Tuesday/Thursday Market Commentary

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11/11/17 5:50 AM

There have been many of the strongest bulls on Wall Street that have changed their minds on the “Bull” side of the market, just recently.  Many of them have been very concerned about the possibility of continued delays in the “Tax Reform” that is being bandied about in the House and the Senate.  Some others such as Jim Paulson, Chief Investment Strategist at The Leuthold Group, just a week ago, was concerned about how most investors are still just looking over the blue skies and thinking nothing can go wrong.  He also was concerned about the Fed tightening more than most investors anticipated, as well as a flattening out of the bond market.  As the shorter term bonds have been rising faster than the longer term bonds, the flattening could turn out to be inverted soon and we all understand that is a precursor to a recession. The financial stocks that usually rise as rates increase, are now declining, and that also signals that something is wrong.  Paulson is also concerned about the Republican Agenda slowing down, as the House and Senate go back and forth with significant delays. 

 Another extremely respected equity analyst for Morgan Stanley, Mike Wilson, has recently changed his opinion, after being a noted bullish economic and equity analyst over the past 8 years.  He now expects either a major decline or at best a bear market pause.  He also sees some of the same problems as Paulson. As stated above, the settlement of the Tax Reform continues to go back and forth as the Republicans are sprinting to the finish line in order to get a compromise between the two chambers.  This is where the Senate Republicans and Senate Democrats have to give something up to get the approval of the Senate Committee first, and then the Full Senate, before this year ends.  So it is crunch time for Republicans as the House Ways and Means Committee enters its final days of hammering out its tax-cut legislation, while a Senate panel has now revealed its own version.  If they don’t get this worked out, the stock market will have a very difficult time throughout the last couple of months in 2017 and all of 2018. Right now they don’t seem to be working out a compromise.

A commentator on CNBC, Mike Santolli, discussed how much the market volatility came to a screeching halt during the wild year of the Trump victory.  Most investors would have to think of this being a strong positive for the markets.  However, according to Santolli, he has gone back for years to show what happens to equity markets after going through long periods of very low volatility-- they are set up to decline significantly.  In fact, the S&P 500 just broke a record today, 11/9/17, by going through the longest streak in history of 370 days without a 3% decline.  Santolli showed that this is not a good streak, and once it breaks, it could turn into a bad bear market. 

There are other Republicans like, Douglas Holtz-Eakin, who in 2003 became the director of the Congressional Budget Office.  He is still very sympathetic to the congressmen that are concerned about the increases in the debt and deficits.  In fact, the budget office undertook a study of tax rates, and found that any tax cuts enacted, that increased the debt and deficits of the U.S., will not generate much growth over the next 10 years.  In fact, the Senate minority leader, Mitch McConnell, appointed Holtz-Eakin to the Financial Crisis Inquiry Commission in 2009, so we are not talking about a novice in this area.  Holtz-Eakin also has a major concern about some of the entitlements that no one seems to bring up during the Tax Reform discussions.  He believes our Social Security entitlements will come back to haunt us, unless we work on them as soon as possible.  Also, he is concerned about the fact that the global debt is three times the global GDP. 

So, as you can see, it looks like we will have plenty of things to worry about for the rest of this year, 2018, and beyond. 

Now that the Fed is About to Start Selling these Bonds, Stocks Should Soon Turn Down
10/09/17 6:00 PM

Asset prices (especially stocks) clearly have risen because of Quantitative Easing (QE, the Fed lowering ST interest rates and purchasing bonds).   So, if that is the case, why doesn’t it make sense for assets and stocks to decline as the Fed, and soon other central banks, will reverse their stance and sell the bonds previously purchased?  As the Fed, and other central banks, are planning on raising interest rates and tightening, by reversing what they have been doing for the past 8 years, it is obvious to us that assets and stocks will surely decline substantially.  Clearly, the QE that has been taking place for years will be reversed and it will probably be called Quantitative Tightening (QT) (and it will be called QT for a reason—if they don’t tighten, inflation could be next).

Our Fed is slowly tightening, as the other large central banks, such as the Bank of Japan (BOJ), the European Central Bank (ECB), Peoples Bank of China, (PBOC), are all moving much more slowly than our Fed.  It looks like these central banks are listening to our Fed, and plan on following them.  After all, this QE started for most of these central banks about the same time as our Fed (because of most of them following our Fed) and so far it has worked well to help all of the countries using it to boost their stock markets and prevent recessions. It is the reversal of all of these QEs that may wind up having “unintended consequences” since the QEs, and the reversal of QEs have never been tried before. We expect the “unintended consequences” to take place before the first quarter of 2018.

The other potential problem we have trouble understanding is that most of our country believes that President Trump will be successful in achieving his broad agenda items such as Tax Reform, Repeal and Replace Obama Care, Infrastructure Spending, and much more.  We don’t believe that most of these agenda items will be passed at all (just as the repeal and replace was stopped cold).  Many stock market mavens are putting a number on the “Tax Cut”, or “Tax Reform” and incorporating the increased earnings into their forward valuations to give stocks a lower P/E multiple for next year.   And even if the “Tax Cut or Reform” comes close to being approved many in Congress will realize that the Budget Deficit will skyrocket, and will clearly be a major factor in potentially leading to a downgrade of our debt (just as what took place in the U.S. in 2012, and more recently in China and Hong Kong).  We also expect that much of the tax cut will only benefit the very rich such as with the “estate taxes”. And also, if interest rates increase as the Fed keeps tightening, the dollar will also rise and restrict the US multinationals from selling goods abroad.

As far as the U.S. stock market, we are still concerned about the extreme valuations, and the fact that we don’t seem to be able to grow fast enough to break through and achieve our “old norm” of GDP 3 % or higher, and get to the goal of "escape velocity".  


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. 

Just how 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.

How about 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.

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 Index. 

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 the world. 

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".

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.

By growing 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.

We believe 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:

  1. 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.)

  2. 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.

  3. 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.

  4. 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. 


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