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Monthly Archives: May 2017

On Friday, Kevin Brady of the House Ways and Means Committee was on my radio program discussing the “Tax Cuts & Jobs Act” bill which was released later in the day.

Here are the details of the release he referenced in the interview.

Of course, the real question is how are you going to “pay for it?”

Even as Kevin Brady noted in our interview, when I discussed the “fiscal” side of the tax reform bill, without achieving accelerated rates of economic growth – “the debt will balloon.”

The reality, of course, is that is exactly what will happen because there is absolutely NO historical evidence that cutting taxes, without offsetting cuts to spending, leads to stronger economic growth.

Those, of course, are the long-term concerns that will lead to lower rates of returns for equity-based investors and will continue to suppress interest rates for the next decade as the “Japanification” of the U.S. continues.

Let’s Be Like Japan

“Bad debt is the root of the crisis. Fiscal stimulus may help economies for a couple of years but once the ‘painkilling’ effect wears off, U.S. and European economies will plunge back into crisis. The crisis won’t be over until the nonperforming assets are off the balance sheets of US and European banks.”Keiichiro Kobayashi, 2010

While Kobayashi will ultimately be right, what he never envisioned was the extent to which Central Banks globally would be willing to go. As my partner Michael Lebowitz pointed out last week:

“Global central banks’ post-financial crisis monetary policies have collectively been more aggressive than anything witnessed in modern financial history. Over the last ten years, the six largest central banks have printed unprecedented amounts of money to purchase approximately $14 trillion of financial assets as shown below. Before the financial crisis of 2008, the only central bank printing money of any consequence was the Peoples Bank of China (PBoC).”

As he noted, the belief was that by driving asset prices higher, economic growth would follow. Unfortunately, this has yet to be the case as debt both globally and specifically in the U.S. has exploded.

“QE has forced interest rates downward and lowered interest expenses for all debtors. Simultaneously, it boosted the amount of outstanding debt. The net effect is that the global debt burden has grown on a nominal basis and as a percentage of economic growth since 2008. The debt burden has become even more burdensome.”

While Mr. Brady is very optimistic about future rates of economic growth, even Ms. Yellen in her latest policy announcement was not so sure. The Fed’s average of long-term growth expectations is currently running at just 1.9%.

The continuing mounting of debt from both the public and private sector, combined with rising health care costs, particularly for aging “baby boomers,” are among the factors behind soaring US debt. While “tax reform,” in a “vacuum”  should boost rates of consumption and, ultimately, economic growth, the economic drag of poor demographics and soaring costs, will offset any of the benefits.

The complexity of the current environment implies years of sub-par economic growth ahead as noted by the Fed last week. Of course, the US is not the only country facing such a gloomy outlook for public finances, but the current economic overlay displays compelling similarities with Japan in the 1990s.

Also, while it is believed that “tax reform” will fix the problem of lackluster wage growth, create more jobs, and boost economic prosperity, one should at least question the logic given that more expansive spending, as represented in the chart above by the surge in debt, is having no substantial impact on economic growth. As I have written previously, debt is a retardant to organic economic growth as it diverts dollars from productive investment to debt service.

Of course, one only needs to look at Japan for an understanding that QE, low-interest rate policies and expansion of debt have done little economically. Take a look at the chart below which shows the expansion of the BOJ assets versus growth of GDP and levels of interest rates.

Notice that since 1998, Japan has not achieved a 2% rate of economic growth. Even with interest rates now pushing into negative territory, economic growth remains mired below one-percent, providing little evidence to support the idea that inflating asset prices by buying assets leads to stronger economic outcomes.

But yet, the current Administration believes our outcome will be different.

The reality is that the U.S. is now caught in the same liquidity trap as Japan. With the current economic recovery already pushing the long end of the economic cycle, the risk is rising that the next economic downturn is closer than not. The danger is that the Federal Reserve is now potentially trapped with an inability to use monetary policy tools to offset the next economic decline when it occurs.

This is the same problem that Japan has wrestled with for the last 20 years. While Japan has entered into an unprecedented stimulus program (on a relative basis twice as large as the U.S. on an economy 1/3 the size) there is no guarantee that such a program will result in the desired effect of pulling the Japanese economy out of its 30-year deflationary cycle. The problems that face Japan are similar to what we are currently witnessing in the U.S.:

  • A decline in savings rates to extremely low levels which depletes productive investments
  • An aging demographic that is top heavy and drawing on social benefits at an advancing rate.
  • A heavily indebted economy with debt/GDP ratios above 100%.
  • A decline in exports due to a weak global economic environment.
  • Slowing domestic economic growth rates.
  • An underemployed younger demographic.
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases to offset reduced employment

The lynchpin to Japan, and the U.S., remains demographics and interest rates. As the aging population grows becoming a net drag on “savings,” the dependency on the “social welfare net” will continue to expand. The “pension problem” is only the tip of the iceberg.

If interest rates rise sharply it is effectively “game over” as borrowing costs surge, deficits balloon, housing falls, revenues weaken and consumer demand wanes. It is the worst thing that can happen to an economy that is currently remaining on life support.

Japan, like the U.S., is caught in an on-going “liquidity trap”  where maintaining ultra-low interest rates are the key to sustaining an economic pulse. The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the ongoing battle with deflationary pressures. The lower interest rates go – the less economic return that can be generated. An ultra-low interest rate environment, contrary to mainstream thought, has a negative impact on making productive investments and risk begins to outweigh the potential return.

More importantly, while there are many calling for an end of the “Great Bond Bull Market,” this is unlikely the case. As shown in the chart below, interest rates are relative globally. Rates can’t rise in one country while a majority of economies are pushing negative rates. As has been the case over the last 30-years, so goes Japan, so goes the U.S.

Unfortunately, for the Administration, the reality is that cutting taxes, and MORE debt, is unlikely to change the outcome in the U.S. The reason is that monetary interventions and government spending don’t create organic, and sustainable, economic growth. Simply pulling forward future consumption through monetary policy continues to leave an ever-growing void in the future that must be filled. Eventually, the void will be too great to fill.

But hey, let’s just keep doing the same thing over and over again, which hasn’t worked for anyone as of yet, hoping for a different result. 

What’s the worst that could happen?  

The “tax bill cometh.” According to the press, this is going to be the single biggest factor to jump-starting economic growth since the invention of the wheel.

Interestingly, even the Fed’s economic projections are suggesting that economic growth will pick up over the next two years from the impact of tax cuts. (Chart is the average of the range of the Fed’s estimates.)

Of course, you should note the Federal Reserve has NEVER accurately forecasted future economic growth. In fact, it has become an annual tradition of over-estimating growth and then slowly ratcheting down estimates as reality failed to achieve overly optimistic assumptions.

However, despite the Administrations hopes of long-term economic growth rates of 3% or more, in order to pay for the deficits created by cutting revenue, even the Fed has maintained their long-run outlook of less that 2% annualized growth. (Down from 2.7% in 2011) Hardly the supportive stamp of endorsement for the “greatest tax cut” of all-time.

But for economic growth to blossom, the consumer will have to pull their weight given consumption makes up roughly 70% of GDP. The problem, as witnessed by the latest retail sales report, is that consumptive spending is far weaker than headlines suggest.

On Thursday, the retail sales report for November clicked up 0.8%. Good news, right?

Not so fast.

First, sales of gasoline, which directly impacts consumers ability to spend money on other stuff, rose sharply due to higher oil prices and comprised 1/3rd of the increase. Secondly, building products also rose sharply from the ongoing impact of rebuilding from recent hurricanes and fires. Again, this isn’t healthy longer-term either as replacing lost possessions drags forward future consumptive capacity.

But what the headlines miss is the growth in the population. The chart below shows retails sales divided by those actually counted as part of the labor force. (You’ve got to have a job to buy stuff, right?) 

As you can see, retail sales per labor force participant was on a 5% annualized growth trend beginning in 1992. However, after the financial crisis, the gap below that long-term trend has yet to be filled as there is a 22.7% deficit from the long-term trend. (If we included the entirety of the population, given the number of people outside of the labor force that are still consuming, the trajectory would be worse.)

But wait, retail sales were really strong in November?

Again, not so fast.

The chart below shows the annual % change of retail sales per labor force participant. The trend has been weakening since the beginning of 2017 and shows little sign of increasing currently.

While tax cuts may provide a temporary boost to after-tax incomes, that income will simply be absorbed by higher energy, gasoline, health care and borrowing costs. This is why, 80% of Americans continue to live paycheck-to-paycheck and have little saved in the bank. It is also why, as wages have continued to stagnate, that the cost of living now exceeds what incomes and debt increases can sustain.

Yes, corporations will do well under the “tax reform” plan, and while the average American may well see an increase in take-home pay, it will unlikely change their financial situation much. As a result, economic growth will likely remain weak as the deficit expands to $1 Trillion over the next couple of years and Federal debt marches toward $32 trillion. As noted by the CFRB

“Fiscal conservatives on the right have lost a massive amount of credibility based on the GOP budget they passed this year. After many years of calling for a budget that cut spending, reformed entitlements, controlled the debt and balanced the budget, they failed to enact even one of those goals when they finally had a chance.

Out of a possible $47 trillion in spending over 10 years, the budget called for cutting an utterly pathetic $1 billion. Their fiscal credibility died with a whimper. I doubt that credibility can be regained, but it seems quite likely that some of the more conservative GOP members will call for letting the sequester hit.”

So, when someone acts astonished that things didn’t work out as planned…just remind them that “ignorance is no excuse.” 

Just something to think about as you catch up on your weekend reading list.


Trump, Economy & Fed


Markets


Research / Interesting Reads


“When the music stops in terms of liquidity, things will get complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” – Chuck Prince, Citigroup

Questions, comments, suggestions – please email me.

Near the end of each year, Barron’s magazine highlights the outlooks for the next year from 10, or so, Wall Street strategists. As noted recently by Sentiment Trader:

“Strategists are a little more optimistic than the Big Money was, forecasting a gain of around 7% for the S&P 500 in 2018. That’s about how much they thought the S&P would rally in 2017. And 2016. And pretty much every other year. When forecasting, it’s often a good bet just to go with the base rate – the average probability of being positive, or average gain in a random year. For stocks, that’s about a 7% nominal return, with about a 65% probability of showing a gain. Just stick with those, and you’ll have a better record than most. In aggregate, that’s what Wall Street does.”

Of course, 2017, has been a much better than the forecasted year as one of the great triumphs of the Fed’s liquidity-driven policy is that investor’s “animal spirits” finally returned to the investment markets. However, actual results, as Sentiment Trader showed, can vary.

” They overestimated the market’s 2008 return by 50% (!) and underestimated the 2012 return by 20%. Like most outlooks, forecasts, and research pieces, the biggest value isn’t necessarily in the bottom line, but in the thought processes and data used to get there. In those senses, reading through the outlooks can be a great exercise. Using them just for the bottom-line guess at next year’s S&P level is next to worthless as an indicator.”

But, with the ongoing massive global Central Bank interventions, as Michael Lebowitz discussed yesterday, it should not be surprising that as markets continue their seemingly unstoppable advance. That advance has ultimately triggered the “greed factor” as shown by surging investor confidence and expectations which have surged to historically high levels. (The chart below is a composite index of both the University of Michigan and Conference Board surveys.)

Even the level of individuals believing the financial markets will be higher over the next 12-months has spiked sharply higher in recent months.

However, while Wall Street expects the markets to increase by 7% next year, the long-term historical average, the charts above suggest individuals have bigger aspirations.

How much bigger? A lot!

Schroders Global Investors Study recently surveyed over twenty thousand investors from around the globe to get their expected portfolio returns over the coming 5 years. To wit:

  • Investors expect an annual return of 10.2% on their investments over the next five years
  • The 2017 survey, which surveyed 22,100 globally who invest, found millennials even more optimistic. Those born between 1982 and 1999 expected their money to make average returns of 11.7% a year between now and 2022.
  • Even the Baby Boomer generation is anticipating an above average return of 8.6% a year.
  • Breaking it down by generation:
    • Millennials (born 1982-1999, aged 18-35): 11.7%
    • Generation X (born 1965-1981, aged 36-52): 9.8%
    • Baby Boomers (born 1945-1964, aged 53-72): 8.6%
    • Silent Generation (born 1923-1944, aged 73+): 8.1%”

Such levels of optimism may be a bit egregious given the overly optimistic positioning by investors in the market currently as shown.

Add the overly optimistic outlook and positioning to a market that is the most overvalued, overbought, and extended, in the last 20-years and the risk to future returns becomes much more evident.

The reality, of course, is once again investors are setting themselves up for disappointment. The expectations of “compounding returns” of 6, 8 or 10% is a myth that needs to go away. As Richard Rosso wrote recently:

“When it comes to compounding, investors should never suffer torturous time to breakeven. Compound interest works if the rate of interest is consistent, not variable. You wouldn’t know it from stocks, especially this year, but from what I know, stocks are indeed a variable, and occasionally, volatile asset class.

So sorry, Suze. This bit of knowledge? Strike out. Not everything compounds.

‘Orman explained that if a 25-year-old puts $100 into a Roth IRA each month, they could have $1 million by retirement.’

“As outlined in the chart above, on an inflation-adjusted basis, achieving a million-buck balance in 40 years by dollar-cost averaging $100 a month, requires a surreal 11.25% annual return. In the real world (not the superstar pundit realm), a blind follower of Suze’s advice would experience a whopping retirement funding gap of $695,254.68.

I don’t know about you, to me, this is a Grand Canyon expectation vs. reality-sized unwelcomed surprise.”

But yet, Millennials are currently hoping for “Orman” type returns.

Reality is likely to be extremely disappointing as drawdowns of 10% or more have occurred throughout history with regularity.

Irrational Exuberance

Here’s a little secret, “Animal Spirits” is simply another name for “Irrational Exuberance,” as it is the manifestation of the capitulation of individuals who are suffering from an extreme case of the “FOMO’s” (Fear Of Missing Out). The chart below shows the stages of the previous bull markets and the inflection points of the appearance of “Animal Spirits.” 

At the peak of previous bull market advances, the markets have entered into an accelerated phase of price advances.

Since “the price you pay day is the value you receive tomorrow,” as famously noted by Warren Buffet, it should not come as a surprise that “value investing” is lagging the “momentum chase” in the market currently. But again, this is something that has historically, and repeatedly occurred, during very late stage bull market advances as the “rationalization” for a “never-ending bull market” is promulgated.

Given the length of the economic expansion, the risk to the “bull market” thesis is an economic slowdown, or contraction, that derails the lofty expectations of continued earnings growth.

While tax reform legislation may provide a bump to earnings growth in the near-term, it is the longer-term growth rates of the economy that matters. Furthermore, while providing a tax cut to corporations will certainly boost their bottom line, there is little evidence, historically speaking, “trickle-down economics” actually occurs. If it did, wages as a share of corporate profits wouldn’t look like this.

With an economy that is 70% driven by the 90% of the population who don’t benefit from corporate tax cuts, the long-term effects of a deficit and debt busting tax bill should be worrying investors.

But, for now, that is not the case as the rise in “animal spirits” is simply the reflection of the rising delusion of investors who frantically cling to data points which somehow support the notion “this time is different,” a point recently made by Sentiment Trader:

“We’ve discussed a multitude of momentum studies in the past month or two, with an almost universal suggestion that the types of readings we’ve seen this year are rare and hard to bust. This unrelenting bid has been one of, if not THE, most compelling bullish argument, and it shows little sign of stopping.”

But importantly, they always do.

We have seen this before.

There was no catalyst that we know of that burst the dot-com bubble in 2000. There was no catalyst that started the slide in the markets in 2008 until it triggered the Lehman bankruptcy and “all hell broke loose.” 

Today, we once again have exuberance present and there is a widespread belief that nothing will stop this runaway train. 

But eventually, for whatever reason, the market will top. It is impossible to predict when, or how it will happen. It just most assuredly will, and will do so just as everything seems to be its brightest. 

It will be the rudest of awakenings for the slumbering bulls.

Doubt and fear remain absent from Wall Street despite the specter of numerous potentially adverse economic, interest rate, inflationary, political, geopolitical and market outcomes.

Exaggerating the uptrend is the underappreciated and more dominant role of passive investing strategies (ETFs, risk parity and volatility trending) that, when combined with the global short volatility bubbleis distortive to the markets and limits price discovery.

Every day seems to bring a new high in the S&P Index and every late in the day seems to bring a collapse in the VIX.

Opposition to the primary trend (higher) slowly but surely has been surpressed as Group Stink becomes adopted for investment, business and even emotional reasons. It just becomes too hard for most to fight the overwhelmingly strong trend.

Nearly every cyclical market peak is accompanied by a new and different version of robust speculative activity, and 2017 is no exception as bitcoin has been the subject of media and investors’ attention with the hope of untold riches rising to the investing surface. (Bitcoin was the subject of my opening missive yesterday).

But I have seen this before. I have seen risk underpriced (early 2000 and late 2007 are vivid examples) in my investing career. Actually, it happens with greater frequency than one would think, even in bull markets.

To me, reward always must be weighed against risk. It is like playing Texas Hold ’em or Bridge — it’s about a distribution of probabilities that creates a series of expected outcomes.

Before I go on to discuss stocks today, please re-read and reflect upon “Reflections of a Distorted, Delusional Reality” (below) from two weeks ago and consider upside/downside in the markets and in individual stocks and the outcome risks against currently high price-earnings multiples:

“When history judges this moment, it will not be kind. 

Central banks, oblivious to the real reasons for low wage inflation — namely, globalization and advances in technology — have created a monster bubble and the markets, rather than being frightened by this, have celebrated it.

The passing of a stimulative tax bill that clearly will worsen income inequality and, according to almost all economists, will lead to minimal incremental economic growth while expanding deficits despite a nine-year economic recovery and 4% unemployment, is irresponsible. When the inevitable bust occurs, the public justifiably will reject corrective recommendations from those who have behaved so imprudently, thereby limiting the ability to re-stimulate.

The bad actors who have acted imprudently are the Federal Reserve and Congress. Their failure to prosecute the bad guys in 2008-09 and their continuing and deceitful self-interest will cost them public support when it genuinely is needed in the future and in the next crisis.

Our central bank, the Federal Reserve, in its infinite wisdom, is unconcerned about inflation. Consider $450 million paintings, wild speculation on bitcoins, which are up tenfold in 12 months and are traded by grandmothers and the Boca Biffs of the world, and $100 million New York City apartments bought on spec.

The aforementioned hooligans already have enriched the rich while giving moderate-income people less than 1% in their savings accounts. The income and wealth gaps widen daily as the Screwflation of the Middle Class, a subject I highlighted in a Barron’s piece in 2011, is unaddressed while patently false statements and promises (I am shocked!) are made by President Trump. Meanwhile, in another falsehood, Secretary of the Treasury Steve Mnuchin’s promised analysis of the tax bill apparently was never even conducted (see here and here)!”

Remember Joseph in The Bible? When things were good, he put grain in the silos to have sustenance for an eventual bad day.

Our purported leaders, while often citing The Bible, apparently missed this part. They are eating the nation’s seed corn.

It’s bad all around — substantively, morally and intellectually. It is driven by discredited ideas that few are willing to challenge.

We live in a world where Tesla TSLA and bitcoin are among the most popular investments and trades. Rather than being dedicated to finding value, most traders and “investors” today worship at the altar of price momentum.

This is why we read Charles Kindleberger’s “Manias, Panics and Crashes” and read about Hyman Minsky’s moment to remind us not to lose our way when everyone around us is losing theirs.

As I wrote last evening:

We truly live in a parallel universe inhabited and controlled by passive investing products (ETFs) and strategies (risk parity and volatility trending), which have been delivering a virtuous cycle as their inflows continue to overwhelm the markets and are conditioned to buying every dip.

When interest rates rise and central banks pull back (or an unexpected event occurs), the virtuous cycle could be halted by outflows from ETFs and from these machine dominated algos.

Despite protestations on our site and elsewhere, the recent market leg higher has only partially been influenced by the corporate profit and economic backdrop. As I have documented, this has been a valuation-driven and not an earnings-driven market buoyed by inflows into the aforementioned products and strategies coupled with excess central bank liquidity.

Meanwhile, I continue to pound home that each day that goes by we get closer to a much wider monetary tightening next year — $420 billion to be sucked out by the Fed and about $500 billion less in the way of buying from the European Central Bank. I would note for timing purposes that one trillion dollars of reduced liquidity in 2018 is beginning in just four weeks.

Also, as I noted last evening:

As Grandma Koufax used to say, “Dougie, matzahs don’t grow to the sky. Even in the Bronx.”

This morning’s opening missive, “Here’s What Works For Me,” tracks how I look at the market.

By my calculus the market’s downside is at least 4x greater than the upside today — even with a tax reduction, which will likely not “trickle down” and catalyze.

From my perch there is no margin of safety left in today’s market.

In September, we proposed a theory of the Fed and suggested that the FOMC will soon worry mostly about financial imbalances without much concern for recession risks. We reached that conclusion by simply weighing the reputational pitfalls faced by the economists on the committee, but now we’ll add more meat to our argument, using financial flows data released last week. We’ve created two charts, beginning with a look at cumulative, inflation-adjusted asset gains during the last seven business cycles:

According to the way that the Fed defines its policy approach, our first chart stamps a giant “Mission Accomplished” on the unconventional policies of recent years. Recall that policy makers explained their actions with reference to the portfolio balance channel, meaning they were deliberately enticing investors to buy riskier assets than they would otherwise hold. Policy makers hoped to push asset prices higher, and they seem to have succeeded, notwithstanding the usual debates about how much of the price gains should be attributed to central bankers. (See one of our contributions here and a couple of other papers here and here.) But whatever the impetus for assets to rise, it’s obvious that they responded. In fact, judging by the data shown in the chart, policy makers could have checked the higher-asset-prices box long ago, and with a King Size Sharpie.

 

Consider the measure on the vertical axis, percent of personal income. From the risky asset trough in Q1 2009 through Q3 2017, households accumulated asset gains, in real terms, equivalent to 139% of personal income. (Nominal gains were much greater, but we used the CPI to deduct the amount of purchasing power that households lost on their asset holdings. Also, we defined asset holdings as the four biggest categories that the Fed computes gains for—equities, mutual funds, real estate, and pensions.)

In other words, households are enjoying an investment windfall that amounts to nearly sixteen months of personal income, which is larger than the windfalls accrued in any other business cycle since the Fed began tracking asset gains in 1947. Not only that but the gap continues to widen—as of this writing, we’re likely approaching 145% of personal income and well clear of the previous peak of 128% from the 1991–2001 expansion.

Getting back to policy priorities, the chart seems to tell us that asset prices no longer need boosting. The Fed’s pooh-bahs proved they could boss the investment markets, and they’ve almost certainly moved on to new endeavors.

Bull, bear, or donkey?

But record asset gains are just one of the reasons the Fed’s priorities are likely to be changing. To describe another reason, we’ll first show that policy makers may wield a King Size Sharpie but that it’s not a Permanent Marker:

As you can see, our second chart looks like the first, except that we pinned the tails on the asset price donkeys. We tacked on the down halves of each cycle, showing that the portfolio balance channel has a reverse mode.

So what should we make of the result that asset price cycles, adjusted for inflation, have ended with busts that reverse a large portion and often the entirety of the prior booms?

According to our beliefs about how investment markets work, the up and down phases of asset cycles are closely connected. Also, monetary stimulus influences both phases at the same time. It helped fuel the giant gains of recent expansions, but it also helped create the imbalances that led to giant losses. And after the accelerated advances of 2016-17, it’s fair to wonder if today’s imbalances are approaching the extremes of 2000 and 2007. Even some FOMC members are gently acknowledging that risk.

But we think the committee members are even more concerned than you would know by just reading their meeting minutes. We expect financial imbalances to become their biggest worry, bigger than the risk of recession, which should matter less and less to the central bankers’ reputations as the business cycle expansion continues to lengthen. In fact, a garden variety recession would barely affect their legacies at all by mid-2019, when the expansion, if still intact, would become the longest ever. By that time, the FOMC’s greatest reputational threat would be another financial market debacle, which would suggest that manipulating asset prices maybe wasn’t such a good idea, after all. In other words, the committee’s reputational calculus will change significantly during Jerome Powell’s first few years as chairperson.

All that said, Powell probably wants a recession-free economy in, say, his first year or two in the position. Moreover, he’ll certainly stress continuity with his predecessors’ policies. But once he becomes comfortable in the job, the Fed’s priorities will look nothing like they did under Janet Yellen and Ben Bernanke. Instead of fueling asset gains, Powell’s biggest challenge will be containing imbalances connected to prior gains. He and his peers will aim to avoid pinning another oversized tail on the donkey—or at least to manage the fallout from said tail—and that’s a challenge that could very well define his regime.

“People often make suboptimal decisions for a variety of reasons, including incomplete accounting of costs and benefits, partial risk understanding, and flawed assumptions regarding the probabilities of various outcomes.” – Boombustology: Spotting Financial Bubbles Before They Burst by Vikram Mansharamani.

The investment vs. speculation discussions with ecstatic Bitcoin buyers are a real-time study into behavioral economics.

I understand the thrill of a cryptocurrency ride.

I too, find the dizzying parabolic moves higher, cascading drops, and the shaky trading infrastructure experience fascinating. It’s reminiscent of the heyday of tech stock Wild-West trading when a company like EToys launches an IPO in 1999 at $20 bucks a share, closes at $76 and eventually goes bankrupt in 2001. Although I personally believe cryptocurrencies and blockchain technologies will have a longer shelf life than Pets.com.

However, it’s time to sit “Bitsters” down and explain a few things. Stop squirming and listen! I refer to those who undertake little if any homework and at least try to comprehend Satoshi Nakamoto’s vision, as “Bitsters.”

Nakamoto’s is a purely mathematical design which creates a peer-to-peer, open electronic cash system to allow payments to flow quickly without going through a financial institution.

Bitcoin was never to be an “investment,” or a method to speculate on the moves in its price. That’s the motivation of naive “Bitsters,” who have no clue how badly they may get hurt gambling on price moves and falsely convincing themselves how they’ll maintain Bitcoin no matter how far its price may fall.

You see, “Bitsers,” are venturing into unchartered techno-territory of dedicated Bitcoin “Hodlers,” or those who will never sell their Bitcoins; they perceive minimal value in a fiat currency. They’re a freakishly smart group who speak their own language like the garbage dump freaks on the hit show The Walking Dead.

So “Bitsters,” you’re as human as the rest of us. And as a human you’re plagued by overconfidence and unaware of the limitations of your own knowledge and increasingly unaware of the mis-knowledge (look, I created a word), of others who are affected by a similar fever for cryptocurrencies with Bitcoin being the granddaddy of them all.

In other words, you’re experiencing availability heuristic. Frankly, as people we are hot soup of flesh, blood, experiences and mental shortcuts when it comes to making decisions. An availability heuristic is a psychological quick path which relies on immediate examples that come to mind when evaluating a topic, concept or decision. The readily available and pervasive exhilaration about Bitcoin is that the price seems to climb to astounding records every day (hour).

Here’s what I’d like to say.

Bitsters: I implore you to get a grip.

You’re participating in a boom that will lead to a bust. It’ll happen. I just don’t have a date to share with you.  Bitcoin will survive; however, in five years with increased supply, competition from other cryptos, the inevitable scrutiny by regulatory authorities, and futures contracts (with possible buffers that will quell wild price swings), eventually Bitcoin will find an equilibrium demand price that could be much lower than it is today.

Heck, every new paradigm or technology eventually goes mainstream. As it’s human nature, sexy ostensibly departs. It’s just part of life. The thrill dissipates. Like the internet. Sure, a gamechanger. So was electricity and radio at one time, too. Markets inevitably discover the proper footing and price for everything that trades. The price of Bitcoin is based on scarcity and demand.

As it is currently scarce, (new Bitcoins are generated by a process called “mining,” and will stop at a total circulation of $21 million, with 16.4 million in existence, today), and demand is feverishly high, prices are volatile and distorted.

So, I implore “Bitsters” to humble themselves, don’t attempt to recruit others or drum on your chests like boisterous gorillas about your newfound latest hot-crypto pick. Take your ego out of the trade. Step away; be swift and anxious to take profits, convert Bitcoin into currency you can use to stock up on stuff you can buy at Walgreen’s. You know, like toothpaste.

I’ll reiterate: Bitcoin is NOT an investment.

The creator of Bitcoin has no mention of it as an investment in his original paper. Neither should you consider it one. As a Bitster, I implore you to remain grounded and treat your purchase as a gamble, a thrill ride through a carnival fun house. Purchase with money you can afford to lose. Nothing else.

Why are you creating rules for a medium of exchange that isn’t an investment?

Bitsters I encounter attempt to wrap rules around Bitcoin like “if it drops by 50%, I’ll buy!” I as well as they, are uncertain as to why arbitrary rules of purchase are created. In other words, Bitcoin isn’t an investment; you cannot calculate its value. So, how would I or anyone else know whether a 50% haircut is a buying opportunity? I guess it makes buyers sound smart, or responsible. How is $19,000 expensive and $10,000 a bargain?

You tell me. I have no idea.

If Bitcoin is based on demand and somewhat current limited supply, why not buy it here, take a leap of faith, and pray the price goes higher? There are no price anchors in unchartered territory; when it comes to speculation one must strike when the iron or opportunity is hot and exit before it cools. Therefore, Bitcoin, as I repeat what seems to be every hour, must be considered speculation at this point.

What are my personal thoughts?

Do I personally believe cryptocurrencies are here to stay? Yes. Do I think increased supply, regulation, and competition from other cryptocurrencies, eventually moderate the price of Bitcoin and obliterates “Bitsters?” Why, yes. Yes, I do.

Do I love how gatekeepers (those who make the rules for the rest of us), fear cryptocurrencies and discount their future acceptance? Absolutely.

The financial, banking and systems of Wall Street deserve dissonance. The fear and sorrow that major financial institutions have transferred to the majority of Main Street and the bills they’ve stuck households with for bailouts during the Great Recession, deserves such a threat (albeit small right now).

A vast system for open transaction; a medium of exchange that has nothing to hide is as good a nemesis as any. Who knows? In 50 years, cryptocurrencies could be mainstream. Anything is possible.

Major institutions and financial pundits rail against Bitcoin because it confronts their beliefs and someday may be a formidable threat to their shadow systems. For now, it’s like turning on a kitchen light and watching gatekeeper roaches scatter.

As I’ve read recently from a Blockchain Ecosystem builder:

“For us, Bitcoin IS the end game. We cashed out alright. We cashed out of the current system forced upon us because we did not have a choice in the past. Dedicated Bitcoin holders consider fiat currency dirty money and will spend it before they do their clean version.

Now we do.”

For the amateur players in Bitcoin who can’t keep their emotions in check, cryptocurrency may be a tough but required lesson.

Recently we received the following question from a subscriber:

“If a correction in the stock or bond markets comes, the Central Banks will buy stocks with printed money, like the Japanese Central Bank, etc. Will there ever be a shakeout of the garbage and junk in the system? I am losing all confidence.” –Ron H.

Questions like Ron’s that suggest the decay of capitalism and free markets should raise concerns for anyone’s market thesis, bullish, bearish or agnostic. What stops a central bank from manipulating asset prices? When do they cross a line from marginal manipulation to absolute price control? Unfortunately, there are no concrete answers to these questions, but there are clues.

Global central banks’ post-financial crisis monetary policies have collectively been more aggressive than anything witnessed in modern financial history. Over the last ten years, the six largest central banks have printed unprecedented amounts of money to purchase approximately $14 trillion of financial assets as shown below. Before the financial crisis of 2008, the only central bank printing money of any consequence was the Peoples Bank of China (PBoC).

The central banks’ goals, in general, are threefold:

  • Expand the money supply allowing for the further proliferation of debt, which has sadly become the lifeline of most developed economies.
  • Drive financial asset prices higher to create a wealth effect. This myth is premised on the belief that higher financial asset prices result in greater economic growth as wealth is spread to the masses.
    • “And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”Ben Bernanke Editorial Washington Post 11/4/2010.
  • Lastly, generate inflation, to help lessen the burden of debt.

QE has forced interest rates downward and lowered interest expenses for all debtors. Simultaneously, it boosted the amount of outstanding debt. The net effect is that the global debt burden has grown on a nominal basis and as a percentage of economic growth since 2008. The debt burden has become even more burdensome.

The wealth effect is putting riches in the hands of a small minority of the population, with negligible benefits, if any, flowing to the majority of the population. Bernanke’s version of the virtuous circle, as highlighted above, is far from virtuous unless you are in the upper five to ten percent of households by wealth.  To understand how a real economic virtuous circle works, we recommend you read our article The Death of the Virtuous Cycle and watch The Animated Virtuous Cycle.

Inflation has been low since 2008 and deflation continues to be a chief concern of most central bankers. Because QE, in all cases, was focused on financial asset prices and not the prices of everyday goods and services, the inflation they aimlessly seek has not occurred.

To summarize our views, largely ineffective monetary policies are providing few economic benefits. They are increasing the debt burden and furthering socially destabilizing trends. Worse, these policies are packed with consequences that lie dormant and have yet to emerge. One of our concerns, which is being heralded as a positive, is the massive distortions in financial asset prices worldwide. Consider a few of these facts below and whether they are sustainable:

  • U.S. yields have been among the lowest ever on record dating back to 1776
  • U.S. equity valuations have risen to levels rarely observed and from this perch have always been followed by massive losses
  • Over $9 trillion in sovereign bonds yields in many European countries and Japan have negative current yields
  • European junk-grade debt now trades at yields lower than U.S. Treasuries
  • Veolia, a French BBB rated company, recently issued a 3-year bond at a yield of -.026%.
  • Italian 3-year government bonds yield -0.337%, despite the 3rd highest debt to GDP ratio of all developed nations (132%)
  • Argentina, which has defaulted 6 times in the past 100 years, issued a $2.75 billion 100-year bond paying a paltry 8% interest
  • The BOJ owns over 75% of all Japanese ETFs
  • The Swiss National Bank owns 19.2 million shares of Apple, or 3% of total shares outstanding, and $84 billion in aggregate of U.S. stocks

Yes, Ron, the central bankers have clearly crossed the line between free markets and government controlled markets. To answer your question about the “shakeout,” we must wait until the inevitable day comes and asset prices are in free-fall. When this occurs, we will learn the full extent of their support and how far they have crossed the line. We like to think the central bankers are willing to endure the short-term pain of such a situation and allow the natural cycle of economies and asset prices to run their course. The reality, however, is that the pattern of their actions in the post-financial crisis era argue that they are unlikely to relinquish their grip. To the extent that authority and power is extended to the Fed through the U.S. Congress, it does not seem likely for career politicians to urge action that may be painful in the short-term but highly beneficial in the long-term.

This premonition was supported by recent statements from the October 2017 Federal Reserve minutes and appointed Fed Chairman Jerome Powell respectively. Fed Minutes:

“In light of elevated asset valuations and low financial market volatility, several participants expressed concerns about a potential buildup of financial imbalances,” further “They worried that a sharp reversal in asset prices could have damaging effects on the economy.” Jerome Powell, in prepared remarks to Congress stated: “(the Fed) will respond with force to threats to the nation’s stability.”

Putting two and two together, one can quickly figure out that falling asset prices and the “damaging effects” they will inflict on the economy will not be tolerated by the Fed. 

Ron, while we cannot answer your question with certainty, we are relatively confident the Fed and other central banks’ influence on markets will only increase in time as they continue to perpetuate the debt and economic problems they helped create. Naturally, the next question for consideration is to what extent markets may be bigger than the Fed? That is an article for another day.

We love reader questions. Please submit them to us and we will be happy to respond.

This past weekend, I discussed the current extension of the market. To wit: 

“In the short-term, the market trends are CLEARLY bullish, very overbought, but nonetheless bullish.”

“As such, our portfolios remain ‘long’ on the equity side of the ledger…for now. “

The current momentum behind the market advance is clearly bullish, and with the “smell of tax reform” in the air, there is little to derail the bulls before year-end.

As I previously wrote, I am still somewhat suspicious of the markets going into 2018. As I laid out over the last couple of weeks, I believe the risk of “tax-related” selling is a strong possibility at the beginning of the year as portfolios lock in gains without having to pay taxes until 2019. While the risk to the overall market trend remains small, a correction of 3-5% is possible. I am still looking for the right “setup” by the end of the month to add a small “short S&P 500” position to portfolios and increase longer-duration bond exposure to hedge off some of the potential risks.

I will keep you apprised, of course.

However, in the meantime, there seems to be nothing stopping the market from going higher. As stated in the title, the current push higher puts 2700 in sight by the time Santa fills the “stockings hung by the chimney with care.”

As shown below, price momentum triggered a short-term “buy” signal following Thanksgiving, and after the brief “AMT Tax Debacle” in the Senate Tax Bill, momentum again has turned up as prices continue to press higher.

As noted above, this “momentum” keeps portfolios allocated towards equity risk, but we continue to be prudent about the risk we are taking and continue to hedge risk as necessary.

It’s All About Liquidity

As I have discussed previously, what fundamental strength there is in the market currently was long-ago priced in. The reality is this continues to be a liquidity driven market through Central Bank interventions. The correlation between the NYSE Advance/Decline line and the Japanese Yen shows the “carry trade” that arises from these monetary interventions.

Following the early 2016 correction, the “carry trade” has picked up steam and has continued to force asset prices higher as liquidity seeks opportunity. With the “carry trade” now extremely extended currently, which is also highly leveraged, watch for a triggering of a “sell signal” as a sign to temporarily reduce equity-related risk.

But wait, the Fed is reducing their liquidity flows into the financial system, right?

Not so much.

As shown in the first chart below, the Fed’s balance sheet continues to remain stable even as asset prices surge.

With global Central Banks still flooding the system with liquidity, the Fed has yet to begin rolling off their reinvestments as expected. In fact, the Fed made a timely reinvestment during the “Senate Tax Bill” debacle earlier this month.

Of course, that bump of liquidity sent asset prices rocketing higher.

The question becomes just what will happen to the markets when the Fed actually does begin to aggressively decrease their “reinvestments” in the coming year. The projected decline in the balance sheet looks like the following:

One can only imagine how market which has been repeatedly driven higher on a “feast of liquidity,” either from the Fed or other Central Banks, will react to being put on a diet.

The consequences for investors is likely not optimal particularly given, as discussed this past weekend, the degree of extensions in the market from both long and short-term moving averages. As shown, there are only a few occasions in history where the market has gotten extremely deviated from it 6-year moving average as it is now.

Such deviations do not necessarily mean a crash is coming tomorrow, as shown, irrational exuberance can last much longer than logic would otherwise dictate. However, with the economy running at substantially weaker levels of growth, the ability to leverage debt limited, and valuations already grossly extended, a repeat of the late-90’s is much less likely currently.

The current environment, while bullish, is much more fragile than what was witnessed at the end of the last century hence the need for ongoing “emergency measures” from global Central Banks. This is due to:

  1. Weakness in revenue and profit growth rates
  2. Stagnating economic data
  3. Deflationary pressures
  4. Excessive bullish sentiment
  5. Rising levels of margin debt
  6. Expansion of P/E’s (5-year CAPE)

(For visual aids on these points read: 4 Warnings)

But, for now, the bull charges on.

2700 by Christmas? It’s likely as asset managers try to make up ground, performance wise, before year-end reporting.

How To Play It

With the markets currently in extreme intermediate-term overbought territory, it is likely that the current “hope driven” rally is likely near a short-term top.

For individuals with a short-term investment focus, pullbacks in the market can be used to selectively add exposure for trading opportunities. However, such opportunities should be done with a very strict buy/sell discipline just in case things go wrong. (See last week’s post for guidelines)

However, for longer-term investors, and particularly those with a relatively short window to retirement, the downside risk far outweighs the potential upside in the market currently. Therefore, using the seasonally strong period to reduce portfolio risk and adjust underlying allocations makes more sense currently. When a more constructive backdrop emerges, portfolio risk can be increased to garner actual returns rather than using the ensuing rally to make up previous losses. 

For More Read: “You Can’t Time The Market?”

With our portfolios invested at the current time, it makes little sense to focus on what could go “right.” You can readily find that case in the mainstream media which is biased by its needs for advertisers and ratings. However, by understanding the impact to portfolios when something goes “wrong” is inherently more important. If the market rises, terrific. It is when markets decline that we truly understand the “risk” that we take. A missed opportunity is easily replaced. However, a willful disregard of “risk” will inherently lead to the destruction of the two most precious and finite assets that all investors possess – capital and time.

Just something to consider when the media tells you to ignore history and suggests “this time may be different.” 

That is usually just about the time when it isn’t.

Last week, I discussed the issue of “bubbles” in the market. To wit:

“Market bubbles have NOTHING to do with valuations or fundamentals.”

Hold on…don’t start screaming “heretic” and building gallows just yet. Let me explain.

Stock market bubbles are driven by speculation, greed, and emotional biases – therefore valuations and fundamentals are simply a reflection of those emotions.

In other words, bubbles can exist even at times when valuations and fundamentals might argue otherwise. Let me show you a very basic example of what I mean. The chart below is the long-term valuation of the S&P 500 going back to 1871.”

“First, it is important to notice that with the exception of only 1929, 2000 and 2007, every other major market crash occurred with valuations at levels LOWER than they are currently. Secondly, all of these crashes have been the result of things unrelated to valuation levels such as liquidity issues, government actions, monetary policy mistakes, recessions or inflationary spikes. 

However, those events were only a catalyst, or trigger, that started the ‘panic for the exits’ by investors.”

Market crashes are an “emotionally” driven imbalance in supply and demand. You will commonly hear that “for every buyer, there must be a seller.” This is absolutely true. The issue becomes at “what price.” What moves prices up and down, in a normal market environment, is the price level at which a buyer and seller complete a transaction.

The problem becomes when the “buyer at a higher price” fails to appear.

The markets function much the same way as yelling “fire” in a theater filled to capacity with only one exit. Those closest to the exit will likely get out safely, but once the “bottleneck” forms, there is an inability to exit before the damage is done.

The “exit” problem is exacerbated when everyone is in the same theater.” 

Dana Lyons observed this last week.

“The percentage households’  financial assets currently invested in stocks has jumped to levels exceeded only by the 2000 bubble.

Updating one of our favorite data series from the Federal Reserve’s latest Z.1 Release, we see that in the 3rd quarter, household and nonprofit’s stock holdings jumped to 36.3% of their total financial assets. This is the highest percentage since 2000. And, in fact, the only time in the history of the data (since 1945) that saw higher household stock investment than now was during the 1999 to 2000 blow-off phase of the dotcom bubble. Perhaps not everyone is in the pool, but it certainly is extremely crowded.”

“Note how stock investment peaked with major tops in 1966, 1968, 1972, 2000 and 2007. Of course, investment will rise merely with the appreciation of the market; however, we also observe disproportionate jumps in investment levels near tops as well. Note the spikes at the 1968 and 1972 tops and, most egregiously, at the 2000 top.

Yes, there is still room to go (less than 6 percentage points now) to reach the bubble highs of 2000. However, one flawed behavioral practice we see time and time again is gauging context and probability based on outlier readings. The fact that we are below the highest reading of all-time in stock investment should not lead one’s primary conclusion to be that there is still plenty of room to go to reach those levels.”

Sitting Closer To The Exit

Howard Marks once stated that being a “contrarian” is tough, lonely and generally right. To wit:

“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, particularly when momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that‘being too far ahead of your time is indistinguishable from being wrong.’)

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.”

The problem with being a contrarian is the determination of where in a market cycle the “herd mentality” is operating.

The collective wisdom of market participants is generally “right” during the middle of a market advance but “wrong” at market peaks and troughs.

This is why technical analysis, which is nothing more than the study of “herd psychology,” can be useful at determining the point in the market cycle where betting against the “crowd” can be effective. Being too early, or late, as Howard Marks stated, is the same as being wrong.

The chart below is a historical chart of the S&P 500 index based on QUARTERLY data. Such long-term data is NOT useful for short-term market timing BUT is critically important in not only determining the current price trends of the market but potentially the turning points as well. 

  • The 12-period (3-year) Relative Strength Index (RSI),
  • Bollinger Bands (2 and 3 standard deviations of the 3-year average),
  • CAPE Ratio, and;
  • The percentage deviation above and below the 3-year moving average. 
  • The vertical RED lines denote points where all measures have aligned

While valuation risk is certainly concerning, it is the extreme deviations of other measures to which attention should be paid. When long-term indicators have previously been this overbought, further gains in the market have been hard to achieve. However, the problem comes, as identified by the vertical lines, is understanding when these indicators reverse course. The subsequent “reversions” have not been forgiving.

The chart below brings this idea of reversion into a bit clearer focus. I have overlaid the real, inflation-adjusted, S&P 500 index over the cyclically-adjusted P/E ratio. 

Historically, we find that when both valuations and prices have extended well beyond their intrinsic long-term trendlines, subsequent reversions beyond those trend lines have ensued.

Every. Single. Time.

Importantly, these reversions have wiped out a decade, or more, in investor gains. As noted, if the next correction began in 2018, and ONLY reverts back to the long-term trendline, which historically has never been the case, investors would reset portfolios back to levels not seen since 1997.

Two decades of gains lost.

With everyone crowded into the “ETF Theater,” the “exit” problem should be of serious concern.

“Over the next several weeks, or even months, the markets can certainly extend the current deviations from long-term mean even further. But that is the nature of every bull market peak, and bubble, throughout history as the seeming impervious advance lures the last of the stock market ‘holdouts’ back into the markets.”

Unfortunately, for most investors, they are likely stuck at the very back of the theater.

With sentiment currently at very high levels, combined with low volatility and excess margin debt, all the ingredients necessary for a sharp market reversion are currently present.

Am I sounding an “alarm bell” and calling for the end of the known world? Should you be buying ammo and food? Of course, not.

However, I am suggesting that remaining fully invested in the financial markets without a thorough understanding of your “risk exposure” will likely not have the desired end result you have been promised.

As I stated often, my job is to participate in the markets while keeping a measured approach to capital preservation. Since it is considered “bearish” to point out the potential “risks” that could lead to rapid capital destruction; then I guess you can call me a “bear.” 

Just make sure you understand I am still in “theater,” I am just moving much closer to the “exit.”

(Follow up read on how to approach the market: The 80/20 Rule Of Investing)


Readers of the Unseen, 720Global’s premium service, will be also be receiving an article on liquidity this week. In “Liquidity Defined,” 720Global further explores the types and characteristics of liquidity and the importance of never taking it for granted. The substance of the article is well-summarized in this short excerpt:

“The peer pressure and career risk of bolstering one’s defenses in a Pamplona-style bull run are palatable, but wealth is most effectively compounded by avoiding large losses not chasing returns with the irrationally exuberant. Many investors and others are stumbling confidently forward playing the role of the genius in a bull market. The prudent manager worries about the trifles of liquidity at a time when it is so plentiful it seems unreasonable to worry. Liquidity comes at a cost, but excess liquidity in times of crisis offers both priceless protection and clear-headed decision-making opportunities that are rare indeed.”

As an introduction to what 720Global and Real Investment Advice will offer in our upcoming subscriber services please contact us and we will send you the exclusive Unseen article on liquidity.

I’ve been asked about Bitcoin a lot lately. I’ haven’t written anything about it because I find myself in an uncomfortable place in agreeing with the mainstream media: It’s a bubble. Bitcoin started out as what I’d call “millennial gold” – the young (digital) generation looked at it as their gold substitute.

Bitcoin is really two things: a blockchain technology and a (perceived) currency. The blockchain element of Bitcoin may have enormous future applications: It may be used for electronic contracts, voting, money transfers – and the list goes on. But there is a very important misconception about Bitcoin: Ownership of Bitcoin doesn’t give you ownership of the technology. I, without owning a single bitcoin, own as much Bitcoin technology as someone who owns a million bitcoins; that is, exactly none. It’s just like when you have $1,000 on a Visa debit card: That $1,000 doesn’t give you part ownership of the Visa network unless you actually own some Visa’ stock.

Owning Bitcoin gives you a right to … what, actually? Digital bits?

I can understand gold bugs and the original Bitcoin aficionados. The global economy is living beyond its means and financing its lifestyle by issuing a lot of debt. Normally this behavior would cause higher interest rates and inflation. But not when you have central banks. Our local central bankers simply bought this newly issued debt and brought global interest rates down to near-zero levels (and in many cases to what would have been previously unthinkable negative levels). If you think investing today is difficult, being a parent is even more difficult. I tried to explain the above to my sixteen-year-old son, Jonah. I saw the same puzzled look in his eyes as when he found out where babies come from. I also felt embarrassed, for my inability to explain how governments can buy the debt they just issued. The concept of negative interest rates goes against every logical fiber in my body and is as confusing to this forty-four-year-old parent as it is to my sixteen-year-old.

The logical inconsistencies and internal sickness of the global economy have manifested themselves into a digital creature: Bitcoin. The core argument for Bitcoin is not much different from the argument for gold: Central banks cannot print it. However, the shininess of gold has less appeal to millennials than Bitcoin does. They are not into jewelry as much as previous generations; they don’t wear watches (unless they track your heartbeat and steps). Unlike with gold, where transporting a million dollars requires an armored track and a few body builders, a nearly weightless thumb drive will store a dollar or a billion dollars of Bitcoin. Gold bugs would of course argue that gold has a tradition that goes back centuries. To which digital millennials would probably say, gold is analog and Bitcoin is digital. And they’d add, in today’s world the past is not a predictor of the future – Sears was around for 125 years and now it is almost dead.

A client jokingly told me that his biggest gripe with me in 2016 and 2017 was that I didn’t buy him any Bitcoin. I told him not so jokingly that if I bought him Bitcoin, he’d be right to fire me. Maybe I’m a dinosaur; but, like gold, Bitcoin is impossible to value. What is it worth? It has no cash flows. Is a coin worth $2, $200, or $20,000? But Wall Street strategists have already figured out how to model and value this creature. Their models sound like this:

“If only X percent of the global population buys Y amount of Bitcoin, then due to its scarcity it will be worth Z”.

On the surface, these types of models bring apparent rationality and an almost businesslike valuation to an asset that has no inherent value. You can let your imagination run wild with X’s and Y’s, but the simple truth is this: Bitcoin is un-valuable.

In 1997, when Coke’s valuation started to rival some dotcoms, bulls used this math:

“The average consumer of Coke in developed markets drinks 296 ounces of Coke a year. These markets represent only 20% of the global population.”

And then the punchline:

“Can you imagine what Coke’s sales would be if only X% of the rest of the world consumed 296 ounces of Coke a year?”

Somehow, the rest of the world still doesn’t consume 296 ounce of Coke. Twenty years later, Coke’s stock price is not far from where it was then – but on the way it declined 60% and stayed there for a decade. Coke, however, was a real company with a real product, real sales, a real brand and real tangible, dividend-producing cash flows.

If you cannot value an asset you cannot be rational. With Bitcoin at $11,000 today, it is crystal clear to me, with the benefit of hindsight, that I should have bought Bitcoin at 28 cents. But you only get hindsight in hindsight. Let’s mentally (only mentally) buy Bitcoin today at $11,000. If it goes up 5% a day like a clock and gets to $110,000 – you don’t need rationality. Just buy and gloat. But what do you do if the price goes down to $8,000? You’ll probably say, “No big deal, I believe in cryptocurrencies.” What if it then goes to $5,500? Half of your hard-earned money is gone. Do you buy more? Trust me, at that point in time the celebratory articles you are reading today will have vanished. The awesome stories of a plumber becoming an overnight millionaire with the help of Bitcoin will not be gracing the social media. The moral support – which is really peer pressure – that drives you to own Bitcoin will be gone, too.

Then you’ll be reading stories about other suckers like you who bought it at what – in hindsight – turned out to be the all-time high and who got sucked into the potential for future riches. And then Bitcoin will tumble to $2,000 and then to $100. Since you have no idea what this crypto thing is worth, there is no center of gravity to guide you or anyone else to make rational decisions. With Coke or another real business that generates actual cash flows, we can at least have an intelligent conversation about what the company is worth. We can’t have one with Bitcoin. The X times Y = Z math will be reapplied by Wall Street as it moves on to something else.

People who are buying Bitcoin today are doing it for one simple reason: FOMO – fear of missing out. Yes, this behavior is so predominant in our society that we even have an acronym for it. Bitcoin is priced today at $11,000 because the fool who bought it for $11,000 is hoping that there is another, greater fool who will pay $12,000 for it tomorrow. This game of greater fools is not new. The Dutch played it with tulips in the 1600s– it did not end well. Americans took the game to a new level with dotcoms in the late 1990s – that round ended in tears, too. And now millennials and millennial-wannabes are playing it with Bitcoin and few hundred other competing cryptocurrencies.

The counterargument to everything I have said so far is that those dollar bills you have in your wallet or that digitally reside in your bank account are as fictional as Bitcoin. True. Currencies, like most things in our lives, are stories that we all have (mostly) unconsciously bought into. (I highly encourage you to read my favorite book of 2015: Sapiens, by Yuval Harari.) Of course, society and, even more importantly, governments have agreed that these fiat currencies are going to be the means of exchange. Also, taxation by the government turns the dollar bill “story” into a very physical reality: If you don’t pay taxes in dollars, you go to jail. (The US government will not accept Bitcoins, gold, chunks of granite, or even British pounds).

And finally, governments tend to look at Bitcoin and other cryptocurrencies as a threat to their existence. First, governments are very particular about their monopolistic right to control and print currencies – this is how they can overpromise and underdeliver. No less important, the anonymity of cryptocurrencies makes them a heaven for tax avoiders – governments don’t like that. The Chinese government outlawed cryptocurrencies in September 2017. Western governments are most likely not far behind. If you think outlawing a competitor can happen only in a dictatorial regime like China’s, think again. This can and did happen in a democracy like the US. With Executive Order 6102 in 1933, US President Franklin D. Roosevelt made it illegal for the US population to “hoard gold coin, gold bullion, or gold certificates.”

However, nothing I have written above will matter until it does. Bitcoin may go up to $110,000 by the end of the 2018 before it comes down to … earth. That is how bubbles work. Just because I called it a bubble doesn’t mean it will automatically pop.

Since the election, equity bulls have been pinning their hopes on “tax cuts” as the needed injection to support currently elevated stock prices. Stocks have advanced sharply since the election on these expectations, and while earnings have recovered, primarily due to the rise in oil prices, whatever economic growth was to come from tax reform has likely already been priced in. 

For some background on our views, both Michael Lebowitz and I have been discussing the tax bills as they are currently proposed since May of this year.

Buy The Rumor – Sell The News

We are currently in the second longest economic expansion since WWII. While Republican lawmakers are betting on jump-starting economic growth, the problem becomes the length of the current liquidity-driven expansion. All economic cycles end, and we are already closer to the end of the current expansion than not.

However, Patrick Watson over at Mauldin Economics recently made a brilliant observation. To wit:

“The gap between the gray line (potential GDP) and the red line (actual GDP) represents unused capacity. You can see we had a lot of it at the recession’s 2009 depth. The gap slowly shrank since then. Now it’s closed.

Great news, right? Yes, it is—but don’t celebrate just yet.

Actual GDP can’t stay above potential GDP for long before bad things start happening. This chart proves it:”

“We see here how GDP moved above and below its potential since the 1970s. Notice that each time the green line went above zero, a recession (the gray bars) began soon after.

‘Soon’ can vary, of course. GDP ran above potential for extended periods in the late 1990s and 2006–2007, but in both cases, intense downturns followed. Plus, the Fed wasn’t tightening as it is now—which suggests the current expansion is at least approaching its endpoint.”

While the Trump administration, and congressional Republicans, suggest their tax changes will stimulate years of economic growth and more than pay for themselves, the reality is likely quite the opposite.

What investors are missing is that while tax reform could well provide for a modest bump to GDP growth, that growth bump is being offset by the Federal Reserve tightening monetary policy by lifting interest rates. Don’t forget, the reason the Fed lifts interest rates is to SLOW economic growth to quell inflationary pressures.

Furthermore, as the brilliant minds at the Committee for a Responsible Federal Budget penned recently, the tax reform legislation will likely bring back trillion-dollar deficits by 2019. To wit:

“If they aren’t careful, we estimate legislation under consideration could bring back trillion-dollar deficits by next year. Even under current law, deficits are likely to reach almost $600 billion this year and $700 billion next year. By our estimate, a combination of tax cuts, sequester relief, and other changes would increase deficits to $1.05 trillion by 2019 and $1.1 trillion by 2020.”

Of course, a trillion-dollar deficit would require further debt growth in order to fund the revenue gap. As the debt levels continue to expand, estimated to hit $30 trillion over the next 8-years, the impact to economic growth will continue to be negative. 

With the Federal Reserve already in the process of reducing their balance sheet, with the rest of the world set to follow, the primary support of the markets is quickly fading. This elevates the risk of a policy mistake by the Fed, and as Doug Kass noted Wednesday, the risk of a Congressional mistake has also risen: 

History shows that if the Senate version is adopted and the corporate tax rate reduction is delayed for another year, the odds of a recession are greatly increased. (A position that Art Laffer has publicly taken.)

The biggest mistake made by the Reagan Administration was to delay the corporate cuts by a year as the Senate version does. Companies waited a year to expand capital investments back then — causing a recession in 1981-82.”

Just something to think about as you catch up on your weekend reading list.


Trump, Economy & Fed


Markets


Research / Interesting Reads


“As contrarians, the only thing to fear is the lack of fear itself.” – Bernie Schaeffer

Questions, comments, suggestions – please email me.

Real Investment Advice is pleased to introduce J. Brett Freeze, CFA, founder of Global Technical Analysis. Going forward on a monthly basis we will be providing you their valuable S&P 500 Valuation Chart Book. This unique analysis provides an invaluable long term perspective of equity valuations. 

If you are interested in learning more about their services, please connect with them.

Introduction

We believe that the chief determinant of future total returns is the relative valuation of the index at the time of purchase. We measure valuation using the Price/Peak Earnings multiple as advocated by Dr. John Hussman. We believe the main benefit of using peak earnings is the inherent conservatism it affords: not subject to analyst estimates, not subject to the short-term ebbs and flows of business, and not subject to short-term accounting distortions. Annualized total returns can be calculated over a horizon period for given scenarios of multiple expansion or contraction.

Our analysis highlights expansion/contraction to the minimum, mean, average, and maximum multiples (our data-set begins in January 1900) . The baseline assumptions for nominal growth and horizon period are 6% and 10 years, respectively. We also provide graphical analysis of how predicted returns compare to actual returns historically.

We provide sensitivity analysis to our baseline assumptions. The first sensitivity table, ceterus paribus, shows how future returns are impacted by changing the horizon period. The second sensitivity table, ceterus paribus, shows how future returns are impacted by changing the growth assumption.

We also include the following information: duration, over(under)-valuation, inflation adjusted price/10-year real earnings, dividend yield, option-implied volatility, skew, realized volatility, historical relationships between inflation and p/e multiples, and historical relationship between p/e multiples and realized returns.

Our analysis is not intended to forecast the short-term direction of the SP500 Index.  The purpose of our analysis is to identify the relative valuation and inherent risk offered by the index currently.


The term “priced in” is a phrase used frequently by Wall Street and the financial media. This expression is used to describe how much the price of stock or a market has accounted for an anticipated event. For example, consider a pharmaceutical stock that has risen 50% over the last few days on the prospects of getting regulatory approval for a new drug. If the collective “market” deems that the stock should increase a total of 100% if the drug is approved, then we can say the “market” has “priced in” a 50% chance the drug will be approved.

The term “market”, as used above, is vague. It is meant to represent the consensus view. Importantly to investors, it represents potential opportunity when an investor has a view that differs from the consensus.  If you were 100% certain the drug in the prior example would be approved, you could make a 50% gain on the stock if proven correct.

This article is a follow-up to one published November 29, 2017, Corporate Tax Cuts – The Seen and the Unseen. In that piece, we provided an analysis of the proposed corporate tax reduction that lies within the pending tax reform bill. We pointed out that, while investors appear focused on the benefits to corporations, they are grossly negligent ignoring the negative economic effects that higher individual taxes will have on consumption (70% of GDP) and the adverse influence of an additional $1.5 trillion deficit.

In this piece, we consider how the consensus is quantifying the positive effect the tax bill should have on stocks. Specifically, we discuss what is “priced in” to the market. This example, unlike that of the drug maker, is not black and white. However, by explaining how market projections are created, we offer guidance on how much the market has priced in for corporate tax cuts. This in turn offers investors a non-market opinion on what the corporate tax cut is worth and a basis to take appropriate actions.

To be clear, our view of the implications of this legislation are likely negative to GDP and therefore corporate earnings. That said, we also want to understand how the consensus views the proposal in order to form an opinion about how the market may trade. In due time the consequences of poorly constructed tax reform will appear but in the meantime, 720Global does not set the market price, the consensus does.

Corporate Tax Cuts

Since at least 1947, historical data has provided sufficient evidence to show that corporate tax reductions, subsidized by federal deficits and individual taxpayers, have resulted in slowing GDP growth. Accordingly, we believe that the current proposal will follow the path of prior tax reductions and result in weaker economic growth and ultimately lower corporate earnings than would have occurred without the legislation.

While our opinion, as stated above and detailed in the previously referenced article, differs widely from the “market”, we thought it might be helpful to provide a framework using the logic of most investors to value the corporate tax reduction.  The following paragraph from the article reviews our findings.

Based on this simple analysis thus far, it is easy to understand why equity investors are giddy over a sizeable reduction in the corporate tax rate. If the statutory rate is reduced to 20% as proposed, and the effective rate remains 10% lower, the amount of money corporations pay in taxes will be reduced sharply. Based solely on this assumption, corporate after-tax profits, in year one alone should increase by almost $200 billion, while federal corporate tax receipts will be reduced by the same amount. Such a boost in corporate earnings would increase the forecasted internal rate of return (IRR) on the S&P 500 by approximately .90%. Holding everything else constant, this equates to a price increase of 285 points for the S&P 500 or an 11% gain from today’s level.

We recently read an article in which the Swiss investment firm UBS claims “Stocks could surge 25% if the Republican tax bill passes.” Given the juxtaposition between the paragraph above and the UBS forecast, we wanted to walk you through the math and let you judge for yourself what investors think the tax cut is worth.

Valuation Math

The graph below compares corporate earnings with a tax cut (green line) to one without the cut (red line).  As a reminder, corporate earnings will be affected by the changes in the effective tax rate not the statutory rate. As such, we base our analysis on an expected decrease in the effective tax rate from the current level of 22% to 10%, and assume earnings in both cases grow at 5% a year.

The present value of the difference between the two lines above is the likely approach that most investors are using to price the value added from the tax plan. In turn, the present value figure of that differential yields a dollar premium that can then be added to the current price of the S&P 500 to arrive at an expected price after the tax cut. Based purely on the earnings shown in the graph, an investor looking to receive those cash flows would be indifferent between paying the current price for current earnings and paying the current price plus $285 per share or 2925 for the earnings benefiting from the tax cuts. The current price of the S&P 500 is 2640. Thus, investors that believe the tax cut will reduce the effective tax rate by 12% should expect the S&P 500 to increase by approximately 11%.

In order to validate our findings above, we take a different approach and quantify how the change in earnings would affect the price to earnings ratio (P/E). Currently, the one year trailing earnings for the S&P 500 are $107 per share and the P/E is 24.63. If earnings increased by 12% due to tax cuts, the P/E would decline to 21.99. If the market were to price in the increased earnings under the assumption that valuations are unchanged, the price of the S&P 500 would need to increase 12% to bring P/E back to its current level. This different approach delivers a very similar result.

Starting Line

Thus far, the analysis seems relatively straight forward, however there is another major concern when gauging how much of the tax bill is priced in to the market. We need to ask, “When did the market begin to price in the benefits of tax relief for corporations?”  Obviously it is impossible to pinpoint a date, but we selected three possibilities to show why this matters. The table below uses the night before the Presidential election, the date Congress began debating tax reform and the current date. The current price of 2640 allows us determine how much the S&P 500 has priced in.

As shown above, those that believe the tax deal has not been priced in and its passage will increase corporate valuations by 12% ought to expect a full adjustment in the price of the index from current levels. On the flip side, those that similarly believe the tax bill will boost valuations but believe this has been known by the market since the day Donald Trump was elected might expect a decline of 9.59%. They would argue the market has priced in a corporate tax reduction and then some. Another option is that in addition to tax cuts, the market is giving some consideration to other Trump policies that may be beneficial to the market such as regulatory reform. Although we try to isolate and quantify the effects of tax cuts, there are clearly many other dynamics in play.

Summary

UBS believes stocks are worth 25% more than current levels if proposed tax cuts become law. While we do not know how they arrived at such a large number, we can use our analysis above to solve for possible answers. Based on the framework of our analysis, it is likely that UBS thinks corporations will reap the entire 12% tax benefit and corporate earnings will grow 1.25% faster due to broad economic benefits stemming from the bill. Their assumption also implies that none of the 25% is priced in. In other words, the true gains due to the tax bill are likely even higher.

UBS clearly presumes the tax cut will benefit the corporate bottom line due to a decreased tax burden and will also spur economic growth. As we discussed in the aforementioned article, there is no precedent for such a claim. History does not support UBS’s case, nor does common sense. We also remind you that UBS makes money selling stocks. Despite spurious math, as a for-profit financial institution, their interests are well-served by pitching the idea of a big post-tax cut rally.

If you believe like we do that the benefits to corporate earnings are being grossly overestimated by the consensus you are at a distinct advantage. This does not mean you must sell all stocks and short the market immediately. It does however require you to proceed with caution, for when reality catches up with the consensus, market valuations could be at risk.

To reiterate a point we made in the prior article:

Given the historical evidence regarding the implications of corporate tax cuts, we are left questioning the so-called “Trump bump.” We argue that a market rally based on that premise is incoherent, and the market should be discounting prices and valuations due to the tax cuts not inflating them.”

The week after Christmas begins with thoughts of lofty resolutions dancing around in our heads along with high expectations for success through the new year. There lies the great opportunity to settle in and take several financial actions that jump starts 2018 on solid fiscal footing.

Clean house.

Consider tax-loss selling where underperforming or losing investments are sold in brokerage in non-IRA accounts. Capital losses that are realized can be used to offset long and short-term capital gains or reduce ordinary taxable income by a maximum of $3,000 a year if gains aren’t achievable.

Losses not used against gains or income may be carried forward to future tax years; make sure to keep track of them. A smart idea is to inform your financial adviser or partner so that he or she may track and utilize losses accordingly.

Mutual fund investors will likely realize record capital gains for 2017 which makes scrutiny of losses to offset gains an important financial move by year end.

Realign to your original portfolio target.

So, you’ve allowed stocks in your portfolio to run year to date on momentum of tax-reform hopes, a somewhat dovish Fed and a solid synchronized global growth story? Well, good for you. Now, do your wealth a favor for 2018 and manage risk accordingly by taking profits, thus reducing your allocation to stocks to where they were last December.

At the least, your portfolio should be rebalanced to a neutral point where risk is in line with your emotional makeup or gut. And it’s fine to maintain the proceeds in cash or a short-term bond option. If anything, your weighting to fixed income probably requires a fresh look and additional investment. No, bonds are not dead.

Read: Bond Bears and Why Rates Won’t Rise.

Profit-taking this year may be especially prescient as the Senate tax bill has introduced a “FIFO mandate,” or first-in-first-out edict where retail investors (institutional is excluded), must sell their oldest shares first which most likely possess the lowest cost basis.

Ostensibly, unlike today where a retail investor can identify specific lots to sell, preferably the ones with the highest cost basis (and lowest capital gain tax liability), the Senate proposal would punish retail investors with heavier tax burdens by forcing them to sell the most profitable shares first.

The mandate has potential to alter behavior; retail investors may be hesitant to sell to avoid greater tax burdens. Thankfully, the mandatory FIFO provision is not included in the bill passed by the House Of Representatives.

Stash cash virtually.

Still stashing emergency cash in an outdated brick & mortar bank? Spend at most, 10 minutes online, to open a high-yield savings account with an FDIC-insured virtual bank like www.synchronybank.com. Due to lower overhead costs, savings and CD rates at online banks are anywhere from 50-65% higher than their outdated walk-in brethren. Worried about customer service? Don’t be. A chat feature and 800 number are available to communicate with bank representatives.

Make it a habit to transfer extra cash from your current institution to a new virtual choice. It’s easy to establish an electronic connection and easily move cash between them.

Drop a liability.

You may be surprised by the number of stealth monthly charges that hit your credit card accounts. It happened to me recently. After going through a paper credit card statement, I realized I’ve been auto-subscribed to a periodical I haven’t read in well over a year. Ostensibly, I racked up over $200 in charges.

If it happened to me, it can happen to you, too. Every year I go through and cut a recurring charge for a service I don’t use often enough to warrant the cost. This year it’s Netflix for me. What is it for you?

Drop me an e-mail and let me know what you cut, and why, and I’ll discuss it on the Real Investment Advice radio hour (anonymously, of course.)

Give yourself credit that pays you to use it.

If you’re going to use credit, consider cash back.

If you’re above average managing credit and paying off balances monthly, step up to cash-back rewards. Why not? Several issuers offer 5% cash back on everyday purchases like groceries, gas and restaurants.

Cards may charge annual fees ranging from $39 to $95 a month. However, if you spend $30-$65 a week on groceries or gas, you’ll more than make up for them.

Check out Nerdwallet’s list of best cash-back cards for a thorough review of issuers and pros, cons of each.

Bolster the “pay yourself first,” mantra.

Program yourself to pay yourself before everything else. Proactively adjust household expenditures so that company retirement and or emergency savings accounts are funded first. Payroll deductions or some form of automatic deposit feature make it easy to create and stick with an aggressive saving and investment program.

Make an initial bold move. A financial leap of faith: Take a step to super-saver status and immediately increase your retirement payroll deduction to 15%. Don’t even think about it, just do it. Before consideration to your household spending.

Micro-track expenses for the month of January after the new deduction is in effect. Adjust spending to meet the new, increased deduction. Then work on the necessary cuts to expenses to continue the 15% or possibly adjust even higher, to 20%.

My thought is you’ll be amazed to see how quickly the change is accepted and the impact minimal to the quality of life. I’ve witnessed how this action alters thinking to attach good feelings and reward to savings vs. spending.

Get a portfolio health assessment.

How much thought have you given to your overall portfolio allocation to stocks vs. bonds and cash? For example, many contribute to their company retirement accounts and ignore how their money is invested over time, or fully understand investment choices available.

The last week of December is perfect to meet with a financial professional, preferably a fiduciary, to assess the current risk in your portfolio vs. future return prospects.

Keep in mind, the stock market has appreciated 35% since 2014 while reported earnings growth has risen by a mere 2% through the same period. Sooner or later, this extreme premium in stock prices will work off through correction or long periods of much lower than average returns. Hey, it’s math and eventually math prevails over emotion.

Prep a reading list (include Real Investment Advice Survival Guides and blog).

My 2018 book choices are listed, purchased and ready to go! Need some ideas of seminal books or “must reads,” on the topic of finance? Click here for my personal favorites. I refer to at least one of these tomes annually. My 2018 choices include Richard Reeves’ Dream Hoarders and Ray Dalio’s Principles: Life and Work.

At www.realinvestmentadvice.com, there are several Financial Survival Guides available free for download. From questions you must ask when interviewing a financial adviser to investment and planning rules, these guides were created to help investors and savers make the most of their money.

Our latest Guide, “The Real Investment Advice Investing Manifesto,” is a Roberts & Rosso creation, suitable for framing or display, that outlines our financial philosophy in a creative, aesthetically-pleasing format.

Flip your money script.

According to Brad T. Klontz, Psy.D., CFP® & Sonya L. Britt, Ph.D., CFP®, money scripts as coined by Brad and Ted Klontz, are the core beliefs about money that drive ongoing behavior. Money scripts are unconscious beliefs about money formed in childhood, passed down from generations.

They may develop in response to an emotional charge or impact such as parental abandonment, devastating macroeconomic episodes like the Great Depression and the lingering impact of significant financial losses. I’ll add lack or volatility of household financial security. Also, I’ll add embarrassment to the list. As I pre-teen it was embarrassing for me to use food stamps when purchasing groceries for my tiny household.

So, what is your money script? How was it formed? How are you wired? Have you thought about it?

If you possess negative money habits, writing and exposing them consciously will help you to change them. Engage the assistance of a spouse, close friend or objective financial professional to rewire how you perceive money and keep you on track.

Financial changes don’t need to be difficult. Simple moves as outlined can prepare you for a fiscally strong 2018.

Reflections

“Through the mirror of my mind
Time after time
I see reflections of you and me

Reflections of
The way life used to be
Reflections of
The love you took from me

Oh, I’m all alone now
No love to shield me
Trapped in a world
That’s a distorted reality”

–The Supremes, “Reflections

When history judges this moment, it will not be kind.

Central banks, oblivious to the real reasons for low wage inflation — namely, globalization and advances in technology — have created a monster bubble and the markets, rather than being frightened by this, have celebrated it.

The passing of a stimulative tax bill that clearly will worsen income inequality and, according to almost all economists, will lead to minimal incremental economic growth while expanding deficits despite a nine-year economic recovery and 4% unemployment, is irresponsible. When the inevitable bust occurs, the public justifiably will reject corrective recommendations from those who have behaved so imprudently, thereby limiting the ability to re-stimulate.

The bad actors who have acted imprudently are the Federal Reserve and Congress. Their failure to prosecute the bad guys in 2008-09 and their continuing and deceitful self-interest will cost them public support when it genuinely is needed in the future and in the next crisis.

Our central bank, the Federal Reserve, in its infinite wisdom, is unconcerned about inflation. Consider $450 million paintings, wild speculation on bitcoins, which are up tenfold in 12 months and are traded by grandmothers and the Boca Biffs of the world, and $100 million New York City apartments bought on spec.

The aforementioned hooligans already have enriched the rich while giving moderate-income people less than 1% in their savings accounts. The income and wealth gaps widen daily as the Screwflation of the Middle Class, a subject I highlighted in a Barron’s piece in 2011, is unaddressed while patently false statements and promises (I am shocked!) are made by President Trump. Meanwhile, in another falsehood, Secretary of the Treasury Steve Mnuchin’s promised analysis of the tax bill apparently was never even conducted (see here and here)!

Remember Joseph in The Bible? When things were good, he put grain in the silos to have sustenance for an eventual bad day.

Our purported leaders, while often citing The Bible, apparently missed this part. They are eating the nation’s seed corn.

It’s bad all around — substantively, morally and intellectually. It is driven by discredited ideas that few are willing to challenge.

We live in a world where Tesla TSLA and bitcoin are among the most popular investments and trades. Rather than being dedicated to finding value, most traders and “investors” today worship at the altar of price momentum.

This is why we read Charles Kindleberger’s “Manias, Panics and Crashes” and read about Hyman Minsky’s moment to remind us not to lose our way when everyone around us is losing theirs.

As I wrote last evening:

We truly live in a parallel universe inhabited and controlled by passive investing products (ETFs) and strategies (risk parity and volatility trending), which have been delivering a virtuous cycle as their inflows continue to overwhelm the markets and are conditioned to buying every dip.

When interest rates rise and central banks pull back (or an unexpected event occurs), the virtuous cycle could be halted by outflows from ETFs and from these machine dominated algos.

Despite protestations on our site and elsewhere, the recent market leg higher has only partially been influenced by the corporate profit and economic backdrop. As I have documented, this has been a valuation-driven and not an earnings-driven market buoyed by inflows into the aforementioned products and strategies coupled with excess central bank liquidity.

Meanwhile, I continue to pound home that each day that goes by we get closer to a much wider monetary tightening next year — $420 billion to be sucked out by the Fed and about $500 billion less in the way of buying from the European Central Bank. I would note for timing purposes that one trillion dollars of reduced liquidity in 2018 is beginning in just four weeks.

Also, as I noted last evening:

As Grandma Koufax used to say, “Dougie, matzahs don’t grow to the sky. Even in the Bronx.”

This morning’s opening missive, “Here’s What Works For Me,” tracks how I look at the market.

By my calculus the market’s downside is at least 4x greater than the upside today — even with a tax reduction, which will likely not “trickle down” and catalyze.

From my perch there is no margin of safety left in today’s market.

I will leave it at that.

Since the election, markets have accelerated the pace of the advance as shown in the chart below.

The advance has had two main story lines to support the bullish narrative.

  • It’s an earnings recovery story, and;
  • It’s all about tax cuts.

There is much to debate about the earnings recovery story but as I showed previously, and to steal a line from my friend Doug Kass, this “new meme increasingly resembles ‘Group Stink.’” To wit:

“Despite many who are suggesting this has been a ‘rational rise’ due to strong earnings growth, that is simply not the case as shown below. (I only use ‘reported earnings’ which includes all the ‘bad stuff.’ Any analysis using “operating earnings” is misleading.)”

“Since 2014, the stock market has risen (capital appreciation only) by 35% while reported earnings growth has risen by a whopping 2%. A 2% growth in earnings over the last 3-years hardly justifies a 33% premium over earnings. 

Of course, even reported earnings is somewhat misleading due to the heavy use of share repurchases to artificially inflate reported earnings on a per share basis. However, corporate profits after tax give us a better idea of what profits actually were since that is the amount left over after those taxes were paid.”

“Again we see the same picture of a 32% premium over a 3% cumulative growth in corporate profits after tax. There is little justification to be found to support the idea that earnings growth is the main driver behind asset prices currently.

We can also use the data above to construct a valuation measure of price divided by corporate profits after tax. As with all valuation measures we have discussed as of late, and forward return expectations from such levels, the P/CPATAX ratio just hit the second highest level in history.”

The reality, of course, is that investors are simply chasing asset prices higher as exuberance overtakes logic.

The second meme of “it’s all about tax cuts” is also not entirely accurate. The current rally, following the nearly 20% decline in early 2016 is actually an extension from the transition of “quantitative easing” from the Federal Reserve to the global Central Banks. What is clearly seen in the chart below is that as the Fed signaled the end of their QE program, and begin hiking interest rates, Global Central banks took the lead.

As noted, a correction back to critical support, the 2016 lows, would entail a 29.1% decline from current levels. More importantly, a decline of such magnitude will threaten to trigger “margin calls” which, as discussed previously, is the “time bomb” waiting to happen.

Here is the point. The “excuses” driving the rally are just that. The election of President Trump has had no material effect on the market outside of the liquidity injections which have exceeded $2 Trillion.

Importantly, on a weekly basis, the market has pushed into the highest level of overbought conditions on record since 2005. I have marked on the chart below each previous peak above 80 which has correlated to a subsequent decline in the near future.

The problem for investors is not being able to tell whether the next correction will be just a “correction” within an ongoing bull market advance, or something materially worse. Unfortunately, by the time most investors figure it out – it is generally far too late to do anything meaningful about it. 

As shown below, price deviations from the 50-week moving average has been important markers for the sustainability of an advance historically. Prices can only deviate so far from their underlying moving average before a reversion will eventually occur. (You can’t have an “average” unless price trades above and below the average during a given time frame.)

Notice that price deviations became much more augmented heading into 2000 as electronic trading came online and Wall Street turned the markets into a “casino” for Main Street.

At each major deviation of price from the 50-week moving average, there has either been a significant correction, or something materially worse. 

This time is unlikely to be different.

Just how big could the next correction be? 

As stated above, just a correction back to the initial “critical support” set at the 2016 lows would equate to a 29.1% decline.

However, the risk, as noted above, is that a correction of that magnitude would begin to trigger margin calls, junk bond defaults, blow up the “VIX” short-carry and trigger a wave of automated selling as the algorithms begin to sell in tandem. Such a combination of events could conceivably push markets to either strong support at the previous two bull market peaks or to support at the 2011 peak which coincides with the topping formations of 2000 and 2007.

Such a correction would entail either a 41.1% to 49.2% decline.

I won’t even mention the remote, but real, possibility of a nearly 75% retracement to the previous lows of the last two “bear markets.”

That can’t happen you say?

It wouldn’t even match the decline following the 1929 crash of 85%.

Furthermore, as technical analyst J. Brett Freeze, CFA, recently noted:

“The Wave Principle suggests that the S&P 500 Index is completing a 60-year, five-wave motive structure. If this analysis is correct, it also suggests that a multi-year, three-wave corrective structure is immediately ahead. We do not make explicit price forecasts, but the Wave Principle proposes to us that, at a minimum, the lows of 2009 will be surpassed as the corrective structure completes.”

Anything is possible.

There are probabilities and possibilities.

Both can happen.

You play the probabilities; but prepare for the possibilities.

No one knows with certainty what the future holds which is why we must manage portfolio risk accordingly and be prepared to react when conditions change.

While I am often tagged as “bearish” due to my analysis of economic and fundamental data for “what it is” rather than “what I hope it to be,” I am actually neither bullish or bearish. I follow a very simple set of rules which are the core of my portfolio management philosophy which focus on capital preservation and long-term “risk-adjusted” returns.

As such, let me remind you of the 15-Risk Management Rules I have learned over the last 30-years:

  1. Cut losers short and let winner’s run(Be a scale-up buyer into strength.)
  2. Set goals and be actionable. (Without specific goals, trades become arbitrary and increase overall portfolio risk.)
  3. Emotionally driven decisions void the investment process.  (Buy high/sell low)
  4. Follow the trend. (80% of portfolio performance is determined by the long-term, monthly, trend. While a “rising tide lifts all boats,” the opposite is also true.)
  5. Never let a “trading opportunity” turn into a long-term investment. (Refer to rule #1. All initial purchases are “trades,” until your investment thesis is proved correct.)
  6. An investment discipline does not work if it is not followed.
  7. “Losing money” is part of the investment process. (If you are not prepared to take losses when they occur, you should not be investing.)
  8. The odds of success improve greatly when the fundamental analysis is confirmed by the technical price action. (This applies to both bull and bear markets)
  9. Never, under any circumstances, add to a losing position. (As Paul Tudor Jones once quipped: “Only losers add to losers.”)
  10. Market are either “bullish” or “bearish.” During a “bull market” be only long or neutral. During a “bear market”be only neutral or short. (Bull and Bear markets are determined by their long-term trend as shown in the chart below.)
  11. When markets are trading at, or near, extremes do the opposite of the “herd.”
  12. Do more of what works and less of what doesn’t. (Traditional rebalancing takes money from winners and adds it to losers. Rebalance by reducing losers and adding to winners.)
  13. “Buy” and “Sell” signals are only useful if they are implemented. (Managing a portfolio without a “buy/sell” discipline is designed to fail.)
  14. Strive to be a .700 “at bat” player. (No strategy works 100% of the time. However, being consistent, controlling errors, and capitalizing on opportunity is what wins games.)
  15. Manage risk and volatility. (Controlling the variables that lead to investment mistakes is what generates returns as a byproduct.)

The current market advance both looks, and feels, like the last leg of a market “melt up” as we previously witnessed at the end of 1999. How long it can last is anyone’s guess. However, importantly, it should be remembered that all good things do come to an end. Sometimes, those endings can be very disastrous to long-term investing objectives.This is why focusing on “risk controls” in the short-term, and avoiding subsequent major draw-downs, the long-term returns tend to take care of themselves.

Everyone approaches money management differently. This is just the way I do it.

All I am suggesting is that you do “something” as the alternative will be much less beneficial.

This past weekend, I was in Florida with Chris Martenson and Nomi Prins discussing the current backdrop of the markets, economic cycles, and future outcomes. A bulk of the conversations centered around the current “everything bubble” that currently exists globally. Elevated valuations in stock prices, extremely low yields between in “junk bonds,” or intense speculation around “cryptocurrencies” all suggest we have entered once again into “bubble” territory.”

Let me state this:

“Market bubbles have NOTHING to do with valuations or fundamentals.”

Hold on…don’t start screaming “heretic” and building gallows just yet. Let me explain.

Stock market bubbles are driven by speculation, greed, and emotional biases – therefore valuations and fundamentals are simply a reflection of those emotions.

In other words, bubbles can exist even at times when valuations and fundamentals might argue otherwise. Let me show you a very basic example of what I mean. The chart below is the long-term valuation of the S&P 500 going back to 1871.

First, it is important to notice that with the exception of only 1929, 2000 and 2007, every other major market crash occurred with valuations at levels LOWER than they are currently. Secondly, all of these crashes have been the result of things unrelated to valuation levels such as liquidity issues, government actions, monetary policy mistakes, recessions or inflationary spikes. However, those events were only a catalyst, or trigger, that started the “panic for the exits” by investors.

Market crashes are an “emotionally” driven imbalance in supply and demand. You will commonly hear that “for every buyer, there must be a seller.” This is absolutely true. The issue becomes at “what price.” What moves prices up and down, in a normal market environment, is the price level at which a buyer and seller complete a transaction.

In a market crash, however, the number of people wanting to “sell” vastly overwhelms the number of people willing to “buy.” It is at these moments that prices drop precipitously as “sellers” drop the levels at which they are willing to dump their shares in a desperate attempt to find a “buyer.” This has nothing to do with fundamentals. It is strictly an emotional panic which is ultimately reflected by a sharp devaluation in market fundamentals.

Bob Bronson once penned:

“It can be most reasonably assumed that market are sufficient enough that every bubble is significantly different than the previous one, and even all earlier bubbles. In fact, it’s to be expected that a new bubble will always be different than the previous one(s) since investors will only bid up prices to extreme overvaluation levels if they are sure it is not repeating what led to the last, or previous bubbles. Comparing the current extreme overvaluation to the dotcom is intellectually silly.

I would argue that when comparisons to previous bubbles become most popular – like now – it’s a reliable timing marker of the top in a current bubble. As an analogy, no matter how thoroughly a fatal car crash is studied, there will still be other fatal car crashes in the future, even if the previous accident-causing mistakes are avoided.”

He is absolutely right. Comparing the current market bubble to any previous market bubble is rather pointless. Financial markets have already studied and adapted to the causes of the previous “fatal crashes” but this won’t prevent the next one.

I previously discussed George Soros’ theory on bubbles which is worth reviewing at this juncture:

“First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced. When there is a significant divergence between market prices and the underlying reality the markets are far from equilibrium conditions.

Every bubble has two components:

  1. An underlying trend that prevails in reality, and; 
  2. A misconception relating to that trend.

When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow, and more people lose faith, but the prevailing trend is sustained by inertia.

As Chuck Prince, former head of Citigroup, said, ‘As long as the music is playing, you’ve got to get up and dance. We are still dancing.’ Eventually, a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.”

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions.

The chart below is an example of asymmetric bubbles.

The pattern of bubbles is interesting because it changes the argument from a fundamental view to a technical view. Prices reflect the psychology of the market which can create a feedback loop between the markets and fundamentals.

This pattern of bubbles can be clearly seen at every bull market peak in history. The chart below utilizes Dr. Robert Shiller’s stock market data going back to 1900 on an inflation-adjusted basis with an overlay of the asymmetrical bubble shape.

There is currently a strong belief that the financial markets are not in a bubble. The arguments supporting those beliefs are all based on comparisons to past market bubbles.

The inherent problem with much of the mainstream analysis is that it assumes everything remains status quo. However, the question becomes what can go wrong for the market?

In a word, “much.”

Economic growth remains very elusive, corporate profits appear to have peaked, and there is an overwhelming complacency with regards to risk. Those ingredients combined with an extraction of liquidity by the Federal Reserve leaves the markets more vulnerable to an exogenous event than currently believed.

It is likely that in a world where there is virtually “no fear” of a market correction, an overwhelming sense of “urgency” to be invested and a continual drone of “bullish chatter;” markets are poised for the unexpected, unanticipated and inevitable reversion.

As Chris Martenson recently penned:

I hate to break it to you, but chances are you’re just not prepared for what’s coming.

 These bubbles – blown by central bankers serially addicted to creating them (and then riding to the rescue to fix them) – are the largest in all of history. That means they’re going to be the most destructive in history when they finally let go.

 Millions of households will lose trillions of dollars in net worth. Jobs will evaporate, causing the tens of millions of families living paycheck to paycheck serious harm.

These are the kind of painful consequences central bank follies result in. They’re particularly regrettable because they could have been completely avoided if only we’d taken our medicine during the last crisis back in 2008.  But we didn’t. We let the Federal Reserve –the institution largely responsible for creating the Great Financial Crisis — conspire with its brethren central banks to ‘paper over’ our problems.

So now we are at the apex of the most incredible nest of financial bubbles in all of human history.”

I am not trying to scare the “bejeebers” out of you, but he is right.

“All financial assets are just claims on real wealth, not actual wealth itself.  A pile of money has use and utility because you can buy stuff with it.  But real wealth is the “stuff” — food, clothes, land, oil, and so forth.  If you couldn’t buy anything with your money/stocks/bonds, their worth would revert to the value of the paper they’re printed on (if you’re lucky enough to hold an actual certificate). It’s that simple.

But trouble begins when the system gets seriously out of whack.

‘GDP’ is a measure of the number of goods and services available and financial asset prices represent the claims (it’s not a very accurate measure of real wealth, but it’s the best one we’ve got, so we’ll use it). Look at how divergent asset prices get from GDP as bubbles develop.

“What we see in the above chart is that the claims on the economy should, quite intuitively, track the economy itself.  Bubbles occurred whenever the claims on the economy, the so-called financial assets (stocks, bonds, and derivatives), get too far ahead of the economy itself.

This is a very important point. The claims on the economy are just that: claims.  They are not the economy itself!”

Take a step back from the media, and Wall Street commentary, for a moment and make an honest assessment of the financial markets today. If our job is to “bet” when the “odds” of winning are in our favor, then exactly how “strong” is the fundamental hand you are currently betting on?

This “time IS different” only from the standpoint that the variables are not exactly the same as they have been previously. Of course, they never are, and the result will be “…the same as it ever was.”

In her last testimony before Congress as head of the Federal Reserve, Janet Yellen made a curious statement:

I would simply say that I am very worried about the sustainability of the U.S. debt trajectory. Our current debt-to-GDP ratio of about 75 percent is not frightening but it’s also not low. It’s the type of thing that should keep people awake at night.”

 I find this statement interesting given that both Michael Lebowitz and I have been arguing the point that tax cuts and reforms “pay for themselves” through stronger rates of economic growth, employment or wages.

As Mike stated this past week:

“The historical evidence above tells a different story than the bill of goods being sold to citizens and investors.  Corporate tax rates are positively correlated with economic growth which means that lower corporate tax rates equate to slower economic growth. Further, there is strong evidence that corporate profits are largely unaffected by tax rates.

Investors buying based on the benefits of the tax proposal appear shortsighted. They value the benefits of corporate tax cuts, but they are grossly negligent in recognizing how the tax cuts will be funded.”

But while Janet Yellen was focused on Federal Debt, the real issue is total debt as a percentage of the economy. Every piece of leverage whether it is government debt, personal debt and even leverage requires servicing which detracts “savings” from being applied to more productive uses. Yes, in the short-term debt can be used to supplant consumption required to artificially stimulate growth, but the long-term effect is entirely negative. As shown in the chart below, total system debt how exceeds 370% of GDP and is rising.

It now requires ever increasing levels of debt to create each $1 of economic growth. From 1959 to 1983, it required roughly $1.25 of debt to create $1 of economic activity. However, as I have discussed previously, the deregulation of the financial sector, combined with falling interest rates, led to a debt explosion. That debt explosion, which allowed for an excessive standard of living, has led to the long-term deterioration in economic growth rates. It now requires nearly $4.00 of debt for each $1.00 of economic growth.

Yellen is right. The level of debt, not just at the government level, but on the whole, should keep investors “up at night.” The Fed’s monetary interventions over the last 9-years to aggressively push interest rates lower led to a high-degree of “complacency” as the assumed “riskiness” of piling on leverage was removed. However, while the cost of sustaining higher debt levels is lower, the consequences of excess leverage in the system remains the same.

The illusion of liquidity has a dangerous side effect. The process of the previous two debt-deleveraging cycles led to rather sharp market reversions as margin calls, and the subsequent unwinding of margin debt fueled a liquidation cycle in financial assets. The resultant loss of the “wealth effect” weighed on consumption pushing the economy into recession which then impacted corporate and household debt leading to defaults, write-offs, and bankruptcies.

You will notice in the chart above, that even relatively small deleveraging processes had significant negative impacts on the economy and the financial markets. With total system leverage spiking to levels never before witnessed in history, it is quite likely the next event that leads to a reversion in debt will be just as damaging to the financial and economic systems.

Of course, when you combine leverage into investor crowding into “passive indexing,” the risk of a “disorderly unwinding of portfolios” due to the lack of market liquidity becomes an issue.

While Ms. Yellen dismisses her own warnings…maybe you shouldn’t. 

In the meantime, here is your weekend reading list.


Trump, Economy & Fed


Video – Myths About Tax Cuts


Markets


Research / Interesting Reads


“You never go broke taking a profit.” – Old Wall Street Axiom

Questions, comments, suggestions – please email me.

As the markets push once again into record territory the question of valuations becomes ever more important.  While valuations are a poor timing tool in the short term for investors, in the long run, valuation levels have everything to do with future returns.

Yesterday, Doug Kass penned an interesting note on the current market advance:

“Consistently advancing and uninterrupted rising stock prices have a way of spreading fallacious arguments not grounded in fact. Here are some recent examples of that meme — namely, of an earnings-driven market.

This is the new meme, but it increasingly resembles ‘Group Stink.’

Contrary to the pablum delivered by many in the business media, the rise in stocks over the last 12 predominantly has been a valuation-driven story, just as it was in 2016 when S&P 500 profits were up 5% and the S&P Index rose by about 11%.

And going back even further, since 2012 S&P earnings have risen by 30% compared to an 80% rise in the price of the S&P lndex.”

The current belief is the market will surge even higher as a result of corporate “tax cuts” which further boost corporate profits. While the estimates of higher profits via tax cuts is obvious, the question remains as to how much of any tax cut received by corporations is already priced in? More importantly, is the sustainability of the growth of earnings going forward.

John Hussman, via Hussman Funds, once penned:

“I’ve noted frequently that after-tax corporate profits as a share of national income are about 70% above historical norms; that these profit shares are heavily mean-reverting and strongly (inversely) associated with subsequent profit growth over the following 3-4 year period; and that the current surplus of corporate profits is the mirror-image of corresponding deficits in household and government savings (a relationship detailed in prior weekly comments). Recent profits data, as well as the entire historical record, are tightly explained by these factors.

Notably, this data is derived from the national income accounts computed by the Bureau of Economic Analysis, and it’s worth understanding how the BEA computes profits. Specifically, the BEA points out, ‘Because national income is defined as the income of U.S. residents, its profits component includes income earned abroad by U.S. corporations and excludes income earned in the United States by foreigners.’”

The chart below shows corporate profits, per the BEA, divided by GDP.  (You can substitute GNP but the result is virtually identical between the two measures.)

Note, that while operating earnings per share are hitting a record this quarter, reported corporate profits after tax have not. The difference comes from the accounting gimmicks used to report higher earnings while the profits on which tax is paid is an entirely different matter. Furthermore, corporate profits should be a reflection of the underlying economic strength, but due to financial engineering, wage and employment suppression and increase in productivity, they have become extremely deviated.

This deviation begs the question of sustainability. The chart below is an expansion of the real, inflation-adjusted, profits after-tax versus the cumulative change to the S&P 500. Here is the important point – when markets grow faster than profitability, which it can do for a while, eventually a reversion occurs. This is simply the case that all excesses must eventually be cleared before the next growth cycle can occur. Currently, we are once again trading a fairly substantial premium to corporate profit growth.

Again, since corporate profit growth should be a function of economic growth longer term, we can also see how “expensive” the market is relative to corporate profit growth as a percentage of economic growth. Once again, we find that when the price to profits ratio is trading ABOVE the long-term linear trend, markets have struggled and ultimately experienced a more severe mean reverting event. With the price to profits ratio once again elevated above the long-term trend, there is little to suggest that markets haven’t already priced in a good bit of future economic and profits growth.

While none of this suggests the market will “crash” tomorrow, it is supportive of the idea that future returns will substantially weaker than in recent years.

The sustainability of corporate profits is dependent on two primary factors; sustained revenue growth and cost controls. From each dollar of sales is subtracted the operating costs of the business to achieve net profitability.  The chart below shows the percentage change of sales, what happens at the top line of the income statement, as compared to actual earnings (reported and operating) growth.

Since 2000, each dollar of gross sales has been increased to more than $1 in operating and reported profits through financial engineering and cost suppression. The next chart shows that the surge in corporate profitability in recent years is a result of a consistent reduction of both employment and wage growth.  This has been achieved by increases in productivity, technology, and off-shoring of labor.  However, it is important to note that benefits from such actions are finite.

(Note the acceleration in profits starting with the Reagan Tax Cuts in the 1989’s. There is no evidence that cutting taxes for corporations leads to higher wages for employees.)

Given the economic landscape of recent years, large offsetting sectoral deficits and surpluses are not surprising, but they should not be taken as evidence that the long-term profitability of the corporate sector has permanently shifted higher. Stocks are not a claim to a few years of cash flows, but decades and decades of them. By pricing stocks as if current profits are representative of the indefinite future, investors have ensured themselves a rude awakening over time. Equity valuations are decidedly a long-term proposition, and from present levels, the implied long-term returns are quite dim.

The chart below (CPATAX/GNP) provides a good summary of the present situation, and a reasonable sense of what we expect for corporate profit growth over the coming several years.”

As we know from repeatedly from history, extrapolated projections rarely happen. Could this time be different?  Sure.  However, believing that historical tendencies have evolved into a new paradigm will likely have the same results as playing leapfrog with a Unicorn.

There is mounting evidence, from valuations being paid in M&A deals, junk bond yields, margin debt and price extensions from long-term means, “irrational exuberance” is once again returning to the financial markets. However, such does not mean a mean reversion process is imminent. It was in 1996 when Alan Greenspan first uttered those famous words, it was 4 years later before investors regretted not paying attention them. It is likely that the same will be true this time. With the Central Banks still pushing liquidity into the markets, there is little to deter the “bullish bias” presently.  However, as noted above, investors that fail to heed the warning signs will likely ensure themselves a rude awakening over time.

By Mike S. a.k.a. GubbmintCheese


“I got me a man named Doctor Feelgood

Yeah! Yeah!

That man takes care of all of my pains and my ills” – Aretha Franklin,”Dr. Feelgood” –  1967

Before Aretha Franklin sang about “Dr. Feelgood” there was a German doctor named Max Jacobson who ran a thriving medical practice in New York City. Dr. Jacobson’s office catered specifically to high profile celebrities such as Truman Capote, Eddie Fisher, Thelonious Monk, Anthony Quinn and Judy Garland. He also served as the physician of choice for U.S. President John F. Kennedy from 1960 to 1962. Jacobson’s patients nicknamed him “Dr. Feelgood” in response to the feelings of euphoria and energy they experienced after the doctor administered his ”specialized” vitamin injection therapy.

What most of the patients didn’t realize was that Jacobson’s magical cure actually contained between 30 and 50 milligrams of amphetamines, a mood elevating neural energizer that goes by the street name “speed.” The drugs were then combined with a jumble of other ingredients including multivitamins, steroids, enzymes, hormones, bone marrow, animal organ cells and solubilized placenta.

Obviously, given the true contents of the injections, the patient’s symptoms were never really “cured” but rather masked by the powerful psychotropic effects of the amphetamines. Thus, patient relief was artificial in nature and short term in duration as once the drugs wore off, the unaddressed ailments would inevitably return.

As one would expect, reality finally came crashing down on Max Jacobson and his fake remedies. In December 1972, Jacobson’s practice was exposed in a New York Times 1972 piece entitled “Amphetamines Used by a Physician to Lift Moods of Famous Patients.” As a result, Jacobson was charged with 48 counts of unprofessional conduct, and in 1975 the State Department of Education revoked his license to practice medicine. Jacobson died a few years later in 1979.

During his heyday, Jacobson bragged that his patients “went out the door singing,” which may have been exactly what inspired Aretha Franklin to sing about him in 1967.

Financial Parallels:

Ever since the start of the “Great Financial Crisis” in 2008, global central banks, including the Federal Reserve, have aggressively resurrected the role and unconventional remedies of “Dr. Feelgood.” Using a dangerous mix of liquidity, monetary accommodation, asset purchases and risk suppression, central banks have managed to create a sense of confidence and euphoria within the stock market that has served to mask the ongoing ailments within the U.S. economy. Put plainly, the economic recovery we “feel” today has been vastly overstated thanks to the regular financial amphetamine injections that have taken place since 2009.

In my 2014 macroeconomic thesis, “The View from 30,000 Feet, The US Economy Was Sick before the Crisis,” I showed how middle and lower income earners tend to hold fewer, if any, financial assets. As such, they have not been able to participate or benefit from the rising stock market as much as the extremely wealthy.

The growing gap between the wealthy and lower income earners is called “income inequality” and it is just one example of the many negative side effects that inevitably arise when a stock market is subjected to nine continuous years of aggressive drug therapy.

While central banks believe wholeheartedly in their amphetamine therapies, and regard the record level of the stock market as definitive proof that their injections are working, a more granular and thorough inspection of the global economy reveals continued sickness.

For example, Gross Domestic Product (GDP) in the United States continues to trend WELL below its’ historical norm. Absent central bank” injections,” it would be highly unlikely that these anemic levels of economic growth would result in the same kinds of stock market gains we’ve enjoyed since 2009.

If there were no dangerous side effects to using amphetamines over the longer term, there would be no need for the government to strictly regulate its use. Doctors would be free to use injections regularly to suppress their patient’s underlying symptoms and all would be well. Unfortunately, this is not the case. Instead, physicians must focus on the health of the patient over the LONGER TERM, which suggests these extreme forms of drug therapies must be used sparingly, and over very short periods of time.

I believe we will eventually realize the central bank’s heavy handed and extended use of financial amphetamines did not result in a ”miracle cure” for the global economy at all. It instead created a false sense of wellness and euphoria within the stock markets that served to mask and suppress the ongoing problems that continue to exist within our economy.

As a portfolio manager, it is my job to obsess about stock market fundamentals and capital preservation for my clients over the longer term. The biggest concern I have today is that the vast majority of the stock market’s rise since 2009 has been a direct result of a drug induced state of euphoria that has been created and maintained by central bank monetary policy. I believe that as central banks begin to wean the stock market off their aggressive nine year drug program, these feelings of euphoria will fade and once again expose the true economic pain that’s been suppressed for all of these years.

It is for these reasons that I continue to invest with a very conservative and defensive bias. I am not allowing my strategies and investment advice to be influenced by the central bank induced hallucinations that I believe exist within the stock market and underlying global economy.

With the benefit of hindsight, the dot.com and sub-prime housing bubbles are now considered two periods where underlying fundamentals were usurped by a similar sense of strong stock market euphoria. In both “bubbles,” euphoria ultimately gave way to reality and the stock markets corrected sharply. When one looks at the stock market’s relentless rise since 2009, it’s very hard not to wonder if we aren’t perhaps falling for Dr. Feelgood’s short term ”cure” once again.

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