The Debt, ZIRP, and Valuation
As we write the US stock market, as measured by the S&P 500 and Nasdaq Composite Index, hovers at or near new highs. We will take this as an opportunity to reiterate that this is a bubble that is the direct creation of the Federal Reserve. We continue to refer to this phenomenon as the “Central Bank Bubble”.
Just under one year ago, analysts were estimating S&P 500 operating earnings to increase for the first quarter of 2015 by over 10%. That number is now substantially lower and has gone negative for the entire index. According to “FactSet Earnings Insight”, both Q1 and Q2 2015 earnings are now expected to be lower. Through May 1, the blended result of companies that have reported and have yet to report for Q1 2015 stood at -.4%. Analysts are in fact expecting year over year declines through Q3 2015 but are then expecting a strong rebound in Q4 2015. We agree with the former and strongly disagree with the latter. But whether attributed to weather, the west coast port strike, or dollar strength, the fact remains that for whatever the reason, two declining quarters constitutes an “earnings recession”. We have had 13 “earnings recessions” since 1945, and all but three of those have led to an economic recession. We continue to believe corporate earnings will not grow as a whole at a meaningfully different rate than US Gross Domestic Product (GDP), as corporate earnings are a proxy for economic growth. Growth in the economy, in turn, is heavily influenced by “Total Credit Market Debt”, which is the sum of government, corporate and household debt.
Only at the time of the great depression of the 1930’s has “Total Credit Market Debt” been greater than 200% of GDP in the United States (see attached chart from Ned Davis Research)). That is, of course, until the middle 1980’s when this metric again penetrated that barrier. After that time it went on an inexorable march to a whopping 367% of GDP just prior to the bursting of the “Housing Bubble” and stood at just under 332% as of the end of 2014. The level of debt continues to be a headwind to economic growth that will persist until the debt is paid down.
What has acted to somewhat mask this headwind is, what we believe, is the most reckless policy ever adopted by the Fed. The Fed was wrong on the “Dot Com Bubble”; was wrong on the “Housing Bubble”; and we believe will be wrong in the creation of the current “Central Bank Bubble”. This Fed is in a major experimentation mode which is very dangerous. The policy of which we speak is, of course, Zero Interest Rate policy, or (ZIRP). This policy has driven the Fed’s Balance Sheet from $800 billion in 2008 to $4.4 trillion currently.
It is because of ZIRP that stocks do not appear, to some, to be expensive. After all, if the alternative is a 2% ten year treasury or 2.6% thirty year treasury, maybe a 2% dividend yield isn’t so bad; or so the thinking goes. But as stated above, the growth in corporate profits in the long run is a proxy for the growth in the economy, or GDP. And right now stocks, measured by market capitalization, are near the highest they have ever been relative to GDP. Every major market bottom and top has been coincident with very low or very high ratios of “Stock Market Capitalization to GDP”(see attached chart from Ned Davis Research). It is likely the reason is that this metric has purported to be a favorite of Warren Buffet. In fact, the only time this metric has been higher was just before the” Dot Com Bubble” burst. It comes at a time when deflation is playing out all over the world. The dollar is strengthening, which hinders multinational companies from exporting goods abroad. In addition, it appears that companies do not have enough pricing power to increase margins.
We at Comstock have been telling our viewers that we have been in a deflationary environment for years. It seems the markets now are agreeing with us as there are currently few countries that are expecting any material inflation over the next ten years. This is evident by the yields in ten year sovereign paper. The following are yields as of the date of this writing: United States 2.19%; United Kingdom 1.97%; Italy 1.81%; Spain 1.78%; France .82%; Japan .36%, and Germany .52%.
What all of these countries have in common, in addition to being democracies, is that their respective central banks are in a “Liquidity Trap” situation, where low and even negative interest rates do not encourage consumer spending but rather consumer savings. Businesses in turn do not have the confidence to invest in new plant and equipment. This is particularly true in the United States, where the average age of private fixed assets is the oldest in the past fifty years.
So, to our viewers we say, we have been early on this, as we were with the Dot Com and Housing Bubbles, but we are confident this will end the same way as those bubbles. The US stock market is historically expensive and financial assets have been inflated by an experimental central bank policy. It is an error that is now being repeated by central banks in Europe, Japan and just recently, China. These markets are being influenced in similar ways as ours, rather than fiscal and tax policies that would stimulate sustainable growth. We will hold our view that stocks are expensive until they become priced more reasonably relative to the growth prospects of the economy. We have maintained consistently that high levels of debt are the main problem affecting growth and those debt levels will not be going away any time soon.
Central Bank Bubble is Similar to the Dot Com and Housing Bubbles
The Debt Built Up Over the Past 34 Years Still Haunts Us
3/04/15 3:00 PM
criticized during the late 1990s as we continued to warn our loyal readers that
the dot com bubble would eventually burst and would be written about for years
to come. In fact, we stated that Harvard
would have case studies about the fundamentals of how many eyeballs were
looking at the internet stocks rather than P/E ratios or even EBITDA
ratios. We were charging a substantial
amount of money from our viewers throughout the 1980s and 1990s until we got so
frustrated by saying the same thing over and over, we decided to stop charging
for our research reports in 1999.
report entitled “Analyze This” in the mid-1990s was the last report we charged
for and you will be able to understand our frustration by quoting the first
paragraph of it now. “When stock market
history is written the current period will be looked upon as a textbook example
of the conditions that exist at a major market top, and future investors will
wonder how so many did not see it at the time.
This should not be surprising since one of the hallmarks of a market top
is that the majority are not aware of it, since a market top coincides with the
point of maximum optimism, just as a bottom occurs at the point of maximum
pessimism.” We went on to describe just
how outrageous the valuations were at the time as we pointed out the extremes
of earnings, cash flow, sales, book value and dividends.
of time during the housing bubble in 2005, 2006, and 2007 was just about as
frustrating to us as the dot com bubble.
In fact if you scroll down at the end of any of our comments you will
find a box showing “archives”. If you
click on it and type in “housing”, you will see that in each and every report
we warned about the housing bubble. And
now the “Central Bank Bubble” is becoming just as frustrating to us as the
other two bubbles.
tried to point out to our current viewers that the Federal Reserve has not
raised interest rates for the past 9 years.
Instead, they lowered Fed Funds rates to zero, and increased their
balance sheet from $800 bn. to $4.5 tn. mostly thru 3 QE programs and one “Operation
Twist” where they bought long term securities while they sold short
maturities. The result of all of this
was raising financial assets to almost record levels. The stock market has tripled over the past 6
years while art, houses, and collectibles rose substantially during the same
the Fed is just about ready to reverse all of the extremely loose monetary
policies they used to push these assets up to hopefully create a wealth effect
for the consumers (especially the wealthy consumers). Now that the Fed will be taking the punch
bowl away while many of our trading partners are filling up their punch bowls,
what do you think will happen to the assets that were driven up by the reverse
of the present Fed monetary policy?
Now that the
U.S. is in the process of reversing the loose monetary conditions, many of our
trading partners are copying similar U.S. QE procedures as well as lower
interest rate strategies. This will
drive their currencies down while the U.S. dollar will continue climbing. These “Currency Wars” will help the stock
markets and economies of our trading partners.
While this should drive up the stock markets of our trading partners,
the U.S. stock market could reverse.
Japan and Europe are in the midst of QE programs, while China and India
both just lowered rates twice over the past two months. Although the Fed is acting like they have
bailed us out of the “great recession” we still have plenty to worry about in
our opinion. Our stock market could
easily reverse the current break out to new highs and begin trending lower
since we still have not solved the enormous debt problem built up over the past
34 years, when the total credit market debt vs. GDP grew from 155% to 367% in
2007, but has only declined to 330% presently!
A Race to the Bottom
2/05/15 1:30 PM
As our viewers know, we have been sounding the alarm about the
deflationary process that is playing out in the world’s equity, bond and
currency markets for quite some time. Because of the activity by central banks in
major and more recently in developing countries we have described what is going
on as “The Central Bank Bubble”.
It is truly an irony that in their efforts to fight the
forces of a crushing deflationary environment, central
banks have been the direct cause of one of largest inflations of financial
assets in history. This asset inflation
even extends to collectibles such as art.
As we write, equities in several major markets around the world are
trading at or near all-time highs while growth in those economies remains
anemic. In others, such as Japan,
equities are trading near the highs of recent years with the same anemic growth. On the fixed income front, sovereign yields
in the US, Japan, and most countries in the Eurozone are trading at all-time
lows. In the latter case there is an
unprecedented negative yield curve out 3-6 years for the very best credits
(France and Germany). All of this, as
many currencies are falling rapidly relative to the dollar. To paraphrase the character Marcellus from
Hamlet; something is clearly rotten in the state of the currency markets!
We strongly believe that the Currency Wars, (described in
our Cycle of Deflation as “competitive devaluation”) have begun. Many countries have now joined “the race to
the bottom”. Since the beginning of 2015 no fewer than 8
countries have unexpectedly cut interest rates in an effort to stimulate their
economies. In our view, they clearly
took these actions in a desperate attempt to export the deflationary forces
that are plaguing them. For its part,
Switzerland would have no part of defending the value of the Euro versus the
Franc and decided to get “out of the way” and remove the cap that had existed since
2011. The reaction in the Swiss export
dependent equity market was an immediate 15% correction. Imagine for a moment what the Swiss must expect
to happen to the Euro once the ECB starts their “Quantitative Easing” program
of about $1 tn. in March. They had to be
frightened about the Euro declining sharply to be willing to take a valuation
loss of that magnitude to their equity market in one day!
We continue to reiterate that all of this will not be good
for US equities. The decline of oil,
copper, iron ore, the Baltic Dry Index, and many other commodities, is starting
to have a telling impact. In the past
few days Chevron has suspended its $5 Billion (2014) share buyback and cut its
2015 capital spending budget by 13%.
Exxon, for its part, while refusing to give a cap-ex budget, reduced its
share repurchase by 75%. We fully expect
a cascading effect as companies down the chain feel the pinch. Included will be commensurate effects on wages
and employment which we strongly believe are not the improving picture the
government has painted.
Lastly, volatility has ramped higher in response to all of
this. The VIX Index and futures on VIX,
while not on their recent highs, are well off of their lows. More volatility is coming and we expect the
US equity market to begin a large corrective phase shortly as most of our
trading partners will do whatever they can to “win the race to the bottom” with
their currencies. This process will
continue to drive the U.S. dollar up. We
can’t win this race since we have virtually run out of ammunition after the
most outrageous monetary easing ever over the past 7 years.
THIS is WHY the FED is BETWEEN a ROCK and a HARD PLACE
12/31/14 3:00 PM
We write to
reiterate that the United States and other major stock markets are in what we
have termed the “Central Bank Bubble”.
In December, the U.S. stock market staged a furious comeback rally following a rapid and substantial decline. Just
prior to the latest upturn, the market seemed ready and poised for further and
even more substantial declines. The
rally appears to have been precipitated by the Fed substituting the word
“patience” for “considerable time” in their latest policy statement. While we were disappointed that the markets
rallied based on the simple parsing of words, we remain convinced that deflation,
overvaluation, and Fed policy in response have intertwined to cause one of the
largest stock market bubbles in history.
We see nothing
that would cause us to change our opinion.
Let us once again point out the near zero interest rate policy and three
quantitative easings (along with operation twist) that have not only expanded
the Fed balance sheet to unprecedented levels but have thoroughly distorted our
capital markets. With returns to
investors in money market funds at zero, investors have had to chase yield in
both the stock and bond markets. A
glaring example of capital market distortion is at the sovereign level where the
US 10 year Treasury yields 2.16%; while Portugal's 10 year trades at 2.76%, Italy trades at 1.92%, Spain at 1.63%
and Germany at .54%. A further example
of distortion caused by zero rate policy is near record low yields in US
Corporate Bonds combined with record high issuance; now over $2tn. for three
years running. Much of the debt sale proceeds have been used
to fund share repurchases, which in our view has artificially propped up
earnings, while leaving corporate balance sheets more leveraged and revenues
the velocity (turnover of money) of the M2 money supply has remained near the lows of the past 60
years. That statistic serves as proof
that the Fed’s efforts are getting very little “bang for the buck”. We also observe that the several different commodity price indexes declined to their lowest point in the past 5
years and shows no sign of bottoming. And as you all know energy prices have been collapsing, as supply is overwhelming demand--many think that energy prices are holding back the U.S. bull market by hurting other countries abroad. Soon they will realize that the commodity price decline (see attachment) is caused by the global distress--not the other way around. For example, Europe will be attempting to do whatever it takes to prevent more deflation with a vote to start a new QE policy at the January 22nd ECB meeting. Japan is lowering corporate taxes to try to exit 25 years of deflation, and China is trying to prevent a credit bubble crises now that they are no longer the growth engine of the world. And while they are attempting to move from an exporting led economy to a consumer led economy, in the face of a property overhang. There are many more examples of stress in the global economy.
The Fed is about to raise interest rates
sometime in 2015 (for the first time in 6 years), and that could be
trouble for stocks just as it was after the ending QE-1, and QE 2. On the other hand, if they don’t raise rates it
would only be based on failed QE policies that were supposed to revive the
economy. This is the incredible dilemma that the
Fed faces in the coming year.
All of the
aforementioned factors are screaming "deflation". Thus far the market has not
heard the message. But we are convinced
that it will be heard, and when it does, we believe the U.S. stock market will
decline precipitously (see Cycle of Deflation attachment).
With that being said, we still wish all of you a Happy and Prosperous New Year!
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