Tuesday/Thursday Market Commentary

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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”.


The Two Presidential Candidates Don't Have The Answers
8/05/16 2:00 PM

This comment discusses the assumptions we have been using in our commentaries over the past 20 years or more.  We have been consistently reminding our viewers that the debt built up over the years has a major bearing on the economic health of the U.S. economy, as well as the economic health of other developed countries, who have also built up significant  debt positions.  It should be clear to investors that are as concerned about the debt how these same countries’ GDP slowed down, just like the U.S. We will also discuss why the plans of the two candidates running for the Presidency of the U.S. will not begin to solve the debt problems that are overwhelming us.

It is clear to us that the increase in debt in the U.S. is responsible for the slowdown in the economy that we discussed for many years.  It was made even clearer when the GDP revisions were reduced sharply downwards this past week.  In fact, the GDP results have been significantly lower in all of the developed countries than virtually all the U.S. economists have been predicting for the past eight years (ever since the “Great Recession”). 

We are glad to have recently seen another individual who is also of the same opinion on the worldwide debt as we are.   His name is Atif Mian and he was interviewed by one of the financial networks recently about this situation.  He is a Princeton University professor and he wrote a book, entitled “Household Debt & Business Cycles Worldwide”.  He showed that whenever Household Debt (H/H Debt) rose sharply, it would be followed by a consumption boom.  But debt financed booms of any kind are not permanent as at some point the debt has to be paid back. This boom would be followed by a reversal in the trade deficit, as imports collapse.  Countries with an H/H Debt cycle more correlated with the global debt buildup would be followed for years with a sharper decline in GDP growth. 

Over the past 11 years we have consistently pointed out that the level of H/H Debt caused the “Great Recession” in the U.S.  We believe the same consequences were also prevalent in virtually every advanced economy that built up their H/H Debt before the “Great Depression”.  It is the result of the fluctuations of aggregate demand as monies are borrowed and spent. But, once that spending dries up, something else is needed to substitute for the missing aggregate demand.  When borrowers can’t or won’t borrow any more the economy slows.  

This is a key cause of the economies’ sub-standard growth since the “Great Recession” of 2008 and 2009.  Since then, the Fed tried to increase demand through monetary policy (with QE 1, 2, and 3 as well as building up their balance sheet from $500 bn to over $4.5 tn.).  The US ZIRP and the European and Japanese NIRP, that were intended to solve everything by stimulating financial assets directly and then have a spillover effect to spending and growth, have only successfully stimulated the former.  People are saving what they can, but growth remains anemic.  While debt remains at near record levels, bond yields are near all-time low levels and stock prices are near all-time highs.  Valuations are also not far from all-time highs.  In the meantime corporations are buying back stock, hand over fist, and in many cases borrowing the money to do it at the expense of long term capital investment.  This is not the formula for a vibrant economy and financial markets.

Countries that have been able to weaken their currencies have been able to handle these shocks more effectively than those that haven’t weakened their respective currencies.  But as we have stated many times in referring to the “Cycle of Deflation” (see attachment), devaluations and competitive devaluations (as countries attempt to export their deflation to other countries) are followed by protectionism and tariffs.  It appears to us that is exactly the mantra of candidates Trump and Clinton.  The Fed and financial press have many times used the term “escape velocity”, referring to an acceleration of growth that would allow the Fed to normalize rates.  So far, unfortunately, “escape velocity” is nowhere to be found.  We believe it will be very difficult to extricate our country from this unprecedented situation.

From our point of view, neither Trump nor Clinton have articulated policies that will solve our debt problems.  Though Trump has payed lip service to the size of the $19 tn public debt the protectionist policies he espouses, we believe, will only slow the economy further and thus decrease tax revenue while at the same time adding to the debt and deficit.  For her part, Clinton has not made any mention of the debt as that would be critical of the third Obama term for which she appears to be running. When viewed from the standpoint of Total Credit Market Debt and GDP growth (see attachment courtesy of Ned Davis Research) it is crystal clear to us that as debt has grown at higher rates than GDP, the economy continues to slow further.  Please note that the Total Credit Market Debt to GDP Ratio, while off its all- time high, is still in the stratosphere.  We believe Trump’s stated tax and trade policies should drive debt up by a staggering number.  Clinton’s giveaways to the middle class (such as free college tuition) and the continuation of the Obama regulatory morass should also make our debt problem even worse.  And keep in mind we have not even addressed unfunded liabilities (Social Security, Medicare, etc.) which are estimated to be between $80 - $200 tn.

In summary, we once again state that we are in the “Central Bank Bubble”.  The Fed got things rolling with ZIRP and the Europeans and Japanese upped the ante with NIRP.  The Chinese, it should be mentioned, do have “normal” interest rates.  That’s the only thing that’s normal for their economy and stock market that are not remotely free.  They too are ultra-extended and sitting on a Mount Everest of debt.  The politicians do not appear to have the answers currently, so in closing we say, “Buyer Beware”!

The Central Bank Bubble Is Worse Than The Dot.Com & Housing Bubbles
"Unintended Consequences"
7/07/16 5:05 PM

We warned our viewers, over and over again, how the Dot.Com Bubble and Housing Bubble would play out.  We are now warning our viewers that the unwinding of the “Central Bank Bubble” will be worse than either of the other two bubbles.  It seems like most investors continue to show apathy even with the warnings by us and quite a few others of the “unintended consequences” of the central banks doing things that have never been done before.  Those investors are in good company because it appears to us that the leaders of the major central banks of the world do not have any idea of the “unintended consequences” either.

Think for a moment about exactly what changes the Federal Reserve took in continuing to keep the Federal Funds rate at zero or close to zero for approximately the past 8 years.  This is called ZIRP (Zero Interest Rate Policy) and the Fed, or any of the central banks that followed the Fed’s lead, had any idea of the “unintended consequences” of this policy.  However, if you think they took a chance with ZIRP, just think about the chances our Fed took while building their balance sheet up from $800 bn. in 2008 to over $4.5 tn presently.  They did this by using three Quantitative Easing (QE) programs and one “operation twist” program.  These programs were designed to increase the Fed’s balance sheet by buying U.S. mortgage bonds and U.S. Treasury notes and bonds. The other major central banks followed the Fed’s lead and grew their balance sheets in similar fashion to the Fed.

Our central bank (The Federal Reserve) is now attempting to unwind these extremely risky policies, while the rest of the world is attempting to copy the same risky policies that wound up painting the Fed into a corner.  We believe the unwinding will be extremely negative for the U.S. stock market. 

The “unintended consequences” of which we speak have recently taken place for the Bank of Japan (BOJ) and the European Central Bank. They each discovered this when they implemented negative interest rate policy (NIRP).  It is hard to believe that these powerful central banks experimented with things never tried before and will probably wind up burying the economies and countries that they are supposed to be helping.  Now we have long spoke of currency wars as part of the “Cycle of Deflation”.  The countries that have gone to negative interest rates, in an attempt to weaken their currencies and stimulate their economies have seen their currencies strengthen, their economies hardly budge and stock markets fall…exactly the opposite of the intended effect! 

We believe the Fed’s unwinding (as they continue to try to do things that have never been tried before) will again lead to the “unintended consequences” of a significant bear market and global recession.  They already found out what happens when they stopped each of the QE’s and “operation twist” as the stock market declined sharply.  This time they believe they can stop QE 3 and at the same time raise the Fed Funds rate.  Again, this has never been tried before and will probably lead to a major bear market once interest rates are normalized.  As we have stated time and time again, the only things that U.S. QE’s have stimulated have been financial assets, real estate and certain collectibles.  Stock prices have been driven to near all time highs on both and absolute and relative valuation basis while U.S. debt has yields that have been driven to all time lows.

The S&P 500 made its peak level in May of 2015 at 2134 and has subsequently had major declines while the peak has not been penetrated in 10 unsuccessful attempts to exceed it.  This has brought us to having to drive through all of the technical resistance brought about from these 10 attempts to break through the 2134 peak.  On the downside, we think the “unintended consequences” of this combination of stopping QE and raising rates will drive the S&P 500 substantially lower than the 1810 trough that took place earlier this year.  In fact, we wouldn’t be surprised to see the market drop at least to the 50% level of the Dot.Com decline in 2000 which would take it to 1067, or the Housing Bubble breaking down by 58% in 2008-2009, which would take the market down to 896.  We hope we are wrong, but we believe this is where the market could reach as the result of the aforementioned central bank policies.

The central bankers just can’t seem to understand that the problems of the global economy and stock markets came about from the central bank (especially the Fed’s) mistakes and interference while they just guess at solutions.  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 causing the Housing Bubble.  They continued to shut their eyes to the obvious sub-prime housing loans that were being sold as if they were valuable.  Back then the sub-prime market was only $1.3 tn while now we have negative interest rate sovereign debt of close to $12 tn and all time low yield U.S. debt to the tune of $19 tn.  The global debt has increased by about $60 tn since 2007 and there is no way to have a smooth and quick recovery after the debt has grown so quickly (see attachment). 

In summary, remember that the root cause of the many worldwide economic problems, especially the slow growth everywhere, is the overwhelming debt incurred by almost every country.  As long as the major central banks continue to ignore the persistent debt build-up (even encourage it) we certainly do not see how we can avoid a recession and bear market.  The major central banks of the world are now implementing never tried before experimental policies that have distorted financial markets to a point that is nearly unrecognizable.

Operating Versus GAAP Earnings
This Time is Not Different
6/02/16 8:15 AM

As we write this month’s comment the S&P 500 stands at 2,099, 1.33% away from its all-time high of 2,134. So we thought this would be a good time to discuss whether stocks are cheap or expensive relative to historical norms. When investors consider this question they most frequently analyze stock prices relative to past and future earnings. We have the privilege of having written articles on this subject that were published by Barron’s magazine. The articles are titled “What’s the Real P/E Ratio” and “A Simple Calculation” (see attachments).  In the articles we describe the various and often confusing ways that Price/Earnings (P/E) ratios are calculated, and which are used primarily by bulls, and which are used primarily by bears. If you are not familiar with this topic or need a refresher we urge you to open the attachments and read these articles. We continue to subscribe to all that we stated which can be summarized most succinctly as our belief that it is most correct to use GAAP (Generally Accepted Accounting Principles) earnings on a trailing twelve month (TTM) basis when calculating the P/E.


We explain in the attached article that “operating earnings” exclude write offs, while “GAAP reported earnings” include write offs.  That is the main difference, but the difference that is getting much more important as more and more companies resort to using “operating earnings” in order to increase their earnings while bringing down the P/E ratio.  As recently as the early 1990’s GAAP earnings were used exclusively when we started the entrance into the greatest financial mania of all time.  There were so many write offs by companies making unwise investments and then reversing them, that “operating earnings”, grew much faster than the companies using GAAP earnings.  The write offs that had been unusual (using write offs as temporary) became common for more and more companies.


So here is some information based on data from S&P’s website that we believe to be particularly pertinent. With about 97% of the S&P 500 companies having reported first quarter earnings it appears to us that the GAAP number will be $22.43, give or take a little. When added to the previous three quarters we get $87.15 a share in earnings. We should add that Operating Earnings (Non GAAP) look to us to be $99.48, about 14% higher. That differential is slightly higher than when the market peaked in Q3 2007 and also higher than when the market peaked in Q1 2000. Recall that the main difference between Operating and GAAP earnings are that inclusion of extra-ordinary, non-recurring items in GAAP Earnings. Thus to the extent that extra-ordinary items exist, Operating Earnings will always be higher than GAAP Earnings. We also suspect that a good part of this differential (Operating vs. GAAP) is due to the large volume of stock buybacks (many financed by debt and at excessive valuations) that we believe have been a major support for the market. When restricted stock and options that were granted to corporate executives become vested, the “in the money” amount comes directly out of shareholders equity.   GAAP Earnings capture this while Operating Earnings do not.


So given the above numbers of $87.15 in TTM GAAP Earnings versus a 2,099 close the S&P 500 is selling at a 24 multiple. To put that in perspective, if you had a business that you worked hard to build that made $100,000 after taxes and someone walked in off the street and offered you $2.4 million for it you might be inclined to respond “sold to you”! That decision, of course, might be more complicated and largely be a function of expected growth rate, but as we see the numbers, 24 is a historically very high multiple for the stock market in general.


So again from numbers we obtained from S&P here are a few data points that we believe are enlightening. At the end of 1988 the index was 278, the P/E was 11.69. The index “took off” from 306 at Q3 1990 and the P/E was 14.08. Those type of P/E’s might be the kind one would therefore view as on the cheap side, where the market has large potential. On the other side of the coin, for the several quarters preceding the bursting of the “Dot Com Bubble” in 2000 the P/E was in the high 20’s to middle 30’s, the highest that we can document at a top. When the “Housing Bubble” burst, the market dropped from 1527 at end of Q3 2007 and the P/E was 22.19. It had dropped all the way to 1166 (-24%) at end of Q3 2008 and the P/E was 25.38… and THEN the bottom fell out. The point here is that we are in the ballpark of all time rich valuations and while it’s impossible to predict the day a bear market begins, history tells us it is more likely that there is much more downside risk than upside potential. In our opinion, when this period in stock market history is in the record books it will prove to have been a major selling opportunity.


History has many examples of “this time is different“ and we suppose that a big part of the “different” this time is that the economy is finally ready to take off after a “great job” by the Fed in navigating the economy out of a crisis (that began almost 8 years ago!) In other words we finally are about to grow our way out of the low growth/high valuation mess that we’re in. We fully understand what the bulls are saying or more accurately, hoping. We and others call this “The Central Bank Bubble”.  The Fed did its part by stepping on the gas to get us out of the recession caused by the bursting of “The Housing Bubble” (which they and the government were complicit in causing in the first place.)  By keeping its foot on the gas for almost 8 years all it did was inflate financial assets and increase wealth disparity.   We continue to believe that “this time is NOT different” and that in due course “The Central Bank Bubble” will burst.


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