Tuesday/Thursday Market Commentary

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But Normalized Interest Rates Will End The Party
1/03/17 11:00 AM

The past eight years provided a phenomenal environment for stocks, bonds, and real estate due to the tremendous expansion of the Fed’s balance sheet and the resulting eight year zero interest rate policy.  During that eight year period the world became familiar with terms like Quantitative Easing (QE) and Operation Twist as the Fed moved into uncharted waters in both the magnitude and length of its easing programs.  What began as an emergency program to rescue the U.S. and the world from the Global Financial Crisis turned into a longer term attempt to stimulate growth through the inflation of financial assets; the theory being that wealthy people would spend more and that wealth would “trickle down”,  and result in economic growth.  As it turned out, it should also be mentioned, that the Fed alone pretty much carried the economic football as the budget sequester limited the impact of fiscal policy as the U.S. government continues to struggle with debt and deficits.

Several times during the past eight years, sell offs in the stock market were alleviated or reversed as the Fed “rode to the rescue” with more QE and the aforementioned Operation Twist.  So powerful were the effects of the Fed’s activity that other major central banks in Europe and Asia started QE programs of their own.  The ECB and BOJ have “upped the ante” by taking interest rates to negative levels several years out on the yield curve, and in the case of the BOJ, have even resorted to buying equities through the ETF market.  As a result approximately $12tn of sovereign debt in Europe and Japan have negative yields and in addition, the Government Investment Fund of Japan is a top ten shareholder in the majority of the market capitalization of the Japanese stock market.  We don’t know where the Japanese buying of equities stops or possibly reverses, but it is not healthy to have the national government interfere in free markets and substitute public for private capital in the ownership of what should be the nation’s growth engine.

We have discussed many times how ill advised, to put it mildly, the major central bank policies are.  In essence these policies distort the relationship between risk and return that is essential for the efficient pricing of capital.  This causes bad investments to be made and good investments not to be made.   Zero and negative interest rates also push investors into riskier investments than would otherwise be made as they chase yield.   The companies themselves, in the U.S. and increasingly elsewhere, have been on a “feeding frenzy”, buying stock back at extremely inflated levels to the detriment of investing in their businesses.  In many cases, compensation of senior managements is determined by EPS metrics not adjusted for stock buybacks.  Since it is the managements and boards of companies that authorize and execute these programs, an inherent conflict of interest exists as managements ”knock” options “into the money”, thus influencing their own compensation.  With the stock market at or near all-time highs the public is not focused on this, as the “music is still playing”.  But we maintain that the day may come when the focus of politicians and regulators will be how much money was stripped from shareholder’s equity of U.S. companies as stock was bought back at valuations that in more normal times would cause them to want to SELL equity, not buy!

The rally that has taken place since the election of Donald Trump comes at a time that the Fed is (slowly, so far) reversing the zero interest rate policy of the past eight years. In addition, they are not selling the bonds they bought and are holding on their balance sheet, but rather are letting the balance sheet “run off”.  Said another way, this is money printing, i.e., currency debasement, plain and simple.  In our view, the market is betting the Trump promises of tax cuts, deregulation, repatriation, and fiscal stimulus across defense and infrastructure related industries will outweigh the potential negatives of possible trade wars and tariffs, a stronger dollar, inflation, and further rising debt and deficits.  To our way of thinking, and to no surprise to our readers, we believe the market’s positive reaction thus far will be dead wrong.

The damage has been done over the last eight years by the Fed’s ill-conceived and irresponsible zero interest rate policy and unprecedented money printing.  Financial assets have been inflated to at or near the most expensive levels in history.  As the Fed raises rates and tries to normalize, debt will continue to climb, and in our view, Trump or no Trump, we will not grow our way out of the problems that exist.  Whether we have low growth and low inflation, or whether we have stagflation remains to be seen.  But either way, when rates normalize, as they must, the markets will become rational again.  In our view, when that happens, both stock and bond prices will be substantially lower.

But The National Debt Could Grow Even More
12/02/16 4:30 AM

We have to admit to being as surprised as everyone else at the stock market’s reaction to the Donald Trump victory.  And it is not because we think the policies of the incoming administration will be less growth oriented than the Obama or the not to be Clinton administration.  Quite the contrary.  President-Elect Trump’s policies will be friendlier to business and to the taxpaying public than the alternative.  The problem is that those policies could also explode the debt, which we believe is the most significant financial threat to the country’s growth and economic well being.

On the positive side, there are a number of pro growth initiatives in the Trump plan.  A partial list would include, infrastructure related spending and jobs resulting from the fiscal response, rebuilding a depleted military including new investment in weapons systems, scaling back or eliminating Obamacare, tax cuts for individuals and corporations, reducing the maze of Federal regulations that are choking certain business activity including energy production, building the Keystone and other pipelines, possible corporate investment in neglected real plant and equipment due to a shift to optimism from pessimism, and importantly, repatriation of corporate profits that are being held offshore, mainly in Europe.

On the opposing side, there are at least several negatives.  Among those are building a wall financed by Mexico that causes friction and reverse immigration of low skilled workers (ultimately very inflationary), minimum wage laws, which are not only inflationary but actually can destroy jobs, renegotiation of trade agreements that slows business activity, trade tariffs that are ultimately borne by the U.S. consumer, and possible political interference in the activity of the Fed (our readers know that we have vehemently criticized this Fed in particular, but we have never espoused political interference).

Below are a few statistics, sourced from www. usdebtclock.org.  We compare to the same series eight years ago, at the end of 2008, and encourage our readers to view for themselves.

  1. The National Debt went from $10.9tn to $19.9tn, an increase of 82.5%.

  2. GDP went from $14.1tn to $18.7tn, an increase of 32.6%. (This increase in debt relative to increase in GDP is clearly unsustainable.)

  3. Though the National Debt stands at $19.9tn, which given GDP is an increasing and ominous number, the Unfunded Liabilities, which include Social Security and Medicare, stand at an almost unfathomable $104tn.

  4. Total Public and Private Debt is now $66.8tn, up from $50.8tn.  Given the above, Total Credit Market Debt now stands at 357% of GDP.

We could go on and on with many more statistics but we think that you, the reader, get the point.  Our thesis is, and has been, that the excessive debt that exists has slowed growth.  This is evident in the anemic GDP growth statistics since the end of “The Great Recession”.  We believe the better than expected 3.2% increase in GDP increase reported by the government last week will prove to be another false start, especially in light of the rapidly increasing dollar relative to the currencies of our trading partners. 

At the same time that debt was going through the roof, the Fed was increasing its balance sheet from $800bn to $4.5tn.  Said another way, the increase in debt, at least on the public side, was financed in large part through the printing of money.   That has, in our view, led to the inflating of financial assets to levels not seen before on the fixed income side, and to near the most expensive valuations in history on the equity side.  In its most recent reporting summary S&P 500 Trailing Twelve Month  GAAP earnings are $89.29 (24.2X P/E on 9/30/16 Close).  We have written about what we view as dangerously high equity valuations many times, most recently in the piece entitled “Malaise” on this website.

That brings us back to President-Elect Trump and what he will face as he attempts to implement the policies he espoused during the campaign.  In March 2017, the federal debt limit, which has been suspended since the fall of 2015, will be reinstated.   It is at the time, or more likely, in the weeks immediately preceding, that the markets will focus on the issue.  We could again get a glimpse of just how topsy-turvy the world has become, for it may be the republicans that become the debt lovers and the democrats that, in the spirit of obstruction by both parties that has existed for some time, try to put the brakes on.   While it may not be possible to predict the outcome, we feel it is safe to say that this is one of several catalysts that have the potential to ignite the bear market we have been anticipating for some time.

We think President-Elect Trump would be wise to heed the advice espoused by Randall Forsythe in the last two issues of Barron’s magazine.  Essentially, it boiled down to taking advantage of artificially low interest rates and issuing  50 or 100 year bonds while cutting corporate tax rates to a theoretically revenue neutral 22%.  At $20tn in debt, each 25 bps is $200bn of interest.  In the longer term, this will have the effect of crowding out other spending.   In our view massive infrastructure spending may boost the economy temporarily.  But more spending means more debt and potentially more inflation and interest rate exposure.  Whether President-Elect Trump and his advisors heed the advice remains to be seen.  But from our perspective, we see more money printing, more currency debasement, and more risk to the financial assets that have been so grossly inflated by the Fed’s irresponsible experiment.


The CB's have to Learn You Can't Go To "Cold Turkey" from "Wild Turkey"
The Central Bankers Continue to Guess on What to do
11/02/16 11:30 AM

We have been discussing (in the most critical way possible) the Central Banks all over the world for the past 16 years.  In fact, a journalist called us this past January and asked what we thought of the stock market?  We responded that we expected the stock market to decline sharply during the year 2016 as the Fed raised rates.  The journalist countered that every time the Fed raised rates in the past the stock market still did quite well.  So far the journalist has been correct and we have been wrong.  We believe this will change again within the next few months since the Fed will be forced to finally reverse the damage done over the past 8 years. 

We tried to explain to the journalist that we are presently in a completely different situation than we were in the past, when the stock market rose as the Fed raised rates because the economy was doing well and/or there were inflationary risks.  Now we have gone through QE1, QE2, QE3, and “Operation-Twist” where we drove rates down to zero (ZIRP), or close to it for the past 8 years.  This time the Fed has grown its balance sheet from about $800 bn. to over $4.5 tn.  This enormous amount of money has to be eventually wound down.  This injection of money printed by the Fed has not driven us into an inflationary bubble because there is very little “velocity” (the pick-up of transactions).  The injection of money does not lead to inflation since the money printed by the government or Fed does not get the public to spend the money and they save it instead.  This is called a “liquidity trap”, which is what Japan went through for the past 27 years.  The high debt that we have generated, as well as Japan, has caused a deflationary environment, which neither one of us seems able to achieve any type of “escape velocity”.  

This time is also different from the past rate hikes since now our Fed is about to raise Fed Funds right into the face of a manufacturing recession (down for over 6 quarters in a row).  We also are threatening to raise rates right into the face of virtually every other central bank that is still in the loosening phase of printing more money and lowering interest rates.  All this while we are about to tighten by increasing rates and raising the value of the US dollar.  And because of the US dollars rise and continued rise as we raise rates, it will be more difficult to compete with our trading partners and lower our exports.  Most of our trading partners are participating in a race to the bottom, as they do whatever they can to lower their currency in order to sell more goods and services to the US. 

We have given this journalist at least 4 more reasons why we believe the increase in rates will lead to a bear market for US stocks.  Right now, we would have to admit it looks like the journalist was right this past January.  At first, we looked like geniuses as the US stock market dropped sharply in January. However, we still think we will win the prediction contest with the journalist (but maybe a little later this year or early next year).  The reason we haven’t been accurate is because there were no interest rate increases since we essentially made the challenge to whether the US market would rise or fall with the interest rate hike that was expected.  Remember, in December of 2015 Stanley Fischer predicted that there would be at least four interest rate hikes in 2016.  So far, there were frequent predictions by voting members of the Fed that they would be voting for increases.  In fact, at the latest meeting there were 3 dissenters who voted against passing up the increase in rates.  We do believe there will be enough votes to raise rates this December, and that is when we will reverse our losing ways with the journalist.  This past month 3 Fed officials stated that we should hike the rates because they are worried about already keeping the rates far too low for too long.  They were all worried about the risk of financial instability.  We will have to see how it works out, and will let you know as we continue to believe we will win the so called “bet” with the journalist as soon as we start tightening, while every other central bank is driving rates lower or even into negative territory.  As we stated before, we believe all the central banks are guessing at the new made up remedies, that have never been tried before, and will result in “unintended consequences” that could be disastrous.                      

 Our debt (helped by the central banks), as well as Japan and the rest of the world, will eventually drive us into a global deflationary debacle.  We would put the probability of inflating our way out of this mess at about 30 % and continuing to fall into a deflationary global bear market at about 70%.  Please keep in mind the debt is not just our national debt of $20 tn. but the total debt of over $100 tn. if you include the promises made by the government of Social Security, Medicare, Medicaid, and the promises of pensions to Federal employees. 

Our Fed and other Central Bankers have been propping up financial markets all over the world.  But now that there are record outflows of equity mutual funds, all bond funds, and other actively managed funds, there will be nobody (including the Central Banks) remaining to buy the financial assets as the money is going into ETF’s, savings accounts, and under their mattresses. There is no one left to buy as the selling increases and there are record low amounts of insider buying and corporate borrowing to buy shares to increase earnings per share by lowering the number of shares outstanding.  This could turn out to be a bear market worse than 2000-2001 and 2007-2008.     

37 Years Later Debt Has Made Jimmy Carter Right And Stocks Are Expensive
10/06/16 9:00 AM

Back in 1979 President Jimmy Carter addressed the nation and told his fellow citizens the country suffered from a “crisis of confidence” in what became famously known as the “malaise speech”.    Back then the country was suffering from “Stagflation” or inflation with sluggish growth.  The former president was on to more than he knew because now, thirty seven years later, the nation suffers from a great “malaise” by virtue of the fact that we are in the weakest recovery ever following the Global Financial Crisis of 2008-2009.  While the nation is not suffering from high inflation (tell that to someone cashing a weekly paycheck trying to make ends meet) as measured by the government, the fact is that GDP continues to suffer from a “malaise” as it grows in the sub 2% area.

We have addressed this many times and just to update new readers, we believe that the slow growth has everything to do with the excessive levels of government, corporate, household, and student loan debt.  The Federal Reserve, for its part, has mainly addressed this problem by increasing its balance sheet (buying U.S. government and agency debt) and lowering interest rates (such that the price of money is determined by fiat, rather than true price discovery in the marketplace).  While these activities were intended to stimulate growth, what they really have done is inflate financial assets to levels, that both on an historical basis and relative to future growth prospects, are among the most inflated in history.  For their part, the central banks of Europe and Japan have “upped the ante” and gone to negative interest rates, and are buying government debt, corporate debt (Europe) and also equities (Japan).  They too suffer from the “malaise” of slow growth and are having little to no success in stimulating their respective economies.  The one area where these policies have been successful is in stimulating the savings rate, which has the exact opposite effect that they intend!  This slows economic activity even more.

So given the slow growth and low growth prospects, how has profit growth faired and where are U.S. equities priced?  As always, we will be referring to GAAP Earnings, as they are by far the better metric for corporate profitability versus Operating Earnings, which exclude extraordinary items (share repurchases, for example).    According to the latest data from Standard and Poors, with 97% of companies having reported for the 2nd quarter,  the S&P 500 will just eek out a 2% gain in GAAP Earnings on a quarter versus quarter basis versus a year ago.  This is following six straight quarters of sequential declines, with two being defined as an earnings recession.  If we give securities analysts the benefit of the doubt on third quarter projections, 12 month trailing GAAP Earnings will be $90.65 and given a 2,168.27 close at quarter end, the trailing P/E will be 23.9.  If you, the reader, do not see this as expensive, ask yourself the following question: If you owned a mom and pop business that made $100,000 per year after taxes, that was growing at 2% or less, that could even have negative growth, and if someone offered you $2,390,000 for it, would you sell it? (That is a 23.9 multiple.)  We think you should (and go do something else…like start another business)!  To not do so means that either you are much more optimistic about the growth prospects or that you believe a “greater fool” will offer you even more later.  But, understand that the passive act of not selling puts you in the position of possible greatest fool when the bottom falls out. (If you are a regular reader of ours you likely believe that will happen.)

For historical perspective let’s compare to the two previous bubbles of the modern era, the Dot Com and Housing bubbles.  The Dot Com Bubble topped on 3/24/2000 with the S&P 500 closing at 1,527.  A few days later the quarter ended with the trailing P/E at 27.8.  Keep in mind that tech stocks were on fire (thus the name Dot Com) and the insanity had grown so great that clicks were actually considered a valuation metric.  Needless to say, the bubble burst and when the market bottomed at 777 in October of 2002, it had fallen 49%.  While true that 27.8 is higher than the current 23.9 trailing P/E, they are both in the stratosphere and to justify valuation on the basis of an even higher degree of insanity is just flat out wrong.

In the Housing Bubble, the top of the market was actually about a year before the bottom fell out.  The closing high of 1,565.15 took place on 10/9/07.  When quarter end came the trailing P/E was 17.8 and earnings were $69.93.  As the third quarter of 2008 ended, and just before the bottom fell out,  earnings had fallen to $45.95 and the trailing P/E stood at 25.4 (not far from where we are now).  When the decline ended at 666 on 3/9/2009, the market had fallen 57% from its high in October of 2007.

The point we are making, and as our readers know, we are of the strong belief that for the many reasons we’ve espoused over the years, a bear market of giant magnitude is close at hand.  The possible (if earnings come in as projected) 23.9 trailing P/E is very, very, rich historically.  At the top of other bubbles and with similar rich valuations, the subsequent downside was extremely large.  When the bear market begins in earnest and what the catalyst will be is basically a black swan that at this time, no matter what anyone tells you, is a guess.  However, given the “Central Bank Bubble” that we are in, as we’ve discussed in these last many months and given the fact that investors all over the world have been forced to chase yield and prices all the way to the insanity of negative territory, it cannot end well.   The last many years of zero interest and negative rates have pushed savers into being investors, and investors into being speculators.  They are all on the same side of the life boat.  And when the seas get rough, as we believe they will, it will be their position in the boat that further exacerbates and accelerates the tipping!


Central Bankers Have Failed to Stimulate Thus Far
But Have Produced Unintended Consequences
9/01/16 3:00 AM

As most of our viewers know, we have not been happy with the world’s central bankers over the past twenty years and have expressed those feelings.  The U.S. Fed is the most important central bank among the major central banks of the world, as the U.S. economy is the most important of all major economies.   But, unlike corporations that are usually managed by people that have spent their lives working in business and industry, the Fed is managed by people that are in many cases from the academic world.  The U.S. economy is now in the hands of those running models based on theories and formulas that they can only “hope” are correct. 

We have stated in the past that the Fed, through the largest expansion of its balance sheet ever, several QEs and an operation twist, is conducting a grand monetary experiment.  Now it is possible that they will accomplish their objectives and the economy will de-lever and grow, and all will be fine…but we don’t think so.  In fact, we give a good outcome a close to zero chance.   We are also of the opinion that we are in “uncharted waters” and are certain nothing like this has ever happened previously.  We speak, of course, of the unprecedented intrusion into price discovery (interest rates) on the part of the Fed and other major central banks. Through this intrusion, stocks, bonds, major currencies, real estate, collectibles, and just about anything you can think of, that has to do with the cost of money, is terribly overpriced.   There are, however, two things we think are underpriced, risk and precious metals.   The aforementioned intrusion into the pricing mechanism of financial markets have pushed investors of all kinds much farther out on the risk curve than is generally perceived.  In addition, the across the board printing of money to expand their balance sheets will,  in our opinion, debase the major currencies versus precious metals over time.

We started discussing our criticisms of the Fed in the late 1990s.  Since then, we have criticized these officials many times with our latest documented criticism being:

We wrote in May of 2013, “The Fed is in a Lose-Lose Situation”.

In January of 2016, “Difference between Past Fed Tightening and Now”.

In February of 2016, “More Fed Criticism—We Are in Good Company”.

In July of 2016, "The Central Bank Bubble Is Worse Than the Dot Com & Housing Bubbles.”

There were many more-- and you can find them by clicking on the latest comments and scroll down the older comments.  When you get to the bottom, just click “next” to find the others.

The central banks of Europe and Japan have gone even farther than our Fed.  On their balance sheets they carry corporate bonds (ECB) and equities (BOJ).  Through ETFs the BOJ is now a top 10% shareholder in 90% of the market capitalization of the Nikkei 225.  To add to the insanity, in Europe, Japan and other non EU countries, interest rates on government bonds are negative, out in some cases past 10 years, and are nominal out to 30 years. There are $12 tn of bonds now trading at negative rates and central banks own $25 tn in stocks and bonds.  Clearly, investments cannot be efficiently made by corporations when the cost of capital is being determined by fiat, rather than the marketplace.  It will take time, but lots of bad investments are being made, and lots of productivity and capital will be lost.

Just when we thought this was about as insane as it could get, we find that Ben Bernanke visited Japan recently and it was reported that the topic of “Helicopter Money” was discussed.  “Helicopter Money” is turbo charged QE.  In QE, central banks create money from thin air to buy financial assets in the marketplace from investors.  Now imagine central banks creating money to fund infrastructure projects, tax cuts, bombs that blow up or “helicopter drops”.  That’s “Helicopter Money”!! 

Even more insane is the fact that the central bankers don’t realize that the most likely outcomes will be those that are “unintended consequences”.  So let’s summarize by stating what we believe the Fed and other central banks have intended.  Simply stated, the central banks have tried to stimulate their respective economies by inflating financial asset prices and lowering interest rates to near zero (ZIRP), and in some cases below zero (NIRP).  That was supposed to cause people that owned financial assets to feel wealthier and spend money, and also to cause businesses to borrow to invest in plant and equipment to help grow the economy. 

That was the intention.  Here is list of just a few unintended consequences we can think of:

  1.  ZIRP and NIRP have punished savers and caused those who choose not to earn zero or less, or to spend, to invest in inflated/riskier financial assets.  Stocks are trading near the most expensive levels in history while bonds in the U.S., Europe, and Japan have traded at the most expensive levels ever.

  2. Those who choose not to invest are not spending enough to stimulate the economy.  Instead, they are saving.

  3. Corporations should be investing in plant and equipment for future growth.  They are doing less of that, and instead, are repurchasing stock (at shareholders expense) hand over fist, along with other mispriced money based financial engineering.  The investments they are making are being made using the same mispriced rates.

  4. The economy continues to grow at the slowest post recession rate ever since coming out of the “Great Recession”.

  5. Inflation (why a central banker would want inflation is in itself insane!) remains below target.

  6. By creating money in record amounts from thin air, the U.S., E.U, Japan, and China are risking a loss in confidence in paper/fiat money.  That could manifest itself in hyper-inflation.

  7. The debt accumulated during the housing bubble and great recession could unwind and we could be at risk of a major deflation.

In closing we would like our viewers to understand that what central banks are doing has not been done before.  To that extent investors, markets, corporations and populations are all in “uncharted water”.   No one knows for sure how this will all play out.   But, we believe that what has been done by central bankers for 7.5 years has not worked.   With or without “Helicopter Money”, we believe a major bear market is coming. If and when that happens this era will be forever known as “The Central Bank Bubble”.



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