Tag Archives: balance sheet

Earnings Lies & Why Munger Says “EBITDA is Bull S***”

Earnings Worse Than You Think

Just like the hit series “House Of Cards,” Wall Street earnings season has become rife with manipulation, deceit and obfuscation that could rival the dark corners of Washington, D.C.

What is most fascinating is that so many individuals invest hard earned capital based on these manipulated numbers. The failure to understand the “quality” of earnings, rather than the “quantity,” has always led to disappointing outcomes at some point in the future. 

As Drew Bernstein recently penned for CFO.com:

“Non-GAAP financials are not audited and are most often disclosed through earnings press releases and investor presentations, rather than in the company’s annual report filed with the Securities and Exchange Commission.

Once upon a time, non-GAAP financials were used to isolate the impact of significant one-time events like a major restructuring or sizable acquisition. In recent years, they have become increasingly prevalent and prominent, used by both the shiniest new-economy IPO companies and the old-economy stalwarts.”

Back in the 80’s and early 90’s companies used to report GAAP earnings in their quarterly releases. If an investor dug through the report they would find “adjusted” and “proforma” earnings buried in the back.

Today, it is GAAP earnings which are buried in the back hoping investors will miss the ugly truth.

These “adjusted or Pro-forma earnings” exclude items that a company deems “special, one-time or extraordinary.” The problem is that these “special, one-time” items appear “every” quarter leaving investors with a muddier picture of what companies are really making.

An in-depth study by Audit Analytics revealed that 97% of companies in the S&P 500 used non-GAAP financials in 2017, up from 59% in 1996, while the average number of different non-GAAP metrics used per filing rose from 2.35 to 7.45 over two decades.

This growing divergence between the earnings calculated according to accepted accounting principles, and the “earnings” touted in press releases and analyst research reports, has put investors at a disadvantage of understanding exactly what they are paying for.

As BofAML stated:

“We are increasingly concerned with the number of companies (non-commodity) reporting earnings on an adjusted basis versus those that are stressing GAAP accounting, and find the divergence a consequence of less earnings power. 

Consider that when US GDP growth was averaging 3% (the 5 quarters September 2013 through September 2014) on average 80% of US HY companies reported earnings on an adjusted basis. Since September 2014, however, with US GDP averaging just 1.9%, over 87% of companies have reported on an adjusted basis. Perhaps even more telling, between the end of 2010 and 2013, the percentage of companies reporting adjusted EBITDA was relatively constant, and since 2013, the number has been on a steady rise.

So, why do companies regularly report these Non-GAAP earnings? Drew has the answer:

“When management is asked why they resort to non-GAAP reporting, the most common response is that these measures are requested by the analysts and are commonly used in earnings models employed to value the company. Indeed, sell-side analysts and funds with a long position in the stock may have incentives to encourage a more favorable alternative presentation of earnings results.”

If non-GAAP reporting is used as a supplemental means to help investors identify underlying trends in the business, one might reasonably expect that both favorable and unfavorable events would be “adjusted” in equal measure.

However, research presented by the American Accounting Association suggests that companies engage in “asymmetric” non-GAAP exclusions of mostly unfavorable items as a tool to “beat” analyst earnings estimates.

How The Beat Earnings & Get Paid For It

Why has there been such a rise is Non-GAAP reporting?

Money, of course.

“A recent study from MIT has found that when companies make large positive adjustments to non-GAAP earnings, their CEOs make 23 percent more than their expected annual compensation would be if GAAP numbers were used. This is despite such firms having weak contemporaneous and future operating performance relative to other firms.” – Financial Executives International.

The researchers at MIT combed through the annual earnings press releases of S&P 500 firms for fiscal years 2010 through 2015 and recorded GAAP net income and non-GAAP net income when the firms disclosed it. About 67 percent of the firms in the sample disclose non-GAAP net income.

The researchers then obtained CEO compensation, accounting, and return data for the sample firms and found that “firms making the largest positive non-GAAP adjustments… exhibit the worst GAAP performance.”

The CEOs of these firms, meanwhile, earned about 23 percent more than would be predicted using a compensation model; in terms of raw dollars. In other words, they made about $2.7 million more than the approximately $12 million of an average CEO.

It should not be surprising that anytime you compensate individuals based on some level of performance, they are going to figure out ways to improve performance, legal or not. Examples run rampant through sports from Barry Bonds to Lance Armstrong, as well as in business from Enron to WorldCom.

This was detailed in a WSJ article:

One out of five [20%] U.S. finance chiefs have been scrambling to fiddle with their companies’ earnings.”

This rather “open secret” of companies manipulating bottom line earnings by utilizing “cookie-jar” reserves, heavy use of accruals, and other accounting instruments to flatter earnings is not new.

The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big ‘restructuring charge’ that would otherwise stand out like a sore thumb.

What is more surprising though is CFOs’ belief that these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.

Manipulating earnings may work in the short-term, eventually, cost cutting, wage suppression, earnings adjustments, share-buybacks, etc. reach an effective limit. When that limit is reached, companies can no longer hide the weakness in their actual operating revenues.

There’s a big difference between companies’ advertised performance, and how they actually did. We discussed this recently by looking at the growing deviation between corporate earnings and corporate profits. There has only been one other point where earnings, and stock market prices, were surging while corporate profits were flat. Shortly thereafter, we found out the “truth” about WorldCom, Enron, and Global Crossing.

The American Accounting Association found that over the past decade or so, more companies have shifted to emphasizing adjusted earnings. But those same companies’ results under generally accepted accounting principles, or GAAP, often only match or slightly exceed analysts’ predictions.

“There are those who might claim that so far this century the U.S. economy has experienced such an unusual period of economic growth that it has taken analysts and investors by surprise each quarter … for almost two decades. This view strains credulity.” – Paul Griffin, University of California & David Lont, University of Otago

After reviewing hundreds of thousands of quarterly earnings forecasts and reports of 4,700 companies over 17 years, Griffin and Lont believe companies shoot well above analysts’ targets because consistently beating earnings per share by only a penny or two became a red flag.

“If they pull out all the accounting tricks to get their earnings much higher than expected, then they are less likely to be accused of manipulation.” 

The truth is that stocks go up when companies beat their numbers, and analysts are generally biased toward wanting the stock they cover to go up. As we discussed in “Chasing The Market”, it behooves analysts to consistently lower their estimates so companies can beat them, and adjusted earnings are making it easier for them to do it.

For investors, the impact from these distortions will only be realized during the next bear market. For now, there is little help for investors as the Securities and Exchange Commission has blessed the use of adjusted results as long as companies disclose how they are calculated. The disclosures are minimal, and are easy to get around when it comes to forecasts. Worse, adjusted earnings are used to determine executive bonuses and whether companies are meeting their loan covenants. No wonder CEO pay, and leverage, just goes up.

Conclusion & Why EBITDA Is BullS***

Wall Street is an insider system where legally manipulating earnings to create the best possible outcome, and increase executive compensation has run amok,. The adults in the room, a.k.a. the Securities & Exchange Commission, have “left the children in charge,” but will most assuredly leap into action to pass new regulations to rectify reckless misbehavior AFTER the next crash.

For fundamental investors, the manipulation of earnings not only skews valuation analysis, but specifically impacts any analysis involving earnings such as P/E’s, EV/EBITDA, PEG, etc.

Ramy Elitzur, via The Account Art Of War, expounded on the problems of using EBITDA.

“One of the things that I thought that I knew well was the importance of income-based metrics such as EBITDA, and that cash flow information is not as important. It turned out that common garden variety metrics, such as EBITDA, could be hazardous to your health.”

The article is worth reading and chocked full of good information, however, here are the four-crucial points:

  1. EBITDA is not a good surrogate for cash flow analysis because it assumes that all revenues are collected immediately and all expenses are paid immediately, leading to a false sense of liquidity.
  2. Superficial common garden-variety accounting ratios will fail to detect signs of liquidity problems.
  3. Direct cash flow statements provide a much deeper insight than the indirect cash flow statements as to what happened in operating cash flows. Note that the vast majority (well over 90%) of public companies use the indirect format.
  4. EBITDA, just like net income is very sensitive to accounting manipulations.

The last point is the most critical. As Charlie Munger recently stated:

“I think there are lots of troubles coming. There’s too much wretched excess.

I don’t like when investment bankers talk about EBITDA, which I call bulls— earnings.

It’s ridiculous. EBITDA does not accurately reflect how much money a company makes, unlike traditional earnings. Think of the basic intellectual dishonesty that comes when you start talking about adjusted EBITDA. You’re almost announcing you’re a flake.”

In a world of adjusted earnings, where every company is way above average, every quarter, investors quickly lose sight of what matters most in investing.

“This unfortunate cycle will only be broken when the end-users of financial reporting — institutional investors, analysts, lenders, and the media — agree that we are on the verge of systemic failure in financial reporting. In the history of financial markets, such moments of mental clarity most often occur following the loss of vast sums of capital.” – American Accounting Association

Imaginary worlds are nice, it’s just impossible to live there.

QE – Then, Now, & Why It May Not Work

Since the beginning of the year, the market has rallied sharply. That rally has been fueled by commentary from both the Trump Administration and the Federal Reserve of the removal of obstacles which plagued stocks in 2018. The chart below is an abbreviated, and a bit sarcastic, version of events.

While the resolution of the trade war is certainly beneficial to the economy, as it removes an additional tax on consumers, the biggest support for the market has been the assumption the Fed will return to a much more accommodative stance.

As we summed up previously for our RIA PRO subscribers (try it FREE for 30-days)

  • The Fed will be “patient” with future rate hikes, meaning they are now likely on hold as opposed to their forecasts which still call for two to three more rate hikes in 2019 and more in 2020.
  • The pace of QT, or balance sheet reduction, will not be on “autopilot” but instead driven by the current economic situation and tone of the financial markets. It is expected the Fed will announce in March that QT will end and the balance sheet will stabilize at a much higher level.
  • QE is a tool that WILL BE employed when rate reductions are not enough to stimulate growth and calm jittery financial markets.

In mid-2018, the Federal Reserve was adamant a strong economy, and rising inflationary pressures, required tighter monetary conditions. At that time they were discussing additional rate hikes and a continued reduction of their $4 Trillion balance sheet.

All it took was a rough December, pressure from Wall Street’s member banks, and a disgruntled White House to completely flip their thinking.

The Fed isn’t alone.

China has launched its version of “Quantitative Easing” to help prop up its slowing economy.

Lastly, the ECB downgraded Eurozone growth, and as announced today, not only will they not raise rates in 2019, they also extended the TLTRO program, which is the Targeted Longer-Term Refinancing Operations scheme which gives cheap loans to struggling Eurozone banks, into 2021.

But there is nothing to worry about, right?

Think about this for a moment.

For a decade the global economy has been growing. Market participants are crowing about the massive surge in asset prices as clear evidence of the strength of the economy.

However, such hasn’t been the case. As I discussed previously for the Fed, China, and the ECB, are signaling their concerns about “economic reality,” which as the data through the end of December shows, the U.S. economy is beginning to slow.

“As shown, over the last six months, the decline in the LEI has been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. As shown, the downturn in the LEI predicted the current economic weakness and suggests the data is likely to continue to weaken in the months ahead.”

More importantly, monetary policy never really impacted the economy as prolifically as was anticipated following the financial crisis. The two 4-panel charts below show the percentage change in the Fed’s balance sheet from 2009-present (309%) versus the total percentage change in various economic components. I have also included the amount of stimulus required to create those changes.

First, it is interesting to note that despite headlines of strong employment growth, the percentage of people considered “Not In Labor Force or NILF” has grown more than full-time employment. Of course, and not surprisingly, the biggest beneficiary of monetary policy was…corporate profits.

Secondly, where monetary policy did work was lifting asset prices as shown in the chart and table below.

The table above shows that QE1 came immediately following the financial crisis and had an effective ratio of about 1.6:1. In other words, it took a 1.6% increase in the balance sheet to create a 1% advance in the S&P 500. However, once market participants figured out the transmission system, QE2 and QE3 had an almost perfect 1:1 ratio of effectiveness. The ECB’s QE program, which was implemented in 2015 to support concerns of an unruly “Brexit,” had an effective ratio of 1.5:1.

Clearly, QE worked well in lifting asset prices, but not so much for the economy as shown above. In other words, QE was ultimately a massive “wealth transfer” from the middle class to the rich which has created one of the greatest wealth gaps in the history of the U.S., not to mention an asset bubble of historic proportions.

But Will It Work Next Time?

This is the single most important question for investors.

The current belief is that QE4 will be implemented at the first hint of a more protracted downturn in the market. However, as we noted above, QE will likely only be employed when rate reductions aren’t enough. Such was noted in 2016 by David Reifschneider, deputy director of the division of research and statistics for the Federal Reserve Board in Washington, D.C., released a staff working paper entitled “Gauging The Ability Of The FOMC To Respond To Future Recessions.” 

The conclusion was simply this:

“Simulations of the FRB/US model of a severe recession suggest that large-scale asset purchases and forward guidance about the future path of the federal funds rate should be able to provide enough additional accommodation to fully compensate for a more limited [ability] to cut short-term interest rates in most, but probably not all, circumstances.”

In other words, the Federal Reserve is rapidly becoming aware they have become caught in a liquidity trap keeping them unable to raise interest rates sufficiently to reload that particular policy tool. There are certainly growing indications, as discussed recently, the U.S. economy maybe be heading towards the next recession. 

Interestingly, David compared three policy approaches to offset the next recession.

  1. Fed funds goes into negative territory but there is no breakdown in the structure of economic relationships.
  2. Fed funds returns to zero and keeps it there long enough for unemployment to return to baseline.
  3. Fed funds returns to zero and the FOMC augments it with additional $2-4 Trillion of QE and forward guidance. 

In other words, the Fed is already factoring in a scenario in which a shock to the economy leads to additional QE of either $2 trillion, or in a worst case scenario, $4 trillion, effectively doubling the current size of the Fed’s balance sheet.

Here is what is interesting, as reported by Jennifer Ablan:

So, 2-years ago David lays out the plan and yesterday Williams reiterates that plan.

Does the Fed see a recession on the horizon? Is this the reason for the sudden change in views by Powell in recent weeks?

Maybe.

But there is a problem with the entire analysis. The effectiveness of QE, and zero interest rates, is based on the point at which you apply these measures. This was something I pointed out previously:

“In 2008, when the Fed launched into their “accommodative policy” emergency strategy to bail out the financial markets, the Fed’s balance sheet was only about $915 Billion. The Fed Funds rate was at 4.2%.

If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.”

But there is more to the story than just the Fed’s balance sheet and funds rate. The entire backdrop is completely reversed. The table below compares a variety of financial and economic factors from 2009 to present.

The critical point here is that QE and rate reductions have the MOST effect when the economy, markets, and investors have been “blown out,” deviations from the “norm” are negatively extended, confidence is hugely negative.

In other words, there is nowhere to go but up.

Such was the case in 2009. Even without Federal Reserve interventions, it is highly probable that the economy would have begun a recovery as the normal economic cycle took hold. No, the recovery would not have been as strong, and asset prices would be about half of where they are today, but an improvement would have happened nonetheless.

The extremely negative environment that existed, particularly in the asset markets, provided a fertile starting point for monetary interventions. Today, as shown in the table above, the economic and fundamental backdrop could not be more diametrically opposed.

This suggests that the Fed’s ability to stem the decline of the next recession, or offset a financial shock to the economy from falling asset prices, may be much more limited than the Fed, and most investors, currently believe.

The Fed’s hope has always been that at some point they would be able to wean the economy off of life support and it would operate under its own strength. This would allow the Fed to raise interest rates back to more normalized levels and provide a policy tool to offset the next recession. However, given the Fed has never been able to get rates higher than the last crisis, it has only led to bigger “booms and busts” in recent decades.

Summary

It has taken a massive amount of interventions by Central Banks to keep economies afloat globally over the last decade and there is rising evidence that growth is beginning to decelerate.

While another $2-4 Trillion in QE might indeed be successful in further inflating the third bubble in asset prices since the turn of the century, there is a finite ability to continue to pull forward future consumption to stimulate economic activity. In other words, there are only so many autos, houses, etc., which can be purchased within a given cycle. There is evidence the cycle peak has been reached.

If I am correct, and the effectiveness of rate reductions and QE are diminished due to the reasons detailed herein, the subsequent destruction to the “wealth effect” will be far larger than currently imagined. There is a limit to just how many bonds the Federal Reserve can buy and a deep recession will likely find the Fed powerless to offset much of the negative effects. 

If more “QE” works, great. But as investors, with our retirement savings at risk, what if it doesn’t.

The Fed Doesn’t Target The Market?

Earlier this month, I penned an article asking if we “really shouldn’t worry about the Fed’s balance sheet?” The question arose from a specific statement made by previous New York Federal Reserve President Bill Dudley:

“Financial types have long had a preoccupation: What will the Federal Reserve do with all the fixed income securities it purchased to help the U.S. economy recover from the last recession? The Fed’s efforts to shrink its holdings have been blamed for various ills, including December’s stock-market swoon. And any new nuance of policy — such as last week’s statement on “balance sheet normalization” — is seen as a really big deal.

I’m amazed and baffled by this. It gets much more attention than it deserves.”

As I noted, there is a specific reason why “financial types” have a preoccupation with the balance sheet.

The preoccupation came to light in 2010 when Ben Bernanke added the “third mandate” to the Fed – the creation of the “wealth effect.”

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. 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, Washington Post Op-Ed, November, 2010.

As he noted, the Fed specifically targeted asset prices to boost consumer confidence. Given that consumption makes up roughly 70% of economic growth in the U.S., it makes sense. So, not surprisingly, when the economy begins to show signs of deterioration, the Fed acts to offset that weakness.

This is why the slowdown in global growth became an important factor behind the central bank’s decision to put plans for interest rate increases on hold. That comment was made by Federal Reserve Vice Chairman Richard Clarida during a question-and-answer session last week.

“The reality is that the global economy is slowing. You’ve got negative growth in Italy, Germany may just grow…1% this year, [and] a slowdown in China. These are all things that we need to factor in. 

Slower global growth would crimp U.S. exports and could also negatively influence financial and asset markets, a primary transmission mechanism for monetary policy.”

As we noted previously in “Data or Markets,” the Fed is not truly just “data dependent.” They are, in many ways, co-dependent on each other. A strongly rising market allows the Fed to raise rates and reduce accommodative as higher asset prices support confidence. However, that “leeway” is quickly reduced when asset prices reverse. This has been the Fed cycle for the last 40-years.

The problem for the Fed is they have now become “liquidity trapped.”

What is that? Here is the definition:

“A liquidity trap is a situation described in Keynesian economics in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence fail to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.

The chart below shows the correlation between the decline of GDP and the Fed Funds rate.

There are two important things to notice from the chart above. The first is that prior to 1980, the trend of both economic growth and the Fed Funds rate were rising. Then, post-1980, as then Fed Chairman Paul Volker and President Ronald Reagan set out to break the back of inflation, each successive cycle of rate increases were started from a level lower than the previous cycle.

The difference between the two periods was the amount of debt in the system and the shift from an expansive production and manufacturing based economy to one driven primarily by services which have a substantially lower multiplier effect. Since 1980, it has required increasing levels of debt to manufacture $1 of GDP growth.

In every case, the rate cycle increase ALWAYS led to either a recession, bear market, crisis, or all three. Importantly, those events occurred not when the Fed STARTED hiking rates, but when they recognized that their tightening process was confronted by weakening economic growth. 

The Trap

The problem for the Fed is that while lower interest rates may help spur economic growth in the short-term, the growth has come from an increasing level of debt accumulation. Therefore, the economy cannot withstand a reversal of those rates. As shown above, each successive round of rate increases was never able to achieve a rate higher than the previous peak. For example, in 2007, the Fed Funds rate was roughly 5% when the Fed started lowering rates to combat the financial crisis. Today, if the Fed started lowering rates to combat economic weakness,  they would do so from less than half that previous rate.

As Richard Clarida noted in his speech, one of the potential risks to Central Banks globally is the lack of monetary policy firepower available. We previously pointed out that in 2009, the Fed went to work to rescue the economy with a $915 billion balance sheet and Fed Funds at 4.2%. Today, that balance sheet remains above $4 trillion and rates are at 2.5%.

It isn’t lost on the Fed that if a recession were to occur, their main lever for stimulating economic activity, interest rate reductions, will have little value. Given the amount of debt outstanding and the onerous burden of servicing it, the marginal benefit of lower rates will likely not be enough to lift the country out of a recession. In such a tough situation the next lever at their disposal is increasing their balance sheet and flooding the markets with liquidity via QE.

However, even that may not be enough as both Ben Bernanke and Janet Yellen have acknowledged that they were aware that each successive round of QE was somewhat less effective than the last. That certainly must be a concern for Powell if he is called upon to re-engage QE in a recession or another economic crisis.

For the Federal Reserve, they are now caught in the same “liquidity trap” that has been the history of Japan for the last three decades. 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 the 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 still near zero, 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.

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 30-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 real concern for investors, and individuals, is the actual economy. We are likely experiencing more than just a ‘soft patch’ currently despite the mainstream analysts’ rhetoric to the contrary. There is clearly something amiss within the economic landscape and the ongoing decline of inflationary pressures longer term is likely telling us just that. The big question for the Fed is how to get out of the ‘liquidity trap’ they have gotten themselves into without cratering the economy, and the financial markets, in the process.

The One Thing

However, the one statement, which is arguably the most important for investors, is what Bill Dudley stated relative to the size of the balance sheet and it’s use a tool to stem the next decline.

“The balance sheet tool becomes relevant only if the economy falters badly and the Fed needs more ammunition.”

In other words, it will likely require a substantially larger correction than what we have just seen to bring “QE” back into the game. Unfortunately, as I laid out in “Why Another 50% Correction Is Possible,” the ingredients for a “mean-reverting” event are all in place.

“What causes the next correction is always unknown until after the fact. However, there are ample warnings that suggest the current cycle may be closer to its inevitable conclusion than many currently believe. There are many factors that can, and will, contribute to the eventual correction which will ‘feed’ on the unwinding of excessive exuberance, valuations, leverage, and deviations from long-term averages.

The biggest risk to investors currently is the magnitude of the next retracement. As shown below the range of potential reversions runs from 36% to more than 54%.”

“It’s happened twice before in the last 20 years and with less debt, less leverage, and better-funded pension plans.

More importantly, notice all three previous corrections, including the 2015-2016 correction which was stopped short by Central Banks, all started from deviations above the long-term exponential trend line. The current deviation above that long-term trend is the largest in history which suggests that a mean reversion will be large as well.

It is unlikely that a 50-61.8% correction would happen outside of the onset of a recession. But considering we are already pushing the longest economic growth cycle in modern American history, such a risk which should not be ignored.”

While Bill makes the point that “QE” is available as a tool, it won’t likely be used until AFTER the Fed lowers interest rates back to the zero-bound. Which means that by the time “QE” comes to the fore, the damage to investors will likely be much more severe than currently contemplated.

Yes, the Fed absolutely targets the financial markets with their policies. The only question will be what “rabbit” they pull out of their hat if it doesn’t work next time?

I am not sure even they know.

The Fed Conundrum – Data Or Markets?

Following the Fed’s last meeting, we published for our RIA PRO subscribers (use code PRO30 for a 30-day free trial) a simple question:

“What does the Fed know?”

Of course, this meeting followed the stock market plunge at the end of 2018 where their tone that turned from “hawkish” to “dovish” in the span of just a few weeks. Seemingly, despite the previous commentary about concerns over rising inflationary pressures, it was pressure from Wall Street and the White House that quickly “realigned” the Fed’s views.

  • The Fed will be “patient” with future rate hikes, meaning they are now likely on hold as opposed to their forecasts which still call for two to three more rate hikes this year.
  • The pace of QT or balance sheet reduction will not be on “autopilot” but instead driven by the current economic situation and tone of the financial markets.
  • QE is a tool that WILL BE employed when rate reductions are not enough to stimulate growth and calm jittery financial markets.

This change in stance, not surprisingly, buoyed the stock market as the proverbial “Fed Put” was back in place.

But the change view may have also just trapped the Fed in their own “data dependent” decision-making process.

The Fed Should Be Hiking Rates

As we noted in our RIA Pro article:

“During the press conference, the Chairman was asked what has transpired since the last meeting on December 19, 2019, to warrant such an abrupt change in policy given that he recently stated that policy was accommodative, and the economy did not require such policy anymore.

In response, Powell stated:

‘We think our policy stance is appropriate right now. We do. We also know that our policy rate is now in the range of the committee’s estimates of neutral.'”

Powell’s awkward response, and unsatisfactory rationale to a simple and obvious question, the question must be asked if it is possible that economic or credit risks are greater than currently believed which would account for the policy U-turn?

However, given that the Fed’s two primary mandates are supposed to be “full employment” and “price stability,” the conflict between managing inflation and supporting the markets is a conundrum.

For example, there is currently sufficient data which suggests “real inflationary pressures” are mounting in the economy. For example, with a 300,000 job print in January and rising wage pressures, the Fed should raise interest rates. The chart below of labor costs clearly show the problem business owners are facing.

As noted employment remains strong and data suggests there is upward pressure on companies to hire more workers.

That pressure to hire is coming from the reality there are currently more demands on labor than there are people to fill them.

Wage pressures are clearly rising in recent months putting additional upward pressures on pricing as companies pass on higher labor costs.

More importantly, inflationary pressures as measured by both PPI, CPI, and the Fed’s preferred measure of Core PCE, continue to rise as well.

The chart below is the spread between PPI and CPI, historically, when “producer price” inflation rises faster than consumer prices, it has impacted economic growth by suggesting that inflation can’t be passed on to consumers.

The composite inflation index is also screaming higher suggesting that if the Fed pauses they could potentially get well “behind the curve.” 

Even the Federal Reserve’s favorite measure of inflation, PCE, is also suggesting the Fed should be hiking rates rather than pausing.

All of this data clearly suggests that the Fed should be hiking rates currently, rather than pausing. 

The Conundrum

However, all of this data is also consistent with the end of an economic cycle rather than a continued expansion. As we quoted last week from John Mauldin:

I think because unemployment is lowest when the economy is in a mature growth cycle, and stock returns are in the process of flattening and rolling over. Sadly, that is where we seem to be right now. Unemployment is presently in the ‘low’ range which, in the past, often preceded a recession.

That loss of confidence is already beginning to show signs as noted recently by Zerohedge:

“American small-business owners are growing increasingly anxious about a looming economic slowdown.

After a report published last week by Vistage Worldwide suggested that small-business confidence had collapsed with the number of small business owners worried that the economy could worsen in 2019 numbering more than twice those who expected it to improve, the NFIB Small Business Optimism Index – a widely watched sentiment gauge – apparently confirmed that more business owners are growing fearful that economic conditions might begin to work against them in the coming months.”

Furthermore, most of these data points are at levels that typically precede economic slowdowns and recession, so hiking rates further from current levels could exacerbate the recessionary risk.

The problem the Fed faces currently, as we discussed previously, is that when the last recession started the Fed Funds rate was at 4.2% not 2.2% and the Fed balance sheet was $915 billion not $4+ trillion.

“If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion dollar balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.”

But…what do you do?

The Trap

There are clearly rising inflationary pressures on the market, which are also beginning to impede economic growth. Those pressures, combined with a sharp decline in asset prices, spurred the Fed to react to political and market pressures.

The Fed is most likely aware that if a recession were to occur, their main lever for stimulating economic activity, interest rate reductions, will have little value. Given the amount of debt outstanding and the onerous burden of servicing it, the marginal benefit of lower rates will likely not provide enough benefits to lift the country out of a recession. In such a tough situation the next lever at their disposal is increasing their balance sheet and flooding the markets with liquidity via QE.

Sure, Powell might be taking a dovish tone to placate the markets, the President and his member banks and concurrently buying time to further normalize the balance sheet? But this approach is like pouring liquid out of your cup so you can add more when the time is right. You would do this because it is not clear just how much “the cup” will ultimately hold.

Bernanke and Yellen have both acknowledged that they were aware that each successive round of QE was somewhat less effective than prior rounds. That certainly must be a concern for Powell if he is called upon to re-engage QE in a recession or another economic crisis.

If this is the case, Powell will continue to publicly discuss minimizing reductions to the balance sheet and refrain from further rate hikes. Despite such dovish Fed-speak, he would continue to shrink the balance sheet at the current pace. This tactic may trick investors for a few months but at some point, the market will question his intentions and damage Fed credibility.

So, therein lies the trap. Do you hike rates and reduce the balance sheet anyway to be better prepared for the onset of the next recession, OR reverse policy to try to “kick the recession can” down the road a bit which leaves you under-prepared for the next crisis?

For the Fed, it is a choice between the lesser of two evils. The only question is did they make the right one?

While the Fed has a long history of using economic jargon and, quite frankly, non-truths to help promote their agenda, they also have a long history of making the wrong policy moves which spark either some sort of crisis, recession or both.

As Michael Lebowitz concluded for our RIA PRO subscribers last week:

“The market has largely recovered from the fourth quarter swoon, as such the Fed should be resting more comfortably. Economic data remains strong, and if anything it is slightly better than December when the Fed was ready to raise rates three times and put balance sheet reduction on “autopilot.”

Today the Fed has all but put the kibosh on further rate hikes and, per Mester’s comments, will end balance sheet reduction (QT) in the months ahead.

It is becoming more suspect that the Fed knows something the market does not.”

But, exactly what is it?

Recession Risks Are Likely Higher Than You Think

It is often said that one should never discuss religion or politics as you are going to wind up offending someone. In the financial world it is mentioning the “R” word.

The reason, of course, is that it is the onset of a recession that typically ends the “bull market” party. As the legendary Bob Farrell once stated:

“Bull markets are more fun than bear markets.”

Yet, recessions are part of a normal and healthy economy that purges the excesses built up during the first half of the cycle.

economic_cycle-2

Since “recessions” are painful, as investors, we would rather not think about the “good times” coming to an end. However, by ignoring the risk of a recession, investors have historically been repeatedly crushed by the inevitable completion of the full market and economic cycle.

But after more than a decade of an economic growth cycle, investors have become complacent in the idea that recessions may have been mostly mitigated by monetary policy.

While monetary policy can certainly extend cycles, they cannot be repealed.

Given that monetary policy has consistently inflated asset prices historically, the reversions of those excesses have been just as dramatic. The table below shows every economic recovery and recessionary cycle going back to 1873.

Importantly, note that the average recessionary drawdown historically is about 30%. While there were certainly some recessionary drawdowns which were very small, the majority of the reversions, particularly from more extreme overvaluation levels as we are currently experiencing, have not been kind to investors.

So, why bring this up?

“In the starkest warning yet about the upcoming global recession, which some believe will hit in late 2019 or 2020 at the latest, the IMF warned that the leaders of the world’s largest countries are ‘dangerously unprepared’ for the consequences of a serious global slowdown. The IMF’s chief concern: much of the ammunition to fight a slowdown has been exhausted and governments will find it hard to use fiscal or monetary measures to offset the next recession, while the system of cross-border support mechanisms — such as central bank swap lines — has been undermined.” – David Lipton, first deputy managing director of the IMF.

Despite recent comments that “recession risk” is non-existent, there are various indications which suggest that risk is much higher than currently appreciated.  The New York Federal Reserve recession indicator is now at the highest level since 2008.

Also, as noted by George Vrba recently, the unemployment rate may also be warning of a recession as well.

“For what is considered to be a lagging indicator of the economy, the unemployment rate provides surprisingly good signals for the beginning and end of recessions. This model, backtested to 1948, reliably provided recession signals.

The model, updated with the January 2019 rate of 4.0%, does not signal a recession. However, if the unemployment rate should rise to 4.1% in the coming months the model would then signal a recession.”

John Mauldin also recently noted the same:

“This next chart needs a little explaining. It comes from Ned Davis Research via my friend and business partner Steve Blumenthal. It turns out there is significant correlation between the unemployment rate and stock returns… but not the way you might expect.

Intuitively, you would think low unemployment means a strong economy and thus a strong stock market. The opposite is true, in fact. Going back to 1948, the US unemployment rate was below 4.3% for 20.5% of the time. In those years, the S&P 500 gained an annualized 1.7%.”

“Now, 1.7% is meager but still positive. It could be worse. But why is it not stronger? I think because unemployment is lowest when the economy is in a mature growth cycle, and stock returns are in the process of flattening and rolling over. Sadly, that is where we seem to be right now. Unemployment is presently in the ‘low’ range which, in the past, often preceded a recession.

The yield spread between the 10-year and the 2-year Treasury yields is also suggesting there is a rising risk of a recession in the economy.

As I noted previously:

“The yield curve is clearly sending a message that shouldn’t be ignored and it is a good bet that ‘risk-based’ investors will likely act sooner rather than later. Of course, it is simply the contraction in liquidity that causes the decline which will eventually exacerbate the economic contraction. Importantly, since recessions are only identified in hindsight when current data is negatively revised in the future, it won’t become ‘obvious’ the yield curve was sending the correct message until far too late to be useful.

While it is unwise to use the ‘yield curve’ as a ‘market timing’ tool, it is just as unwise to completely dismiss the message it is currently sending.”

We can also see the slowdown in economic activity more clearly we can look at our RIA Economic Output Composite Index (EOCI). (The index is comprised of the CFNAI, Chicago PMI, ISM Composite, All Fed Manufacturing Surveys, Markit Composite, PMI Composite, NFIB, and LEI)

As shown, over the last six months, the decline in the LEI has actually been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. As shown, the downturn in the LEI predicted the current economic weakness and suggests the data is likely to continue to weaken in the months ahead.”

With the exception of the yield curve, which is “real time,” the rest of the data is based on economic data which has a multitude of problems.

There are many suggesting currently that based on current economic data, there is “no recession” in sight. This is based on looking at levels of economic data versus where “recessions” started in the past.

But therein lies the biggest flaw.

“The problem with making an assessment about the state of the economy today, based on current data points, is that these numbers are ‘best guesses’ about the economy currently. However, economic data is subject to substantive negative revisions in the future as actual data is collected and adjusted over the next 12-months and 3-years. Consider for a minute that in January 2008 Chairman Bernanke stated:

‘The Federal Reserve is not currently forecasting a recession.’

In hindsight, the NBER called an official recession that began in December of 2007.”

The issue with a statement of “there is no recession in sight,” is that it is based on the “best guesses” about the economy currently. However, economic data is subject to substantive negative revisions in the future as actual data is collected and adjusted over the next 12-months and 3-years. Consider for a minute that in January 2008 Chairman Bernanke stated:

“The Federal Reserve is not currently forecasting a recession.”

In hindsight, the NBER called an official recession that began in December of 2007.

But this is almost always the case. Take a look at the data below of real (inflation-adjusted)economic growth rates:

  • September 1957:     3.07%
  • May 1960:                 2.06%
  • January 1970:        0.32%
  • December 1973:     4.02%
  • January 1980:        1.42%
  • July 1981:                 4.33%
  • July 1990:                1.73%
  • March 2001:           2.31%
  • December 2007:    1.97%

Each of the dates above shows the growth rate of the economy immediately prior to the onset of a recession.  In 1957, 1973, 1981, 2001, 2007 there was “no sign of a recession.” 

The next month a recession started.

So, what about now?

“The recent decline from the peak in the market, is just that, a simple correction. With the economy growing at 3.0% on an inflation-adjusted basis, there is no recession in sight.” 

Is that really the case or is the market telling us something?

The chart below is the S&P 500 two data points noted.

The green dots are the peak of the market PRIOR to the onset of a recession. In 8 of 9 instances, the S&P 500 peaked and turned lower prior to the recognition of a recession. The yellow dots are the official recessions as dated by the National Bureau of Economic Research (NBER) and the dates at which those proclamations were made.

At the time, the decline from the peak was only considered a “correction” as economic growth was still strong.

In reality, however, the market was signaling a coming recession in the months ahead. The economic data just didn’t reflect it as of yet. (The only exception was 1980 where they coincided in the same month.) The chart below shows the date of the market peak and real GDP versus the start of the recession and GDP growth at that time.

The problem is in waiting for the data to catch up.

Today, we are once again seeing many of the same early warnings. If you have been paying attention to the trend of the economic data, the stock market, and the yield curve, the warnings are becoming more pronounced. In 2007, the market warned of a recession 14-months in advance of the recognition. 

So, therein lies THE question:

Is the market currently signaling a “recession warning?”

Everybody wants a specific answer. “Yes” or “No.

Unfortunately, making absolute predictions can be extremely costly when it comes to portfolio management.

There are three lessons to be learned from this analysis:

  1. The economic “number” reported today will not be the same when it is revised in the future.
  2. The trend and deviation of the data are far more important than the number itself.
  3. “Record” highs and lows are records for a reason as they denote historical turning points in the data.

As Doug Kass noted on Tuesday there are certainly plenty of risks to be aware of:

  1. Domestic economic growth weakens, Chinese growth fails to stabilize and Europe enters a recession
  2. U.S./China fail to agree on a trade deal
  3. Trump institutes an attack on European Union trade by raising auto tariffs
  4. U.S. Treasury yields fail to ratify an improvement in economic growth
  5. The market leadership of FANG and Apple (AAPL) subsidies
  6. Earnings decline in 2019 and valuations fail to expand
  7. The Mueller Report jeopardizes the president
  8. A hard and disruptive Brexit
  9. Crude oil supplies spike and oil prices collapse, taking down the high-yield market
  10. Draghi is replaced by a hawk

While the call of a “recession” may seem far-fetched based on today’s economic data points, no one was calling for a recession in early 2000, or 2007, either. By the time the data is adjusted, and the eventual recession is revealed, it won’t matter as the damage will have already been done.

Pay attention to the message markets are sending. It may just be saying something very important.

Dalio’s Fear Of The Next Downturn Is Likely Understated

“What scares me the most longer term is that we have limitations to monetary policy — which is our most valuable tool — at the same time we have greater political and social antagonism.” – Ray Dalio, Bridgewater Associates

Dalio made the remarks in a panel discussion at the World Economic Forum’s annual meeting in Davos on Tuesday where he reiterated that a limited monetary policy toolbox, rising populist pressures and other issues, including rising global trade tensions, are similar to the backdrop present in the latter part of the Great Depression in the late 1930s.

Before you dismiss Dalio’s view Bridgewater’s Pure Alpha Strategy Fund posted a gain of 14.6% in 2018, while the average hedge fund dropped 6.7% in 2018 and the S&P 500 lost 4.4%.

The comments come at a time when a brief market correction has turned monetary and fiscal policy concerns on a dime. As noted by Michael Lebowitz yesterday afternoon at RIA PRO

“In our opinion, the Fed’s new warm and cuddly tone is all about supporting the stock market. The market fell nearly 20% from record highs in the fourth quarter and fear set in. There is no doubt President Trump’s tweets along with strong advisement from the shareholders of the Fed, the large banks, certainly played an influential role in persuading Powell to pivot.

Speaking on CNBC shortly after the Powell press conference, James Grant stated the current situation well.

“Jerome Powell is a prisoner of the institutions and the history that he has inherited. Among this inheritance is a $4 trillion balance sheet under which the Fed has $39 billon of capital representing 100-to-1 leverage. That’s a symptom of the overstretched state of our debts and the dollar as an institution.”

As Mike correctly notes, all it took for Jerome Powell to completely abandon any facsimile of “independence” was a rough December, pressure from Wall Street’s member banks, and a disgruntled White House to completely flip their thinking.

In other words, the Federal Reserve is now the “market’s bitch.”

However, while the markets are celebrating the very clear confirmation that the “Fed Put” is alive and well, it should be remembered these “emergency measures” are coming at a time when we are told the economy is booming.

“We’re the hottest economy in the world. Trillions of dollars are flowing here and building new plants and equipment. Almost every other data point suggests, that the economy is very strong. We will beat 3% economic growth in the fourth quarter when the Commerce Department reopens. 

We are seeing very strong chain sales. We don’t get the retail sales report right now and we see very strong manufacturing production. And in particular, this is my favorite with our corporate tax cuts and deregulation, we’re seeing a seven-month run-up of the production of business equipment, which is, you know, one way of saying business investment, which is another way of saying the kind of competitive business boom we expected to happen is happening.” – Larry Kudlow, Jan 24, 2019.

Of course, the reality is that while he is certainly “spinning the yarn” for the media, the Fed is likely more concerned about “reality” which, as the data through the end of December shows, the U.S. economy is beginning to slow.

“As shown, over the last six months, the decline in the LEI has actually been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. As shown, the downturn in the LEI predicted the current economic weakness and suggests the data is likely to continue to weaken in the months ahead.”

Limited Monetary Tool Box

As Dalio noted, one of the biggest issues facing global Central Banks is the ongoing effectiveness of “Quantitative Easing” programs. As previously discussed:

“Of course, after a decade of Central Bank interventions, it has become a commonly held belief the Fed will quickly jump in to forestall a market decline at every turn. While such may have indeed been the case previously, the problem for the Fed is their ability to ‘bail out’ markets in the event of a ‘credit-related’ crisis.”

“In 2008, when the Fed launched into their “accommodative policy” emergency strategy to bail out the financial markets, the Fed’s balance sheet was only about $915 Billion. The Fed Funds rate was at 4.2%.

If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion dollar balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.”

But it isn’t just the issue of the Fed’s limited toolbox, but the combination of other issues, outside of those noted by Dalio, which have the ability to spur a much larger

The nonprofit National Institute on Retirement Security released a study in March stating that nearly 40 million working-age households (about 45 percent of the U.S. total) have no retirement savings at all. And those that do have retirement savings don’t have enough. As I discussed recently, the Federal Reserve’s 2016 Survey of consumer finances found that the mean holdings for the bottom 80% of families with holdings was only $199,750.

Such levels of financial “savings” are hardly sufficient to support individuals through retirement. This is particularly the case as life expectancy has grown, and healthcare costs skyrocket in the latter stages of life due historically high levels of obesity and poor physical health. The lack of financial stability will ultimately shift almost entirely onto the already grossly underfunded welfare system.

However, that is for those with financial assets heading into retirement. After two major bear markets since the turn of the century, weak employment and wage growth, and an inability to expand debt levels, the majority of American families are financially barren. Here are some recent statistics:

  1. 78 million Americans are participating in the “gig economy” because full-time jobs just don’t pay enough to make ends meet these days.
  2. In 2011, the average home price was 3.56 times the average yearly salary in the United States. But by the time 2017 was finished, the average home price was 4.73 times the average yearly salary in the United States.
  3. In 1980, the average American worker’s debt was 1.96 times larger than his or her monthly salary. Today, that number has ballooned to 5.00.
  4. In the United States today, 66 percent of all jobs pay less than 20 dollars an hour.
  5. 102 million working age Americans do not have a job right now.  That number is higher than it was at any point during the last recession.
  6. Earnings for low-skill jobs have stayed very flat for the last 40 years.
  7. Americans have been spending more money than they make for 28 months in a row.
  8. In the United States today, the average young adult with student loan debt has a negative net worth.
  9. At this point, the average American household is nearly $140,000 in debt.
  10. Poverty rates in U.S. suburbs “have increased by 50 percent since 1990”.
  11. Almost 51 million U.S. households “can’t afford basics like rent and food”.
  12. The bottom 40 percent of all U.S. households bring home just 11.4 percent of all income.
  13. According to the Federal Reserve, 4 out of 10 Americans do not have enough money to cover an unexpected $400 expense without borrowing the money or selling something they own. 
  14. 22 percent of all Americans cannot pay all of their bills in a typical month.
  15. Today, U.S. households are collectively 13.15 trillion dollars in debt.  That is a new all-time record.

Here is the problem with all of this.

Despite Central Bank’s best efforts globally to stoke economic growth by pushing asset prices higher, the effect is nearly entirely mitigated when only a very small percentage of the population actually benefit from rising asset prices. The problem for the Federal Reserve is in an economy that is roughly 70% based on consumption, when the vast majority of American’s are living paycheck-to-paycheck, the aggregate end demand is not sufficient to push economic growth higher.

While monetary policies increased the wealth of those that already have wealth, the Fed has been misguided in believing that the “trickle down” effect would be enough to stimulate the entire economy. It hasn’t. The sad reality is that these policies have only acted as a transfer of wealth from the middle class to the wealthy and created one of the largest “wealth gaps” in human history.

The real problem for the economy, wage growth and the future of the economy is clearly seen in the employment-to-population ratio of 16-54-year-olds. This is the group that SHOULD be working and saving for their retirement years.

The current economic expansion is already set to become the longest post-WWII expansion on record. Of course, that expansion was supported by repeated artificial interventions rather than stable organic economic growth. As noted, while the financial markets have soared higher in recent years, it has bypassed a large portion of Americans NOT because they were afraid to invest, but because they have NO CAPITAL to invest with.

To Dalio’s point, the real crisis will come during the next economic recession.

While the decline in asset prices, which are normally associated with recessions, will have the majority of its impact at the upper end of the income scale, it will be the job losses through the economy that will further damage and already ill-equipped population in their prime saving and retirement years.

Furthermore, the already grossly underfunded pension system will implode.

An April 2016 Moody’s analysis pegged the total 75-year unfunded liability for all state and local pension plans at $3.5 trillion. That’s the amount not covered by current fund assets, future expected contributions, and investment returns at assumed rates ranging from 3.7% to 4.1%. Another calculation from the American Enterprise Institute comes up with $5.2 trillion, presuming that long-term bond yields average 2.6%.

The massive amount of corporate debt, when it begins to default, will trigger further strains on the financial and credit systems of the economy.

Dalio’s View Is Likely Understated. 

The real crisis comes when there is a “run on pensions.” With a large number of pensioners already eligible for their pension, the next decline in the markets will likely spur the “fear” that benefits will be lost entirely. The combined run on the system, which is grossly underfunded, at a time when asset prices are dropping will cause a debacle of mass proportions. It will require a massive government bailout to resolve it.

But it doesn’t end there. Consumers are once again heavily leveraged with sub-prime auto loans, mortgages, and student debt. When the recession hits, the reduction in employment will further damage what remains of personal savings and consumption ability. The downturn will increase the strain on an already burdened government welfare system as an insufficient number of individuals paying into the scheme is being absorbed by a swelling pool of aging baby-boomers now forced to draw on it. Yes, more Government funding will be required to solve that problem as well. 

As debts and deficits swell in the coming years, the negative impact to economic growth will continue. At some point, there will be a realization of the real crisis. It isn’t a crash in the financial markets that is the real problem, but the ongoing structural shift in the economy that is depressing the living standards of the average American family. There has indeed been a redistribution of wealth in America since the turn of the century. Unfortunately, it has been in the wrong direction as the U.S. has created its own class of royalty and serfdom.

The issue for future politicians won’t be the “breadlines” of the 30’s, but rather the number of individuals collecting benefit checks and the dilemma of how to pay for it all.

The good news, if you want to call it that, is that the next “crisis,” will be the “great reset” which will also make it the “last crisis.”

3 Things: “R” Probabilities, Middle-Class, Bear Market Over

“3 Things” is a weekly post of thoughts I am pondering, usually contrarian, with respect to the markets, economy or portfolio management. Comments and thoughts are always welcome via email,  Twitter, and/or Facebook.


Recession Probabilities Rise

As I penned earlier this week:

“Speaking of weather, last year, the BEA adjusted the ‘seasonal adjustment’ factors to compensate for the cold winter weather over the last couple of years that suppressed first quarter economic growth rates. (The irony here is that they adjusted adjustments for cold weather that generally occurs during winter.) 

However, the problem with ‘tinkering’ with the numbers comes when you have an exceptionally warm winter. The new adjustment factors, which boosted Q1 economic growth during the last two years will now create a large over-estimation of activity for the first quarter of this year. This anomaly will boost the ‘bullish hope’ as  the onset of a recession is delayed until those over-estimations are revised away over the course of the next year. ” 

The reason I reiterate this point is due to a recent research note from Wells Fargo discussing the increased risk of a domestic recession. To wit:

“One possible way to summarize the results from all these models is to calculate the average of these probabilities and then examine historical performance of the average probability. The current average probability is 37.3 percent and this method predicted all recessions successfully since 1980 without producing any false positives (Figure 11). Different models utilize different predictors to capture the state of different sectors of the economy and therefore an average probability may reflect the average risk posed by these sectors.

At present, we are not calling for a recession within the next six months. However, given that the recession probabilities based on our official model and average of all models are somewhat elevated, it is not wise to dismiss recession risk.”

Recession-Probit-WellsFargo-030316-2

The combined Probit Model based on the entire series of indicators utilized by Wells Fargo, (which includes LEI, VIX, Yield Spread, Stock Prices, Commodities and more) also confirms the same recessionary stresses shown in the Economic Output Composite Index (EOCI).

EOCI-Index-LEI-030216
(The EOCI Index is a composite of the Chicago Fed National Activity Index, ISM Composite, Several Fed Regional Surveys, Chicago PMI, LEI, and the NFIB Small Business Survey.)

As shown, the economy is currently operating at levels that have normally been associated with recessionary environments. The only thing that has kept the economy from registering a recession in the past has been the interventions by the Fed that have led to a “forward-pull” of future economic activity. (Beginnings and endings of QE programs noted by gold squares)

While there are many mainstream economists insisting that the U.S. economy is nowhere near recession, considering much of the current data will be negatively revised in the quarters ahead will likely prove those views wrong.

With economic data having remained extremely weak in recent months, it will NOT be surprising to see a short-term pickup in economic activity as a restocking cycle once again leads to temporary bounce. However, as we have repeatedly seen since 2009, those bounces in activity have been transient at best. Without monetary support from the Federal Reserve to once again “drag forward future consumption,” the risk of sliding into recession becomes a very real possibility. 

The Decline Of The Middle Class

I have often written about the broad decline in the financial conditions of the middle class.

There is a financial crisis on the horizon. It is a crisis that all the Central Bank interventions in the world cannot cure.

No, I am not talking about the next Lehman event or the next financial market meltdown. Although something akin to both will happen in the not-so-distant future. It is the lack of financial stability of the current, and next, generation that will shape the American landscape in the future.

The nonprofit National Institute on Retirement Security released a study in March stating that nearly 40 million working-age households (about 45 percent of the U.S. total) have no retirement savings at all. And those that do have retirement savings don’t have enough. As I discussed recently, the Federal Reserve’s 2013 Survey of consumer finances found that the mean holdings for families with retirement accounts was only $201,000.”

Fed-Survey-2013-NetWorthbyAge-091014

Such levels of financial “savings” are hardly sufficient to support individuals through retirement. This is particularly the case as life expectancy has grown, and healthcare costs skyrocket in the latter stages of life due historically high levels of obesity and poor physical health. The lack of financial stability will ultimately shift almost entirely onto the already grossly underfunded welfare system.”

Just recently the Pew Research Center confirmed the same:

After more than four decades of serving as the nation’s economic majority, the American middle class is now matched in number by those in the economic tiers above and below it. In early 2015, 120.8 million adults were in middle-income households, compared with 121.3 million in lower- and upper-income households combined, a demographic shift that could signal a tipping point, according to a new Pew Research Center analysis of government data.

In at least one sense, the shift represents economic progress: While the share of U.S. adults living in both upper- and lower-income households rose alongside the declining share in the middle from 1971 to 2015, the share in the upper-income tier grew more.”

Pew-MiddleClass-Chart-030216

“Over the same period, however, the nation’s aggregate household income has substantially shifted from middle-income to upper-income households, driven by the growing size of the upper-income tier and more rapid gains in income at the top.Fully 49% of U.S. aggregate income went to upper-income households in 2014, up from 29% in 1970. The share accruing to middle-income households was 43% in 2014, down substantially from 62% in 1970.

And middle-income Americans have fallen further behind financially in the new century. In 2014, the median income of these households was 4% less than in 2000. Moreover, because of the housing market crisis and the Great Recession of 2007-09, their median wealth (assets minus debts) fell by 28% from 2001 to 2013.”

Importantly, this is why economic growth remains weak. While the Federal Reserve was focused on boosting asset prices for the wealthy, they forgot to create an economic environment that was conducive to increasing the consumptive power of the middle-class and their near 70% participation in economic growth.

Oops.

The True Definition Of A Bear Market

The sharp rally over the last couple weeks, which has been primarily driven by massive short-covering, has brought the “bulls” out once again declaring the recent “bearish decline” over. However, is such really the case, or is this yet another of the many rallies we have seen as of late that ultimately fail?

In order to answer that question, we must first define what a bear market really is. The currently accepted definition of a “correction” is a 10% decline and an official “bear market” begins with a 20% fall in the market. However, both of these definitions are not accurate we have seen both such events occur during longer-term market trends.

For investors, the difference between a “bull” and a “bear” market, regardless of the short-term fluctuation in prices, is whether the overall “trend” in prices is rising or falling. When the “trend” is positive, speculating in the financial markets is advantageous as the “rising tide” increases the value of portfolios. Conversely, when the overall trend is “negative,” speculating in the financial markets has a generally negative result.

(We are not investors, we are speculators. Warren Buffett is an investor. When he invests in a company he can control its destiny by appointing operating managers, defining directives, etc. YOU are a speculator placing bets with your “savings” on ethereal pieces of paper that you “hope” will rise in price over time. Understanding this point is important.)

The utilization of a simple moving average is one way the overall trend of the market can be determined. A moving average is an “average” of prices over a given period of time. In order for there to be an average price, prices must have traded at two points of extreme over the sample period. If prices are generally “trending” higher, the average will be positively sloped as each new low and high point is greater than the last. The opposite is true when prices are generally “trending” lower.

Overall bullish and bearish trends are revealed when looking at longer-term price trends of the market. The chart below is an example.

SP500-MarketUpdate-030316

(Note: This is a WEEKLY price chart to smooth out short-term price volatility. We are using an 80-week moving average and a 52-week RSI for this example.)

During “Bull Markets” – prices tend to remain above an “upward” or “positively” sloping moving average. Also, the relative strength index (RSI) stays above 50 during that period.

During “Bear Markets” – prices tend to remain below a “downward” or “negatively” sloping moving average. RSI also remains below 50 during this period confirming a more “risk adverse” environment.

Currently, all indications currently suggest the markets are in the early stages of entering into a confirmed “bear market” as the longer term moving average is turning from a positive to a negative slope and RSI has fallen below 50.

Yes, things could change very quickly with the intervention of Central Bank action. The same was seen during the summer and fall of 2011 as then Fed Chairman Ben Bernanke quickly acted to stave off a more serious market decline. However, with the Fed more focused on “tightening” monetary policy currently, such a salvation seems to be a low probability event.

The value in changing your definition of a “bear market” is by waiting to lose 20% of your portfolio before acting, it takes a 25% subsequent rise in the market to get back to even. That is “time” lost that you can never regain.

As stated earlier this week, the rules for managing your portfolio are relatively simple:

  1. In rising market trends – buy dips.
  2. In declining market trends – sell rallies.

Despite the ongoing “hopes” of the always bullish media, the recent rally has not changed the slope, or scope, of current market dynamics. The current “bear market” is not over just yet.

Just some things to think about.

Lance Roberts

lance_sig

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, and Linked-In

3 Things: Earnings Lies, Profits Slide, EBITDA Is BullS***

“3 Things” is a weekly post of thoughts I am pondering, usually contrarian, with respect to the markets, economy or portfolio management. Comments and thoughts are always welcome via email,  Twitter, and/or Facebook.


Earnings Worse Than You Think

Just like the hit series “House Of Cards,” Wall Street earnings season has become rife with manipulation, deceit and obfuscation that could rival the dark corners of Washington, D.C.

What is most fascinating is that so many individuals invest hard earned capital based on these manipulated numbers. The failure to understand the “quality” of earnings, rather than the “quantity,” has always led to disappointing outcomes at some point in the future. 

According to analysts at Bank of America Merrill Lynch, the percentage of companies reporting adjusted earnings has increased sharply over the past 18 months or so. Today, almost 90% of companies now report earnings on an adjusted basis.

Adjusted-Earnings-022516

Back in the 80’s and early 90’s companies used to report GAAP earnings in their quarterly releases. If an investor dug through the report they would find “adjusted” and “proforma” earnings buried in the back. Today, it is GAAP earnings which are buried in the back hoping investors will miss the ugly truth.

These “adjusted or Pro-forma earnings” exclude items that a company deems “special, one-time or extraordinary.” The problem is that these “special, one-time” items appear “every” quarter leaving investors with a muddier picture of what companies are really making.

As BofAML states:

“We are increasingly concerned with the number of companies (non-commodity) reporting earnings on an adjusted basis versus those that are stressing GAAP accounting, and find the divergence a consequence of less earnings power. 

Consider that when US GDP growth was averaging 3% (the 5 quarters September 2013 through September 2014) on average 80% of US HY companies reported earnings on an adjusted basis. Since September 2014, however, with US GDP averaging just 1.9%, over 87% of companies have reported on an adjusted basis. Perhaps even more telling, between the end of 2010 and 2013, the percentage of companies reporting adjusted EBITDA was relatively constant and since 2013, the number has been on a steady rise.

We are increasingly concerned with this trend, as on an unadjusted basis non-commodity earnings growth has been negative 2 of the last 4 quarters, representing the worst 4 quarter average earnings growth in a non-recessionary period since late 2000.”

This accounting manipulation to win the “beat the earnings” game each quarter is important to corporate executives whose major source of wealth is stock-based compensation. As confirmed in a WSJ article:

“If you believe a recent academic study, one out of five [20%] U.S. finance chiefs have been scrambling to fiddle with their companies’ earnings. 

Not Enron-style, fraudulent fiddles, mind you. More like clever—and legal—exploitations of accounting standards that ‘manage earnings to misrepresent [the company’s] economic performance,’ according to the study’s authors, Ilia Dichev and Shiva Rajgopal of Emory University and John Graham of Duke University. Lightly searing the books rather than cooking them, if you like.”

This should not come as a major surprise as it is a rather “open secret.” Companies manipulate bottom line earnings by utilizing “cookie-jar” reserves, heavy use of accruals, and other accounting instruments to flatter earnings.

The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big ‘restructuring charge’ that would otherwise stand out like a sore thumb.

What is more surprising though is CFOs’ belief that these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.

Why is this important? Because, while manipulating earnings may work in the short-term, eventually, cost cutting, wage suppression, earnings manipulations, share-buybacks, etc. reach their effective limit. When that limit is reached, companies can no longer hide the weakness in their actual operating revenues. That point has likely been reached.

From the WSJ:

There’s a big difference between companies’ advertised performance in 2015 and how they actually did.

How big? With most calendar-year results now in, FactSet estimates companies in the S&P 500 earned 0.4% more per share in 2015 than the year before. That marks the weakest growth since 2009. But this is based on so-called pro forma figures, results provided by companies that exclude certain items such as restructuring charges or stock-based compensation.

Look to results reported under generally accepted accounting principles (GAAP) and S&P earnings per share fell by 12.7%, according to S&P Dow Jones Indices. That is the sharpest decline since the financial crisis year of 2008. Plus, the reported earnings were 25% lower than the pro forma figures—the widest difference since 2008 when companies took a record amount of charges.

The implication: Even after a brutal start to 2016, stocks may still be more expensive than they seem. Even worse, investors may be paying for earnings and growth that aren’t anywhere near what they think. The result could be that share prices have even further to fall before they entice true value investors.

The difference shows up starkly when looking at price/earnings ratios. On a pro forma basis, the S&P trades at less than 17 times 2015 earnings. But that shoots up to over 21 times under GAAP.

S&P-500-Earnings-WorseThanRealized-022416

History is pretty clear. As long as earnings are deteriorating, you don’t want to be invested in stocks.

Fantasy Vs. Reality

What is most interesting, is that despite the ongoing earnings recession, Wall Street firms continue to predict an onward and upward push of profitability into the foreseeable future. As shown in the estimates below from Goldman Sachs, there is NO consideration for the impact of economic recession over the next several years.

GS-Profits-SP500-Targets-022316

Of course, this was the same prediction made in 1999 and in 2006 until the eventual and inevitable “reversion to the mean” occurred.

Eric Parnell recently penned an excellent piece in this regard entitled “Fantasy vs. Reality:”

The perpetual optimism of the corporate earnings forecast is remarkable. And while its well understood that things almost never turn out as good as we might anticipate, it is notable how widely divergent these earnings forecasts are from the actual outcomes that ultimately come to pass. Beware the analysis pinning its conclusions on the forward price-to-earnings ratio on the S&P 500 Index or any of its constituents for that matter, for it may lead to conclusions that are ultimately built on sand.

Clearly, relying on corporate earnings forecasts for the basis of investment decision making should be done at an investors own risk. Forecasts start out as wildly optimistic, with greater hopes the longer the time horizon. Which leads to a final point worth mentioning. Standard & Poor’s recently released a first look at the earnings forecasts for 2017. And if past experience is any guide, it may be indicating trouble on the horizon for the coming year. For instead of the robust +20% earnings forecasts throughout 2017, we instead see a notable fade as the year progresses. Perhaps these forecasts will improve with the passage of time.

But if forecasters are this unenthusiastic about a point that is so far away in the future, what will the reality look like once we finally arrive?”

Corporate-Profits-Growth-2017-022416

Unfortunately, considering that historically analysts future forecasts are 33% higher on average than reality turns out to be, the case for a deeper “bear market” is gaining traction.

EBITDA Is BullS***

I have written in the past about the fallacy of using EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) due to the ability to fudge/manipulate the number. To wit:

Cooking-The-Books

“As shown in the table, it is not surprising to see that 93% of the respondents pointed to “influence on stock price” and “outside pressure” as the reason for manipulating earnings figures. For fundamental investors this manipulation of earnings skews valuation analysis particularly with respect to P/E’s, EV/EBITDA, PEG, etc.”

Ramy Elitzur, via The Account Art Of War, recently expounded on the problems of using EBITDA.

“Being a CPA and having an MBA, in my arrogance I thought that I am well beyond such materials. I stood corrected, whatever I thought I knew about accounting was turned on its head. One of the things that I thought that I knew well was the importance of income-based metrics such as EBITDA and that cash flow information is not as important. It turned out that common garden variety metrics, such as EBITDA, could be hazardous to your health.”

The article is worth reading and chocked full of good information, however, here are the four-crucial points:

  1. EBITDA is not a good surrogate for cash flow analysis because it assumes that all revenues are collected immediately and all expenses are paid immediately, leading, as I illustrated above, to a false sense of liquidity.
  2. Superficial common garden-variety accounting ratios will fail to detect signs of liquidity problems.
  3. Direct cash flow statements provide a much deeper insight than the indirect cash flow statements as to what happened in operating cash flows. Note that the vast majority (well over 90%) of public companies use the indirect format.
  4. EBITDA just like net income is very sensitive to accounting manipulations.

The last point is the most critical. As discussed above, the tricks to manipulate earnings are well-known which inflates the results to a significant degree making an investment appear “cheaper” than it actually is.

As Charlie Munger once said:

“I think that every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.”

Just some things to think about.

Lance Roberts

lance_sig

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, and Linked-In

3 Things: Bear Rallies, Dividends, Empathy

“3 Things” is a weekly post of thoughts I am pondering, usually contrarian, with respect to the markets, economy or portfolio management. Comments and thoughts are always welcome via email,  Twitter, and/or Facebook.


Biggest Rallies Occur In Bear Markets

As expected, the market was oversold enough going into last Friday to elicit a short-term reflexive bounce. Not surprisingly, it wasn’t long before the “bulls” jumped back in proclaiming the correction was over.

If it were only that simple.

First, as I have discussed in the past, market prices remain in a “trend” until something causes that trend to change. This can be most easily seen by looking at a chart of the S&P 500 as compared to its 400-day moving average.

SP500-MarketUpdate-021716

As you will notice in the main body of the chart, during bull markets, prices tend to remain ABOVE the 400-dma (orange-dashed line). Conversely, during bear markets, prices tend to remain BELOW the 400-dma.

The one event in 2011, where all indicators suggested the market was transitioning back into a bear market, was offset by the Federal Reserve’s intervention of “Operation Twist” and eventually QE-3.

During cyclical bear markets, bounces from short-term oversold conditions tend to be extreme. Just recently Price Action Lab blog posted a very good piece on the commonality of short-term rebounds during market downtrends:

“The S&P 500 gained 3.63% in the last two trading sessions. About 75% of back-to-back gains of more than 3.62% have occurred along downtrends. Therefore, a case for a bottom cannot be based solely on performance.”

SP500-Downtrends-Rallies-021716

It may be seen that 73.85% back-to-back gains of more than 3.62% have occurred along downtrends, i.e., this performance is common when markets are falling. The sample size consists of 195 back-to-back returns greater than 3.62%.

Therefore, strong rebounds along a downtrend cannot be used to support a potential bottom formation.”

After a rough start to the new year, it is not surprising that many are hoping the selling is over.

Maybe it is.

But history suggests that one should not get too excited over bounces as long as the downtrend remains intact.

I Bought It For The Dividend

One of the arguments for “buy and hold” investing has long been “dividends.” The argument goes this way:

“It really doesn’t matter to me what the price of the company is, I just collect the dividend.”

While this certainly sounds logical, in reality, it has often turned into a very poor strategy, particularly during recessionary contractions.

A recent example was Kinder Morgan (KMI). In late-2014, as I was recommending that individuals begin to exit the energy sector, Kinder Morgan was trading around $40/share. The argument then was even if the share price of the company fell, the owner of the shares still got paid a great dividend.

Fast forward today and the price of the company has fallen to recent lows of $15/share (equating to a 62.5% loss in value) and the dividend was cut by 80%.

Two things happened to the investor’s original thesis. The first, was that after he had lost 50% of his capital, the dividend was no longer nearly as important. Confidence in the company eroded and the individual panic sold his ownership into the decline. Secondly, when a company gets into financial trouble, the first thing they will do is cut the dividend. Now you have lost your money and the dividend.

But it is not just KMI that has cut dividends as of late. Many companies have been doing the same to shore up internal cash flows. As pointed out recently by Political Calculations:

“Speaking of which, the pace of dividend cuts in the first quarter of 2016 has continued to escalate. Through Friday, 12 February 2016, the number of dividend cuts has risen into the “red zone” of our cumulative count of dividend cuts by day of quarter chart.”

Dividend-Cuts-021716

Importantly, while the media keeps rambling on that we are “nowhere” close to a recession, it is worth noting the following via NYT:

“The only year in recent history with more dividend cuts was 2009, when the world was staggering through a great financial crisis. A total of 527 companies trimmed dividends that year, Mr. Silverblatt’s data shows. Coca-Cola and other dividend-paying blue chips like IBM and McDonald’s were under severe stress in those days, too, but their financial resources were deep enough to allow them to keep the dividend stream fully flowing.”

Buying “dividend yielding” stocks is a great way to reduce portfolio volatility and create higher total returns over time. However, buying something just for the dividend, generally leads to disappointment when you lose your money AND the dividend. It happens…a lot.

Preservation of capital is first, everything else comes second.

Empathy For The Devil

Danielle DiMartino Booth, former Federal Reserve advisor and President of Money Strong, recently penned an excellent piece that has supported my long-held view on the fallacy of “consumer spending.” To wit:

“As for the strongest component of retail sales, it’s not only subprime loans that are behind the 6.9-percent growth in car sales over 2015. Super prime auto loan borrowers’ share of the pie is now on par with that of subprime borrowers – each now accounts for a fifth of car loan originations. What’s that, you say? Can’t afford that new set of wheels? Not to worry. Just lease. You’ll be in ample company — some 28 percent of last year’s car sales were made courtesy of leases, an all-time high. ”

Retail-Sales-021716

What has been missed by the vast majority of mainstream economists is that in a country driven 68% by consumer spending, there are limits to that consumption. A consumer must produce (work) first to be paid a wage with which to consume with. Each dollar is finite in its ability to create economic growth via consumption. A dollar spent on a manufactured good has a greater multiplier effect on the economy than the same dollar spent on a service. Likewise, a dollar spent on a manufactured good or service has a greater economic impact than a dollar spent on paying taxes, higher healthcare insurance costs, or interest payments.

The only way to increase the level of spending above the rate of income is through leverage. However, rising debt levels also suggests more of the income generated by households is diverted to debt service and away from further consumption. The chart below shows the problem.

Debt-GDP-021816

Over the 30-year period to 1982, households accumulated a total of $2 trillion in debt in an economy that was growing at an average rate of 8%. Wages grew as stronger consumption continued to push growth rates higher. Over the next 25-year period, households abandoned all fiscal responsibility and added over $10 trillion in debt as the struggle to create a higher living standard outpaced wage and economic growth.  Since the turn of the century, average economic growth has been closer to 2%. See the problem here.

The bailouts following the financial crisis kept households from going through a much needed deleveraging. Likewise, since banks were taught they would be bailed out repeatedly for bad behavior, no lessons were learned there either. Not surprisingly, as shown by the recent Fed Reserve 2016 Loan Officer Opinion Survey, lending standards are now back to levels seen just prior to the financial crisis.

Loan-Officer-Mortage-Survey-021816-2

Loan-Officer-Mortage-Survey-021816

What could possibly going wrong? The problem is the consumer is all spent out and all leveraged up. While you shouldn’t count the consumer out, just don’t count on them too much.

Just some things to think about.

Lance Roberts

lance_sig

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, and Linked-In

3 Things: Billions Lost, Tax Withholding, Yield Curve

“3 Things” is a weekly post of thoughts I am pondering, usually contrarian, with respect to the markets, economy or portfolio management. Comments and thoughts are always welcome via email,  Twitter, and/or Facebook.


Companies Lose Billions On Stock Buybacks

I recently wrote an article about why “Benchmarking Your Portfolio Is A Losing Bet.” In that missive, I discussed all the things that benefit a mathematically calculated index versus what happens in an actual portfolio of securities. One of those issues was the impact of share buybacks:

“The reality is that stock buybacks are a tool used to artificially inflate bottom line earnings per share which, ultimately, drives share prices higher. As John Hussman recently noted:

The preferred object of debt-financed speculation, this time around, is the equity market. The recent level of stock margin debt is equivalent to 25% of all commercial and industrial loans in the U.S. banking system. Meanwhile, hundreds of billions more in low-quality covenant-lite debt have been issued in recent years.”

Note the surge in debt to fund those buybacks.

Hussman-StockBuyBacks-Debt-113015

“The importance of buybacks cannot be overlooked. The dollar amount of sales, or top-line revenue, is extremely difficult to fudge or manipulate. However, bottom line earnings are regularly manipulated by accounting gimmickry, cost cutting, and share buybacks to enhance results in order to boost share prices and meet expectations. Stock buybacks DO NOT show faith in the company by the executives but rather a LACK of better ideas for which to use capital for.”

The entire article is worth a read to understand how indices and your portfolio are two very different things.

I bring this up because surges in stock buybacks are late bull market stage events. This is something I have repeatedly warned about in the past it is a false premise that companies repurchase stock at high prices because they have faith in their company. Such actions eventually lead to rather negative outcomes as capital is misallocated to non-productive resources.

Bernard Condon via AP picked up on this issue:

“When a company shells out money to buy its own shares, Wall Street usually cheers. The move makes the company’s profit per share look better, and many think buybacks have played a key role pushing stocks higher in the seven-year bull market.

But buybacks can also sap companies of cash that they could be using to grow for the future, no matter if the price of those shares rises or falls.

Defenders of buybacks say they are a smart use of cash when there are few other uses for it in a shaky global economy that makes it risky to expand. Unlike dividends, they don’t leave shareholders with a tax bill. Critics say they divert funds from research and development, training and hiring, and doing the kinds of things that grow the businesses in the long term.

Companies often buy at the wrong time, experts say, because it’s only after several years into an economic recovery that they have enough cash to feel comfortable spending big on buybacks. That is also when companies have made all the obvious moves to improve their business — slashing costs, using technology to become more efficient, expanding abroad — and are not sure what to do next to keep their stocks rising.

‘For the average company, it gets harder to increase earnings per share,’ says Fortuna’s Milano. ‘It leads them to do buybacks precisely when they should not be doing it.’

And, sure enough, buybacks approached record levels recently even as earnings for the S&P 500 dropped and stocks got more expensive. Companies spent $559 billion on their own shares in the 12 months through September, according to the latest report from S&P Dow Jones Indices, just below the peak in 2007 — the year before stocks began their deepest plunge since the Great Depression.”

While buybacks work great during bull market advances, as individuals willfully overlook the fundamentals in hopes of further price gains, the eventual collision of reality with fantasy has been a nasty event. This is shown in the chart below of the S&P 500 Buyback Index versus the S&P 500 Total Return.

Buyback-Index-021016

If this was the Dr. Phil Show, I am sure he would ask these companies;

“Well, how is that working out for you ?”

Tax Withholding Paints Real Employment Picture

I always find the mainstream media and blogosphere quite humorous around employment reporting day. The arm waving and cheering, as the employment report is released, reaches the point of hilarity over some of the possibly most skewed and manipulated economic data released by any government agency.

Think about it this way. How can you have the greatest level of employment growth since the 1990’s and the lowest labor force participation rate since the 1970’s? Or, how can you have 4.9% unemployment but not wage growth? Or, 95.1% of the population employed but 1/3rd of employable Americans no longer counted?

The importance of employment, of course, is that individuals must produce first in order to consume. Since the economy is nearly 70% based on consumption, people need to be working to create economic growth. Of course, there is another problem with the data. How can you have 4.9% unemployment and an economic growth rate of sub-2%?

A recession is coming and a look at real employment data, the kind you can’t fudge, tells us so. David Stockman recently dug into the data.

“If we need aggregated data on employment trends, the US government itself already publishes a far more timely and representative measure of Americans at work. It’s called the treasury’s daily tax withholding report, and it has this central virtue: No employer sends Uncle Sam cash for model imputed employees, as does the BLS in its trend cycle projections and birth/death model; nor do real businesses forward withholding taxes in behalf of the guesstimated number of seasonally adjusted payroll records for phantom employees who did not actually report for work.

My colleague Lee Adler…now reports that tax collections are swooning just as they always do when the US economy enters a recession.

The annual rate of change in withholding taxes has shifted from positive to negative. It has grown increasingly negative in inflation adjusted terms for more than a month and it is the most negative growth rate since the recession.”

Tax-Withholding-021016

“Needless to say, the starting point for overcoming the casino’s blind spot with respect to the oncoming recession is to recognize that payroll jobs as reported by the BLS are a severely lagging indicator. Here is what happened to the headline jobs count in just the 12 months after May 2008. The resulting 4.6% plunge would amount to a nearly a 7 million job loss from current levels.”

Employment-Post-2008

Good point.

Is The Yield Curve Indicator Broken?

As one indicator after another is signaling that the U.S. economy is on the brink of a recession (see here and here), the bulls are desperately clinging to the yield curve as “proof” the economy is still growing.

There are a couple of points that need to be addressed based on the chart below.

Yield-Curve-GDP-021116-3

  1. As shown in the chart above, the 2-year Treasury has a very close relationship with the Effective Fed Funds Rate. Historically, the Federal Reserve began to lift rates shortly after economic growth turned higher. Post-2000 the Fed lagged in raising rates which led to the real estate bubble / financial crisis. Since 2009, the Fed has held rates at the lowest level in history artificially suppressing the short-end of the curve.
  2. The artificial suppression of shorter-term rates is likely skewing the effectiveness of the yield curve as a recession indicator.
  3. Lastly, negative yield spreads have historically occurred well before the onset of a recession. Despite their early warnings, market participants, Wall Street, and even the Fed came up with excuses each time to why “it was different.” 

Just as the yield spread was negative in 2006, and was warning of the onset of a recession, Bernanke and Wall Street all proclaimed that it was a “Goldilocks Economy.” It wasn’t.

Here is the point, as shown in the chart above, the Fed should have started lifting rates as the spike in economic growth occurred in 2010-2011. If they had, interest rates on the short-end of would have risen giving the Fed a policy tool to combat economic weakness with in the future. However, assuming a historically normal response to economic recoveries, the yield curve would have been negative some time ago predicting the onset of a recession in the economy about…now.  Of course, such would simply be a confirmation of a majority of other economic indicators that are already suggesting the same.

Just some things to think about.

Lance Roberts

lance_sig

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, and Linked-In

3 Things: Fed Late, Rate Review, Pricing In “R”

“3 Things” is a weekly post of thoughts I am pondering, usually contrarian, with respect to the markets, economy or portfolio management. Comments and thoughts are always welcome via email,  Twitter, and/or Facebook.


The Fed Is Behind The Curve…Again

Over the last couple of months, I have been discussing the technical deterioration of the market that is occurring beneath the surface of the major indices. I have also suggested there is more than sufficient evidence to suggest we may be entering into a more protracted “bear market cycle.”

The caveat to this, of course, has been the potential for a renewed round of Central Bank interventions that would theoretically once again postpone the onset of such a decline. To wit:

“The top section of the chart is a basic ‘overbought / oversold’ indicator with extreme levels of ‘oversold’ conditions circled. The shaded area on the main part of the chart represents 2-standard deviations of price movement above and below the short-term moving average.”

SP500-MarketUpdate-020416

“There a couple of very important things to take away from this chart.

  • When markets begin a ‘bear market’ cycle [which is identified by a moving average crossover (red circles) combined with a MACD sell-signal (lower part of chart)], the market remains in an oversold condition for extended periods (yellow highlighted areas.)
  • More importantly, during these corrective cycles, market rallies fail to reach higher levels than the previous rally as the negative trend is reinforced.

Both of these conditions currently exist.

Could I be wrong? Absolutely.

This entire outlook could literally change overnight if the Federal Reserve leaps into action with a rate cut, another liquidity program or direct market intervention.”

This is just the most recent observation. I begin discussing the deterioration in the markets beginning last summer as early signs of the topping process began and I lowered portfolio model exposures to 50% of normal allocations.

However, despite the fact that interest rates have continued to trend lower, economic data and corporate profits have deteriorated, and inflationary pressures non-existent; most Fed speakers have sounded consistently hawkish and steadfast in their views of 4-rate hikes in 2016.

I have been steadfast in my claims that hiking rates given the current economic conditions is a mistake and will rapidly push the markets and economy towards a reversion. To wit:

“Looking back through history, the evidence is quite compelling that from the time the first rate hike is induced into the system, it has started the countdown to the next recession. However, the timing between the first rate hike and the next recession is dependent on the level of economic growth at that time.

When looking at historical time frames, one must not look at averages of all rate hikes but rather what happened when a rate hiking campaign began from similar economic growth levels. Looking back in history we can only identify TWO previous times when the Fed began tightening monetary policy when economic growth rates were at 2% or less.

(There is a vast difference in timing for the economy to slide into recession from 6%, 4%, and 2% annual growth rates.)”

Fed-Funds-GDP-5yr-Avg-Table-121715

“With economic growth currently running at THE LOWEST average growth rate in American history, the time frame between the first rate and next recession will not be long.”

It is now becoming quite apparent that the majority of economists, analysts, and Fed members have been quite mistaken in their assessments of the impact of global turmoil and the collapse in commodity prices on the domestic economy. (Read my previous commentary on oil and China)

From Market News: (Via ZeroHedge)

“Top Federal Reserve policymakers are leaving little doubt the financial turbulence and souring of the global economy could have significant implications for U.S. monetary policy, but they are loathe to draw too many conclusions about the appropriate path of interest rates at this juncture.

One thing is for certain: The tightening of financial conditions that has taken place since the Fed began raising short-term rates in mid-December is a matter of considerable concern to the Fed, New York Federal Reserve Bank President William Dudley said in an exclusive interview with MNI Tuesday.

But, it was supposed to signal the US economy is ‘strong enough’ to sustain a lift off and decouple from the rest of the world which is scrambling to cut rates. Guess not.

As MNI adds, “a weakening of the global economy accompanied by further appreciation in an already strong dollar could also have “significant consequences” for the U.S. economy, Dudley told MNI.”

“I can give you my own interpretation,” the committee’s vice chairman replied. “I read that as saying we’re acknowledging that things have happened in financial markets and in the flow of the economic data that may be in the process of altering the outlook for growth and the risk to the outlook for growth going forward.”

But it’s a little soon to draw any firm conclusions from what we’ve seen,” he cautioned.”

If history serves as any guide, with the entire flow of data from economic underpinnings, high-yield markets, commodity prices and deteriorating profits screaming for help, by the time the Fed “draws any firm conclusions” it will be far too late to make any real difference. 

Interest Rate Predictions Come To Fruition

Well, that didn’t take long.  At the beginning of this year, I wrote in the 2016 Market Outlook & Forecast the following:

“With the Federal Reserve raising interest rates on the short-end (Fed Funds), it will likely push the long-end of the curve lower as the economy begins to slow from the effects of monetary policy tightening.

From a purely technical perspective, rates have been in a long-term process of a tightening wedge. A breakout to the upside would suggest 10-year treasury rates would soar to 3.6% or higher, the consequence of which would be an almost immediate push of an economy growing at 2% into recession. The most likely path, given the current economic and monetary policy backdrop, will be a decline in rates toward the previous lows of 1.6-1.8%.(Inflation will also remain well below the Fed’s 2% target rate for the same reasons.)

InterestRate-Update-020416

“Of course, falling rates means the ongoing “bond bull market” will remain intact for another year. In fact, if my outlook is correct, bonds will likely be one of the best performing asset classes in the next year.”

When I wrote that missive, rates were at 2.3%. Yesterday, they touched 1.8% and intermediate and long duration bonds have been the asset class to own this year.

While rates will likely bounce in the short-term, I still suspect rates will finish this year closer to the low-end of my range.

Have Stocks Priced In A Recession?

I have read a significant amount of commentary as of late suggesting that the current decline in stocks have “priced in” the economic and earnings weakness we are currently witnessing.

Such is hardly the case.  There are two primary indicators that warrant such skepticism.

The first is valuations.

CAPE-5yrAvg-020416

The chart above is a 5-year Cyclically Adjusted Price Earnings (CAPE) ratio (data source: Dr. Robert Shiller.)  By speeding up the time frame from 10-years to 5-years, we find that valuation changes have shifted from being more coincident prior to 1970, to more leading currently. As shown, the downturn in valuations has been a leading indication of more severe market corrections particularly since the turn of the century.

The second is profits.

SP500-Ann-Pct-Chg-Earnings-020416

While still early into 2016, it already appears that earnings will post an annual decline for the second year running. Annual declines in earnings have historically been more evident during recessionary economic cycles (which only makes sense as consumption slows.)

It is not just me suggesting that risk is currently high either. Here is a note from RBC:

“Based on current valuations, the prices of most stocks don’t appear to have factored in a recession scenario, ‘hence the downside should we see a recession could be rather severe,’ RBC Capital Markets’ global equity team wrote in a research note to clients who believe the shares of most companies could still fall another 50% or more from current levels.”

Such declines have been consistent with past economic/earnings recessions as “overvaluation” reverts back to “undervaluation.”

Just some things to think about.

Lance Roberts

lance_sig

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, and Linked-In

3 Things: Fed Error, Houston R/E, No Bounce?

“3 Things” is a weekly post of thoughts I am pondering, usually contrarian, with respect to the markets, economy or portfolio management. Comments and thoughts are always welcome via email,  Twitter, and/or Facebook.


The Potential Of A Policy Error Has Risen

Yesterday, the Fed clearly showed they are trapped in their decision to raise rates. Despite an ongoing deterioration in the underlying economic and financial market fabric, Yellen & Co. stayed firm in their commitment to a gradual increase in interest rates.

What is most interesting is their focus on headline employment data while ignoring their very own Labor Market Conditions Index (LMCI) which shows a clear deterioration in the employment underpinnings.

Employment-LMCI-012816

But here is the potential problem for the Fed’s dependence on current employment data as justification for tightening monetary policy – it is likely wrong. Economic data is very subject future revisions. While the current employment data has indeed been the strongest since the late 1990’s, there is a probability that the data is currently being overestimated.

The reason is shown in the chart below.

Employment-FullTime-LFPR-012816

If the employment gains were indeed as strong as the Fed, and the BLS, currently suggest; the labor force participation rate should be rising. This has been the case during every other period in history where employment growth increased. Since the financial crisis, despite employment gains, the labor force participation rate has continued to fall.

This suggests that at some point in the future, we will likely see negative revisions to the employment data showing weaker growth than currently thought.

The issue for the Fed is by fully committing to hiking interest rates, and promoting the economic recovery meme, changing direction now would lead to a loss of confidence and a more dramatic swoon in the financial markets. Such an event would create the very recession they are trying to avoid.

Inflation expectations are also a problem which compounds the probability of a policy error at this point. As Danielle DiMartino Booth, who left the Fed earlier this year, stated:

“Less anticipated was the adamancy of Committee members that inflation would hit their stated goal of ‘two percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.’

‘Strengthens further?’ Anyone bother to share the last few weekly jobless claims reports with monetary policymakers?

As for inflation’s prospects, a year and a half into crashing oil prices, the FOMC’s use of the word ‘transitory’ leads one to wonder if they are stuck in some space age time warp. Or maybe they declared it Opposite Day but failed to share that with the rest of us.

While the Fed clearly remains giddily detached from reality, the bond market communicated unequivocally what it thinks about the economy’s prospects: the 10-year Treasury closed below the two percent line in the sand that’s been drawn since the start of the year.

 

With fourth quarter GDP likely to be closer to 0% than 2%, the Fed has clearly gotten on the wrong side of the economic landscape. This puts the possibility of a monetary policy error at extremely high levels, the outcomes of which have historically been severe.

Houston Has A Problem – Commercial R/E

In February of 2015, I penned the following missive discussing the coming real estate crisis for the Houston market:

“Houston has a problem when it comes to tumbling oil prices.

As oil prices rise and fall so does the number of rigs being utilized to drill for oil which ultimately also impacts employment. This is shown in the chart below of rig count versus employment in the oil and gas sector of the economy.”

Oil-RigCount-Employment-012816

“Obviously, the drawdown in energy prices is going to start to weigh on the Texas economy rather sharply over the next several months. Several energy companies have already announced layoffs, rig count reductions and budgetary cuts going into 2015. It is still very early in the cycle so it is likely that things will get substantially worse before they get better.”

While much of the mainstream media continues to tout that falling oil prices are good for the economy, (read here for why that is incorrect ) the knock-off economic impacts are job losses through the manufacturing sector and all other related industries are quite significant.

However, most importantly as I pointed out at the beginning of 2015:

“One of those areas is commercial real estate.  If you look in any direction in Houston, you see nothing but cranes. The last time I saw such an event was just prior to 2008 when I commented then that overbuilding was a sign of the maturity of the boom. The same has happened yet again, and not surprisingly, the “sirens song” has been “this time is different.” 

Unfortunately, not only is this time not different, the economic impacts are likely to much more substantial, not only in the Houston economy, but nationwide. To wit:

“The jagged skyline of this oil-rich city is poised to be the latest victim of falling crude prices. As the energy sector boomed in recent years, developers flocked to Houston, so much so that one-sixth of all the office space under construction in the entire U.S. is in the metropolitan area of the Texas city.”

office-construction

But here is the economic problem:

“And as a reminder, every high-paying oil service jobs accounts for up to 4 downstream just as well-paying jobs. Case in point:

The rush of building has created thousands of jobs—not only at building sites, but also at window manufacturers, concrete companies, and restaurants that feed the workers.

But just as the wave of office-space supply approaches, energy companies, including Halliburton Co. , Baker Hughes Inc., Weatherford International and BP PLC, have collectively announced that more than 23,000 jobs would be cut, with many of them expected to be in Houston.

Fewer workers, of course, means less need for office space.

No one believed me then. However, here is the latest update from real-estate services firm Savills Studly via Business Insider:

“New sublease blocks are expected to hit the market in 2016, particularly in the CBD [Central Business District]. Shell is projected to vacate 250,000 sf in One Shell Plaza and EP Energy, likewise, is anticipated to leave 100,000 sf in the Kinder Morgan Building. Shell would likely also shed space at BG Group Place should its pending $70-billion acquisition of BG Group clear governmental hurdles and finalize.

Many large tenants who paid at the very top of the market in the last few years warehoused space in anticipation of continued headcount growth. As a result, many firms had surplus space even prior to the implementation of layoffs in the last year. In 2016, the office market should see more shadow space listings….

Occupancy, after five years in a row of increases, fell by 1.4 msf (“negative absorption”), the biggest decrease in occupancy since 2009. Going forward, M&A and bankruptcies “will contribute to additional negative absorption” and will hit the vacancy rate. It already spiked to 23.2%.

After a tremendous building boom in 2013 and 2014, a total of 17 msf is expected to hit the market over the next few years, with 7.9 msf scheduled for completion in 2016. Only about two-thirds have been pre-leased. Some of these pre-leased properties will enter the shadow inventory as soon as they’re completed. But 5.5 msf has not been leased.

These new buildings will hit the market at the worst possible time, competing with 7.9 msf of sublease space and large amounts of shadow inventory, during a period of negative absorption.

While the media and mainstream analysts discount the negative economic impact of falling energy costs, I have personally witnessed it in the mid-80’s, the late 90’s and just prior to 2008. In all cases, the negative outcomes were far worse than predicted which left economists scratching their heads as to what went wrong with their models.

This time won’t be different.

Markets May Not Bounce

Over the last few weeks, I have suggested the markets would likely provide a reflexive rally to allow investors to reduce equity risk in portfolios. This was due to the oversold condition that previously existed which would provide the “fuel” for a reflexive rally to sell into.

I traced out the potential for such a reflexive rally to weeks ago as shown in the chart below.

SP500-MarketUpdate-012816

The oversold conditions that once existed have been all but exhausted at this point due to the gyrations in the markets over the last couple of weeks without the markets making any significant advance.

Just as an oversold condition provides the necessary “fuel” for an advance, the opposite is also true. This almost overbought condition comes at a difficult time as I addressed earlier this week:

“February has followed those 20 losing January months by posting gains 5-times and declining 14-times. In other words, with January likely to close out the month in negative territory, there is a 70% chance that February will decline also.

The high degree of risk of further declines in February would likely result in a confirmation of the bear market. This is not a market to be trifled with. Caution is advised. “

Just some things to think about.

Lance Roberts

lance_sig

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, and Linked-In

3 Things: “R” Signs, Looks Like 2008, QE-4

“3 Things” is a weekly post of thoughts I am pondering, usually contrarian, with respect to the markets, economy or portfolio management. Comments and thoughts are always welcome via email,  Twitter, and/or Facebook.


Warning Signs Of A Recession

In late 2007, I was giving a presentation to a group of about 300 investors discussing the warning signs of an impending recessionary period in the economy. At that time, of course, it was near “blasphemy” to speak of such ills as there was “no recession in sight.”

Then, in December of that year, I penned that we were either in, or about to be in, the worst recession since the “Great Depression.” That warning too was ignored as then Fed Chairman Ben Bernanke stated that it was a “Goldilocks Economy.” The rest, as they say, is history.

I was reminded of this as I was reading an article by Myles Udland, via Business Insider, entitled “The US economy is nowhere near a recession.” 

It is an interesting thought. However, the problem for most analysts/economists is that they tend to view economic data as a stagnant data point without respect for either the trend of the data or for the possibility of future negative revisions. As shown in the chart below, this is why it SEEMS the financial markets lead economic recessions.

SP500-NBER-RecessionDating-012016

However, in reality, they are more coincident in nature. It is just that it takes roughly 6-12 months before the economic data is negatively revised to show the start of the recession. For example, the recession that started in 2007 was not known until a year later when the data had been revised enough to allow the NBER to make its official call.

The market decline beginning this year is likely an early warning of further economic weakness ahead. I have warned for some time now that the economic cycle was exceedingly long given the underlying weakness of the growth and that eventually, without support from monetary policy, would likely give way. The following charts are the same ones I viewed in 2007, updated through the most recent data periods, which suggested the economy was approaching a recessionary state. While not all are in negative territory yet, they are all headed in that direction.

PCE-Imports-012016

LEI-Coincident-Lagging-012016

LEI-vs-GDP-012016

SP500-Ann-Pct-Chg-Earnings-012016

SP500-NetProfit-Margins-012016

Retail-Sales-012016

Is the economy “nowhere near recession?” Maybe. Maybe not. But the charts above look extremely similar to where we were at this point in late 2007 and early 2008.

Could this time be “different?” Sure. But historically speaking, it never has been.

The Topping Process Completes

For the last several months I have repeatedly discussed the topping process in the markets and warned against dismissing the current market action lightly. To wit:

“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.

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.

Take a look at the graphic above, and the one below. See any similarities?

SP500-MarketUpdate-012016

As you will notice, the previous two bull-market cycles ended when the topping process ended by breaking the rising support levels (red line). The confirmation of the onset of the “bear market” was marked by a failed rally back to the previous rising support level. Currently, that has not occurred as of yet.

The next chart is another variation of the above showing the break-down of the rising bullish trend in the market.  In all cases, investors were given minor opportunities to reduce equity risk in portfolios well before the onset of the bear market decline. 

SP500-MarketUpdate-012016-2

I have been asked repeatedly as of late whether or not the markets will provide a similar “relief rally” to allow for escape. The answer is “yes.” However, as in the past, those relief rallies tend to be short-lived and don’t get investors “back to where they were previously.”

The risk to the downside has risen markedly in recent weeks as the technical, fundamental and economic deterioration escalates. This is not a time to be complacent with your investments.

“One & Done Yellen” And The Rise Of QE4.

Back in December, when Janet Yellen announced the first hike in the Fed Funds rate in eleven years from .25% to .50%, the general mainstream consensus was “not to worry.”  It was believed that a rate hike by the Fed would have little impact on equities given the strong economic recovery at hand. Well, that was what was believed anyway as even Ms. Yellen herself suggested the “odds were good” the economy would have ended up overshooting the Fed’s employment, growth and inflation goals had rates remained at low levels.

The problem for Ms. Yellen appears to have a been a gross misreading of the economic “tea leaves.” With economic growth weak, the tightening of monetary policy had a more negative impact on the markets and economy than most expected. As I wrote previously:

“Looking back through history, the evidence is quite compelling that from the time the first rate hike is induced into the system, it has started the countdown to the next recession. However, the timing between the first rate hike and the next recession is dependent on the level of economic growth at that time.

When looking at historical time frames, one must not look at averages of all rate hikes but rather what happened when a rate hiking campaign began from similar economic growth levels. Looking back in history we can only identify TWO previous times when the Fed began tightening monetary policy when economic growth rates were at 2% or less.

(There is a vast difference in timing for the economy to slide into recession from 6%, 4%, and 2% annual growth rates.)”

Fed-Funds-GDP-5yr-Avg-Table-121715

“With economic growth currently running at THE LOWEST average growth rate in American history, the time frame between the first rate and next recession will not be long.”

Given the reality that increases in interest rates is a monetary policy action that by its nature slows economic growth and quells inflation by raising borrowing costs, the only real issue is the timing.

With the markets appearing to have entered into a more severe correction mode, there is little ability for Ms. Yellen to raise interest rates any further. In fact, I would venture to guess that the rate hike in December was likely the only one we will see this year. Secondly, we are likely closer to the Federal Reserve beginning to drop “hints” about further accommodative actions (QE) if conditions continue to deteriorate.

It is important to remember that in 2010, when Ben Bernanke launched the second round of QE, the Fed added a third mandate of boosting asset prices to their roster of full employment and price stability. The reasoning was simple – create an artificial wealth effect encouraging consumer confidence and boosting consumption. It worked to some degree by pulling forward future consumption but failed to spark self-sustaining organic economic growth.

With market pricing deteriorating sharply since the beginning of the year, it will not take long for consumer confidence to slip putting further downward pressure on already weak economic growth. With Ms. Yellen already well aware she is caught in a “liquidity trap,” there would be little surprise, just as we saw in 2010, 2011 and 2013, for the Fed to implement another QE program in hopes of keeping consumer confidence alive.

SP500-QE-012016-2

The issue is at some point, just as China is discovering now with failure of their monetary policy tools to stem the bursting of their financial bubble, the same will happen in the U.S. With the Fed unable to raise rates to reload that particular policy tool, a failure of QE to stabilize the markets could be deeply problematic.

Just some things to think about.

Lance Roberts

lance_sig

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, and Linked-In