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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.

Deflation Finally Broke the Market
Global Deflation
9/03/15 3:00 PM

We ended the last special comment, “DEFLATION”, by explaining the support and resistance levels of the stock market and concluded that the stock market will break below the support level of 2040 on the S&P 500.  We continue our very strong feelings that we still have much more downside risk.  We will also explain why we believe the deflation we have been warning you about for years will spread into a much more globally based deflation than was experienced in the past.  The reason for this is that significant economies around the world are overloaded with debt levels that are similar to the United States. 


The main reason we believe the stock market will decline sharply is because the deflation we discussed with you over the last few years has finally permeated the globe and the only thing missing from the “Cycle of Deflation” (first attachment) is the significant stock market decline.  As the chart shows, we have been stuck in the part of the cycle called “competitive devaluation” for years. Many of our trading partners have been attempting to devalue their currencies in order to compete and export deflation.  China just recently devalued their currency by 4% and Jack Lew stated in a recent interview this morning that China will be accountable to the U.S. for the less transparent manner they used to devalue.  They have been pegging the renminbi (Chinese Yuan) to the dollar for years.


We were absolutely astonished that the stock market didn’t collapse before we started hitting the worst part of the cycle.  The market usually discounts any serious problems before they start.  The commodities collapse was the only “canary in the coal mine” to give a clear indication of what to expect in the future---debt defaulting, or collapsing, as well as plant closings. 


The S&P 500 finally broke and collapsed through the trading range (both the 8 month trading range support as well as the 4 year uptrend line going back to October of 2011).  We believe it will break down sharply and eventually break through the October low of 1820 and continue down to around the 1500 area (30% from the peak), but more likely it will reach the 1070 area (50% from the peak). 


Another reason we believe the 1820 support level won’t hold up is due to the fact that when the S&P 500 broke on Monday, August 24th (during the 1,000 + point decline) the futures on the S&P 500 declined to 1830 while the cash market only retreated to 1867.  After these major market crashes with both the cash and futures, we suspected strongly the market would rise enough to pull investors back into the stock market, believing the crash was caused by the robot traders (high frequency traders).  The market has already lured many of the investors back in, but we suspect the market will not rise up to the prior support area of 2040.  Stocks (DJIA, and S&P 500) are now on the way to the worst quarter since the third quarter of 2011. 


The next thing we want to explore is the premise that this deflation will not be restricted to the USA.  As you recall from last month’s report, deflation starts with excess debt and over-investment leading to excess capacity and weakness in pricing power.  This combination leads to deflation.  The key to the cycle is the excess debt. Deflation is the consequence of eventually deleveraging the debt.  The last report showed just how over leveraged the U.S. is by viewing the chart (second attachment) showing the debt relative to GDP was 260% at the beginning of the “Great Depression” before the deleveraging and eventually grew to 367% of debt to GDP in 2008.  Subsequently this debt was deleveraged down to 335% of GDP, but is still way too high to prevent deflation. In fact, the Fed instituted Quantitative Easing (QE) three times, one “Operation Twist” (buy LT government bonds and sell ST government bonds), as well as increasing their balance sheet over $4.5 tn to $18.5 tn over the last 4 years. 


This excess debt has to be either defaulted on or paid off, and is almost always accompanied by the Federal Reserve and other central banks doing whatever they can to reverse the deflation.  This is usually done by lowering interest rates, increasing the money supply, or buying bonds and stocks to flood the system with “liquidity” (money).  Many times this is easier said than done since in order to grow the money supply that’s needed, you to have to make sure there is strong circulation of the money (3rd chart -- velocity of money).  If the population is afraid of spending the money, but would rather save it or even put in under their mattress it is impossible to reverse the deleveraging of the debt.  Right now the central bankers around the world are getting very frustrated by the fact that whatever means used, they can’t seem to control the deflationary forces. 


Japan’s economy entered their deflation in 1989 with their stock market close to 40,000 (NIKKEI 225--4th chart).  They did whatever they could to reverse the deflation but to this day they are still suffering from its impact.  They resorted to QE from 2001 to 2006, where they bought both bonds and stocks attempting to reverse the deflation.  They stopped as soon as there was a touch of inflation and subsequently went right back into deflation as their stock market fluctuated between 7,000 and 20,000.  Just imagine how difficult it has been for Japan to extricate themselves from deflation for the past 26 years while trying everything under the sun.  Keep in mind that there market peaked in 1989 at more than double where it is trading presently.  The ECB and Peoples Bank of China are just starting to experience this frustration presently.  The Euro Zone just lowered their forecast of economic growth and inflation even with the promises from the head of the ECB, Mario Draghi, that he would do “whatever he has to do” in order to save the Euro and Euro Zone.    


The last few attachments (by our best source of data-- Ned Davis Research) shows that the world’s public and private debt is similar to the U.S. (some worse and others better) but they are in just as much trouble as the U.S.  This is because we still have much more net worth per capita than our trading partners.  As the U.S. leads the globe with enormous debt relative to GDP we will be followed by the rest of the globe that is also constrained by an abundance of debt. 


We have been warning our viewers since 1999 about the word “deflation”, and the negative stock market action when the deflation occurs.  In fact, we authored the chart, “Cycle of Deflation” (first attachment) which shows the flow of the typical deflation.  The deflation starts with excess debt and over-investment leading to excess capacity and weakness in pricing power.  This leads to the devaluation of the countries’ currency.  When that starts to affect exports the deflationary country typically gets into a “currency war” with its’ trading partners.  This competitive devaluation leads to protectionism and tariffs followed by “beggar-thy-neighbor”, where countries affected by deflation resort to selling goods and services below cost in order to keep their plants open.  As you can see this is a vicious cycle that eventually leads to plant closings and debt defaults until pricing power returns. 

 The full effect of this deflation has not really permeated the USA, but you can see many indicators point to more deflation.  The U.S. has not experienced serious deflation since the “great depression” but we can use the example of the deflation that took place and is still taking place in Japan.  Their deflation started in 1989 and has continued for the past 26 years.  Their currency (the Japanese Yen) started declining as far back as the early 1980’s as their debt accelerated sharply. 

As you can see in the second attachment (Total Credit Market Debt as a % of GDP) the U.S. total debt started accelerating sharply from 155 % of GDP in 1981 to 367% at the peak in 2009, and is still staying at an incredibly high percentage of 334% of GDP.  Keep in mind that the total debt to GDP was 260% just before the “great depression” and troughed at 130% in 1953. As stated previously, the U.S. debt to GDP peaked at 367% and if we were to follow the path of the “great depression” the U.S. debt would decline from $60 tn to about $30 tn after the unwinding of the debt we expect will continue to decline for years following the compounding of total debt for the past 35 years. This kind of excess debt is responsible for the anemic recovery in the economy and stagnate wages over the past 15 years.   

Commodities are clearly the “canary in the coal mine” as far as deflation is concerned.  Remember when we first talked about this in 1999, (Windows Word) never heard of deflation and kept trying to correct us by stating, “do you mean inflation?”  Now, the world is concerned about almost every commodity on earth declining in sync with each other.  Ever since Saudi Arabia announced last fall that they will not decrease oil production to support crude oil prices, the price of crude has plummeted.  The concurrent economic slowdown in China has exacerbated this decline not only for oil but also most other industrial commodities.  Zinc, lead, copper, nickel, aluminum, precious metals and many more commodities are breaking through technical support areas that have held up for years.  Actually the CRB Raw Industrial Spot Index (Chart 3 from our best data resource Ned Davis Research—middle chart) represents these metals as well as many more commodities.  Since we started warning our viewers about the impact of deflation the CRB had some major declines and rebounds as the Fed pumped in a flood of money to try to prevent the inevitable deflation as the debt continues to decline.  This index peaked about 1998 as the dot com bubble was about to burst and declined to the 220 area in 2002 (that also troughed after the 1987 stock market crash).  Then the Fed dropped the Fed Funds Rate to 1% in 2003 and kept it there for a year.  This started the housing bubble which was made worse when sub-prime loans exploded as Alan Greenspan encouraged banks and mortgage companies to make these loans (and put his blessing on the home price frenzy).  The peak of the housing market in 2010 coincided with the next peak in the CRB at 610.  The CRB has declined to 440 presently from 610 and it is our opinion that this decline will continue down below the trough of 310 in 2009 and the 220 trough that occurred in 2002 and 1987. 

Another key to the deflationary scenario we anticipate is the velocity of money (chart 4-the personal income divided by M2) declining substantially from 2000 as the dot com bubble burst to 2003 when the Fed lowered rates to 1%.  It was 180 at the 2000 peak and 159 at the 2003 trough.  It rose to 168 in 2007 at the housing peak before declining to 144 in 2009.  It rose for a year to 147 in 2010 before declining to 127 presently.  The velocity of money is measured by the number of dollars spent to buy goods and services per unit of time.  In other words, it is the measurement of money circulating sharply when it is rising and not circulating as much if it is declining.  We expect it to continue declining as consumers and businesses will not be making transactions as frequently as they have in the past. 

We are very surprised that the stock market has held up so well with this pending deflation overhang, however, it is trading in a range that we believe will break out to the downside.  The trading range for the S&P 500 is 2135 resistance, 2040 is support, and the 200 day moving average is 2072.  The trading range for the DJIA is 18,352 resistance, 17,036 support, and the trading range for the NASDAQ is 5233 resistance, and 4900 support.  The S&P 500 is now is 2083, the DJIA is 17,410, and the NASDAQ is 5056. 



The Fed Continues to Project Weak Growth
Happy Fourth of July
7/02/15 8:30 AM

To say the least, the Fed’s own projections of GDP growth continue anemic at best.  For 2015 the Fed now projects 1.9% growth in GDP followed by 2.55% in 2016 and 2.3% in 2017.  We have stated many times that the recovery since the bursting of the “Housing Bubble” is the most tepid recovery since the great depression and as you can see, the Fed is forecasting more of the same.  We have also stated that the primary reason for this is that debt, i.e., government, corporate, household and student loans, are eating us alive.  At the same time, the Fed is predicting relatively “full employment” with an unemployment rate of 5% starting in 2016.  It turns out that the only way to get to a 5% unemployment rate is to eliminate those people that were not able to find work and have given up from the equation.  Our analogy here is to say the Fed is like the golfer that gives himself every putt over 20 feet and then tells everyone he’s “scratch”.  It is not reality!


From time to time, however, there are bright spots that seemingly appear.  One such spot is automobile and truck sales that were very strong in June.  It turns out that those sales were achieved through a record percentage of leases and/or record length car loans.  Said another way, debt is the reason that auto sales were good.  We therefore do not believe this is a “turn for the better”.


If we are wrong, the Fed will have to raise interest rates sooner and faster than the market expects.  If we are right, the economy will continue to grow at somewhere between anemic or even negative rates.  Either way, stocks by almost any valuation measure are expensive and when that is the case the forward rate of return suffers; it always has throughout history and we expect it will now.  This is why we remain so bearish on U.S. equities! 


We would like to wish all of our viewers a happy and safe 4th of July!


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