journal op-ed article by Martin Feldstein regarding the Fed on January 14th 2016.  The title of the article was, “A Federal Reserve Oblivious to its Effect on Financial Markets”.  We were struck at how closely this article mirrored everything we have been talking about for years.  The synopsis of the article was in the second paragraph,   The overpriced share values are a direct result of the Federal Reserve’s quantitative easing (QE) policy. Beginning in November 2008 and running through October 2014, the Fed combined massive bond purchases with a commitment to keep short-term interest rates low as a way to hold down long-term interest rates. Chairman Ben Bernanke explained on several occasions that the Fed’s actions were intended to drive up asset prices, thereby increasing household wealth and consumer spending.“  The Federal Open Market Committee last month didn’t even mention the risk from persistent low rates.  You can well deduce from the title of the article that Feldstein does not have much confidence in the Fed and FOMC in extricating the U.S. from the mess the Fed has put us in over the past 7 years.

Also, Bill Gross asked a sarcastic question of the central banks in his written piece for his clients yesterday.  He asked, “How’s it Working for Ya?” central bankers.  He then went on to criticize virtually every country that has been under the thumb of their central bank.  We were happy to see that Bill Gross is on the same page as us.   

Just recently, Rand Paul also criticized the Fed and the entire way our governmental system works.  He stated that the U.S. spends over $600 bn. on the military in this country which compares to the top 10 countries spending on their military (including Russia, China, and the other top eight countries spending on the military).  The right wing governmental forces want to spend more than $1 tn. more on the pentagon while the left wing wants to spend much more on the domestic side of our economy.  Both get their way, and the taxpayers get stuck with the bill as we borrow $1 million a minute to support this and other spending.  As we stated in our last comment, the total debt of the county exceeds $100 tn. if you include unfunded liabilities and promised entitlements.  This debt is enormous relative to our $18 tn. economy.   These numbers are the main reason our economy is growing so anemically. 

We recently heard a radio interview with economist Lacy Hunt, whose point of view we very much agree with.  The common theme here keeps coming back to what the Fed has done to the financial markets by essentially controlling the price of money rather than have the free market determine it.  It has forced savers to chase return, which cannot be done without increased risk.  And investors are not the only ones farther out on the risk curve than ever before.  We see announcements almost every day about companies buying back their own stock, often with borrowed money.  As Mr. Hunt pointed out in his interview, corporations are making financial investments in their own stock at very inflated levels instead of making capital investments in their businesses.   This phenomenon does not bode well for future economic growth or for future stock market returns. 

We have been talking about the Fed and government deficit spending over the past 15 years. The Fed cannot expect to control the price of money and not have the economy and markets suffer adverse consequences.  Continuing the rate increases risks further weakening of an already weak economy recovering at the slowest rate in history from the last recession.  While a cessation or reversal of the rate rise has, on its own, potential to cause a panic as the markets realize that the economy is weak and not likely to recover before there is a bursting of what we and others have termed the “Central Bank Bubble”.

Difference between Past Fed Tightening and Now
1/04/16 8:30 AM

A reporter asked us about the prospects of the stock market if the Fed raises the Fed Funds rate, since at the time there was a strong possibility of a rise in the rate to around 25 basis points.  We explained that, in our opinion, the ending of the ZIRP (Zero Interest Rate Policy) and increase in Fed Funds will be a significant negative for the stock market.  The reporter asked why this is a negative since many times when the Fed raised rates in the past, the stock market also rose.  We explained that the difference between the Fed raising rates in the past and today is that raising rates now has a lot more to overcome than in the past. We then explained the difference.

Difference between Past Fed Tightening and Now

  1. ZIRP has been going on for the past 84 months (7 years) and will probably now end.  During the past 7 years with interest rates far below where they should have been, investments in risk assets are much higher now than they would have typically been.  Also, the Quantitative Easing (QE) 1, 2, and 3 has ended after years of the Fed starting and stopping major purchases of Treasury Bonds and Mortgage Backed Securities.  Whenever they stopped the purchases in the past the stock market declined. 
  2. This time the Fed is raising interest rates right into the face of a profits recession as well as a manufacturing recession (both down at least 2 quarters in a row).
  3. This time the Fed has grown its balance sheet since the “great recession” from about $800 bn. to over $4.5 tn.  This enormous amount of money has to eventually be wound down.  This injection of money printed by the Fed has not driven us into an inflationary environment because there is very little “Velocity” (or transactions) associated with the liquidity.  This is because of the “Liquidity Trap”.  A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war.  Common characteristics of a liquidity trap are interest rates that are close to zero and fluctuations in the money supply that fail to translate into fluctuations in price levels.  Japan went through this process (back and forth) for the past 26 years since the high debt they generated caused a deflationary environment.
  4. Our Government debt is not just the $18-$19 tn that all the Presidential candidates constantly talk about. That amount is much lower than the actual government debt.  If you include the unfunded liabilities and entitlement promises the government debt skyrockets to over $100 tn.
  5. Global debt has grown by just about double the global GDP over the past 10 years and over indebtedness causes deflation.  In the U.S. the Fed made sure we had plenty of money over the past 7 years with QE and ZIRP. Easy money is the cause of indebtedness and as we said before, over-indebtedness is the cause of deflation.  We will attach the “Cycle of Deflation”, which we authored years ago, to explain exactly what takes place after excess debt drives weakness in pricing power.  The Bloomberg Commodity index is at its lowest level since 1999 and is not far from its lowest level since the start of the index in 1991. Virtually all commodities are “canaries in the coal mine” warning of a global recession.  These commodity price declines are all you need to see in order to put everyone on guard for a significant recession.  Don’t let anyone convince you that the reason for the declines are all related to over-supply.  OPEC as well as Russia and the U.S. are continuing to pump oil and Iran is trying desperately to get rid of the sanctions that are holding them back from selling more oil (they would love to add another 500,000 barrels of oil to the world’s supply).  Also, there are some crops that are plentiful, but the main reason for most of the commodity declines is a lack of “demand”!  It is the slowdown in demand that starts most commodity price declines, and they continue to decline as businesses refuse to close down plants, and mines that keep pumping out their commodities in the face of the slowing demand.  It is difficult to reduce the supply as the mining and oil companies do whatever they can to maintain or increase their market share.  The only way to stop the mines from producing commodities is for them to go bankrupt.  It is hard to imagine continuing to pump out commodities (like copper and iron ore), while at the same time there is a worldwide slowdown occurring. China is slowing at the same time it is having environmental problems, and Japan just emerged from a recession that saved them from going through 5 recessions in 5 years.  Brazil and Ireland are already in recessions.  Europe is also struggling, and if we do slip into a global recession the stock markets worldwide will be a disaster along with the commodities. 
  6. U.S. stock market valuations are also extended and if the employment rate stays low there will be wage pressures which probably will affect profit margins that are at extremely high levels now.  The market is trading around 17 – 18 times earnings and if profit margins come down it will also be very negative for the US stock market.  Also, Robert Shiller’s CAPE (Cyclically adjusted PE ratio—take the S&P 500 and divide by the average of 10 years of earnings) shows that US stocks are around 50% to 60% overvalued. 
  7. In the past when the Fed was raising interest rates corporations were making normal capital expenditures.  Presently most corporations have been replacing cap-ex by borrowing money to buy-back their own shares in order to increase their earnings per share (EPS) as well as increase the stock price.  The announced buybacks in 2015 reached close to $1.2 tn., which shattered the prior yearly record of $863 bn. in 2007. 
  8. Geopolitics—The US and even the rest of the globe will have potential terrorism problems for some time until we can contain or deal with ISIS.
  9. Because of the US dollar’s rise, and probably continued rise as rates move higher, it will be more difficult to compete with our trading partners.  Most of our trading partners are participating in a race to the bottom as they do whatever they can to lower their currency.  This is called a “Currency War”.  And even with the fanatical lowering of rates and currencies, Brazil, South Africa, Russia and other countries that are tied to commodities (which are in a deflationary downtrend) are still doing worse than us economically. Of course, if the spread of interest rates and their currencies continue it will not be good for the U.S. long-term.  The best signals to watch for will be the high yield spread widening, and a flattening yield curve that turns inverted.      

Will all of these Headwinds be the Catalyst for a U.S. Recession or even a Global Recession?

The most controversial question for 2016 and 2017 is whether the U.S. will collapse into a recession ….one that could wind up as a global recession?  In mid-year 2016 we will have 8 years of global expansion even though the expansion in the U.S. has been one of the weakest expansions on record.  Global recessions typically occur on the average of about 8 years.  This potential recession may not be due to the U.S. consumer because unemployment has improved and wages are finally starting to rise after 20 years of stagnation in real wages.  Oil and food prices declined significantly, but have been somewhat offset by health care costs and apartment rentals.  Also, the unemployment rate is partially distorted since the labor force participation is near a 40 year low.  Even though there could be a consumer produced U.S. or global recession, the greater risk is the American export sector, which has been a larger factor in the weak recovery due to the dollar’s rise and if the dollar, as well as rates, rise in 2016 watch out for a recession.  

Now that the Fed has started its tightening policy whereas almost all other parts of the world are now following the Fed’s easy money position, this will take the global economy into the awkward position of easing as the U.S. is tightening.  This will probably cause interest rates and the currencies of our trading partners to decline just as they are starting to rise in the U.S.  This will put pressure on the U.S. manufacturing sector and will probably drive the U.S. into a recession while our trading partners could prosper.  The manufacturing sector is important to the U.S. economy because it has provided many of the skilled jobs in the U.S.  This may seem fine for the global economy until the world’s largest economy pulls down the global economy as we did in 2007 and 2008 with the housing bubble bursting.  Keep in mind that the bubbles of the dot coms in the late 1990s, housing in 2007, and now central banks have had an enormous negative influence abroad.  We discussed this in many comments in 2006, 2007, and 2008 (just type “housing” in the archives of our comments to see how many times we warned our viewers about the housing bubble and you can do the same for the dot com bubble and central bank bubble).  It was the Fed that drove us into the housing bubble and it was also the Fed that was oblivious to the U.S. having the most expensive valuations in the world during the dot com bubble.  You would have to reach far and wide to find a market more expensive than the U.S. stock market (especially NASDAQ) in the late 1990s (maybe the tulip bulb mania of the 1600s). 

We believe strongly that the Fed will be to blame for the central bank bubble we find ourselves immersed in presently.  After all, it was the Fed (under Greenspan) that missed the dot com valuations, and it was the Fed that lowered rates to 1% in June of 2003 that brought on the housing bubble with virtually no discipline of the banks and other mortgage lenders.  When the credit markets and housing markets imploded in 2007-2008, driving the U.S. into the “great recession”, the Fed resorted to whatever it took to save our economy from collapsing into another depression.  As stated previously, the measures the Fed took in the “central bank bubble” and inspired other central bankers to follow our lead (like QE and dramatic increases in the balance sheet) could be worse than the dot com bubble and housing bubble combined.  When this breaks there will be no shortage of business school textbooks about the inter-relationships between these three bubbles.

Another reason we are skeptical about the U.S. economy avoiding a recession in 2016 is because of the breadth being as weak as it was in 2015.  The top 10 companies in the S&P 500 accounted for virtually all the gains, but were overwhelmed by the 490 stocks that accounted for the decline in the index.  This is also true about the number of stocks in the S&P 500 above the 10 day, 150 day and 200 day moving averages.  We are also very concerned about the unsustainable path of the entitlements in our country.  We have to elect the politicians who can get us on a sustainable path for the promises we made for the Affordable Care Act, Social Security, Medicare, and Medicaid by increasing the retirement age, means testing, and adjusting for inflation properly (for the ACA we need a program that doesn’t increase the premiums while making sure we increase the participants).   

In fact, we believe the Fed’s decisions over the past 20 years were instrumental in the dot com and housing bubbles.  In the Fed’s mind they have done everything possible (including increasing their balance sheet from $800 bn. to $4.5tn.) to resurrect the U.S. economy.  Instead, their legacy will be tarnished by the outrageous policies that were used over the past 8 years, and in our view, will not result in the salvaging of our economy, but rather what may become one of the greatest destructions of wealth in history.

We hope that we satisfied the reporter’s question about why the stock market may not do well this year.  Keep in mind, every time the Fed raised rates in the past, there was never a time that the financial environment was even close to being this difficult.  In fact, the only time we can remember the Fed raising rates while interest rates were very low like now, was in 1937, and that drove us into another recession on top of the great depression.    

This Stock Market Is Long In The Tooth
12/03/15 1:45 PM

At Comstock we continue to believe that the world is in an accelerating deflationary environment.  This is the result of many interrelated factors we have written about in the past.   The most important of these is the exceedingly large levels of debt that exist in the world today.   In an effort to combat this deflation and stimulate the real economy the Federal Reserve has done three quantitative easings (QEs) and an “Operation Twist” (purchase of long term and sale of short term government securities).  These actions grew the Fed’s balance sheet from $800B to over $4.5T.  Also, as part of this program, it has maintained a zero interest rate policy (ZIRP) for 84 months.  This has not only punished traditional savers but has forced many of those savers to take risk in financial markets with money they cannot afford to lose.   But the real economy has not been stimulated in any meaningful sense.  The main effect has been the inflation of financial assets, real estate and certain art.  We strongly believe that ZIRP has made the financial markets much more vulnerable than normal.

As is evident from trends in GDP and its revisions, the US economy continues to grow at an anemic 2%-2.5% since the bursting of the Housing Bubble in 2008.  Globally, GDP has grown by 5.3% ($28T to $78T) over the past 10 years while Total Global Debt has grown by 9% ($40T to $225T); with much of the slowest growth being more recent.  Not only is this not sustainable but it is, in fact, the main reason growth worldwide is so poor.  As further evidence of the deflationary situation the world is in, the Bloomberg Commodity Index, which calculates back to 1991 and is broadly representative  of the entire commodity complex, is at its lowest level since 1999 and not far from its lowest level in that entire 24 year time frame.  Commodities across many complexes are screaming deflation and warning of global recession. 

Europe, Japan and China have now followed the United States with QEs of their own.  In response to Japanese government policies the market has devalued the Japanese currency by approximately 60% versus the dollar since 2012; and in spite of that, the Japanese economy has just entered another recession!   Growth numbers in China remain highly suspect and the Chinese economy has been overbuilt though massive debt to levels where productive capacity far exceeds aggregate demand. 

Today, the ECB unveiled its latest attempt to stimulate the economy.  It expanded the bond buying program to 360 billion euros, extended the length of QE by 6 months to March 2017, included local and regional debt in the mix of assets it would buy and reduced the deposit rate by -10 bps to -.3%.  The latter also becomes the floor rate that it will pay in the marketplace for credit instruments.    Interest rates are already negative out to 6 years in Germany and out to 4 years in France and we expect this action over time to weaken rates further.  The sum of this is worldwide deflation, plain and simple!

One of the main observations made in the bull case for equities is that corporations continue to buy back large volumes of their outstanding stock.  In fact, for many companies, that accounts for more EPS increases than does improved revenues or margins.  But, it should also be noted that these purchases have been in record amounts financed with debt for the past several years.  Corporate debt issuance surpassed $1T in the United States in the first 9 months of this year, for only the second time ever.   In fact, debt is more, not less, expensive in a deflationary environment.  Therefore we expect these large debt levels to act as an albatross around corporate necks for years to come.  It should also be noted that share repurchases are taking place at valuation levels that we consider extremely inflated by historical standards. 

By and large technology and financial innovation has been a good thing in many ways, but we think, relative to market liquidity it is a two edged sword.  Fully electronic trading and penny spreads have in large part caused markets to become less liquid.  The traditional NYSE Specialist and Nasdaq Market Makers do not exist in the form they did in the past.  Market making today is more “technology arbitrage”, where the objective is trying to be proficient in squeezing out fractions of pennies based on taking advantage of the quirks, rules and business models that exist as part of market microstructure.  We, therefore, believe that when most needed, liquidity will be greatly diminished.  We’ve seen this before, going all the way back to the “crash of 87” and most recently through the “flash crash” on August 24th of this year.  Additionally, we believe that those ETF’s that contain illiquid securities (e.g. Junk Bonds) will prove to be no more liquid than the securities they contain, and will therefore not provide investors with a safe haven.

In summary, we believe the market is very vulnerable and extremely overvalued.  We are not looking for a mild correction here, but rather believe that a move far lower is justified. 

The Global Debt Controls the Global Economy
11/05/15 4:40 PM

The main reason the US economy is struggling to recover from the “Great Recession” of 2007 and 2008 is because the debt load is so very difficult to overcome.  The global debt has increased by about $60 trillion since 2007 and there is no way to have a smooth and quick recovery after the debt has grown so much so quickly (see first attachment).  Keep in mind that the reason for the “great recession” was due to the overwhelming debt incurred by almost every country (this includes the developed nations as well as the emerging markets).  The main reason for the increased debt burden started with the Federal Reserve reducing the Fed Funds Rate to 1% in June of 2003 and keeping it there for a year.  They thought that they were giving relief to the U.S. due to the bursting of the dot.com bubble.   They were not aware of the possibility of being the main cause of the “housing bubble” (which they were).  In fact the Fed had no idea they were the cause of the dot.com bubble after Fed Chairman Greenspan warned global investors about the possibility of “irrational exuberance” in 1998.  After the market dipped it came roaring back enough for Greenspan to reverse his warnings to state, “everything is OK now”.  Our Federal Reserve also tried to alleviate U.S. investor’s concerns by stating that there was “no housing bubble in 2005, 2006, and 2007.”  When the housing bubble turned out to be worse than the dot.com bubble they invented Quantitative Easing (QE), which essentially meant that the Fed bought a tremendous amount of U.S. Treasury securities.  The theory, at least, was that by lowering interest rates and buying Treasury securities that bank reserves would be increased and that would find its way into the real economy as loans to businesses and individuals.  This turned into QE 1, followed by QE 2, then QE 3 (interspersed with “Operation Twist”--- purchases of longer term Treasuries while selling shorter term Treasuries).  This caused the Fed’s balance sheet to grow from $800 billion in 2007 to $4.5 trillion now.  The most amazing part of this was that the rest of the worlds’ central banks decided to copy the Fed and start their own QE, which drove up all of the central banks’ balance sheets to outrageous levels. 


There have been many very sophisticated investors and money managers that have warned about the U.S. debt explosion over the past 35 years (and especially the last 15 years) when the dot.com bubble burst (see second attachment).  Just this week Stanley Druckenmiller warned about the devastation of the U.S. economy due to the promise of entitlements.   He stated that if the entitlements (mostly Social Security and Medicare) in the U.S. were paid to everyone that expected to receive them, and the revenues that would be coming in as expected over the next 20 years the National Debt would no longer be the $18-$19 trillion that all of the Presidential Candidates talk about as an impossible burden.   In fact, if you take the present value of the entitlements promised to the expected recipients, the National Debt would no longer be $18 -$19 tn. but would be closer to $205 trillion.  If that number doesn’t scare you nothing will. David Stockman also has gone through his present value of entitlements that comes in around $80 trillion.  Either one shows just how outrageous entitlement promises have become and that they must be corrected.  Stockman has also shown the growth in global GDP and global debt from 1994 to present.  He shows that global GDP grew from $28 tn in 1994 to $78tn presently (CAGR-Compound Annual Growth Rate—5.3%) and the global debt grew from $40 tn in 1994 to 225 tn presently (CAGR-9%).  This kind of growth relative to GDP is unprecedented and this is why the growth in global GDP is being smothered by global debt.  The only thing close to this is the growth in debt relative to GDP in the U.S. presently and Japan back in 1989. 


We presently have the problem of tightening while the rest of the world is now following our footsteps in printing money and essentially having a “currency war” (3rd attachment) with us.  About half the Federal Reserve Governors are “hawks” and espouse raising rates.  The other half are “doves” and espouse keeping rates around zero.   It is our opinion that the Fed will not raise rates.  We believe the economic data will not support a rise in rates now and, in fact, we may not support a rate rise in all of 2016.  This is because of the debt load we discussed in the second paragraph has made the recovery weaker than any recovery since World War II.  And once the entitlement debt problem becomes more well- known the recovery will slow down even more next year.  We have been predicting for some time that not only will we not raise rates, but we will resort to using every tool we have in order to compete with Europe, China, Japan, and all other central banks that are using the “Quantitative Easing” (QE) we have been using for the past seven years.  In fact, we believe that we will probably use QE-4 after the three other QEs we used in the past.  That sure didn’t work very well for us the first 3 times, but it is our last resort except to drive rates down to negative rates.  We don’t believe that negative rates will work because if banks have to pay money to the Fed on their excess reserves they will not hold excess reserves.  The American public won’t accept having to pay money to hold their money in banks. 


All in all, it looks to us like the global debt has run out of steam and we believe the global debt will start shrinking as commodities continue declining (copper is a good example of this making a low not seen since 2009).  This should continue the deflationary aspects of the worldwide stock markets and end the rally over the past month.  The stock market range in the U.S. expressed by the S&P 500 has been from 2040 to 2135 until just recently when it broke down through the 2040 support.  After the recent rally the S&P got back to about 2100, but we still don’t believe it will rise above the range high of 2135 and instead decline below the support again, but this time it should continue down just like Japan did in the early 1990s. 

10/01/15 8:00 AM

We would be hard pressed to name an event where the outcome was more closely watched than the 9/17/15 Fed meeting.  That was the meeting that was finally supposed to be liftoff from the zero interest rate policy (ZIRP) of the Fed.  The Fed held steady, which was dovish, and the market’s reaction was up…for about an hour. Post announcement, the market rallied about 1.7% from low to high before closing down on the day.  In the text of the Fed’s announcement was reference to world economic conditions, specifically China, as a reason to remain at zero.  That sounded pretty far from the traditional “full employment and low inflation” mandate and the market didn’t like it one bit.  One week later Janet Yellen gave a speech where she said that liftoff was likely this year.  That more hawkish statement, which came after the close on Thursday 9/24, caused the market to be strong through a good part of the day on Friday…until the market decided it didn’t like it and closed lower.  There were also statements from present and former FRB members both for and against liftoff. It seems the market can’t make up its collective mind for good reason, since the members of the FRB and Chairman Yellen can’t seem to make up their minds.  In short, the Fed is nearing the end of its credibility “rope”.

Though our viewers are certainly familiar with ZIRP and our thoughts on it, for purposes of historical perspective we have provided a chart (see chart 1; each vertical box = 5%), courtesy of Bloomberg, that shows the upper bound of the Fed Funds target range going back to 1971.  Apart from the times in the 70’s and 80’s that the rate rose above 10% and as high as 20% (recall stagflation and Paul Volker’s tough love cure) the vast majority of the time was spent between 3% and 10%.  In fact, the rate did not drop below 3% until well after the bursting of the “Dot Com Bubble” in March of 2000.  But there is nothing in memory, recent or otherwise, that can match the length or low absolute level of the Bernanke/Yellen ZIRP.

To state in the simplest of terms, our view has been and remains that ZIRP has grossly distorted the allocation of capital investment by supplying credit, in large amounts, to borrowers at the wrong prices (interest rates).  Equally importantly are “down the line” savers, who are being punished by zero interest rates and thus have turned to taking risk and speculation.  We know people with the attitude that at zero interest rates, to quote several directly, “where else am I going to put my money”, referring to the stock and bond markets.  The flip side of chasing yield is to take too much risk and in our view the market is much riskier than it is at normal levels of interest rates because investors have moved farther out on the risk curve as part of a self-re-enforcing process that now depends on the Fed to “keep the party going”. 

“Going” is the operative word here.  Because where we are going, unfortunately, is into a perfect storm.  That storm is what we have referred to as “The Central Bank Bubble”.  To be sure it has taken a long time and making of poor decisions by people at many levels, both public and private.  This started in our country and now has spread more broadly to both other developed and emerging world countries.  Those countries have emulated us by following the lead of our central bank and implementing quantitative easing programs designed to stimulate their economies, but in the final analysis doing nothing but inflating financial assets to bubble levels.

In theory, QE was supposed to work in the following way:  Quantitative easing would cause financial assets to go up in price.  Then people that held those assets would feel and actually be wealthier and they in turn would spend more.  By those wealthy people spending more the economy would grow, jobs would be created, wages and employment would rise and we would all be better off.  It was all good except for one thing…it didn’t work.  The only thing that happened is that financial assets, real estate and art have gone up to bubble levels.

As we have stated many times, the US and economies around the world are in a secular period of deflation. The deflation has been caused by excess credit provided to governments, corporations and individuals that has grown to levels that are so large that they have become THE headwind for economic growth.  In the US, government debt alone is nearing $19 trillion (T) and is over 100% of the last reported $17.9T GDP.  When corporate and personal debt is added in, the figure grows to $56T.  If that situation were not bad enough when you add in $75T or so for Social Security, Medicare and other unfunded liabilities it is hard to see where this money will come from other than printing, higher taxes and lower spending. 

The situation is in fact worse in the rest of the world. World total credit market debt in the past 20 years has grown from $40T to $200T, a 500% increase.  In contrast world GDP has grown by a total of $40T in that same time frame.  So debt has grown at 400% of GDP on a worldwide basis.  Also, included in that number are things like $130 billion (B) of Petrobras debt; which may never be repaid!  So like in the US, around the world this deflation will continue as taxes rise, spending falls, defaults rise and financial assets deflate.

Let’s consider our own stock market.  It is widely acknowledged that corporate share repurchases have been a major factor in the demand for equities. According to Factset Research S&P 500 trailing 12 month (TTM) share repurchases in Q2 stood at $555.5B, a 1.3% increase YOY.  However, TTM free cash flow fell 28.6% to $514B YOY.   In other words, not withstanding the fact that energy and financials were main contributors to the shortfall, S&P 500 companies spent more (108%) on buybacks than their free cash flow!

It is also true corporate borrowing has never been higher.   Four years ago, corporate bond issuance set all-time records; and has gone up 15% a year since.  Said another way, share repurchases have in large part been funded by borrowing.  That this debt will need to be repaid is another reason that we believe growth headwinds will persist far into the future. 

Normally, debt used to purchase an undervalued asset is not a bad thing but in our view (for many of the reasons above) the US stock market is extremely expensive.  Consider the S&P 500 price/sales indicator that we believe shows good correlation to subsequent returns.  (See attached charts courtesy of Ned Davis Research).  Whether looking at the S&P 500 as a whole (chart 2) or the median company (chart 3), price to sales is at or not far from historical extremes.  As can be seen in the charts, those extremes in the past have been at or near significant market tops.

In conclusion we reiterate, as we have in the past, we are in a “Central Bank Bubble”.  Actions by the US, Japanese, European, Chinese and lesser central banks have created a worldwide bubble in financial assets that has begun and will continue to deflate in a calamitous manner.  Deflation is here.  It was precipitated by government and central bank actions and caused prosperity almost exclusively for holders of financial assets only.   Many commodities are crashing or have crashed. Countries are devaluing their currencies in a race to the bottom.  Companies have bought back over a trillion dollars in stock at high valuations and borrowed the money to do it.  Capital investment has suffered and investors have piled into risky assets.  As of this writing, 231 companies of the S&P 500 are more than 20% from their highs of the last year while 277 made all time highs in the last year.  The markets have started their decent and we expect that drops along the way will be quick and steep.  The effect of 80 months of zero interest rates and mountains of debt will not be corrected in a few weeks.  We expect equities to remain under pressure for some time before the excesses are corrected.


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