WE ARE AS BEARISH AS WE HAVE EVER BEEN
And The Central Banks Have Not Even Begun To Shrink Their Balance Sheets
9/06/17 7:25 AM
A reader of
this commentary recently asked us if we were “throwing in the towel? The reader was, of course, referring to our
long running bearish outlook for the U.S. stock market. To quote the great Bob Dylan, “The times they
are a changin”…for the bulls, but not for us!
We remain in the bearish camp as firmly as we have in the past. So below
is a summary of our latest thoughts as to where things stand.
Let’s start with
the root cause of what we believe will be among the most vicious bear markets
in history, when it does occur. The
major central banks of the free world have, since the Great Recession hit with
full force as the Housing Bubble burst in the fall of 2008, expanded their
balance sheets and printed money like no central bank has ever done before. The term for this is Quantitative
Easing. The Fed, European Central Bank
(ECB), Bank of Japan (BOJ), and Bank of England (BOE) have all purchased
trillions of dollars of government debt and related securities. The ECB has also purchased large amounts of
corporate debt, and the BOJ has upped the ante by even purchasing Japanese
equity ETFs. They have yet to reduce
their balance sheets by the equivalent of a single penny, and we believe they
will find it very difficult, it not nearly impossible, to extricate themselves
from the situation without highly negative effects on the markets. If Quantitative Easing was largely
responsible for creating the bubble in financial assets we believe exists, it
stands to reason that when they start doing the reverse the results could be
very negative for the markets.
One of the
major effects of Quantitative Easing is to drive interest rates lower than the
free market would otherwise price them.
In the case of Europe and Japan this has even resulted in negative
interest rates. This is a first in the
history of financial markets. Low and
negative rates mainly punish savers.
This has resulted in overpricing of stocks and bonds as investors from
the developed countries, in particular, have chased returns.
mispriced are the markets? Let’s start
with U.S. equities. As of 8/31/17,
the S&P 500 Reported Earnings were 23.8X Trailing Twelve Months (TTM). This is with the index less than 1% from its
all-time high. By way of contrast, the
Housing Bubble burst in 2008, but the market actually peaked in October of
2007. At the end of September 2007, the
TTM P/E was 19.4X. Admittedly, the TTM P/E
was higher before the DOT Com Bubble burst.
The number was 29.4X and was skewed by the Tech sector. Though quarterly earnings peaked coincident
with the highs, both earnings and prices continued to decline dramatically for
the next two years. Other metrics, like
price to sales, are by far the highest ever for the S&P 500 median company.
government bonds? Here is a recent cross
section of ten year Government rates: United States
2.07%, Italy 2.02%, Spain 1.55%, United Kingdom 1.04%, France .67%, Germany
.36%, and Japan .006%. Ask
yourself. Does this make any sense? Could it exist in any world but a world where
the central banks have run amok, and distorted financial asset relationships
like never before. Clearly, at these
prices, the bond markets are pricing in little, if any, growth. And apparently pricing in little, if any,
default risk. Is Italy a better credit
than the U.S.?
We are not
the first to point out the dichotomy between the pricing of stocks versus
bonds. In the US, 23.8X TTM earnings and
a 2.07% ten year just doesn’t jive.
Stocks are saying growth and bonds are saying no growth. We believe the bond market will be right for
reasons we have stated in the past. The
recent 3% print in Q2 GDP will, we believe, prove to be a blip. The long term population demographics, trends
in numbers of both employed and those out of the workforce, low long term growth
in productivity, and skilled immigration (or lack thereof) will all prove to be
a long term inhibitor to growth.
As far as
President Trump’s ability to get his agenda through congress it is not at all
clear that he will be successful. And even
if he is, in our view, it is already priced in.
There used to be a saying that “politics stops at the waterline”. This referred to the fact that even though we
Americans have our differences, we are still Americans and when a foreign
threat arises, we are united as one and all politics cease. Today that old saying seems to have morphed
into “politics stops at the center of the aisle”. Anyone that thought that acrimony had peaked
at the end of the Obama administration, (naively) thought wrong! Never before have we witnessed such political
division that seems to be mainly for the sake of division. So we’ll see where that all goes, but it
doesn’t appear to be a good development given we are hovering near all-time
highs in the major indexes.
We thank our
readers for their loyalty and attention and assure them that the towel still
rests in the corner. We’ve wiped some
sweat from our brow, but are standing and waiting for the bell and the next
round, when the central banks reverse what they have been doing for the past
few years (8 years for the Fed). And when they reverse, it
could be very detrimental for stocks.
A RECESSION COULD BE COMING
And Asset Bubbles Caused by Central Banks May Burst
7/06/17 11:40 AM
The Wall Street Journal recently published an article by
Greg Ip entitled “Why Soaring Assets and Low Unemployment Mean It’s Time to
Start Worrying”. While Mr. Ip stops
short of predicting a recession or its timing, he details a list of
preconditions for recession, all which exist now. These include a labor market
at full strength, frothy asset prices, tightening by central banks, and a
pervasive sense of calm, as illustrated by the very low levels of the VIX
At the same time, the Fed, led by Janet Yellen, continues
the narrative that they will normalize interest rates while slowly reducing the
Fed balance sheet. This follows what we
believe was an insane monetary experiment beginning with the bursting of the
“Housing Bubble” in 2008 and lasting until the present day. The Fed would have you believe that its
policies, after helping the economy avoid an outright collapse, have helped the
economy grow at a moderate rate with low inflation. In our view, the word moderate is a gross overstatement. We think the better description is “anemic”,
because no recovery since the Great Depression has been as slow as this one,
even though it’s the second longest in the country’s history.
As the situation now stands, the trailing 12 month (TTM) P/E
ratio of the S&P 500 based on GAAP (Generally Accepted Accounting
Principles) earnings stands at just over 24X, which is among the most expensive
in history. A casual observer might
think, therefore, that a TTM P/E of 24X means that the stock market is
expecting growth to accelerate. After
all, there is no shortage of television commentators and portfolio managers
that think we are on the path to an accelerating economy. All one needs to do is tune into any of the
financial news networks to confirm that observation.
We do not agree with that assessment, and to no surprise,
neither does the bond market. One of the
most telling indicators of what the bond market “sees” as prospects for
economic growth is the spread between 10 year and 30 year US Government
Bonds. The steeper the slope of the
yield curve, the more the bond market sees growth, and vice versa. So for the month ending 6/30/17 the 10 year
to 30 year spread closed at 53 basis points.
To find a lower monthly close for that series, one has to go all the way
back to December of 2008, just as the effects of the bursting of the “Housing
Bubble” were hitting with full force. So
while the stock market “sees” prospects for growth as strong, as evidenced by the
24X TTM P/E, the bond market is just the opposite. Not only is the yield curve relatively flat,
but the absolute level of bond yields are also very low. It should be also noted that an inversion in
the yield curve, should that occur, would be a clear alarm bell as it pertains
to the possibility of a recession. In
the past, on the 12 occasions when the yield curve has been this flat,
according to Mr. Ip, it went on to invert on 10 of those occasions.
In our view, the Fed, European Central Bank (ECB) and Bank
of Japan (BOJ) all recognize that the main result of the massive money printing,
and the low to negative interest rates of the last several years have done
little more than increase the value of financial assets rather than generating
solid economic growth. We, and others,
have said as much for quite some time now.
We also believe the central banks are “between a rock and a hard place”.
They realize the need to not burst the
“bubble”, but on the other hand, they do not want to negatively affect the
already anemic economic growth rates of their respective economies. So the Fed continues on the path to
“normalization”, speaking of one more rate increase this year and three each in
2018 and 2019. We agree with the Fed
Funds market, which is calling the Fed’s bluff.
The futures market on Fed Funds is priced for one increase this year and
only one each in the next two.
The Fed is, of course, fully aware of the fact that of the
thirteen tightening cycles since the Great Depression, ten of those were
followed by recession. So the odds are
not good, as we see them. We think the
bond market will prove to be right and the stock market will prove to be
wrong. As we have written in the past,
the economy is swimming against a stream of rising debt, unfunded federal,
state and local liabilities, low productivity growth, and negative labor force
demographics. At the same time, the
booming stock market has been partially fueled both by stock buybacks (that
strip equity from shareholders, as in the money stock options are exercised by
corporate managements) and “yield chasing” by return starved investors around
Whether the Fed tightens aggressively,or not, remains to be
seen. But in our view the damage has
already been done by its policies and those of the other major central
banks. Years of artificially low
interest rates have resulted in mal investment and asset bubbles. When the
market does start down in earnest, our view is that the move will be large and rapid. We believe it will then take considerable time, as in years, for the stock market to get back to highs that were achieved courtesy of "The Central Bank Bubble".
VALUATION WILL MATTER...IT ALWAYS DOES
6/01/17 5:00 PM
As the U.S.
stock market continues to make new all-time highs it may appear to many
investors that valuations no longer matter.
We do not see it that way now, nor have we ever in the past. We maintain our long held belief that the
U.S. stock market is extremely overpriced, relative to past earnings and future
earnings prospects. This overpricing is
the direct result of the largest financial experiment in history, i.e., the
growth in the Fed’s balance sheet from $800bn. to $4.5tn. and the setting of
the overnight Fed Funds rate to near zero from December of 2008 to December of
2015. Today, eighteen months after the
first rate increase in seven years, the daily effective Fed Funds rate
typically comes in at a mere 91 bps. We
have repeatedly referred to this period as the “Central Bank Bubble”, as asset
values have inflated.
its balance sheet and keeping interest rates low, the Fed reasoned asset prices
would be backstopped and stimulated. The
increase in asset prices would create a “wealth effect” as those in our society,
fortunate enough to own these assets, would feel wealthier and spend
money. This, in turn, would result in
economic growth that would benefit society as a whole, including those at the
bottom end of the economic ladder. The
result has not been what the Fed intended, and in fact, has caused some
unintended consequences. The economy has
grown at the most anemic rate ever, around 2% per year, when recovering from any
recession. Wealth disparity in our
society is at an all-time high. At the
same time, by many different valuation metrics, the stock market is near or in excess
of the highest valuations in history. As
of this writing, the trailing 12 month P/E based on generally accepted
accounting principles (GAAP) is approximately 24.2, a historically very high
number when the economy is not in a recession and earnings have already dropped
more than prices.
that in the long run, corporate earnings should grow about as fast as the
economy. The stock market, in our view,
is imputing a higher growth rate to future earnings than we think is likely, or
even possible, for the following reasons:
We believe that the debt outstanding
in the US, which consists of federal, state, local, corporate, household, and
student loans, has been a major factor in the anemic growth of the past several
years. This number currently stands at
$66tn, or about 330% of GDP. The
servicing of this debt diverts resources from otherwise productive uses. In addition, given the artificially low level
of interest rates, the exposure to rising rates is enormous and a major risk that
is not, in our view, universally appreciated.
There is also the non-trivial matter of the unwinding of the Fed’s
balance sheet. Selling bonds in the
market does not appear to be a consideration as that could cause a stampede out
of fixed income markets here and around the world. We would like to point out that the “running
off” of the balance sheet (letting bonds mature) is another “experiment”. In addition, estimates of the size of the
U.S. government’s unfunded liabilities and entitlements range from $80tn. to
$150tn.; and that is not even in the above numbers. (More on this below.)
The ECB, BOJ, and BOE have also adopted
“whatever it takes” policies. They too
have greatly expanded their balance sheets and have even “upped the ante” with
previously unheard of negative interest rate policies. Because of the liquidity of currency spot and
forward markets, much of that money has come into the U.S. to “chase
yield”. This has further inflated and
distorted asset prices in the US. Also,
the world’s second largest economy, China, has inflated a credit bubble with
breathtaking speed that, relative to its banking system, is the largest in the
world. All of this further adds fuel to
the worldwide credit bubble fire.
The growth rate in GDP is a function of
the change in total hours worked and the output per hour. With the economy at, or near, full employment
there is not much room for growth in the total hours worked. In addition, we are now at the point that the
“baby boomers” are retiring at the rate of about 10,000 people per day, while
new workers entering the work force number much less than that. Immigration of skilled workers could
potentially help the problem, but thus far we see no rush on the part of the
Trump administration to address this meaningfully.
On the productivity side, the alarm
was recently sounded by former Fed Chairman Greenspan. He contends that the growth in entitlements
has crowded out savings, which in turn, means less capital flowing into
productive assets. He calls entitlement
reform the third rail of US politics as our leaders are afraid to confront the
problem head on, for fear of being voted out.
We completely agree.
Thus, given the level of debt and commensurate interest rate
exposure, along with negative population demographics, and the lack of
addressing entitlement reform as it relates to long term productivity growth,
it is our strong belief that the US economy will not grow at rates that will
vindicate current equity market valuations.
We remain committed to the thesis that the experimental Fed policies of
the past years have inflated and distorted equity and other asset prices
tremendously (while generating “unintended consequences”).
In our view, this time is NOT different. Ultimately the stock market will reflect an
economic reality much different than it does currently. When that happens, as in past times when bull
markets ended, stocks will likely fall much faster than they went up.
HOW DOES GROSS DOMESTIC PRODUCT GROW?
Population Demographics Will Work Against President Trump's Plan
5/01/17 9:00 AM
variable in the determination of GDP (Gross Domestic Product) is the growth of
the labor force. What a nation produces
can be thought of, in simple terms, as the number of hours worked multiplied by
the output per hour (productivity). It
is a documented fact that the growth rate of the U.S. labor force is declining
and is expected, by the U.S. Bureau of Labor Statistics, to only increase by
.5% per year over the coming decade.
This is slower than it has grown in past decades and is due to a combination
of many demographic factors, including the relative aging of the population.
Trump and members of his cabinet have stated that once his agenda items are
signed into law, the country will be on its way to 3%-4% growth. As our viewers know, we have written many
times on the anemic sub 2% economic growth of the Obama years. President Trump intends to reverse the trend
of lower growth by 1), Repealing and replacing the ACA (Affordable Care Act),
which has thus far been rejected. 2)
Shrinking regulations, including Dodd Frank. 3) Lower taxes for individuals and
corporations, both large and small. 4) Repatriation of $2 tn. to $ 3tn of
corporate cash residing abroad. 5) Implementing a national infrastructure
rebuilding plan that will replace many roads, bridges, airports and other major
items in desperate need of repair.
President Trump left out of these 5 “agenda” items is the fact that the only
way to double the growth in GDP is to increase population enough that more
people enter the labor force. The
increase in the labor force should also coincide with an increase in
productivity. Anything that President Trump does that inhibits growth of the
part of the population that could become part of the labor force (such as
curbing legal immigration) will have a negative effect on the increase in
growth that he seeks to achieve.
understand that President Trump is expressing his position of doubling the
growth rate of GDP with U.S. population demographics as a major road
block. Due to the aging of the “baby boomers”,
10,000 potential labor force participants are retiring every day. According to the Bureau of the Census, about
5,800 people are added to the U.S. population daily. That is the net difference between births,
deaths, and immigration. This is hardly
the situation that took place in the mid 70’s, 80’s and 90’s when “baby
boomers” entered the workforce in great numbers and the economy grew rapidly as
a result. Thus, Presidents Reagan, GWH
Bush, and Clinton had relatively great economies in their presidential years,
from a growth standpoint.
Trump needs to understand that the population demographics are working against
him, as never before, with fewer and fewer people entering the workforce. Policies that he and his cabinet espouse need
to reflect the fact that our economy needs more, not less, workers. Those workers should be as highly skilled as
possible, so that the productivity side of the equation is also a tailwind.
Debt Can be Looked Upon in Various Ways
What is the Real Total Debt in the U.S.A.?
4/07/17 10:00 AM
been discussing the debt situation in our country for years. We wrote a “special report” discussing the
various forms of debt and explained how the debt is incorporated in “The Cycle
of Deflation” (see attachment) as the debt was hindering many speculators and
investors just before the dot.com bubble was about ready to collapse. We warned that the debt was the main reason
that the valuations were the highest in history and would eventually break the
market. This was exactly what took place
starting in March of 2000 when the stock market crashed and a severe recession
warned our viewers about the problems of excessive debt during the housing
bubble of 2005 to 2008 when Alan Greenspan, the Chairman of the Federal Reserve
at the time, decided to lower interest rates to 1% in June of 2003. This caused the largest housing mania of all
time. Banks were virtually pushing money
to anyone that wanted a loan to buy a house (whether they could afford it or
not.) Back then--they called these loans
“no doc loans”. These were loans that
were made without any documentation whatsoever.
part of this era was that Greenspan warned stock investors about the
“irrational exuberance” that was taking place in the late 1990s as the stock
market rose almost every day. The “irrational exuberance” speech drove the
market down, but that only scared off investors for just a few days and the
stock investors regained the losses almost immediately. After observing the voracity of the market
that could not be held down, Greenspan changed his mind and confessed to being
wrong about his warnings just before the real break took place in early
2000. He also witnessed the housing
bubble, and not only did he support the banks making the loans, but actually
encouraged the banks to continue making these insane loans.
us to the old time phrase, “fool us one time, shame on you, fool us twice shame
on us.” When the current debt bubble
breaks and the stock market collapses we could say, “Fool us 3 times and we
should be banned from trading and investing in the financial markets.” Unless we can understand why the debt caused
the collapse in 1929 (after the roaring 1920’s), in 2000, and 2008, we should
be forced to compare the debt to GDP in all of these times to the present.
If you were
forced to do this you would look at the debt and be shocked at how much the
debt grew over the past two decades. If
you are a Democrat you might compare how much the debt grew under President George
W. Bush and use examples of how much it grew during the eight years of his
administration. You could make comparisons like the debt grew more under George
W. than all past presidents (going back to George Washington). If you are a Republican, you could make the
same comparisons of how much the debt grew under Barack Obama and make the same
comparisons (going back again to George Washington). If you did make these comparisons you would
come close to going out of your mind, because it would have to scare you.
thing is the fact that you would be making the comparisons erroneously since
you would look at the debt doubling under George W. and then doubled again
under Barack Obama, and think we are in real trouble. However, the debt you would be using is
strictly the government debt, and get scared as hell when you see the debt is
now just about equal to the GDP of the greatest country in the world at about
$20 trillion apiece.
If, on the
other hand, you were looking deeper into the debt and could see that the debt
has grown much more than the GDP of our country. In fact, the real debt relative to GDP is
actually about 370% of GDP if you include the government debt, the state and
local debt, student debt, credit market debt, and the loans made to foreign
banks overseas. The 370% of debt
relative to GDP also should include all of the entitlements and other off
balance sheet debt that we include now.
These are obligations that have been guaranteed to most of the people in
this country such as the entitlement promises of Social Security, Medicare,
Medicaid, and government employee pensions.
If you take all of them into consideration the debt to GDP would not be
just 370% but closer to another $40 trillion of debt which would take the total
debt to over 500% of our GDP. If that
doesn’t scare you nothing will!!
President Donald Trump will probably have as much trouble with his other agenda
items as he did with his repeal and replace of healthcare, the market could
have real problems. And when this
enormous debt comes to light, we would expect the market to decline sharply. The only way that the Trump Administration can survive without moving his agenda quickly this year would be to grow the economy close to the rate of 3 to 4 % as he predicted. But it is very hard to grow nearly that fast with these demographics, retiring baby boomers, fewer immigrants--it is impossible to get corporations to make capital expenditures and productivity to increase without being able to increase the labor force. This is why they are in such a bind!
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